CURRENT COMMENTARY

The last few months have experienced negative market action tied to several factors, some of which have abated, but some of which have lingered. The pressing economic issue of these times is inflation, and along with that the necessary adjustments to interest rates required to combat it. After over a year of denial, the Federal Reserve has come to acknowledge current inflation trends are not merely “transitory”, but structural. There are three fundamental reasons for the recent run-up of inflation. And it is because three factors all came into play at the exact same time that inflation so rapidly went from subdued to the worst in four decades. One of them is supply chain restrictions resulting from lingering Covid imbalances in labor and materials, hindering manufacturing. This is the least significant of the three, but still impactful. The other two go hand-in-hand and have the greatest impact, and those are too much fiscal and monetary stimulus. The monetary side of this ledger has been the policy of holding emergency-level quantitative easing and interest rates for too long. In other words, interest rates have been too low for too long, and Federal Reserve purchasing of Treasury debt and mortgage debt has been excessive, exploding their balance sheet to nearly $9 trillion. Finally, these imbalances are being corrected, with the Fed scaling back and soon completely halting its quantitative easing, and scheduling interest rate increases starting this month. Just a couple weeks ago, the futures markets were pricing in a half-point increase at the March meeting being more likely than a quarter-point increase. That has now flipped with the Russians invading Ukraine. More on this below.

On the fiscal side, over the last couple years, in response to the pandemic, the federal government flooded the economy with trillions of dollars of additional spending, often without regard for where it was going, who was getting it, or if it was even necessary. While we had certain reservations as to the magnitude and nature of some of these efforts at the time, no one knew how the pandemic would play out, so fair enough regarding those early efforts. We won’t Monday-morning quarterback those early decisions. But along the way, even with indicators questioning the need for continuation, and in many cases those programs being counterproductive, they have kept pumping the economy with more money than it could absorb. We wrote about this at the time in our newsletters, so we won’t relitigate that here. This is the fiscal over-stimulus part of inflation. When any economy of a given size is fueled by cheap borrowing costs and more cash than it can absorb, prices are bid up on the things people want, because buyers have more money to spend and supplies are limited. This is Econ 101. Supply and demand. This brings us to the one concern that has largely abated which is of the legislative risk nature. The previous proposed Build Back Better plan would have resulted in trillions of dollars of additional spending and regulation, coupled with a multi-trillion-dollar tax increase component. This would have exacerbated the problem by adding even more dollars chasing still-limited goods and services, jacking up inflation further. And, the added burden of higher taxes would have resulted in a certain recession. However, with this legislation likely permanently sidelined, that risk is severely reduced. That alone calmed the markets earlier this year for a while.

This led to the market re-focusing on the inflation/interest rate issue, along with positive corporate earnings resulting from a healthy economy and labor market. Just yesterday the Labor Department reported unemployment at 3.8% and new jobless claims for last week coming in at a low 215,000. The underlying economy, working off the 2017 tax rates and no damaging policy disruptions, is emerging from the pandemic nicely. The result of all this was the market working on a technical bottom to the correction we are in. Until a week and a half ago. The Russian invasion of Ukraine is now adding an additional element of uncertainty to the equation and specifically the energy sector of the economy. Now, the futures markets are pricing in an almost-100% chance of only a quarter-point rate increase this month, which was largely confirmed a couple of days ago by Chairman Powell’s comments. The markets had a nice positive reversal a week ago as it appeared the Russian army has had more trouble than anticipated in conquering the scrappy and brave Ukrainians. That reversal has led to a new rally attempt, which any day now could lead to a follow-through day, marking a new uptrend. But, with the attack on the Ukrainian nuclear power plant yesterday and evidence that Putin’s frustrations may lead to him taking more desperate measures, uncertainty continues to rule.

At this point, we will continue to study the technical action and focus on long-term fundamentals. Patience is warranted. We’ve made some incremental portfolio adjustments and will do more as necessary if warranted.

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CURRENT COMMENTARY

Building on our last Commentary update from last spring (see below), the markets are back to experiencing some extreme volatility. The difference from then to now is that the Federal Reserve has finally recognized that the inflation they earlier saw as “transitory” is actually here for a while, and action is needed to control it. The Fed’s mandate is for stable prices and full employment. Calls to broaden their areas of responsibility are unwise, but that’s a discussion for another time. For now, the markets are adjusting to the affects of impending Fed tightening. This is necessary, albeit painful, and many growth stocks will be affected the most as their prices are heavily influenced by future earnings, which inflation dilutes. This period of adjustment may go on for some while longer, and we have not yet seen sentiment reach the extreme fear levels notable at market bottoms. But those levels of fear tend to come with little notice, and the resulting bottom establishes itself unpredictably. So, as hard as it may seem, patience is warranted as this plays out. If we were looking at an impending recession, that would be different, but at this point we are not.

The labor markets are holding firm, and the unemployment rate is low. Supply chain imbalances are starting to work free, and that will aid in slightly bringing down inflation. Corporate earnings are holding up, but guidance is mixed. The pandemic has transitioned to an endemic and the Omicron variant, which is more contagious is also less lethal, so we’re collectively starting to just live with Covid. This is good for getting back to normal. Also on the plus side, we are still operating under the 2017 tax structure, and it appears the proposed spending and tax legislation has stalled completely, avoiding damaging inflationary spending and growth-inhibiting taxation. This should hold back recession concerns. This leaves the main driver the inflation and interest rate question. What was previously expected to be three quarter-point increases during this year, is now being priced at four or five. We won’t know what initial actions the Fed will actually take until they conclude their next open market meeting.

Since we know interest rates and bond values move inverse to each other, we have started paring back fixed-income exposure and expect to hold more cash for the duration of the upcoming interest rate cycle. Stock prices are also reacting negatively, but for the immediate period, we want to see how fear gauges play out and are looking for a short-term bottom. These initial reactions tend to lead to overselling, which corrects itself. Many indexes have already slipped into correction territory and some asset classes are in bear markets. But in the absence of damaging policy changes, this may not last much longer. We are monitoring events closely.

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CURRENT COMMENTARY

The recovery from last year’s Corona Crash was dramatic to say the least. Fundamental economic conditions that created the growing economy and greatest labor market in two generations prior to the pandemic, also laid the groundwork for a recovery that was unprecedented in recent history. But now the markets are signaling some warnings we had better pay attention to. While some equity market indexes reached new highs just a week or so ago, others peaked three months ago. And during this time, the fixed-income markets have come under stress. The main driver of this is inflation and tax concerns.

We have enjoyed quite benign inflation for a few decades, but this is showing signs of being interrupted. Recent inflation figures have come in at an annualized rate of over 4%. This is more than double the Federal Reserve’s target rate. The bond markets have been reacting to this. The Federal Reserve has made it clear over their last few statements that they see no conflict with continuing to buy federal government debt at a pace of at least $120 billion per month (known as quantitative easing), holding interest rates to zero for a couple more years, and somehow containing inflation. They view the recent uptick in these inflation figures as “transitory”. The markets aren’t buying that. As a result, in order to defend the dollar, interest rates are rising. Interest rates move in inverse relationship to bond prices. Hence, the bond market has been selling off.

Stocks are also sensitive to these conditions. In particular, technology companies are quite interest-rate sensitive as they are not capital-intensive, but more intellectual-property oriented, and as such rely on strong forward earnings growth projections. Future profits are put at risk when inflation erodes the value of the dollar. As a result, large-cap tech stocks have declined over the last couple months in recognition of this risk. These are the very companies that led the pack in the stock market’s recovery over the last year.

Coupled with this is a divergence in the labor markets. The recovery of many industries is being hampered by a lack of workers to take jobs that employers are offering. The most recent Bureau of Labor Statistics’ Jolts Survey reveals that a record 8.1 million job openings in March are going unfilled. This exceeds the number of unemployed. In other words, there are more jobs available than people who need jobs, but these positions are not being filled. Many governors and business leaders are making the case that the enhanced unemployment benefits in place until September are creating a perverse incentive not to work. The average benefit now exceeds the income a worker can make at a $16-per-hour job. If someone can make more money for not working, it shouldn’t surprise anyone when people decide not to work. The Biden Administration sees no correlation with this, but this Jolts survey from their own executive branch suggests otherwise. Flooding the economy with even more “stimulus” checks is also distorting economic equilibrium. There are some disruptions with the supply chain, predominantly in the chip and micro-processer areas, but these labor market distortions are not mainly happening in those affected industries, so it can be concluded that is not the cause.

The other situation that is alarming to the markets is the administration’s proposals to raise top-tier income tax rates, the corporate tax rate (and eliminate other currently-favorable corporate tax provisions), and most damaging – nearly double capital-gains tax rate on high earners. These would, if enacted, place severe downward pressure on investment assets, which are priced for after-cost and after- tax returns. Our competitiveness in the global economy will be greatly compromised. These taxes would do significant damage to the labor markets, distort efficient allocation of capital, and they don’t even bring in much in the way of revenues. Combined, they cannot come anywhere close to paying for the massive spending proposals presented. In fact, history shows that raising the capital gains tax rate reduces revenue as investors decide not to sell and realize those gains. So, either we continue to run unsustainable deficits and debt levels, or the middle class will get hit with major tax increases. The market is realizing this as well.

All this is to say that we have a strong recovery going that is not in need of continued emergency-level intervention, but the very provision of this intervention is now causing structural economic problems that the market is sending warning signals about. As of now, some technical indicators are showing some mitigation. Since the tax increase proposals have not resulted in legislation, and many politicians are against them, this threat is being watched but not yet acted on. Inflation figures can be volatile and a few more months of data will help in clarifying the extent of this problem. The governors of several states are foregoing the federal government’s enhanced employment benefits in order to prevent the damage to their workforce. And, many measures of market volatility indicate increased fear, which is a contrarian indicator and is actually good for market health. As the market technical indicators are not yet in correction mode, the best course of action at this point is patience and a bias toward market participation. But we’re watching this closely, and are concerned. Defending the great gains of recent years will be our priority.

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CURRENT COMMENTARY

As we head into the Easter weekend, with Good Friday tomorrow closing the markets, we’ve seen some encouraging market action. What will henceforth be known as the “Coronavirus Bear Market” has really tested investors in ways never really seen. But, while this virus continues to spread globally, and the economic damage it will ultimately wreak is not even fully revealed, there is reason for optimism. The market’s recent bottom occurred on March 23. Over the last couple weeks, we’ve seen our normal new confirmed uptrend pattern: a reversal day accompanied later by a follow-through day whereby large institutional investors poured money into the markets with heavy volume. This follow-through day was on day eight of the attempted rally, and the usual pattern is for that to occur between the fourth and seventh day, but there is plenty of precedence for successful later follow-through days. And since then, market action and chart behavior has improved further. This does not guarantee the current uptrend will continue, but each day that new gains are posted gets us farther away from that bottom, rendering it less likely that low will be undercut and kill the rally. That’s the dry but positive technical picture.

On the human side, just as we expected, this disease’s infection tally has been increasing, and will continue to do so. This stands to reason as we have not yet seen the peak and more comprehensive testing is leading to more infections being identified and therefore counted. And, along with increased infections has come, and will continue to come, more unfortunate deaths. The bright side of this are the reports of the pace slowing and pressure relieving somewhat on medical facilities and staff. At this moment, it appears the United States will escape the fate of some other countries’ healthcare systems, which have been overwhelmed. Our care centers are being monumentally stressed, for sure, but not swamped. At least not so far. For the reasons we’ve previously stated, expect our nation to lead the world in cases, and ultimately deaths. At least as to what’s officially reported. Recent stories validate our suspicion that China’s cases were vastly under-reported. But no matter how we analyze it, this has been a human catastrophe.

It’s quite possible that as this virus runs its course, the total tally of infections and deaths will be in line with that of other flu-like illnesses that occur continually. What makes this different are the economic effects of efforts to halt the transmission of the disease. The official narrative is rightly shifting to focusing on getting this economy and its workforce back on the job. This is what the financial markets are sorting out and reacting to now. If the nascent leveling off of cases continues as expected and we start to incrementally re-open businesses, we can presume a resumption of some semblance of normalcy in mere weeks, not several months. Completion of the process will take months, for sure, but progress toward full growth should commence soon. While a second wave or relapse might occur, promising news on a daily basis seems to argue against that for now. We’ve put new cash into the market over the last couple weeks, and will closely watch what comes about in the near future.

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CURRENT COMMENTARY

The correction we are now in has cascaded into a full-blown bear market as of yesterday’s decline. Technical action during the day, especially leading into the close, had the earmarks of a capitulation day, whereby fear crescendos, holdouts finally have had enough and throw in the towel, and very few sellers are left in the market. Whether or not that turns out to be the case, and today’s early market-open stabilization forms a bottom, remains to be seen. However, the action of the last few weeks has been that of classic panic selling. That is always difficult to assess along the way because it isn’t based on sober analysis and rational thinking. It’s emotional and fear-based and therefore impossible to quantify.

The media are in the business of creating sensational, attention-grabbing headlines and talking points. This doesn’t help in sifting through the actual facts to make informed decisions. Some of what is said is just plain false. The press widely reported last week that President Trump characterized the coronavirus as a hoax. This was done to present the notion that he appeared cavalier, unconcerned and lacking in leadership. But that’s not what he said. What he said was the criticism of his administration over this issue was a hoax. It can be left up to each individual to determine if that mischaracterization was intentional. Other media reports are merely misleading. Just today, the Wall Street Journal’s front-page headline reads, “Virus Batters Economy”. But that remains to be seen. Yesterday, the virus battered the markets. The markets are an estimated reflection of the future of the economy. But they are not the economy. But it’s scarier to claim the economy is being battered. Further, we have to look deep and far to find news that puts this into perspective. For example, it is not widely reported, but can be discovered, that nearly 70% of all the cumulatively-infected people worldwide have already recovered. They are back to the level of health they had before they contracted the virus, or if they’d never have gotten it. We don’t want to appear callous, but let’s also remember that just in America alone, every year, about 29 million people get the flu and on average between 30,000 and 70,000 die of it. That doesn’t tank the markets and send people running to the store to clear out shelves. And the vast majority of casualties have been among the old and already weak, not the general population. Globally, since this outbreak started in China several months ago, about 138,000 have been infected, and a little over 5,000 have resulted in deaths. Already, the pace of new infections is declining in most areas, due to measures being taken to prevent exposure. As we move into warmer months in the northern hemisphere, people will be opening windows and flushing stale air out of buildings, and spending more time outside where the atmosphere dissipates concentrations of germs. This is not to say we shouldn’t take reasonable precautions, or dismiss the disease entirely. But let’s not lose our heads. How many months’ supply of toilet paper do you really need? Is Advanced Micro Devices really worth only 60% of what it was three weeks ago?

To be sure, there is no doubt there will be deleterious effects on the global economy, and this has not fully yet run its course. Certain sectors like travel, leisure, conventions, sports, and retail will take hits. Other sectors of the economy will weather the storm more successfully. But this will blow over, and likely sooner than many think. We can expect the total infection and death count to rise all the way up until this is over. So don’t be surprised to read that. But as the rate continues to level off, this will not afford us any new news we can’t already anticipate. Markets will start pricing in the calculation of the actual economic damage and its expected duration and it will very likely reveal this panic selling to be overdone, and recalibration to the upside may well be quite swift. Warren Buffet has warned that the market is a mechanism for transferring wealth from the impatient to the patient. Let’s be the beneficiaries of patience.

In times like this, and we’ve seen plenty of them over the decades, it helps to keep in mind what really drives long-term market trends. Those factors are economic fundamentals which impact corporate earnings, and therefore the value of companies. That’s what stock prices reflect. Let’s review where that stood before this correction started, because they are still in place. Economic growth was accelerating. The labor market is the best it’s been in over 50 years, and just a week ago non-farm payrolls, which were expected to rise 177,000, instead came in at 273,000, and the previous two months’ job gains were revised up a total of 85,000. Inflation is non-existent. Interest rates are more than just accommodative, and are loosening further. The other cloud over the economy, trade battles, have been dissipated. Corporate earnings were on the rise. The point is, prior to the Covid-19 coronavirus spreading across the globe, the American economy was in an uptrend. It is well positioned to withstand this shock. Since then, the government has announced a series of policies to provide assistance to the most highly-impacted among us. The Federal Reserve has injected an additional $1.5 trillion of liquidity into the economy. Last week they lowered the Fed Funds rate 50 basis points, and they’ll likely loosen more next week. We actually think this will not do any good because lower interest rates will not create a vaccine. Economic activity is not contracting because borrowing costs are too high. It’s happening because people are self-quarantining to halt the virus’ spread. Still, lowering rates may provide a bit of a positive psychological boost, which should not be discounted, as we’ve seen the negative psychology of this pandemic become un-moored from reason. Our hope is that the Fed has the discipline and presence of mind to walk back these rate movements when the anxiety subsides.

Already, we’re seeing previously-shuttered factories, manufacturing facilities, and businesses in China reopen – even in Wuhan. This will also happen in South Korea, Italy, and other hard-hit countries. The incubation period for the virus has been revealed to be about five days, not the two weeks previously thought, and the illness period runs a couple weeks. So, with the quarantining measures being taken, which are lowering infection rates, we will soon see this thing die down. The decline in economic activity has, and will continue to, deplete inventories. Those inventories will have to be replenished, and pent-up demand will drive a new wave of growth. We don’t know when that will start, but we do know it will happen. The market will recover from this and go on to new highs. It always has. Just a year and a half ago, the fourth quarter of 2018 looked pretty bleak. But 2019 was a stellar year, and just a month ago, all the major indexes were at all-time highs. This will happen again. Down the road, when viewed in the rear-view mirror, this will be known as a great buying opportunity for those with fresh cash to deploy. This is why many of our clients are making substantial deposits to their portfolios. But even if we can’t come up with new cash, not selling near a bottom is wise. That will pay off.

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CURRENT COMMENTARY

It’s been a rough week-and-a-half for investors, that’s for sure. Most of what makes this correction so unnerving is its pace. This is the fastest decline into correction from a market high in history. In just six trading days, the NASDAQ lost over 12% and the S&P 500 over 10%. Both of those indexes hit all-time highs the day before the first decline. Usually, corrections of this depth take weeks to build up. This, in an of itself, is a bit of a small bright spot. The reason is that almost exclusively, bear markets – the really nasty, deep, long-lasting declines – begin very gradually. Corrections that go on to recover more quickly tend to be more violent and dramatic in their early declines, such as this has been. Of course, there is no guarantee that previous patterns will never be violated, but when we’re assessing damage in an effort to determine a course of action from the current point, relying on steady patterns of previous market behavior is helpful. History repeats itself with regard to market action.

Whenever health-related issues, such as this coronavirus outbreak, become prominent news, that too is unsettling. It doesn’t help that the media has fixated on sometimes hysterical and incorrect reporting. We guess that sells newspapers and website hits, but it doesn’t inform us properly. We saw one headline earlier this week, which stated in percentage terms, that day’s 4.4% loss was the greatest in history. That’s blatantly false. In October of 1987 the DJIA lost 508 points, but back then, that was 22.8% in one day! We did have history’s greatest DJIA point loss Monday, but that was only the 229th largest percentage loss recorded. That was edged out very slightly for the top spot yesterday. So, not as dramatic, but certainly sensational! We’re not trying to minimize this rout, but let’s be clear: we will always and forever have increasingly-more dramatic point movements – both directions – on big action days simply because the indexes have gone up so much. And, as our portfolios rise, we will always and forever have greater dollar swings as well, for the same reason. It’s the percentages that matter, especially when comparing to historical movements.

So where do we go from here? We’re maintaining that staying put, and not selling into this weakness, will reward patient investors. Nothing has been reported negatively about the economy itself to alter our assessment of strong underlying fundamentals. The VIX volatility gauge has surged more than 20% above its 10-day moving average, and is more than 68% above its 10-day line, indicating the fear in this stock market is severe. The put-call volume ratio hit 1.21, above the key 1.15 level for the first time since early October. A reading above 1.15 can help confirm a low in the S&P 500 and Nasdaq. This market has gotten oversold on fear. Keep in mind the VIX and the put-call ratio are secondary indicators, and don’t take precedence over the price and volume action of the indexes. But they indicate extreme fear and panic selling. And, they’ve been quite accurate in finding bottoms. We don’t know how much lower this will go, or how long it will be before a new uptrend resumes. But over the decades we’ve been in very similar situations many times, and we’ve proven over and over that keeping cool is an investor’s ally.

While it may seem scary or even crazy, we all know the recipe for investing success is to “buy low and sell high”. This requires that we have the presence of mind and courage to actually invest when markets are low. And when are markets low? When bad, scary news has driven them down, that’s when. Our most experienced clients are contacting us about adding to their accounts. Infusions of cash at times like this allows us to practice the above-mentioned strategy. We can’t invest cash we don’t have in client accounts. On the other hand, as our clients well know, we never put new money to work in weak markets with bad technical indicators. We are in a technical correction. We will sit on any new cash until we launch into a new confirmed uptrend. But cash must be on hand then. So, if you’re inclined, now is the time to arrange for deposits into accounts.

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CURRENT COMMENTARY

Yesterday, the market indexes took their biggest hit since December 2018, with broad selling across most sectors. Concerns about the coronavirus outbreak had been reasonably contained until late last week, when reports of more infections spread beyond China. Over the weekend, outbreaks surprised people in Italy and South Korea. Estimates now indicate that the effects of the various efforts to contain the virus could shave $1 trillion off of global GDP. So far, the United States has been little affected by the actual virus itself, but shutdowns in China and elsewhere are disrupting the supply chain, leading to parts shortages, and that is hampering production. That’s the bad news.

The good news, is the otherwise underlying fundamentals of our domestic economy are quite healthy. Growth remains solid and is improving. Trade barriers are dropping. Wage gains are rising nicely as a by-product of one of the tightest labor markets in half a century. Corporate earnings are coming in ahead of expectations, and productivity continues to increase. Recent market weakness, just days after achieving all-time highs, and prospects for global growth slowing, will only add pressure for the Fed to maintain, or even reduce, interest rates. Inflation is well under control. These are the factors that drive the markets over the longer trends. And this is what we’re focused on as long-term investors. International markets have borne the brunt of this decline, and we are purposely under-weighted in foreign positions.

Another development came to light over the weekend as well, and while it hasn’t been included in news analysis of yesterday’s market activity, we’d suggest it combines with the coronavirus developments to add fuel to the fire, and made yesterday’s decline worse than it otherwise would have been. That development is the strong finish Bernie Sanders made in the Nevada caucus. It appears a self-proclaimed socialist will very likely secure the Democratic party nomination and go up against President Trump in November. Free markets, which are all about property rights – and your investment holdings are your property – do not like the prospect of wealth confiscation and expanded government control over the economy. That lowers the value of all property, including the stock of corporations. One week from today is Super Tuesday, and that will likely define the outcome of that race.

Some sort of pullback was likely to occur in the near term anyway, as the last year of gains have been blistering, and some profit taking is in order. Specifically, the market has posted more than an average year’s worth of gains just since October. These negative developments provided a catalyst for reversal. Today’s market action appears to be a latent follow-up, with continued sliding. Volatility measures and bearish sentiments are rising, which are historically contrarian indicators of market bottoms. Whether or not indexes are nearing a bottom remains to be seen, but we see holding positions, and not selling into weakness, as the prudent choice at this time.

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Current Commentary

It’s de ja vu all over again, as Yogi Berra might have said. Late last year the markets concerned themselves with the health of the economy in the face of two policy issues: interest rates and trade wars. Here we are again. But much like our assessment at that time when it started almost a year ago, we are focusing on the underlying fundamentals. To be sure, these policies are very important and have the potential to derail the aging economic expansion. They should be taken seriously and we are doing so. At the same time, we are still enjoying a pretty strong economy with historically low unemployment and tight labor conditions, increasing wages, improving productivity, and better-than-expected second quarter preliminary GDP gains. As an aside, do you ever wonder why every economic report is characterized as “better than expected”, or “worse than expected”? You’d think these economists would start getting better at their expectations! In any event, the 2.1% GDP gains, while exhibiting some slowing from the previous growth pace, beat consensus analysts’ 1.9% projection. And, to top it all off, quarterly earnings reports have been surprising to the upside significantly. In other words, while the trade and interest rate issues do bear watching, the economy is doing quite well, and that’s what really drives long-term stock direction, along with subdued inflation and accommodating borrowing costs – something we are enjoying on both those fronts.

The investing class was disappointed mid last week when the Federal Reserve announced only a quarter-point easing, but more tellingly it telegraphed no urgency to keep that going. Interest rate watchers were hoping for about half a point and some guidance regarding further declines. They didn’t get it. The markets started drifting down as a result. Then, late last week, President Trump announced additional 10% tariffs on another $300 billion of Chinese imports. Today’s reaction to that, after having digested it over the weekend, is decidedly negative. The one bright spot in all this, is that last week’s declines came in lighter volume, indicating no real appetite for dumping stocks among professional money managers.

As with the 2018 fourth quarter declines, we expect a bit of continued sliding and some kind of catalyst to reverse course. Perhaps it will be the Fed making some sort of musing about “re-assessing conditions”, as they did last Christmas Eve. Who knows? But what we don’t want to do is sell into steep declines when underlying fundamentals are strong. The weakening global economies are of concern, but the domestic economy is holding up nicely. If we were seeing data points indicating an impending recession, that would be one thing. But we’re not at this point.

The question is, how long in the face of slowing non-US economies and continued world trade burdened by tariffs, can the American consumer keep corporate earnings rising?

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RECENT MARKET VOLATILITY

The last few weeks have seen a dramatic level of fluctuation in the stock market indexes. Speculation is rife as to the causes, but it’s safe to conclude a few things about this. First, it’s been an exceptionally long time since a significant sell-off of any lasting value has occurred prior to the first quarter of this year. Investors will recall that after the trade tariff rounds started in the early part of this year, the market regained its composure and went on to post strong gains, leading indexes to new highs just weeks ago. This current round of volatility seems to be centered on increased fears of the Federal Reserve raising rates too quickly and slowing down the economy too abruptly. And, while a trade deal with Canada and Mexico was codified, lingering trade fights with China don’t seem to be getting resolved. Also, of course, mid-term elections are causing anxiety because the current strong economic and employment performance is predicated on continuation of recent policy changes. If the Democrats take over control of Congress, concerns are legitimate that the economy will suffer again, and revert not just to the slow growth of the previous decade, but an actual recession. On the other hand, bills won’t become law if the president vetoes them. We’ll know about that outcome in a week.

But this sell-off, punctuated with recovery days, doesn’t appear to be the start of a nasty bear market. Analysis of the last 65 years of the S&P500 and the past 27 years of the MSCI All Country World markets done by Morgan Stanley, indicates sharp, initial declines are more consistent with run-of-the-mill corrections, not a slide into bear markets. And this has definitely been sharp, with the NASDAQ dropping about 13% and the S&P500 about 10% just this month. It’s scary, but not unusual. In contrast, when bear markets begin, it is with deceptively gentle declines, making it hard to discern what’s going on. Judging from history, this looks like a correction. In the ten largest 35-day selloffs, stocks ended up bouncing back in nine cases. Only one eventually turned into a bear market. The current decline ranks seventh of those ten. Our last bear market in 2007 didn’t even look like this, with no dramatic early plunges. But bear markets come along with recessions. We just received the 3Q GDP report last week, showing the economy continuing to steam along at a 3.6% rate. Unemployment remains at multi-decade lows. This is not an economy sliding into recession. For sure, eventually we will have another bear market and appropriate changes to portfolios will need to be made. At this point, this doesn’t appear to be happening now.

Bull markets don’t die of exhaustion – they die of harmful policy inputs. The smart money rides through most corrections – and this is definitely a correction – as most of them are relatively shallow and short-lived. The key for a long-term investor is to stay put and be invested when the next uptrend starts. It will come without warning and when least expected. If the slide continues to gain steam, we’ll appropriately defend portfolios.

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Current Commentary

Last week’s market slide has been a long time coming. It’s been a couple years since we’ve seen a correction within what is now this 9-year-old bull market. We’ve been getting concerned about the unabated strong run-up lately. Markets periodically need to pause and digest gains in order to stay healthy and keep overall risk for the trend at reasonable levels. Last week, the Dow Jones Industrial Average shed 4.1%, with a one-day 666-point drop coming on Friday. Other indexes were off a little less. While large numerical movements like this can seem concerning, the percentages are what needs to be focused on, and that translates to 2.5%. Long-time investors may recall the market crash of October 1987, when the DJIA fell 508 points. But back then, that represented over 22%! The point is, with an index around 26,000, it takes large point movements to make impacts of some percentage.

Our concern has been complacency. Many have gotten so used to weekly gains that they’ve forgotten about normal levels of volatility. In fact, the last time the technical indicators were listed as remotely cautionary was last August. The catalyst for Friday’s action was ironic: too strong economic data. Year-over-year wage growth was up a healthy 2.9%. Wage growth was one of the many missing components to the lackluster “recovery” from 2009-16. But the concern among market watchers is that this could lead to inflation, which in turn would spur the Fed to raise overnight fund interest rates even faster than they plan to. That drove up the 10-year Treasury yield to 2.852%, creating a bond market selloff. This may or may not be overblown. While Keynesian theory holds that higher earnings are inflationary, that notion discounts productivity gains and myriad other factors and there is scant data supporting this conclusion. But, that fear has some warrant to it since our policy makers buy into this theory, and therefore have a history of acting on it.

However, it bears keeping in mind the big picture. Last week’s collective decline is in the 4% range from peak – not at all worrisome and as we mention above, overdue and in our view welcome. In fact, we’d like to see this pull back at least 5% or more to shake out some fear and build caution. Today, the losses are less, but helping to get there. Also, recent economic data show the nation’s growth rate in the 3% range, which is double the rate over the aforementioned “recovery” period. Globally, the world’s major economies are in sync, which is unusual but positive. Additionally, unemployment is at low levels and most important in this area is labor force participation, which has been climbing out of the doldrums. Recent actions slashing wasteful and burdensome regulations and the brand-new stimulus affects of the just-passed tax reform package are already evident and will keep things moving along nicely. Stock prices are driven by corporate earnings, interest rates, and inflation. The Fed has been concerned of late that inflation has long been stuck well below its target level of 2% (deflation is a major problem, so some level of inflation is necessary). Maybe now, that target will be achieved. Interest rates are rising, but not to dangerous levels and are still quite accommodative for financing growth. And, corporate earnings are being reported as quite strong and will likely strengthen further with more people working and getting paid more, thereby investing and buying goods and services with those proceeds, creating demand.

In short, while we’re always on alert for significant market declines that may warrant protective strategies, the smart money holds steady in most declines since they are usually short-lived and shallow and knowing the start and end of them in advance is impossible. Missing the rebound is more likely to hurt long-term performance than help. So, we welcome this pullback, but will keep an eye on it to make sure we weather it successfully.

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