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Strategic Insights

Volume 7, Edition 37 | October 22 - October 26, 2018

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Correction: Not a Correction

Doug_Walters Doug Walters | Articles

Read Time: 5:00 min

Bear_Insights

U.S. stocks entered correction territory Friday morning before bouncing back above the (somewhat arbitrary) 10% decline correction threshold…

Market Review

Contributed by Doug Walters

There was no reprieve to be had this week, as the trifecta of uninspiring earnings, domestic terrorism, and a looming contentious election took their toll on sentiment. Stocks briefly fell below the 10% decline that defines a “correction.” These can be nervous times for investors, but “nervous” is normal.

What Do Investing and Reproduction have in Common?

When a favorite retailer holds a sale, marking everything off 10%, consumers will flock to the store. Yet when stocks get 10% cheaper, investors’ first reaction is to run for the hills. Why is this?

Sadly, human brains are not wired to be investors. The same instincts that helped primitive humans survive and flourish hinder investors. “Action Bias” is one of the culprits, and we discuss this in detail in our white paper Market Timing: Investing or Gambling? Another is “Risk Aversion.”

Risk Aversion is the tendency of the human brain to get shortsighted and seek certainty when faced with potential losses.

Some experts believe this traces back to the risk of failing to reproduce in small populations. Rather than risk not finding “mister right,” early humans were more likely to “love the one their with.” Being picky reduced the probability of reproducing, an unacceptable hazard for small communities.

For investors, bear markets create a fear of loss, and investors often prefer the certainty of exiting now versus the “uncertainty” of riding it out. The bigger the market decline, the stronger the impulse to flee. But fleeing is shortsighted. Equities have a long history of success, and we should all be more interested in stocks that are cheaper.

Successful investors recognize this human bias and capitalize on it through a process. Regular portfolio rebalancing and systematic deposits into your investment account will naturally take advantage of market dislocations by purchasing more when stocks are cheap and less when they are expensive.

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Strategy Update

Contributed by Max Berkovich , Aleksey Marchenko

STRATEGIC ASSET ALLOCATION

Bargain Hunting

The volatility in the equity markets caused some uneasiness for investors. Bonds and gold posted small gains, limiting volatility for diversified portfolios. Small-cap domestic and international equities were the biggest laggards for the week. Speaking of these asset classes…

  • While all major U.S. equity indexes experienced some form of correction this month, domestic small-cap and developed international equities declined the most.
  • The average annual earnings growth for small-cap equities in 2018 was over 40% vs. 29% in 2017. Price per earnings ratios have been on the decline for the last three quarters, signaling better value for the asset class relative to itself and large-cap peers.
  • Developed International equities average earnings growth in 2018 declined slightly to about 8.3% vs. 8.9% in 2017, while price per earnings growth rose during the same period. While this might suggest that lower valuations are not as attractive as they were in 2017 they are a lot more attractive as compared to U.S. equities.
  • There is clearly more behind the curtain on both small-cap and international equities, such as rising interest rates and the overall economy, especially global growth, but we are seeing a clear valuation divergence amongst the different markets.

STRATEGIC GROWTH

The Good, the Bad, and the Ugly

The busiest week of earnings season left the Energy sector as the biggest laggard thanks to an ugly earnings report from our lone sector holding. Next to last was the Industrial sector courtesy of a bad feeling about the industrial cycle. The leading sector was Consumer Discretionary on the back of a good earnings report from…

  • Expedia, Inc. (EXPE) the online travel company reported a sizable beat on earnings and 11% bookings growth in the quarter. The company also guided for 10-12% EBITDA growth for full year 2018, versus 7-12% previous guidance.
  • EQT Corp. (EQT) missed expectations and was unable to benefit from higher natural gas prices, due to hedges. The most frustrating part for us is that that company plans to spin-off its midstream operation, complicating its corporate structure when peers are doing the reverse.

STRATEGIC EQUITY INCOME

Good Problems

The Energy sector was the laggard this week as crude prices dipped below $70 per barrel. Technology was the leading sector eking out a positive finish thanks to an earnings report from…

  • Intel Corp. (INTC) the chipmaker crushed consensus estimates this past quarter. Data center related revenue was up 22% year-over-year. The company bumped up full year guidance as well. The company, according to an analyst at Stifel, struggled to keep up with demand. A good problem to have.
  • AT&T Inc. (T) on the other hand, reported a weak quarter. The company missed estimates. Weakness in Latin America and Entertainment Group (Time Warner) was the culprit. Investors also continue to fear dividend growth will halt as the company works on paying-off debt it binged on to buy Time Warner.

The Week Ahead

Contributed by Aleksey Marchenko

Election Day is Very NEAR

Non-farm payroll is scheduled to be released on Friday morning. Economist estimate that the U.S. economy will add around 190,000 jobs in October.

  • This is the all-important job number before the mid-term election.

Economic reports such as Personal Consumption Expenditures (PCE), S&P/Case-Shiller Home Price Indices, and Manufacturing Institute for Supply Management (ISM) are the notable non-jobs reports.

Apple’s earnings will likely gather all attention despite a long list of Strategic Growth tech holdings reporting such as KLA-Tencor (KLAC), TE Connectivity (TEL) Facebook (FB), Cognizant (CTSH) and NXP Semiconductors (NXPI). Consumer Staples will also join in with Mondelez (MDLZ), and Church and Dwight (CHD) on deck.

Rate decisions from the Bank of China (PBoC), Bank of England (BOE) and Bank of Japan (BOJ) will add fuel to currency and fixed income markets.

  • We expect the Chinese central bank to receive the most attention of the three as trade issues and a plummeting stock market coupled with slower growth may require the central bank to boost liquidity in their system.
Indices & Price ReturnsWeek (%)Year (%)
S&P 500-3.9-0.6
S&P 400 (Mid Cap)-4.1-5.5
Russell 2000 (Small Cap)-3.8-3.4
MSCI EAFE (Developed International)-3.5-13.0
MSCI Emerging Markets-2.3-18.1
S&P GSCI (Commodities)-2.05.1
Gold0.7-5.6
MSCI U.S. REIT Index-0.8-4.7
Barclays Int Govt Credit0.5-2.3
Barclays US TIPS0.4-4.0

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Founded in 1979, Strategic is a leading investment and wealth management firm managing and advising on client assets over $1 billion.

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