Quarterly Update

In stark contrast to December’s losses and Q4 2018 in general, the first quarter of this year saw a sharp rally for stocks during January and February. This was largely a snapback from oversold conditions that carried stocks through several economic concerns, severe weather around the country, and the longest government shutdown in history. Stocks started to taper off a bit during the latter half of March before finishing the quarter strong.

The S&P 500 ended up almost 14% year-to-date in a rally that began the day after Christmas. Foreign stocks also staged a comeback following poor performance for all of 2018, with Developed and Emerging markets each ending the quarter higher by about 10%.

Here’s a summary of how major market indexes ended the quarter:

• S&P 500: up 13.7%
• Dow Jones: up 11.8%
• Russell 2000 (small company stocks): up 14.6%
• MSCI EAFE (foreign stocks): up 10.1%
• MSCI EM (emerging markets): up 10%
• U.S. Aggregate Bonds: up 2.9%
• Municipal Bonds: up 3.2%

Top sectors during the Q1 rally included those that had been hit hardest during the Q4 rout, such as Technology and Energy, up about 20% and 16%, respectively. The worst performing sector was Healthcare, up almost 7%, which was relatively low but understandable after having held up well during Q4. Oil was up big during Q1, with West Texas Intermediate (the U.S. crude benchmark) rising about 30% to $60 per barrel.

In foreign markets, Chinese stocks were up about 31% after a dismal 2018. Trade headlines and concerns about slowing economic growth had caused China’s local stock markets to decline precipitously last year. This reversed course during Q1 as trade tensions eased somewhat.

But problems loomed toward the end of Q1. Uncertainty about Brexit weighed on markets, as did fears of slowing global economic growth. Both issues caused investors to move more aggressively into bonds for much of the quarter and this accelerated in mid-March. This, plus reduced expectations for near-term rate hikes from the Federal Reserve, pushed the yield curve (the difference between yields on bonds of various maturities) into what’s known as an inversion, where short-term bonds yield more than longer-term bonds of similar credit quality. Investors are concerned about yield curve inversions because they have been a near-perfect predictor of a coming recession.

The yield curve is even more helpful when matched with another indicator used to track the relative value of stocks, the cyclically adjusted price-earnings (CAPE) ratio. This ratio looks at the price investors are willing to pay for a unit of company earnings. Stocks start looking more expensive the higher this ratio gets compared to its historical average. Currently at about 30 versus an average of about 17, the CAPE has been elevated for some time now. Add this to an inverted yield curve, however, and research shows it’s appropriate to consider reducing exposure to stocks within income-oriented portfolios.

But will the yield curve stay inverted or was this a momentary blip, a false positive? The yield curve has steepened slightly during the past few days and is no longer inverted. Continued monitoring is needed to see where interest rates go from here.

Market indicators can change in the short-term, which is why it’s so important to be patient and monitor these sorts of changes over time without being overly reactionary. It may well be, for example, that the yield curve inverts again and remains so, even as the stock market moves higher and CAPE implies the market is getting more expensive. This combination could make it even harder for income-oriented investors to reduce stock exposure, even though important indicators are signaling it’s appropriate to do so.

Bounce backs like we experienced during Q1 are typical following declines of 10% or more during the prior quarter (the S&P 500 fell nearly 20% in Q4). The rest of the following year is typically positive as well, so that’s a good historical sign in the short-term.

While it’s impossible to time these things just right, appropriate planning is critical to test how sensitive your plan is to market volatility and whether it’s beneficial to trim back stock exposure as we inch toward our next recession.

Have questions? Ask me. I can help.