So we all had been lulled to sleep. In research done by Morgan Stanley, the average number of annual trading days with a 3% market move is 6.5 when one looks back to 1928 through present. 2018 has now had 5 so far, and it’s just a normal year according to historic data.
The last few years of low volatility are historically abnormal, and in our opinion, it’s been driven by the rise of Exchange Traded Funds (ETF’s) and passive management. Plus, the market returns have been driven by a tiny fraction of technology Mega Caps, deemed the FAANG stocks, where the virtuous growth cycle and institutional sponsorship created smooth, steady returns. So, we all have been simply lulled to sleep by low volatility and a steady rising bull market.
Now things have begun to change, and we are seeing the market pivot to reflect changes in the economy. The US has had strong growth and record unemployment. Things are still good, but the economy is decelerating. Record employment numbers, strong housing data, real interest rates (interest rates less inflation rate) that were negative encouraging leverage, and record corporate profits, have all begun to moderate and soften, if not slightly reverse course. The economy is decelerating, yet still healthy.
Headline risk and 24 hours a day news flow exacerbates the market actions. A looming trade war with China, a Tweet- iferous President with no filter, and a Federal Reserve which has aggressively tightened via rate increases, have all spooked the markets and investors. Trade seems the greatest headline risk, and especially among those who have studied history and can recall the effects of the Smoot-Hawley Tariff Act.
Yet, we believe that though certainly late cycle in the recovery, we are not likely very late cycle or at the end, and there is likely more room to go. Markets appear to be beginning to de-risk, causing a shift from Growth stocks to more defensive Value stocks. We have begun to place a bigger emphasis on balance sheet quality and dividend yields and seem to find lots of attractive places to implement capital for long term returns.
Frankly we would be more scared of euphoria than fear in the markets, remembering that bull markets do climb walls of worry. And the last few months and weeks have had plenty of worry and a return of normal volatility. We all may have been lulled to sleep, but the markets have woken us up. Time to pay attention, opportunities will follow.