The Market’s Short Term Emotions

April 5, 2019 – In the first quarter of 2019, the U.S. stock market rebounded from the oversold levels of late December with the highest quarterly return for the S&P 500 in over nine years. The markets, especially equity markets, are prone to overreacting to current events, resulting in market price fluctuations of the kind we experienced in the past six months: the 20% decline last fall and, now, the 20% rebound in the same length of time this past quarter. The true values of the underlying companies change much more slowly. Consider the following analogy of the current state of affairs:

Picture yourself as a local business owner. You recently bought a business at a reasonable price, and the company is profitable. You plan to grow and further increase sales and profits. Three months later someone offers to purchase the business for 10% lower than the price you paid. Would you sell? How about an offer 20% below? Of course not. The fundamentals of the business and its value have not declined 10 or 20%. Perhaps they have even improved. Weeks later another buyer approaches you and offers 20% more than you paid for the business. Would you sell? Possibly, except that all the other businesses in town are also priced higher. Furthermore, you have the ability and the need to own a profitable business for years to come.

Viewing current market prices in perspective, that is, in relation to the true value of the assets, helps us to respond constructively to the fluctuations of the markets. We take advantage of mispriced markets and use our long-term timeframe to our advantage.

The October issue of this letter discussed how we prepare for a market down turn. The January issue focused on how we take advantage of oversold conditions in U.S. stocks, which we viewed at the time as offering their best value in years. We do not intend to predict what the markets will do next. Our purpose is to communicate our view of the current market environment and put the management of long-term portfolios in that context. We keep the focus on a portfolio’s ultimate purpose—a goal that is typically years in the future. We use our views on current conditions to help implement and manage your portfolio. Market downturns offer an opportunity to put new cash to work, shorten our timeline for gradual investment, and rebalance by buying recent underperforming asset classes. Periods of high valuation, when stocks are overpriced, are the times to lengthen those timelines for buying into positions, make more defensive investment selections, and ,again, rebalance by trimming recent outperformers.

In the first quarter, nearly every asset class had substantial gains with equity markets rebounding off of December’s lows and interest rate sensitive investments, such as bonds and real estate, benefiting from lower long-term rates.

We see the current U.S. stock market as near the top of its valuation range. While not overpriced, we believe the easiest market gains for the year have already been achieved in the first quarter, and any move higher must be based on earnings growth. On the positive side, the Federal Reserve has indicated it does not intend to raise short-term rates this year. That has been one of two big factors boosting stocks. The second driving factor, and the biggest wild card, remains trade negotiations. Hopes of a deal with China have supported the stock market. While the trade issue is not purely binary for the markets, if the China trade deal is successful, markets are likely to jump higher for the short-term. If talks deteriorate, stocks would, at a minimum, experience an additional headwind.

In international markets, concerns over slowing global growth, and Brexit are challenges for foreign stocks in developed and emerging markets. We are watching foreign central banks and economic indicators; we are more cautious and selective among foreign stocks, but still maintain an allocation to these markets. Emerging markets such as India have more dynamic growth potential, along with higher risk, compared to developed markets such as Europe and Japan.

The outlook for bonds remains mixed. Concern over slowing global growth and moderate inflation expectations have contributed to a rise in long-term bond prices. The 10-year Treasury bond ended the quarter at a yield of 2.41%, down 0.28% for 2019. The Federal Reserve has paused rate increases with the 2-year Treasury yield at 2.27%. Evidenced by these yields, investors are not being rewarded for the added risk of a 10-year bond compared to a 2-year bond. We continue to use a conservative approach, monitoring interest rate risk and favoring shorter maturities. When possible, we build core portfolios of individual municipal or taxable bonds and supplement with small allocations to specialty bond funds.

We diversify portfolios by including small positions in real estate and broad commodity indexes. Commodity indexes were driven higher by a 27% increase in the price of oil, while real estate benefited from lower interest rates and a demand for income producing investment alternatives.

Although we provide an overview of many areas of the market, our focus when managing your portfolio is on your personal goal and an individualized strategy to reach that goal. We welcome your feedback and questions.