October 2018 Market Update
Written by Brian Johnson, Chief Investment Officer
Summary: Equity markets had a solid 3rd quarter, but they have become much more volatile recently. The bond market looks to have ended its 35+ year bull run (interest rates falling, bond prices rising). The recent volatility is a reminder of the importance of rebalancing portfolios.
After a fairly quiet summer, the first few weeks of October have seen much higher market volatility, not just in equity (stock) markets, but in the fixed-income (bond) market as well. A sustained rise in the 10-year U.S. Treasury note yield—from just over 2.8% in August to over 3.2% last week—has bond investors concerned that much higher rates are ahead.
Equity and Fixed-Income Markets
The third quarter of 2018 was a great one for U.S. stocks, as the Dow Jones Industrial Average (DJIA), Nasdaq Composite and S&P 500 all rose by more than 7% during the quarter. The MSCI World Index, our benchmark for developed nations’ stocks, rose by about 4.5%, while the MSCI Emerging Markets index fell by 2%.
Markets, however, are ever changing, and summer’s low volatility changed abruptly once the calendar flipped from September to October. Markets fall for a variety of reasons, but all of them result in sellers being more motivated than buyers. In this case, the most likely culprit appears to be the pace of recent—and implied future—interest rate hikes by the Federal Reserve (Fed). The Fed tightens credit/raises rates primarily to keep inflation in check by dampening economic growth. Over the past five Fed tightening cycles, the average yearly increase in the Fed Funds rate was 2.5%. Our current pace, four 0.25% rate hikes (a 1% annual rate), is only 40% of that ‘normal’ pace. While it seems like rates have risen quickly, that is primarily because it has been quite a while since they’ve risen even this fast. But, by historical standards, the recent pace of rate hikes is still quite slow, and we could see much larger/faster hikes if the Fed sees too many signs of inflation.
The Power of Rebalancing
If the recent pullback in the stock market emphasizes one thing, it is the importance of rebalancing your investment portfolio. Our goal—both in constructing financial plans and in managing your investments—is to increase the likelihood of you reaching your goals. In bull markets, the average investor becomes more and more over-weighted in stocks as the bull market ages; without rebalancing, the risk is that those larger stock allocations will also proportionally hurt you more when the stock market falls. Periodic rebalancing of assets, whether tactically—as we have done in recent months to bring our equity allocations down from overweight to neutral—or more strategically, as we do when individual holdings deviate from their model allocation by more than a certain amount, helps reduce the risk that a drop in the market will meaningfully hurt the likelihood of you reaching your long-term goals.