In our 2018 Investment Outlook published last December, we forecast “markedly higher volatility” accompanied by market pullbacks that would “become more frequent and pronounced” – albeit within the context of a stock bull market that still had more room to run. As it turned out, this is exactly what happened during the first quarter as market turbulence replaced the market calm of 2017.
As to market volatility, according to Strategas Research Partners, over 55% of the trading days in the first quarter saw the S&P 500 move at least 1% higher or lower intraday. To be precise, there were 34 trading days during the January-March period when this happened – compared to just 10 days total in 2017. Also of note, during the quarter, the CBOE S&P 500 Volatility Index (or “VIX”) spiked to levels not seen since 2015, and finished the quarter about 80% higher than where it began.
Pullbacks, too, within the context of an ongoing stock bull market, characterized the first quarter. After logging 14 record-high closing levels during January, the S&P 500 peaked on January 26th. By February 9th, the index reversed course, falling 10% from its January 26th highs and entering its first correction in two years. This sharp pullback, caused by inflation fears that proved to be premature, slowly dissipated (reducing February’s losses) as March arrived. Just when the correction looked to be over, and we celebrated the 9th anniversary of the bull market that began on March 9, 2009, as well as a new record Nasdaq intraday high on March 13th, the pullback resumed as inflation fears were replaced by new worries: fears of a trade war given newly-announced restrictive trade policies by the Trump Administration; fears of rising borrowing costs as the Federal Reserve again raised interest rates; and fears of increased federal government scrutiny and regulation of big technology companies in the aftermath of the Facebook data privacy issues.
When all the dust settled, the S&P 500 finished the first quarter down 0.8% on a total return basis. Of the eleven sectors in the S&P 500, only the Technology and Consumer Discretionary sectors posted positive returns for the quarter. The worst performing sector was Telecommunications, down over 7%. By style, growth outperformed value across the various market capitalizations while small-cap stocks generally outperformed large-cap. Not surprisingly, small-cap growth had the best quarterly returns, up +2.3%, while large-cap value fared the worst, down 2.8%.
International stocks were mixed. Developed market equities, represented by the MSCI EAFE Index, lost 1.4% during the first quarter. Emerging market stocks, however, gained 1.5%.
Given the rising interest rate climate, bonds did not have a good quarter. The overall U.S. investment-grade taxable bond market, as measured by the U.S. Barclays Aggregate Index, declined 1.5%. High yield did somewhat better, off 0.9%.
Partially reflecting the impact of a falling U.S. dollar, which declined over 2%, certain commodities such as crude oil and gold managed to end the quarter with gains.
We enter the second quarter with greater economic, political, and geopolitical uncertainty. Fears of a trade war with China dominate the headlines. The Federal Reserve may well raise interest rates again in June, and the midterm elections will begin to draw greater attention. This uncertainty likely will lead to continued stock market volatility ahead.
Despite the recent and expected market turbulence, we continue to believe the path of stocks will be higher over the next 12 months. (To be sure, the path will not be straight, and may well be bumpy.) Underlying this outlook is still a very healthy U.S economy. The housing market – as measured by new and existing home sales – remains near post-recession highs. The manufacturing and services industries are strong. Unemployment is near record lows (the number of persons collecting unemployment benefits fell to a 45-year low in March) and consumer confidence remains at 14-year highs. While the Federal Reserve is reducing its monetary stimulus to the economy, Congress is adding substantial fiscal stimulus, both through the tax cuts passed in late 2017 and more recently through the $1.3 trillion spending bill enacted in March.
Another fundamental basis for our belief that the bull market in stocks will keep going is continued strong corporate earnings. During the last three months, companies reported 2017 Q4 results. Of the S&P 500 companies, roughly 75% beat analyst earnings estimates and almost 70% beat revenue estimates. S&P 500 earnings rose approximately 18% on a bottom-up basis (year over year) in Q4. Most importantly, more double-digit earnings growth is forecast for 2018, driven by strong revenue growth.
As we have noted before, we are in the midst of a synchronized global economic expansion. While threats exist to the continuation of this global expansion – most notably if a true trade war were to emerge – no recession is likely in the next 12 months. Equity valuations have become more reasonable as a result of the recent market pullbacks and increased earnings expectations. These factors should support stocks through what likely will be a choppy second quarter. While we have a more modest outlook for bonds, given our expectation of gradually rising yields, we still view bonds as an important part of a diversified investment portfolio, as a hedge on stock market volatility.
As always, we encourage you to reach out to us with any questions, concerns, or perspectives you may have. Please contact your portfolio manager, or you may reach us at 610-975-4300, or email email@example.com.
Mr. McFarland is President, Chief Executive Officer, and Chief Investment Officer of Pennsylvania Trust.