• Derek Prusa

5-Minute Market Update | February 5, 2018

I am happy to present this week’s market commentary from FormulaFolio Investments. The goal is to give our clients and friends a simple way to see everything they need to know about the financial markets on a weekly basis, in 5 minutes or less. After all, investing should be simple, not complicated.

Market Update

Equities: Broad equity markets finished the week negative as large-cap US stocks experienced the largest losses. All S&P 500 sectors finished the week negative as cyclical sectors underperformed defensive sectors.

So far in 2018 consumer discretionary, healthcare, and financials are the strongest performers while utilities, real estate, telecommunications, and consumer staples are the only sectors with negative performance year-to-date.

Commodities: Commodities were negative as oil prices fell 1.04%. Though it was a negative week, US crude oil prices remain near 3-year high levels as US inventories have continued to drop and OPEC production cuts have supported prices.

Gold prices dropped 1.47% as the dollar experienced its first weekly gain since early December. A stronger dollar makes dollar-denominated assets, such as gold, more expensive for holders of other currencies, pushing prices lower.

Bonds: The 10-year treasury yield rose sharply from 2.66% to 2.84%, the highest level since the beginning of 2014, resulting in negative performance for treasury and aggregate bonds. Yields surged higher as speculation that the Fed may hike rates faster than expected increased following a strong jobs report.

High-yield bonds were negative as riskier asset classes faltered and bond yields increased. However, if the economy remains healthy, higher-yielding bonds are expected to continue performing well as the risk of default is moderately low.

All equity asset class indices are currently positive in 2018 while bonds asset class indices are currently negative.


Lesson to be learned: “The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions.” – Seth Klarman. Markets tend to move in broad cycles. However, when crisis seems to strike (or even when things appear too good to be true), a herd mentality can form as investors copy the behavior of others because they are influenced to act and think in a certain way. By maintaining a broadly diversified blend of asset classes and eliminating emotions from the investment process when making decisions, you can look to take advantage of the major trends caused from the herd mentality, improving your probability of long-term success.

FFI Indicators

FormulaFolios has two simple indicators we share that help you see how the economy is doing (we call this the Recession Probability Index, or RPI), as well as if the US Stock Market is strong (bull) or weak (bear).

In a nutshell, we want the RPI to be low on the scale of 1 to 100.  For the US Equity Bull/Bear indicator, we want it to read least 67% bullish.  When those two things occur, our research shows market performance is strongest and least volatile.

The Recession Probability Index (RPI) has a current reading of 19.28, forecasting further economic growth and not warning of a recession at this time. The Bull/Bear indicator is currently 100% bullish. This means our models believe there is a slightly higher than average likelihood of stock market increases in the near term (within the next 18 months).


Weekly Comments & Charts

The S&P 500 finished negative for only the fourth time in the past 21 weeks as shorter-term momentum dissipated. While the Index was lower for the week, the S&P 500 is still up 51.01% since February 12, 2016. Longer-term momentum remains intact as the Index is still near the upper trading range that has been in place over the past two years, illustrating there may still be further gains ahead despite the shorter-term pullback. Stock markets are still in a historically low risk and volatility environment as there has not been a 5%+ correction for the S&P 500 in 404 trading days – the longest streak in the history of the Index. The coming weeks should continue to provide valuable insight about the near-term direction of the S&P 500, but it seems to remain in a long-term bullish pattern for now.


*Chart created at StockCharts.com

Broad US stocks experienced their worst week since January 2016 as major indices faltered on Friday.

The S&P 500 and Dow Jones Industrial Average Indices fell over 2% on Friday to close the week sharply lower. With the economy appearing healthy and many indicators pointing to further economic expansion, what exactly caused this downward movement?

While broad stock markets were modestly lower earlier in the week, the employment report released on Friday was better than expected as the US economy added 200,000 jobs compared to a 180,000 expected gain. Furthermore, wages rose 2.9% on a year-over-year basis, marking the strongest growth rates since June 2009. Though this data was mostly positive, it sent markets plunging as investors began to worry the Fed may be more aggressive than expected with rate hikes this year.

Generally, as the Fed raises rates (tightens monetary policy), economic expansion begins to slow down. While this is a reasonable assumption in the longer-term, a single strong jobs report does not mean the Fed will try to restrict further economic growth. On the contrary, though the Fed has continued to gradually increase interest rates in recent years, monetary policy remains mostly accommodative as rates remain historically low even after the recent run higher.

Friday’s negative reaction to a strong jobs report seems to have been overstated. It seemed like a massive sell-off, but in reality it may have just been normal market noise magnified by the lack of volatility we have experienced since the end of 2016. Even after Friday’s drop, the S&P 500 is up over 3% year-to-date, which would result in an approximate annualized return of 35% for 2018 if this pace were to persist through the remainder of the year. Even in the strongest of bull markets, stocks will not rise every day / week / month, and periodic pullbacks should be expected. These pullbacks can even be considered healthy for the continuation of a longer-term bull market.

Though the past week seemed like a major downturn, the prospects of 2018 remain positive. However, economic data and market sentiment can change quickly. This is why it is still important to include a broad range of asset classes in your portfolio for more consistent and more stable longer-term results, rather than chasing short-term returns.

As investors, we need to stay committed to our long-term financial goals. All the short-term news and market movements can be the most debilitating of all when it comes to making sound investment decisions; especially if we allow them to influence knee-jerk decisions.

More to come soon.  Stay tuned.

Regards,

Derek Prusa, CFA, CFP® Senior Market Analyst

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