Monthly Brief February 2019 – Confirming The Trend
What are we to make of the global equity markets over the last number of months? Are we down from the peak? Or up from the bottom? February saw more follow-through of the market rebound from its late-2018 lows and the news-driven environment has certainly highlighted the impact of traders over investors, requiring a genuine effort to see through the noise to focus on what may truly drive asset prices.
While the issues haven’t changed, investors’ emphasis continues to shift monthly. The list still includes: Is the global economy slowing? When will US/China trade tensions be resolved? Brexit? What’s next for US Federal Reserve policy? And, of course, the ongoing political rhetoric and investigations.
While trade policy seems to grab many of the headlines, a case can be made that Fed policy changes have been the most impactful. In 2018, a market headwind was developing as the Fed was expected to both raise interest rates and begin to reduce their balance sheet, often referred to as “unwinding” quantitative easing (QE). It would follow that if the Fed’s post-financial crisis efforts through QE had helped to stabilize the economy and move asset prices higher (i.e. higher stock prices and lower interest rates), then an unwinding of these measures could risk a reversal in the markets. And this did begin to take shape in late-2018 as equity markets moved lower.
But, as the decline in asset prices continued in conjunction with signs of slowing global economic growth, the Fed said “uncle” and put their plans on pause, emboldening investors to add risk back into their portfolios. And recent gains in equity markets continue to reflect this mindset of clear-sailing so long as the Fed doesn’t return to a policy of higher interest rates and a shrinking balance sheet.
But, now that markets have staged a rebound, will the Fed return to their planned path of policy tightening? As February concludes, investors are left to contemplate what’s next. If market volatility and global economic growth concerns were strong enough risks for the Fed to put policy tightening measures on hold, should asset prices be moving higher so quickly? And, if policy changes have helped global growth pick up again, will the Fed resume prior tightening initiatives? If so, would that again negatively affect asset prices?
Not easy questions to answer, particularly given the broader list of issues mentioned above. And not an easy environment for investors to navigate. But the rebound through February has left markets at an inflection point which, once resolved, will set the stage for the next phase and the proper course of action.
CHART OF INTEREST – CONFIRMING THE TREND
When equity markets experience sharp declines, it is not unusual for markets to fall too far, too fast. When this occurs, a rebound is typical, often driven more by investor psyche than by a change in underlying fundamentals. These bounces can vary in magnitude, sometimes nearly recovering the full prior decline. Late 2015 and into 2016 was an example of this when the rebound from the initial decline reached within 3% of the prior high, before ultimately falling to a new low.
When judging this type of market environment, one metric which can highlight the strength of the rebound is to judge where markets stand relative to their longer-term trends. Using broad indexes and their respective 200-day moving average has proven to be a good reference point for this assessment.
Market rebounds that have strong underlying fundamental support are more likely to persist than those that are, in hindsight, sentiment driven. When a rebound does have underlying fundamental support, it is often led by market segments more sensitive to economic optimism, such as small-cap stocks and the Financials sector. For small-caps, an improving business climate would typically be viewed as a strong tailwind for business with much to gain. As service providers to all sectors, the financial sector would be expected to benefit from an improving business climate that would tend to provide more opportunity and need for banking services, i.e. lending, etc.
A current look at how these two groups compare to the broad, large-cap S&P 500 Index leaves some questions regarding support for 2019’s market bounce. While the S&P 500 Index has managed to move above its long-term trend, small-cap stocks have struggled to retake their long-term trend. And Financials have had an even more difficult time as they have lost momentum prior to reaching their respective long-term trend. More curious (concerning?), is that each had been leading performers off the late-December 2018 market bottom, yet seemingly are slowing earlier than the broader market.
Where markets go from here will ultimately be determined by a number of factors, not the least of which includes the news flow regarding the difficult-to-predict political environment. But these types of analytics can be helpful for investors when assessing risk-taking opportunities in the equity markets going forward.
James Ferrin, CFA
Chief Investment Officer
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