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The Brave Report: Market Commentary for February 2018

Click here for PDF version of this report: The Brave Report-Feb 2018

Well, this has been an interesting month. After having one of the strongest starts to the year in decades and after years of marching higher with no real pullbacks or volatility something finally spooked the markets. The result was a swift sharp drop from all-time highs. All major averages pulled back more than 10% from their January highs over the span of around two weeks. Volatility spiked and interest rates jumped.  We finally saw the correction that many market pundits have been predicting for years. And then, just as quickly as it dropped we saw one of the best weeks we have had in years and we made back many of the losses

The most interesting dynamic of the past two months is if you had told most investors on Dec 31st that on February 22nd the market would be up around 2% YTD almost all of them would be elated. However, the road we have taken to get here was not a straight line like we have become accustomed. This has caused most investors, especially on the retail side, to be much more cautious and has helped to dampen some of the euphoria I discussed last month. Which, in the long run, is probably positive for the longevity of this bull market.

Market Overview

Even after being down more than 10% from their highs, the three major indices all battle back quite well. The S&P and Dow finished the last 30 days down just more than 4% while the NASDAQ again out-performed losing just over 2%.  After experiencing some of the lowest volatility the market has ever seen over the past few years we saw a few of the more volatile weeks we have seen since the financial crisis. While this volatility was higher than average it seemed much more pronounced due to the smoothness we have seen during our march to all-time highs at the end of January.

On the fixed income side of things we pretty much just saw one direction in rates, and that was up. The 10-year treasury climbed to its highest level since the end of 2013. It wasn’t just the level that was worrisome, but the speed at which it has advanced. We have seen the yield climb from around 2% last September to 2.9% today.  This climb should not be unexpected as the Fed has signaled these rate increases for years.  The real question moving forward is whether rates have overshot where they should be due to fears of inflation or are we headed back toward more normal rates?

Market Correction: After such a swift correction there is often a lot of finger pointing as to what caused the market to sell off so quickly. Often times it wasn’t one specific thing but a series of different variables, many that are interconnected. Here are a few of them:

  • Reversion to Trend: With the huge run-up we saw in January, the markets had overshot the longer term trend line that we have seen during this bull market.  The markets got a little over-stretched and it is just natural for them to revert back to the mean.  The speed at which it happened and its timing was due to other factors.
  • Inflation and Rates: This as seen as one of the major catalysts for the correction. Fears about increased inflation were stoked at the end of January, leading to worries of faster rate hikes by the fed. This caused rates, especially on the benchmark 10-year treasury to spike higher and led to some panic selling as fears about a less accommodating Fed got priced into the equity markets.
  • Leveraged VIX Products: As investors searched for yield over the past few years we have seen an increase in leveraged notes tied to the VIX, a common measure of volatility. The most popular trade has been going short volatility meaning investors were betting the volatility would go lower. When the market began to sell off, volatility spiked meaning anyone that owned these leveraged short volatility notes was losing a lot of money and the positions owned by the notes needed to be unwound or they would be worth nothing.
  • Electronic Trading: With the increase in electronic algorithmic trading over the past decade many have feared that a correction could be exacerbated because these computers are trained to sell if something spooks the market. This just adds additional sell pressure to an already falling market. This can cause any correction to happen faster than in the past and could cause a correction to overshoot to the downside. It hasn’t been proven that this contributed to this most recent correction but it definitely added to the chaos
  • Margin Calls: As the markets spiked higher last year and into January many felt they were missing out so as a way to catch up were buying a lot of stock using margin or basically using stock as collateral to borrowing money to buy more stock. When the value of the underlying stock drops quickly, investors need to sell stock in order to raise enough cash to cover the loan.  This forced selling puts additional selling pressure on the markets and can cause a much more severe pullback than the initial cause warranted.

There are probably a number of other factors but what we see with these corrections is there is usually an initial variable or two that gets the dominos falling and then a number of other variables that keep those dominos falling.  The speed and severity of the pullback has to do with the significance of those variables.  In the case of this most recent correction, the positive for the market is that the underlying fundamentals of the economy are strong which helped to cushion the landing and add additional optimism for the rebound.  We saw exactly that as once the bottom was identified we saw rapid buying as investors tried to scoop up quality stocks at a major discount to where they were trading at the end of January.  Had this correction happened during a time that economic fundamentals weren’t strong we easily could have seen an end to the bull market.

Strategy Commentary

Even with the pickup in volatility and the sharp selloff earlier in the month, I maintained my equity exposure throughout.  While the market did over-shoot to the upside in January, the sharp pullback was also overdone especially with the backdrop of strong economic fundamentals and positive earnings. I believe we still have more room to run to the upside and this pullback was simply a reversion back toward the longer term trend.  If the pullback taught us anything it is that panic selling in times of turmoil normally ends with bad results.  Had we panic sold when the markets were down 10% we would have missed out on the sharp recovery.  While this type of recovery isn’t always the case, nothing major changed

fundamentally in the markets so if I was bullish on equities a month ago, I’m even more bullish now that stocks are available at a discount.

Domestically I have maintained my overweights to technology, financials and materials.  Basic materials have been an underperformer and I may look to reallocate away from the sector and probably add consumer discretionary.   I continue to be bullish on financials, especially with the projected rate hikes over the next 12 months. I have touched upon the growth potential in the tech space in previous reports and my thesis is unchanged.

Internationally, I still like emerging markets but it is important to point out that in times of increased volatility, emerging markets tend to experience an even higher level of volatility.  It has been a relatively smooth ride in recent years but don’t be surprised if we continue to see some major swings. That being said, I am still bullish on the region and think that even with the volatility, the returns will be outsized.

I am still negative on fixed income.  This past month we really saw what can happen to bond prices if rates rise rapidly.  With all signs pointing toward continued rate increases, I would still rather maintain an increased cash allocation as a replacement for most fixed-income exposure.

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