Nathan Geraci is President of The ETF Store, Inc. and host of ETF Prime.
Every investor knows the old cliché that the stock market is like a roller coaster, up and downs, twists and turns, both an exhilarating and scary ride. However, the roller coaster analogy doesn’t always quite fit. A roller coaster never really goes anywhere, always ending-up right back where it started. Meanwhile, stocks tend to march higher over time, though certainly not without a few adventures along the way. However, with summer vacations and trips to amusement parks in full swing, it occurs to us the first half of 2018 has actually proven the old roller coaster stock market truism correct. If 2017 was like the tea cups at Disneyland, 2018 has been more like the Viper at Six Flags. Consider the year-to-date chart of the S&P 500:
Source: Yahoo Finance
In 2017, the S&P 500 experienced only eight days with up or down moves exceeding 1%. 2018 has already witnessed 36 such days including a harrowing 10%+ drop from late January into early February. The S&P 500 has managed to squeak out a 2.5% total return, but for diversified investors owning global stocks and bonds, overall year-to-date returns are basically flat. Like a roller coaster, there have been peaks and troughs, but investors are right back where they started, a little worse for the wear.
Why So Many Loops in This Roller Coaster?
The market is taking its cues from expectations about the economy, which if we continue with the theme park analogy, has been like one of those pirate ship pendulum rides, swinging back and forth. On one side, President Trump’s tax cuts, along with robust government spending, have helped propel corporate earnings and boost both business and consumer confidence. Companies have increased hiring, wages have ticked up, the labor market is tightening, multinational companies have repatriated cash from oversees, business investment remains strong, and stock buybacks are at record levels. Smaller companies, in particular, have benefited from this environment.
On the other side, however, are fears of a full-blown trade war and growing Federal deficit. The Trump Administration has initiated tariffs on the U.S.’ top five trading partners, perhaps most notably China who has retaliated in-kind. Heated rhetoric between the Trump Administration and various global trading partners has only heightened concerns over potential escalation. Trade wars can create inflationary pressures, increasing costs for businesses and raising prices for consumers. They can also lead to an overall slowdown in global trade if consumers pull back on spending and businesses decrease investment. The U.S.’ rising debt burden is also causing some anxiety.
This swinging economic pendulum comes against a backdrop of central banks finally removing stimulus some ten years after the global financial crisis. The U.S. Federal Reserve has hiked interest rates twice this year, with markets expecting two additional increases. The Fed has also begun unwinding their bloated balance sheet at an accelerating pace. With signs the economy is moving towards late cycle, the Fed must find the delicate balance between keeping inflation in check and preventing overheating, while not stunting economic growth. If the Fed had their way, they simply wouldn’t let anyone on the pendulum ride – they want it at equilibrium (they would probably prefer to shut down the stock market roller coaster ride as well). The Fed has done a highly commendable job up to this point, but continuing to strike the right balance will be easier said than done.
The swinging economic pendulum might best be reflected in the yield curve, where short-term interest rates have risen, while longer-term interest rates remain flat. Note the contrast between interest rates at the end of 2013 and the current yield curve structure:
Source: J.P. Morgan
The 2-year Treasury yields 2.5%, while the 10-year yields 2.9%. Historically, when the 10-year yields less than the 2-year – what’s referred to as an inverted yield curve – an economic recession tends to follow. As a matter of fact, the past nine recessions have begun with an inverted yield curve. Also, note that the 30-year Treasury yields a paltry 3.0%. This highlights the economic pendulum, with shorter-term concerns over the economy overheating on one end and a less than optimistic longer-term outlook on the other.
Adding to all of this is a jittery situation oversees, with a strengthening U.S. dollar rattling emerging markets and some economic and political headwinds in Europe. It’s easy to understand why interconnected global financial markets are exhibiting some uncertainty – think Disney’s “It’s a Small World”.
“There’s something about a roller coaster that triggers strong feelings, maybe because most of us associate them with childhood. They’re inherently cinematic; the very shape of a coaster, all hills and valleys and sickening helices, evokes a human emotional response.” – Diablo Cody
So Where Does This Leave Us?
As we touched on last quarter, the “volatile” market environment is actually much closer to normal than what we’ve experienced the past several years. When you haven’t ridden the roller coaster in a while, the ups and downs can feel much more pronounced. It’s important to keep emotions in check and remember we are riding the same roller coaster as always. As we sit here today, markets have calmed a bit from earlier in the year. With the roller coaster temporarily in the station, now is the time to reassess your risk tolerance and evaluate your investment plan to ensure you are on the right “rides” in the right “theme park”. Tailoring an investment plan in the midst of a stomach churning drop is less than ideal.
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Source: Bruce Plante Cartoon, The Stock Market