Volatility Takes Center Stage

The fourth quarter of 2018, through December 26, has been a “bear”.  Despite a crazy record-breaking 1,000-point rally on the day after Christmas, preceded by a 600-point drop on Xmas eve, the S&P 500 still shows about a -6% total return loss on the year; with Q4 producing a -15% loss all by itself!

All major asset classes, not including cash, produced negative returns during 2018.  Emerging markets and international developed markets, the favorites of thought leaders for 2018, came in last at about -15%.  Small cap U.S. equities were down about -12%, REITs were down -7%, and even gold was down -3% (despite strong Q4 of +6%).  Bonds were least hurtful with broad bonds only slightly negative at -1%, but short Treasuries showed positive +1% returns.

Leading into the market open on December 27, futures point to a -1.5% retracement after the 1,000 point rally.  Expect more volatility into January as most portfolios get rebalanced back to targets after equity losses.  Selling bonds and buying equities, to get back onside, could prompt a pop in January, but underlying fundamentals should still lead the way.  We are watching the January 3 PMI (and LEI) for confirmation that the economy is still stable.

Tony Ash

December 27, 2018  8:40AM

Trading Places

The worst Xmas Eve stock market performance, ever - that is what CNBC commentator Bob Pisani reported.  Certainly, it was an eventful way to cap off the past few days of selling going into the last trading days of the year.

Utilities, one of the last sectors of the market to hold onto some semblance of rationality, got pummeled in today’s shortened session, down -4.2% (XLU) whereas previously pummeled financials were down only -2.1% (XLF) and the S&P 500 was down -2.7%.  High div stocks were indiscriminately torched with VIG, VYM and DVY, the three largest dividend-paying ETFS down -3% or more.  SPHD, the low vol ETF with a curated collection of the 50 least volatile stocks in the S&P, likewise got thrashed with a daily return of -3.4%.  Bonds continued their (mostly) negative correlation to equities with the AGG ETF flat on the day and long treasuries (TLT) up +0.5%.  Bonds with some equity exposure, though, were hurt with high yield and bank loans both down about -0.75% on the day.

Despite the media proclaiming all of the root causes, including political dysfunction, tightening Fed, and trade wars, all of these factors have been with us for quite a while and did not cause the pain we are seeing until the beginning of October.  Yes, a tightening Fed is likely to cause slower growth in 2019, but not to the extent that the markets are discounting.  In fact, most government statistics and corporate earnings results continued to show positive signals; the weakest signal we have seen is the trading momentum; which is like saying “the market is weak because the market is weak”.  The inverted yield curve between 2s and 5s is likely only a supply/demand artifact that includes influences from overseas markets and is not in and of itself an indicator of a pending recession.

In the face of huge market weakness, it is not reasonable to be bullish.  But, until we see more signs that something fundamental has changed (e.g., a weak PMI or LEI stat), we cannot be certain that we have entered a market with a larger prolonged downdraft.  In the absence of that, I continue to be cautious but hopeful that the fundamentals will rule the market trend and resume an upward bias.

Tony Ash

12/24/2018

Market Volatility Update: December 21, 2018

More pain in the market this week with S&P down -6%.  Though it is safe to assume we will get some slowing in the economy due to this hawkish Fed, we can’t be convinced that it will translate into a larger drawdown (like 2008-09) until we see some other signs.  I (almost) never make market calls, except in the case of a market crisis that leads to a large and long drawdown.

We have two factors currently telling us that the potential of a larger drawdown is possible:  weak price momentum and the yield curve tending to invert (2s-5s; though 2s-10s is better indicator).  Other factors that we look at are still positive such as Purchasing Managers Index (“PMI”, still growing, though less so), Leading Economic Indicators (ditto), and “Financial Turbulence” (a sophisticated measure, but generally flashes a warning sign when returns, correlations, and volatility start deviating from norms; still ok).  Some other factors pointing to “risk off” include relative strength in defensive sectors like Utilities (yes) and Treasuries (yes).  If one or two of the factors turn negative, we could be in for a larger protracted drawdown; we won’t know that until January 3 for the PMI release.  In that case, and depending on the specific client situation, I could be inclined to move some client assets into long maturity bond ETFs or cash, depending on what is driving the dive.  We would get back into the market when the indicators turn positive which could take months!

When is $1 million NOT $1 million?

By now, most every media outlet has run their own take on the GOBankingRates study on how far $1 million will go in retirement in each state.  The study looked at the cost of normal expenditures for the average 65-year old including things like groceries, housing, utilities, etc.  They then factored the expenses by the cost of living index in each state.  Not surprisingly, Hawaii, California, Alaska, New York and my home state of Massachusetts are the most expensive and Mississippi, Arkansas, Oklahoma and Michigan are the least expensive.

Thankfully, some media outlets, including Bloomberg and Huffington Post, thought to question some glaring omissions in the study, but others including CNBC and USA Today merely “parroted” back the results.

The problem with studies like this is that they inevitably rely on averages and ignore the fact that personal situations are the most important factor.  For example, housing costs based on current market levels are mostly irrelevant for a 65-year old who has paid off their mortgage and has no intention of moving, though taxes and upkeep would still be a factor.  Likewise, no reference is made to future inflation or inflation specific to how a person currently or prospectively would spend their money.  Also, no reference is made to expenses for entertainment or travel.  However, the biggest gap in the study is the lack of details related to taxes.

The study seemed to imply that the fictitious 65-year old had $1 million in cash in a checking account to pay their bills.  Of course, if the $1 million was in a retirement account (401-k, IRA, or similar) all withdrawals would be taxed as ordinary income with the requisite income tax liability, depending on the personal tax situation.  Hopefully, this person has other income to pick up the shortfall due to the income tax liability.

It seems that every time we read a story about “your number,” the tax aspect is ignored.  This is certainly due to the difficulty in capturing all the brackets, exemptions and nuances in the U.S. tax code.  However, we at least need to grasp a simple view of the matter so as not to misstate the situation.  In fact, assuming a modest 15% marginal tax bracket (up to $75,900 for married filing jointly) and 5% state tax rate, your $1 million is worth significantly less in spendable cash once it is withdrawn from tax-deferred accounts. 

In round numbers, the $75,900 maximum annual income in the 15% bracket is only worth about $60,720 (75,900*0.8 Federal/State tax) in after-tax income each year from a tax-deferred account.  Withdrawing more would bump you into a higher bracket and provide a progressively lower amount of net income after tax.  In round numbers, $1 million sitting in a tax-deferred account is worth only about $800,000 of net income if you net out the $200,000 that would be due in taxes from annual withdrawals of $75,900 over a 13-year horizon.  For simplicity, I left out the interest-on-interest component; but, assuming a 3% annual return the time horizon would be extended by 4 years.

Tony Ash, 8/29/2017