I know you’ve been aware of the volatility in the stock market recently because it’s been all over the T.V., radio and internet news feeds. So far this year:
What makes this year unusual is the degree to which these asset classes have moved in the same direction, although not nearly in the same magnitude. Typically, the stock and bond markets are negatively correlated and move in opposite directions. Alternative asset classes like commodities are often used to create negative correlation in a portfolio relative to more traditional asset classes such as stocks and bonds. The idea being, when one asset class is down another might be up, thus providing some cushion in a falling market.
When markets are positively correlated, they move in the same direction. That’s great when everything in a portfolio is going up and we’re counting our ever-increasing riches but is painful to watch when all things are moving downward over a period of time.
So how do we explain why downward positive correlation has existed this year? There are a few reasons, though not all the same across different asset classes. Some of the factors are as follows:
Interest rates have been on the rise and this is bad for the bond market (in the short term) because it drives bond prices lower. The Federal Reserve had signaled more rate rises to come which has put further pressure on the bond market. When rates reach a certain level, it also puts fear into the stock market. At a certain rate, investors may forego the risk of stocks and buy risk-free U.S. Treasury securities. There is no magic interest rate where this occurs but when the 10 Year Treasury reaches 3% or above it starts to get investor attention.
At this week’s meeting of the Federal Reserve, Chairman Powell signaled that rates are near the Fed’s target level. This implies that after the December rate hike, the Fed may back off raising rates in 2019. As a result, Wednesday saw a major rally in the stock market.
A prediction of slower growth in China has driven commodity prices lower. In the case of oil, there is a glut of oil on the market and supply & demand forces explain the recent drop from $70 per barrel to $50 per barrel.
Wages in the U.S. have risen this past year in excess of 3% for the first time in several years. That indicates inflation is on the rise and prices could be going up next year. Markets don’t like inflation.
An important meeting of the world’s largest economies takes place this weekend in Argentina. Investors are holding their breath over the outcome of talks from the U.S. and China about tariffs. There have been $250 Billion imposed by the Trump Administration on China with another $267 Billion threatened for January. Negative effects of these tariffs are being felt across industries and countries. Before long the price of toilet paper and shampoo (read: most things) on the Walmart shelves will see noticeable increases in price.
If there is an indication of progress between Presidents Trump and Xi, we’re likely to see a stock market rally for the end of the year. If the talks yield no progress, or if the tone is gloomy, the market is likely to react forcibly negative to the downside.
The timing of these economic and political forces are impossible to predict but years of data support the notion that a portfolio built and managed around a target asset allocation is the best way to make money over the long term. A recent example illustrates the point. From November 9th through the 23rd the S&P 500 dropped 10.2%. During that same period the U.S. Bond market dropped .42%. While they moved in the same direction the magnitude and effect of these moves on a portfolio was dramatically different.
Stay tuned for a fascinating few weeks in the U.S. and Global financial markets.
