• Derek Prusa

5-Minute Market Update | January 2, 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 mixed as international stocks experienced the largest gains and small-cap US stocks experienced the largest losses. S&P 500 sectors finished the week mixed as defensive sectors generally outperformed cyclical sectors.

Technology, consumer discretionary, and materials were the strongest performers in 2017 while energy and telecommunications were the only sectors with negative performance for the year.

Commodities: Commodities were positive for the second consecutive week as oil prices increased 3.34%. US crude oil rose above $60 a barrel for the first time since June 2015 on the finial trading day of the year as an unexpected fall in American output pushed prices higher. Oil prices have closed the year with strong gains as there are signs the global supply glut that started in 2014 is finally shrinking.

Gold prices rose 2.39% as the dollar declined, helping push gold to a 13.85% gain for the year (its strongest annual gain since 2010). A weaker dollar makes dollar-denominated assets, such as gold, less expensive for holders of other currencies, pushing prices higher.

Bonds: The 10-year treasury yield fell from 2.48% to 2.40%, resulting in positive performance for treasury and aggregate bonds. Yields have retreated from the highs experienced immediately following the passage of tax reform, but expectations that the Fed may hike rates faster than originally anticipated amid stronger economic growth remain.

High-yield bonds were positive credit spreads remained steady during the week. If the economy remains strong and healthy, higher-yielding bonds are expected to continue outperforming aggregate bonds as they offer higher interest payments and the risk of default is moderately low.

All indices finished 2017 positive, with equity markets leading the way while commodities and bonds lag behind.

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 21.10, 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 slightly negative for the week, snapping a streak of five consecutive weeks of gains. However, the Index experienced strong gains in 2017 and remains firmly in the upward trend that began in mid-February 2016. Shorter-term momentum has slowed in recent weeks, but the Index closed at a new all-time high 62 times in 2017, representing the second highest tally of new highs in history (behind the 77 all-times highs recorded in 1995) and illustrating there may still be further gains ahead. While volatility and downward pressure have slightly increased, 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 381 trading days – the third 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 bullish pattern for now.

*Chart created at StockCharts.com

With 2017 in the books, what can we expect going into the new year?

2017 started on a positive note for broad equity markets and never looked back. US stocks experienced their strongest year since 2013 while international stocks saw their strongest gains since 2009. As equity markets soared, volatility and downside risk were all but non-existent for most of the year as any “pullback” seemed to offer further buying opportunities for investors. Even geopolitical fears such as tensions between the US and North Korea and tax reform uncertainty did not derail stocks. In fact, the largest drawdown for the S&P 500 based on daily closing values was only 2.86% in mid-April, marking the least severe drawdown in a calendar year ever (the previous record was a 3.3% peak-to-trough drawdown in 1995).

As stock markets moved higher with little resistance, other asset classes experienced more headwinds. Commodities were sharply negative at the midway point of 2017 before rebounding sharply to finish the year positive overall. Bonds also experienced some resistance as the expectations of higher interest rates persisted through the year, though broad bonds experienced modest gains.

Moving into 2018, many experts expect a similar story to 2017, though maybe to a lesser extent than the past year. With improving economic growth and rising corporate earnings, along with a potential boost from tax reform, stocks seem to still have room to run higher. However, investors should prepare for higher volatility at some point as it is unrealistic we will see the same low levels volatility and essentially no drawdowns through the upcoming year.

If economic growth continues to improve, interest rates may continue to rise at a gradual pace as the Fed currently has plans for three rate hikes in 2018. With potentially higher interest rates, bonds may experience another year of steady, but suppressed gains as bond prices move inversely to interest rates.

Though the prospects of 2018 appear positive as we start the year, 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.


Derek Prusa, CFA, CFP® Senior Market Analyst

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