November 2018 Market Update

Brian Johnson

Brian Johnson
CIO and Shareholder

Written by Brian Johnson, Chief Investment Officer

Summary: It’s been hard to find positive returns in 2018. We’ve made a number of allocation updates within our models to respond to the evolving landscape. If market and economic indicators continue deteriorating in the weeks and months ahead, we may reduce risk even more.

Logistically, getting in and out of the stock market is simple; you simply place buy and sell orders. The challenging part, of course, is making prudent decisions about increasing/decreasing your stock exposure, including:

 1. Whether to reduce your stock holdings at all, as opposed to just leaving your “stock money” in stocks all the time, riding bull and bear markets up and down;
 2. When to make changes;
 3. How much to buy/sell;
 4. Which holdings to increase/decrease, e.g., shifting among industry sectors, U.S. versus foreign, etc.
5. Not letting emotions (fear when stocks are falling, exuberance when they’re rising) impact your decisions.

Challenges like these are partially why some people choose to have Viridian oversee their investments.  Over many years, we have developed and refined disciplines that help us make prudent, unemotional portfolio changes.  The past few months serve as an excellent example of how we apply those disciplines in practice.

History shows that trying to take all of your money out of stocks is generally a bad idea (in large part because, by the time it seems “safe” to go back in, a big part of the next bull market has passed).  However, what can work is: (a) incrementally increasing your stock participation (e.g., with more stocks, and more money in high-growth sectors) when risk is perceived to be low and expected future returns expected to be high, as we did 2½ years ago; and (b) reducing stock exposure when evidence points to risks being elevated, as we’ve done in the second half of 2018.  In July, we moved our equity allocation from its long-time “overweight” position down to “neutral,” citing an increased risk of a pullback. In recent weeks, we’ve become even more defensive with our model portfolios, reducing stock exposure further.

2018 has been a rough year for nearly every asset class. Whether you are invested in stocks, bonds, commodities or real estate, you’ve seen little or no progress to the upside this year. As Ned Davis Research reported last week, this is the first year since 1972 when none of the following asset classes returned at least 5%: U.S. large-caps, U.S. small-caps, International developed countries, International emerging markets, U.S. Treasuries, U.S. aggregate bonds, commodities, and real estate. In fact, the median return of these asset classes year-to-date (YTD) is -1.7%.

As you can see in this bar graph, which goes all the way back to 1901, a record share of asset classes (90%!) have posted negative total returns this year. Bull markets—and even positive returns—are increasingly hard to find.

Of course, it isn’t surprising that markets would pause following their outstanding advances (with record low volatility) last year. However, throughout 2018 evidence has mounted that markets may do more than simply pause as prices began to reflect concern over the impact that the growing trade wars will have on the economy and corporate earnings.

By July, we saw enough deterioration in internal market indicators that we felt it prudent to shift our equity allocations from “overweight” to “neutral.” Those indicators included, among other things, weakening market breadth (the number of stocks rising vs. falling), global markets that were trending lower, and a U.S. market that seemed increasingly vulnerable to negative earnings surprises by technology companies.

In recent weeks, we have seen further deterioration of market internals, to the extent that we just reduced our equity allocation again—from a “neutral” allocation to “underweight”—for the first time in many years.

Three of the key factors that resulted in this recent risk reduction are:

1. Increasing evidence of relative strength in defensive industry sectors. Consumer Staples, Healthcare, Utilities and Telecom, together, have been outperforming riskier sectors. Facebook, Amazon, Netflix and Google are currently 18%-37% off their highs, as money has rotated out of such high-growth companies that may be more vulnerable to an earnings slowdown.

2. Despite markets generally undergoing 5% to 30% pullbacks globally, we’ve yet to see the type of selling that we typically associate with “capitulation,” a phenomenon that typically occurs near market bottoms. Capitulation refers to the widespread fear and panic selling, seemingly at any price, that often includes more than 90% of stock prices (and volume) moving lower over a series of days.

3. The market weakness we are seeing, on a country by country level, is similar to that previously associated with short-term, cyclical bear markets (declines of around 20%), occurring within a longer-term, “secular” uptrend.

Practically, this evidence resulted in us moving to an “underweight” allocation to equities. Thus far, that has meant that we’ve moved more of our equity allocation into defensive sectors.  In addition, our Viridian Conservative and Viridian Balanced models now have an equity allocation that is 10% less than a few weeks ago (in addition to the 10% reduction we made in July).  If market and economic indicators continue deteriorating in the weeks and months ahead, we may reduce risk even more.

One thing you should take from the above is that we don’t just sit on our hands and hope for the best.  Your Viridian advisor helps you determine which of our models (strategies) are most appropriate for you, and in what proportions, based on your specific goals, income needs, and risk parameters.  Each of our strategies offer different exposure to short-term market fluctuations, and correspondingly different long-term return expectations.  Once selected, we manage each strategy to produce as much return as we can get within its particular objectives and risk limitations. Thus, unless your personal parameters change, you shouldn’t need to jump from one strategy to another, and certainly not because of short-term fluctuations in the stock market.

Looking ahead, as the above suggests, the market seems likely to get worse before it gets better.  That said, it is important to remember that this correction appears to be primarily the result of an earnings slowdown and Price-Earnings (P-E) multiple compression.  At this point, leading economic indicators aren’t signaling an imminent U.S. recession.  It is therefore likely that, once we see the end of this current correction, even if it turns into a short-term bear market, we have another lengthy bull market to look forward to. Regardless of which way things go, you can be sure we will be ready to take action on your behalf as is warranted.

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