After nine consecutive quarters of positive returns, the S&P 500 Index sustained a modest 0.8% loss for the first quarter of 2018. The quarter’s performance was characterized by a strong advance followed by a sharp decline. The S&P 500 rose 7.5% in the first four weeks of the quarter, but faltered on concerns that the strong job market could lead to inflation and cause the Federal Reserve to move more aggressively to increase interest rates. In addition, the market reacted negatively after the Trump Administration proposed tariffs on steel and aluminum imports and threatened other trade sanctions, sparking fears of a trade war. The reversal in the S&P 500 ended its longest stretch without a 5% decline and resulted in its first 10% correction since early 2016. Volatility, which had been absent for so long, quickly returned to the stock market. After going all of 2017 without a daily price change of more than 2% in either direction, the S&P 500 experienced six such days in the first quarter, with five of those days being declines.
The table below shows the performance of major equity indices for various time periods.
Equity Performance for Periods Ending on March 31, 2018
|Total Return Index||Market Sector||Quarter||1-year||3-year||5-year||10-year||15-year|
|S&P 500||Large U.S. Companies||-0.8%||14.0%||10.8%||13.3%||9.5%||10.1%|
|Russell 2000||Small U.S. Companies||-0.1%||11.8%||8.4%||11.5%||9.8%||11.5%|
|MSCI EAFE||Developed Int’l Markets||-2.4%||11.9%||2.7%||3.7%||-0.2%||5.7%|
|MSCI EM||Emerging Int’l Markets||1.1%||22.2%||6.3%||2.5%||0.6%||10.2%|
From its all-time high in late January, the S&P experienced a 10.2% correction. While the market bounced off its recent lows, volatility remains elevated, as investors appear to be anxious. Since 1946, the average correction (a decline of 10% to 20% from a recent high) has been 13% and has lasted an average of 4 months. (See table below.) While corrections have been relatively short, bear markets (a loss greater than 20%) have been deeper and more prolonged.
Corrections and Bear Markets - S&P 500 Index (1946-2018)
|General Definition||Number||Average Decline||Average Length (Mos.)||Average Time to Recover (Mos.)|
|Corrections||10% to 20% decline||26||13%||4||4|
|Bear Markets||More than 20% decline||11||30%||13||22|
Because all bear markets start out as corrections, declines of 10% or more create concern for many investors. However, bear markets are usually caused by economic weakness that later develops into a recession. We believe the likelihood of a recession over the next year is low. Consumer and business confidence is relatively high, unemployment remains low, and leading indicators are signaling further economic growth. Most major foreign economies are also exhibiting positive economic trends.
The use of the word correction to describe a market decline of 10% to 20% stems from its more general definition: a change to make something right. In this sense, it simply implies that stock prices were previously overvalued and an adjustment in market values was warranted. Corrections are usually healthy for the market in that prices of individual companies are reset at more reasonable values, based on their earnings, dividends, and growth potential. Corrections are also beneficial in that they tend to reduce speculative behavior by market participants.
The combination of weaker stock prices and rising earnings have made stocks more attractively valued. According to FactSet Research, the S&P 500 price-to-earnings ratio declined from 18.2 at the beginning of the quarter to 16.1 by the end of the quarter. S&P 500 earnings, bolstered by lower tax rates and a strong global economy are forecast to grow by 18.5% in 2018—the best performance since 2011. The S&P 500 dividend yield is currently 1.9%, which compares favorably to fixed income investments, especially in a rising interest rate environment.
While stock valuations have improved and fundamentals are strong, the market is likely to remain choppy in the near term. Investors remain worried about the potential for policy mistakes in the areas of trade policy, foreign policy, and monetary policy. Further, large technology companies, which have contributed disproportionately to the market’s overall recent performance, could face greater regulation and slower growth, following Facebook’s highly publicized failure to protect its members’ privacy.
In late March, the Federal Reserve raised its benchmark interest rate to a range of 1.50% to 1.75%. The Fed is signaling two more 0.25% rate hikes for the remainder of the year, but a fourth increase is possible if the economy runs too hot. The yield on the 10-year Treasury bond increased from 2.41% to 2.74% during the first quarter, and traded as high as 2.94% in February. The increase in interest rates resulted in a loss of 1.46% for the Bloomberg Barclays Aggregate Bond Index in the first quarter. We continue to regard long-term fixed income investments as unattractive due to the risk related to rising interest rates. As such, we have maintained a short duration for the fixed income investments in our managed portfolios.
Our near-term outlook for the global economy remains positive. Rising interest rates and concerns over government policy do provide some headwinds for stocks, but improving valuations and strong forecasted earnings growth gives us optimism.
Although some investors may view the market’s recent correction as disappointing or concerning, major market declines are fairly common events. Since it is virtually impossible to predict the short-term direction of markets, long-term investors must accept market volatility as an inevitable part of the investment process and rely on their asset allocation to provide an appropriate hedge for such volatility, consistent with their objectives and risk tolerance.
John D. Frankola, CFA
The author is the president of Vista Investment Management, LLC, a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.