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Calming words amid unsettling markets

watch headlineBy Kyle Tetting

I find myself repeating the mantra that has been the backbone of my ongoing education in investing: “Long-term stock prices are determined by earnings and interest rates.”

That refrain helps investors keep focus on what truly matters and tune out the noise of the current market environment. Still, it’s hard to ignore the recent market weakness.

A late November decline pushed the S&P 500 into its second correction of the year. The broad market index’s price had fallen nearly 10.2% from its Sept. 20 peak. While much of the decline took place during October, volatility has persisted throughout the first two months of the fourth quarter. Unlike earlier in the year, though, defensive positions seem to be paying off this time.

For starters, interest rates moved sharply higher early in the year. The late January stock market decline got little help from bond funds as rising rates put pressure on the prices of even short-term bond funds. This time around, rates have largely held steady, allowing higher-quality bonds to contribute, though investors who reached for yield in lower-quality fare have not seen the benefit of bonds in this latest sell-off.

In other words: Bonds serve to moderate the volatility of stocks in a balanced portfolio and provide a source of uncorrelated returns, but quality matters.

The sell-off that started in late January bottomed nine days later, on Feb. 8. While weakness persisted through the spring, the majority of the selling was swift and orderly. In contrast, the latest correction progressed over two months. It’s too early to say things won’t decline further, but the different durations of the corrections have meant a very different experience despite nearly identical percentage declines. In particular, the slower sell-off has meant more nuance between winners and losers now than during the earlier correction.

In other words: Market corrections come in many forms, and the near-term unpredictability of stocks makes market timing infeasible.

Returns the past few years have been dominated by growth stocks – especially a small number of mostly technology names. But the recent sell-off punished those names more than many others. The Russell 1000 growth index, which was more than 13% ahead of the Russell 1000 value index through the first three quarters of 2018, has seen its lead narrow drastically in October and November. Headlining the shift has been a transition to more defensive names, especially during November.

Historically, utilities, healthcare and consumer staple stocks have exhibited smaller declines in periods of broad market weakness. As growth stocks were being rewarded, those other stocks became largely ignored, in large part because they have less robust growth potential. But, as growth sold off the past few months, utilities and consumer staples have held their own, posting meaningfully positive returns while technology, consumer discretionary and other “growthier” sectors have struggled.

In other words: Trends can persist, though abandoning more defensive positioning comes at a cost, especially during periods of market weakness.

While the latest market correction has taken back some gains from a record long bull market, it has also created some opportunity.

The price-to-earnings ratio for the S&P 500 is now less than 16 times the next 12-months’ earnings, which was the average over the last 25-years. It isn’t fair to say that stocks are cheap just yet, but for the first time in a while, we can say that stocks aren’t a little expensive. While earnings and interest rates drive stock prices, valuation drives potential. A higher price typically suggests there’s less room to grow.

Nevertheless, the latest correction reminds us to temper expectations and reinforces the need for balance. Rather than asking, “What have you done for me lately,” remember the role that each investment has toward accomplishing your long-term objectives. Volatility can be unnerving, which is exactly when a properly balanced portfolio pays off.

Kyle Tetting is director of research and an investment advisor at Landaas & Company.

Learn more
The case for active funds amid volatility, a Money Talk Video with Kyle Tetting
Volatility is back: 5 things to know, a Money Talk Video with Dave Sandstrom
Volatility: What investors should know, a Money Talk Video with Marc Amateis
Be patient holding bonds as rates rise, a Money Talk Video with Steve Giles
Stocks: Long-term, consistent returns, a Money Talk Video with Dave Sandstrom
(initially posted November 29, 2018)

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