Equity market volatility in October is almost as seasonally reliable as the colorful fall foliage, though certainly not as enjoyable. Recent moves down in U.S. equity markets of -5% to –7% raise the important question of whether this is the beginning of a bear market or simply a market correction. Over the past hundred years in the four largest global equity markets, there have been 41 bear markets and 30 market corrections with average declines of -37% and –15% respectively.
One can make solid economic arguments why we might be at a market tipping point with risks tilted to the downside versus an extension of the long-term bull market. It is reasonable to assume that the budget stimulus and 2017 tax cuts have mostly run their course. Late cycle pressures on corporate profits with unemployment at 3.9% and inflation edging higher are also materializing. Finally, the bilateral scrimmages over tariffs are also having some impact in certain sectors.
If you survey a broad list of financial global markets, across equities, bonds, commodities, and credit, almost 80% are in negative territory for the year, particularly when measured in USD. In addition, the returns year to date in the U.S. equity market have been disproportionately driven by a limited group of large cap technology and healthcare stocks. Therefore, it is concerning to note that global returns are primarily concentrated in U.S. equity markets across a limited set of names in an economy where the Federal Reserve is raising short term interest rates. Historically this is typically not a favorable scenario for equities.
We agree that there are good reasons for the equity markets to correct a bit, particularly given the year to date returns, pending mid-term elections, and the economic factors noted above. However, the argument for a bear market and a sharp sell-off consistent with historical return averages appears unpersuasive. The Fed has clearly announced its intention to move rates gradually to a neutral level (between 3% – 5% when adjusting for expected GDP growth and inflation). Corporate profits are expected to be up +21% on average, and GDP has averaged +4% growth in the third quarter. Inflation remains favorable. While the market will naturally correct for the changes in interest rates, the underlying factors for driving Fed interest rate policy remain positive for the U.S. economy and equity markets.
We are monitoring three global economic and geo-political trends and one discrete political event:
- Continued U.S. GDP growth driven by sustained corporate productivity and profitability and declining regulatory burdens;
- Market driven increases in interest rates beyond neutral levels into a tightening range;
- Further escalation of Sino-American tensions across both economic and military spheres;
- U.S. mid-term elections.
Our diversified risk-based investment strategies are designed to withstand both sharp market corrections and bear markets without altering our clients’ future financial goals. Our core strategies typically have 40% less risk than all equity investment portfolios, which matters when markets drop sharply. We run stress test scenarios on our core strategies based on historical market declines to assess expected future performance in bear markets and have been quite pleased with the results.
Therefore, we do not anticipate any significant portfolio rebalances given market conditions. However, adding to cash positions or short dated fixed income securities (from 2% to 6%) should markets resume a continued move down would be considered.
The attractiveness of fall foliage comes with beauty and the realization that eventually seasons change. Our current economic landscape remains appealing, but we know that all bull markets come to an end. Presently, however, we still see bright color and leaves on the trees when it comes to the economic landscape and US equities. May you enjoy the fall and the beauty that it offers!
 Bridgewater Daily Observations, Oct. 5, 2018
 BDO, October 5, 2018.
 The sizing of the increase in cash equivalents would consider the likelihood of a bear market adjusted for the average market decline (i.e. 10% x -37% = 3.7%).