The third quarter (ending September 30, 2018) for financial markets was strong as the Dow Jones Industrial Average (Dow) was up 9.63% and the Standard and Poor’s 500 Stock Index (S&P 500) gained 7.71%. International stocks lagged with a return of 1.42% during the same period.

However most major stock averages reached a historical high right at the end of the third quarter and the beginning of the fourth quarter (S&P 500 on September 20 and the Dow on October 3). Since that time, stocks have experienced significant volatility and a downturn in overall prices.  This has been in sharp contrast to the benign conditions that have existed the last nine months.  However, it feels a lot worse than it is because it is coming at quarter-end; it comes after an all-time high, and at the time of, previously, low volatility.  In truth – it is well within the normal expectations of long-term investing to have episodes like we are currently experiencing.  The outlook for long-term returns has not changed.  It is also impossible to achieve higher rates of long-term returns without volatility.  There is no major structural change occurring that will permanently change the global capital market risk/return equation.

Periods of high volatility and falling stock prices will come and go as we pursue the long-term benefits of investing. It comes with the territory.  Sometimes a downturn in stock prices is fundamental (2007 – 2009).  During these fundamental sell-offs it is important to be pro-active, defensive, and keenly aware of risk exposure.  This is not one of those times.  The current decline in stock prices is the result of technical factors (institutional selling, tax-loss harvesting, programed trading, and mutual fund distributions).  During technical declines is important to not make major allocation change, adhere to your specific strategy, and look for ways to benefit from the market behavior.  Beneficial moves including tax-loss selling, investing cash in lower priced securities, and rebalancing to allocation targets.

The recent stock market can be difficult to watch and experience. However, the sell-off will end.  2018 will likely be a slightly negative year for investing (currently down 4.95% Year-to-Date).  This would be the first negative year in the last decade.  It is important during times like this that we are reminded of all near-term and long-term reasons for being an investor.

  • The Economy is very strong
    • Very low unemployment at 3.7%
    • High job growth (An average of 205,000 jobs are being added each month)
    • High corporate earnings
    • Stocks are not overpriced
    • Energy prices are low
    • Low interest rates
    • Inflation is low
    • High consumer spending
  • Market downturns are an inherent/necessary part of investing. But it is always uncomfortable in the midst of them.
  • Do not make any major portfolio changes until markets return to normal.
  • The stock market can recover very quickly and usually when it is least expected.
  • Despite reports to the contrary, stocks are not overvalued. The estimated price-to-earnings (P/E) ratio of the S&P 500 is 15.57 times. The ten-year average P/E for the S&P 500 is 17.71. times. The P/E for developed foreign markets is 13.02 times and 11.44 times for foreign emerging markets.
  • Do not focus on financial networks or television reports. They are designed to hold viewers using fear, sensationalism, and drama and are not designed to improve your investing success.
  • The daily change numbers are bigger because the index values are bigger. When the Dow was at 10,000, a 2% move was 200 points. Now, the same percentage move is nearly 500 points.
  • Technical sell-offs (similar to what we are experiencing now) often recover much quicker than fundamental sell-offs.
  • Historically, stock markets double about every 7 to 8 years. In 8 years from now the Dow Jones Industrial Index could be around 50,000.

Looking Forward

The Federal Reserve will raise interest rates on Wednesday, December 19th by .25%.  Raising rates are a necessary part of this recovery.  It provides safe source of interest for individuals relying on fixed income, it forces business and individuals to make more disciplined financing decisions, and “re-loads” the Federal Reserve for any future financial stimulus.  The interest rate increase will likely include some softer language about future increase.  This should provide some relief to stock prices.

It is important to understand that interest rates will continue to rise in 2019. Rising interest rates as a result of a healthy economy is not to be feared by stock investors.  It will provide opportunities for higher interest income for bond investors.

In the last several quarterly recaps we have suggested investors avoid the FANGs (Facebook, Apple, Amazon, Netflix, and Google). These stocks have declined in excess of 20% from their highs.  The best way to avoid these stocks is not to invest in passive (Index and ETF) securities.  Active investments should continue to prevail in volatile stock market environment.  At the sector level D’Arcy Capital is overweight international stocks, niche technology, and U.S. financial shares.  Energy is also starting to become more investible.  Although it may appear contrarian, investors should also avoid utility companies, long-dated bonds, and consumer staples.

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