Week in Review January 14th, 2019

Major indices recover over half the losses from late 2018 sell-off as stocks rise for the third straight week

Stocks rose for the third consecutive week as major indices recovered over half the losses from the Q4 2018 sell-off.

Since falling over 15% in the 14 trading days leading up to Christmas (and falling almost 20% since September), stocks have staged a relief rally in recent weeks. The S&P 500 is now up over 10% in the 12 trading days since its late December low, recouping over half the losses from the recent sell-off. Hopes that the US and China may be making progress in the ongoing trade dispute helped drive markets higher as officials of the two countries restarted talks in Beijing on Monday.

As markets have shown renewed signs of life, investors are hoping the upcoming earnings season will provide support for further gains. Major banks are set to report results throughout the week, with investors eagerly watching to see if higher borrowing costs, trade tensions with China, and other global uncertainties have weighed on corporate growth. The estimated blended earnings growth rate for the S&P 500 is currently 10.6%, which would mark its fifth straight quarter of double-digit earnings growth if achieved. Every major sector, excluding utilities, is expected to report positive earnings growth for the quarter.

While the week ended positive, trade tensions and the government shutdown continue to weigh on investor sentiment. Despite these geopolitical concerns, economic and corporate fundamentals remain strong. With conflicting signals, it is reasonable to expect continued heightened levels of volatility as markets remain sensitive to major headlines. This market noise can make it tempting to make knee-jerk decisions, but as investors, we need to stay committed to our long-term financial goals and risk tolerance. Staying focused on our long-term investment objectives and maintaining a disciplined investment strategy can help reduce market noise and increase the odds of a successful outcome over time.

Chart of the week

After nearly entering bear market territory on Christmas Eve (defined as a drop of 20% from high levels), it appeared the worst was still to come for the S&P 500. The widely followed US stock benchmark posted its worst December return (-9.03%) since 1931 and its worst monthly return since February 2009. However, since Christmas the Index has rallied nicely from its recent low levels, gaining over 10%. Although it is too early to determine a clear trend for the remainder of 2019, heightened volatility and the two corrections experienced in 2018 have returned Price-to-Earnings (P/E) ratios closer to normal values. Higher P/E levels can indicate markets being overvalued, with an increase in earnings or a decrease in prices needed to bring levels back down to average. The forward 12-month P/E ratio for the S&P 500 is currently 15.1, still slightly above the 10-year average of 14.6 but below the 5-year average of 16.4.

*Chart source: Bloomberg

Market Update

Equities

Broad equity markets finished the week positive as small-cap US stocks experienced the largest gains. S&P 500 sectors were positive, with cyclical sectors outperforming defensive sectors.

So far in 2019 energy and consumer discretionary stocks are the strongest performers while utilities and healthcare have been the worst performing sectors.

Commodities

Commodities were positive as oil prices increased by 7.57%. This was only the second gain in five weeks as oil attempts to rebound from its extreme losses in 2018. Oil prices fell last year due to excess supply in the markets and fear of lower global demand. Contributing to excess supply was the US, which produced a record level of 11.7 million barrels per day. However, currently supporting a rally in prices has been lower production by OPEC nations and oil rig cuts in the US. Additionally, export levels from Iran continue to fall with analysts expecting a continued decline over the next few weeks.

Gold prices increased by 0.29%, closing the week at $1,289.50/oz. Additional gains were capped as the dollar remained relatively flat throughout the week. Since gold is a US dollar-denominated safe-haven asset, it generally performs best when interest rates are lower and market volatility is heightened.

Bonds

The 10-year Treasury yield increased from 2.67% to 2.71%, resulting in negative performance for traditional US bond asset classes. While yields closed the week slightly higher, the spread between the 10- and 2-year treasury remained relatively unchanged at 0.16%. Historically, a spread inversion (where the two-year yield is higher than the ten-year yield) has preceded recessions by at least a year. As we head into 2019, investors are cautiously watching for the next rate hike, as an untimely increase could cause an inversion. If market sentiment remains strong and investor sentiment rebounds, a yield curve inversion could very much be avoided.

High-yield bonds were positive for the week as riskier asset classes rose and credit spreads tightened. As long as economic fundamentals remain healthy, higher-yielding bonds have the potential to experience further gains in the long-run as the risk of default is still moderately low.

Asset class indices are positive so far in 2019, with small-cap stocks leading the way and traditional US bonds lagging behind.

Lesson to be learned

“The most important quality for an investor is temperament, not intellect.”

– Warren Buffett

While many investors are intelligent, a major flaw for most is the lack of temperament to control the urges that can get them into trouble. It can be tempting to make decisions based on short-term market noise and trends. However, for investors to be successful they must understand investing is a long-term process over many years. This is why it is important to stay disciplined, sticking to an emotion-free investment strategy and long-term plan. By taking emotions out of the equation, we can avoid making irrational decisions based on market noise and improve our odds for success in the long-term.

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 66.67% 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 28.30, forecasting further economic growth and not warning of a recession at this time. The Bull/Bear indicator is currently 100% bearish, meaning the indicator shows there is a slightly higher than average likelihood of stock market decreases in the near term (within the next 18 months).

The Week Ahead

Major banks are set to kickoff earnings season this week. Investors will also be keeping an eye on the ongoing government shutdown.

More to come soon.  Stay tuned.