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Normal or Abnormal? Diagnosing the Market: How Not to React

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Normal or Abnormal? Diagnosing the Market: How Not to React

As the market enters its first correction since the election in November 2016, many investors are calling our office with fears that it is 2008 all over again, and that their wealth will evaporate with a major market plunge.
 

My response to these fears: keep calm and take the long view. It is normal for the market to go down as well as up, and the average investor has not seen their account lose value in nearly 2 years. This consistent upward trend is actually outside of the norm. The recent correction, while distinct in its fundamentals from the last major market slip, is perfectly within the realm of expectations.

For those who do not spend their time closely watching ticker movements, let’s cover a bit of background on how the market has moved leading up to this correction. The market began a sharp upward trajectory following the presidential election in November, continued to move up very quickly through 2017, and rose even faster in January 2018, performing better than any January in recent history. During this time, the market rose almost without any volatility, meaning it had very little of that up or downward wiggle that we associate with equity charts. For more than a year, it virtually only moved up.

As a result of this upward, low volatility movement, investors shifted into what we refer to as a “risk on” mindset. This means more investors were willing to put their money in the market, generally viewed as a high-risk investment space, perceiving a lower-than-usual risk and high potential for returns.  As we tend to see in a “risk-on” investment climate, we had a market that was overvalued, with an under-appreciation for the total risk.

An important note regarding recent market movements: this correction is not a “fundamentals” correction, as the underlying fundamentals of the economy are good.
 

  1. Employment is strong.
  2. Taxes have been lowered.
  3. Wages are starting to rise.
  4. Corporations are reporting earnings in line with high expectations.
     

So, what happened?
 

  1. Natural Correction. The market went up 6% in January, which is a sharp increase following 14 months of already well above-average performance. A correction was likely to occur at some point.
  2. Broker Bots. Computerized selling increased as technical indicators changed, sending many algorithms into “sell mode”. Computerized trading is quickly becoming a huge portion of total trading volume, and can have a dramatic, rapid effect on short-term market movements.
  3. Inflation Fears. An inflation fear hit investors as interest rates rose nearly 20%, and the robust economy sparked a concern about future wage and price increases. Inflation worries were also triggered by US tax cuts, infrastructure plans, and the increased debt required to finance both.
  4. Pocketing Profits. Portfolio managers and individual investors began to take their sizeable profits from 2017, meaning they sold the shares they were holding to book the returns they had earned. Naturally, this created an excess supply which lowered share prices.
  5. Keep it in Perspective. Keep in mind, the current 10% correction means the market is down just 4% since 12/31, and still up nearly 12 % since last February.
     

All of these factors combined for a correction, an unpleasant but ordinary side effect of investing in equities. Again, this is normal. Perhaps a more relevant question on our clients’ minds is, “What is Beacon doing to react, and what have we done to prepare?”

In the final quarters of 2017, we foresaw an eventual interruption in this low-volatility paradise, and Beacon started to position for a changing market:

  1. Increased small cap allocation. Higher growth potential and more realistic valuations.
  2. High-Interest Hotspots. Focused on sectors that do well during rising interest rate markets, such as financials and industrials.
  3. Bonds: Shift from Duration to Credit. Bonds, both public and private, tend to depreciate when interest rates rise, especially longer-term bonds. This effect is known as duration. As smaller companies, whose bonds are viewed as riskier, continue to perform well in a strong economy, their bonds appreciate. In a strong economy with rising interest rates, a shift from duration risk to credit risk is prudent.
  4. Increase Flexible-Rate Bond Investments. When anticipating a higher interest rate environment, bonds that pay a flexible interest rate have the benefit of increasing your return as market interest rates rise. Fixed rate bonds, on the other hand, will pay the same interest regardless of the higher market rate, and the bond price will fall (duration).
     

Related: Tax Reform Planning for 2018 Begins Now

As you can see, Beacon has adjusted to a changing market, but we’re not pulling out just yet. We believe the fundamentals of the economy are still sound, and that there are returns to be enjoyed in the months to come. So, what are the next moves, and what will prompt Beacon to change this thesis?

The moving average, or the average value of an index or stock over a period of time, is an important technical indicator when determining an investment’s long-term trend. A moving average forms a support point, meaning a floor that, should the index drop below, may indicate a more fundamental downward trend. The 200-day moving average value is the support point that the S&P has not yet breached. If it breaches this support point, Beacon will sell some core U. S. Equity positions, increase cash, and be ready to invest in sectors that have gone down in value and are positioned to benefit from a recovery.

In conclusion: the correction is not abnormal, but as with all developments, we are vigilantly observing market indicators as they develop, and carefully assessing our portfolios for entry and exit points. It is very important to remind everyone timing of the market does not work, and that patience and prudence are key to solid performance.

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