27 Dec December Market Update
Written by Brian Johnson, Chief Investment Officer
Summary: The current market decline has yet to show signs that it is bottoming out. It is likely, therefore, that we’ve further to go on the downside before stocks begin moving meaningfully higher again. We’re glad that we reduced risk/stock exposure in our strategies twice this year – in July and again in November – and we may do so again in coming weeks, but we are also watchful for signs that the current decline is bottoming.
Market declines can be painful, but despite dire, frightening predictions by pundits on TV (whose primary goal is more viewers), declines like this are entirely normal and healthy. According to Ned Davis Research, in the half-century since 1969, the MSCI World Index has experienced 17 corrections of 15% – roughly one every three years. Bear markets, which are defined as declines of 20% or more (averaging 31%), occurred 11 times over that period, or roughly one every five years.
For those who are many years from retirement, bear markets serve as opportunities to add to savings at lower prices. For those who need to tap their savings soon, however, declines can be more detrimental unless you’ve planned ahead, since the last thing you want is to be forced to sell stock holdings while they are depressed in value.
That is one of the primary reasons why goals-based financial planning like we employ at Viridian is so important. Money that you won’t need for a decade or more can be entirely in the stock market because there is plenty of time to recover from bear markets…and the average return should be higher than keeping it out of the market. On the other hand, money you’ll need to withdraw and spend in the next few years (e.g., for living expenses if you’re in or nearing retirement) should be mostly invested in more stable assets, such as bonds and money markets. It is important that you be able to say to yourself, when we go through market declines like this and your statement values are falling, “I don’t need to worry because my stocks that are down are part of the money I won’t need for many years.” Of course, if your goals have changed, be sure to talk with your Viridian advisor to make sure you still have an appropriate balance/mix of strategies.
In our November update (link here), we detailed the recent deterioration in several market indicators, and the corresponding changes we made to our model asset allocations. Among those indicators are:
- Weakening market breadth (the number of stocks rising vs. falling);
- Global stock market declines;
- A U.S. stock market that has become too dependent on technology stock earnings;
- Relative strength in defensive sectors of the market; and
- A lack of capitulation (panic selling).
We further mentioned last month that, in spite of having already reduced risk in our strategies in July and again in November, if market and economic indicators continued to weaken, we might reduce risk even further. Well…since that November update we have seen U.S. markets move sharply lower, and we’ve received little reassurance from economic data that the outlook is improving, for example:
- The Federal Open Market Committee (FOMC) just
- raised interest rates again, while signaling two more likely rate hikes next year;
- Continuation of our trade dispute with China;
- A partial government shutdown;
- The surprise resignation of the Secretary of Defense hasn’t helped sentiment.
Someone looking on the bright side might think things can’t get much worse. The reality, however, is that even though no recession is in sight yet, markets are clearly reflecting concern that a worsening trade war and stock market declines, combined with rising interest rates, might end up causing one. Here are two indicators that we’re closely watching right now for signs that the stock market correction is either worsening or coming to an end:
1. Volatility: We spoke early in 2018 of monitoring volatility as a sign that 2017’s steady increases in stock prices were coming to an end. That’s one reason we locked in some gains for you and reduced our stock allocation to “neutral” in July (after several years of an “overweight” allocation). We reduced it again (to “underweight”) in November. Now we’re watching volatility as a sign that the current decline might be entering a more damaging stage. The recent spike in the VIX (S&P 500 Volatility Index) suggests the market decline is picking up momentum, rather than slowing. Thus, don’t be surprised if we reduce your stock/risk exposure even more in coming weeks.
2. Downside Volume/Signs of Capitulation: Major market declines typically end with several days of aggressive and relentless selling (and sharp price declines). We’ve yet to see that this time around. A “sick” market often can’t transition to a healthy one until the last waves of participants panic and sell stocks en masse, no matter the price. In other words, bear market bottoms usually require that everyone who can be frightened into selling has done so, at which point selling pressure subsides and opportunistic buying launches the next bull market.
As painful as market declines can be, they are part of the normal ebb and flow of market cycles. We’ve been reducing risk in our models this year, and we will remain defensive if the weight of the evidence suggests that markets are heading lower. Until we see signs of capitulation and a willingness of market participants to take on risk, rather than shedding/avoiding it, we’re unlikely to start increasing your stock exposure to levels we saw earlier this year.