12/7/2018 Weekly Update: The Gathering Storm
by Zach Marsh on Dec 7, 2018
S&P 500 -4.4%
10 Year Treasury +1.23%
Weekly Update: The Gathering Storm
This week we experienced another rocky week in the stock market, with two factors contributing heavily to the increased volatility. First, Monday we got a bit of a follow through from last week’s impressive 4.7% rally. The S&P 500 opened the Monday session touching levels that on two previous periods had offered substantial resistance, roughly the 2800 level. From there things just got progressively worse.
The rally, which had been precipitated by hopes of a truce to the trade war with China that has been brewing all year long, flamed out on Tuesday, when President Trump announced on Twitter, “I am a Tariff Man.” That day the market fell over 3%. Wednesday the markets were closed in honor of George H.W. Bush’s funeral, but on Thursday they reopened with another bang. Wednesday evening the U.S. Department of Justice announced the arrest of the CFO of China’s largest company Huawei. This news was greeted with a thud, sending the S&P 500 down another 2.8%, effectively retesting the lows set in October. However, the market rebounded strongly mid-day on the back of positive comments from the Federal Reserve about slowing down the pace of interest rate hikes.
Only four trading days this week, but enough volatility to fill an entire month. So, the question has to be asked: what can we make of this noise? And more importantly, does any of this portend a recession or bear market? This brings us to the second factor effecting markets this week: the inverted yield curve. The yield curve is the representation of the relationship of interest rates across different maturities. Typically, the curve is upwardly sloping, meaning shorter term rates are lower than longer dated bond rates. This is the typical shape of a curve during expansionary period. However, pre-dating every recession since 1981, the yield curve has inverted—short-term rates have been higher than long-term rates. The inverted curve typically measures 2-year bond rates vs 10-year bond rates. Currently, this spread, the 2/10 spread, sits at 15 basis points—essentially flat.
This flattening of the curve, with the supposition that it is only a matter of time before it inverts, has gotten the market spooked. Faced with the understanding that an inverted curve has predicted every recession since 1981 has that effect. But, like with nearly everything, there is a caveat. First, it’s not like it has a track record of 25-0—it’s more like 4 out of the last 4, so not a huge sample size. Second, it also doesn’t act as a fantastic timing mechanism. Preceding the 2008 recession, the curve first inverted in December 2005, the S&P 500 would rise an additional 24% before it peaked in October 2007. So, in and of itself, a curve inversion is no reason to hit the panic button.
All that being said, currently nearly all of the economic data being released still shows an economy in expansion—which is precisely why I believe that we are at peak cycle. The stock market is, by its nature, a forward looking prognosis on economic development, economic data is backward looking. The stock market is telling us that there are potential headwinds in store for us. Barring a miraculous turnaround, we will finish the year with nearly every tradable asset class down for the year (see last week’s letter for more on that topic). Now, markets can get things wrong, they frequently do, but if 63 out of the 70 assets tracked by Deutsche Bank are currently in the red for the year, it should open eyes.
Now, with regards to positioning changes in anticipation of a looming recession, an adaptive, momentum-based portfolio, which adjusts portfolio allocation towards assets with positive momentum, will, over time, allocate to more defensive assets. Among individual stocks, the allocation will begin to shift towards more defensive consumer staple stocks, and within multi-asset portfolios, it will allocate more and more towards Treasury bonds. This should help weather the storm, while at the same time keeping our behavioral tendencies from making knee-jerk decisions by sticking to a systematic process.
No system is flawless, but neither is trying to guess what the future economic climate will be, or which way the wind will blow tomorrow. We believe that a quantitative, systematic approach helps avoid catastrophes and prevent against futile guessing.
Thanks for reading,
Zach and Dave
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