We separate the relevant from the noise, to bring you market updates that helps you on the path to and through retirement!
STATE OF THE MARKETS
S&P 500: 2,730.20 (+2.12% YTD as of 11/15/2018)
The S&P 500 Index dropped 6.9% in October, making valuations much more reasonable. The forward price/earnings ratio of the S&P 500 Index has dropped to 15.6 times (from 18.8 times just nine months ago). This is below the five-year average (16.4) but still above the 10-year average (14.5). The shift in price/earnings ratio reflects the rise in interest rates, poor trade relations with China, contentious mid-term elections, and possible mis-steps by the Fed (raising rates too quickly to slow the economy). (1)
While defensive sectors have withstood the decline, sectors most sensitive to economic growth have been hit hard. Energy, materials, industrial’s, technology and consumer discretionary have all fallen more than 10%. The good news is stocks tend to rally after mid-term elections. According to LPL Financial, since World War II, the S&P 500 Index ended the year higher than its October low 18 out of 18 times with the average gain just above 10% (2). In addition, earnings remain on track to grow over 20.5% in 2018 & 10% in 2019, according to FactSet.
After a two-year hiatus, volatility is back. The S&P 500 fell over 10% from January 26th – February 8th and another 6.94% in October. These pullbacks are quite normal. According to Bill O’Grady of Confluence Investment Management, over the last 90 years, the stock market has averaged 3.4 corrections of 5% or greater per year.
Over that same time span, the market also averaged 1.1 corrections of 10% or greater per year. So we are just getting back to more normal volatility. While these pullbacks are uncomfortable, they also provide opportunities to buy great companies at reasonable prices. (3)
ECONOMIC UPDATE
Weakening Housing
Over the last year, Fed rate hikes, has increased home mortgage borrowing costs almost one full percentage point to around 5%. Real wages are lagging and with many young borrowers still saddled with student loans, housing starts have plateaued. The problem is affordability – which has dropped to where it was back in 2000.
New homes sales have slid 11.7% from their peak last November through August. Existing home sales have dropped for the sixth straight month – bringing the decline since last November’s peak to 9.3%. And to top it off, price gains for existing homes are decelerating to a 4.2% annual rate down from 5.3% a year earlier. These are surprising results given record low unemployment – 3.7% and a booming economy.
Rising Interest Rates
The 10-year Treasury rose to 3.26% in early October to its highest level in 7-years. The 2-year, 5-year, and 7-year Treasury climbed to their highest levels in 10-years. These rates rose because we are experiencing strong economic growth. The concern for investors is that borrowing costs are rising.
In addition, President Trump has been critical of the Fed – blaming the central bank’s rate-hiking efforts for the stock market weakness. Some critics think the Fed’s rate strategy is too aggressive, just when the economy is starting to take-off. We have been saying for months that a Fed misstep in terms of tightening too quickly could derail the stock market. In our opinion, the Fed will likely walk back some of their more hawkish comments in the days and weeks to come.
INVESTMENT THEMES
Throttle Back Your Asset Allocation
After the drubbing the market took in the first part of October, it’s only natural to wonder if your exposure to stocks is too high. Particularly, since we are in the midst of the longest bull market since World War II. Some market experts think we are in a secular bull market that has 6-7 more years to go. Others think we are in the 7th inning of a 9 inning game. Obviously, no one can predict the future with any accuracy. However, in our conservative approach to investing, its seems prudent to gradually throttle back your allocation.
Now is the time to start worrying more about losing money than missing opportunities. If you’ve been resistant to reduce your portfolio allocation to stocks, now is the time to re-examine your asset allocation to make sure it’s appropriate given your age, risk tolerance, and income needs.
Focus on Dividends
Most retirees have social security, and if you’re lucky, maybe a pension to rely on for their income needs. Social security and pension income tend to rise only modestly (with inflation) each year. And with bond income having dropped so much over the last 35+ years (lower yields), there is very little that retirees can count on to provide a growing stream of income.
However, dividends from high quality stocks have been a reliable source of growing income for investors for decades. We feel so strongly about dividends, that dividend-paying companies are the bedrock of virtually every portfolio we manage for clients. The growing income stream that dividends can provide also provide stability in volatile markets.
According to Standard & Poor’s, dividends have risen an average of 6% annually over the last 27 years. For these reasons, we believe that the combination of growing income and the more stable nature of a dividend paying stocks will be an important way for investors to protect themselves as the market becomes more volatile.
Bottom Line
Despite the gut-wrenching stock market drop in October, stocks tend to rally after mid-term elections and we wouldn’t be surprised if that happened again this year. Investors looking to protect themselves in volatile markets should stay focused on dividends. Finally, it seems prudent at this stage of the economic cycle to gradually throttle back your allocation.
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