While researching this quarter’s market commentary, I came across an analogy I think is a good reminder for today’s market.
Imagine you are climbing a mountain. As the peak nears, you see a massive grizzly bear. The bear stomps its front paw and charges toward you. Your instincts beg you to run. You only have seconds before it will reach you, yet you are still as a Queen’s Guardsman at the post, you remain in place. Your knowledge that the charge is only a test of willpower protects you.
Bears do not start a charge planning to bluff and peel off at the last second. Instead, the bear is testing your reaction. Stand your ground, and the bear will call off the attack. If you run, you’ll be chased down. It’s your reaction that determines if the charge is a bluff or the real thing – unless the bear’s cubs are nearby, then all bets are off.
Without time to blink before impact, the bear pulls up and lopes back into the woods, appearing more like a clumsy dog than a 1,200-pound killing machine. You have defeated the bear.
During the third quarter of 2018, the Standard and Poor’s 500 (S&P 500), a broad measure of U.S. stock market performance, continued the most extended bull market on record. Strong earnings growth coupled with U.S. economic growth and increased share buybacks bolstered U.S. stocks. These share buybacks were, in no small part, spurred on by tax savings recognized by corporations as a result of the Tax Cut and Jobs Act enacted early this year. In juxtaposition to U.S. stocks, many global stock markets have delivered negative returns, giving back some of the gains from last year. During the quarter, U.S. 10-year bond yields reached a four-month high and surged to a 7-year high in October. High yield bonds outperformed all other bonds during the quarter. On the economic front, most signals remain strong. The most recent Job Openings and Labor Turnover Survey (JOLTS), performed by the United States Bureau of Labor Statistics, shows 7.1 million job postings, the highest number of open jobs reported since the survey started nearly two decades ago. The number of job postings exceeded the number of unemployed by 659,000, meaning there are more open jobs than there are unemployed in the United States. Also, the number of underemployed, people not having enough paid work or not doing work that makes full use of their skills and abilities, fell to a level not seen since 1999. Generally, everything is moving in a positive direction.
With all of this good news, why did we start with a story about bears? The U.S. economy is inevitably late in the economic cycle and has been expanding for the past ten years. There are no strong indicators pointing to a recession around the corner, but some are getting close. The media has speculated much on the future of the yield curve. Historically, if the yield curve inverts (short-term interest rates are higher than longer-term rates), a recession is 18-24 months away. To date, the yield curve has not inverted, though at the end of the third quarter it was closer to inversion than at the end of the second quarter. Another indicator is the spread between the unemployment rate and inflation. In the depths of a recession, the unemployment rate is high and inflation is low as businesses slash prices to attract customers. During recovery, as the economy heats up, unemployment falls as people find work and inflation rises as prices increase. For the past thirty years, a convergence of the inflation and unemployment rates has preceded recessions. Today, the spread between unemployment and inflation is around 1%, and we expect it to continue to converge. So, if a recession might be on the horizon, what should an investor do? The first step is to review portfolios to ensure proper diversification in alignment with goals and time horizon. Harry Markowitz, the father of Modern Portfolio Theory, called diversification “the only free lunch in finance.” The idea is that diversification reduces risk in a portfolio while not sacrificing long-term returns. Late in the economic cycle, diversification and rebalancing are more crucial than ever. Just like when facing a bear, market volatility should not be a trigger for reaction. If your portfolio is appropriately diversified, has been rebalanced to your target allocations, and is in alignment with your goals, you can stand, like the Queen’s Guardsman at post, steady and ready to weather any coming storm.
The views and opinions expressed are of Persium Advisors, LLC. This commentary is provided for educational purposes only and should not be construed as investment advice. Persium Advisors is an investment advisor firm located in Atlanta, GA.
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