Fourth Quarter 2017 - Market ReviewSubmitted by Karstens Investments on October 31st, 2017
By Michael Karstens, CFP, AIFA
As I write, we are just a few days shy of the 30th anniversary of Black Monday. Monday, October 19, 1987 was the single worst day in the U.S. stock market history. At the time we were amid a multiyear bull market. However, cracks were beginning to show as the Wednesday and Friday that preceded this historic date recorded the two biggest point losses in history at that time. I still remember the feeling of uneasiness heading into the weekend. What happened on Monday exceeded the worst fears as the market opened down and then cascaded lower. As stocks plummeted, there seemingly were no buyers at any price. For the day, the Dow Jones Industrial Average (DJIA) fell an unprecedented 22.6% or 508 points to 1,738. I remember a few weeks later being on a conference call with legendary portfolio manager Sir John Templeton during which he explained that they were putting offers in for stocks 20-30% below the asking price and they were getting filled! On Tuesday, the market opened higher then turned negative leading most people to believe that the rout would continue. To ease investor fears, the Federal Reserve declared their willingness “to serve as a source of liquidity to support the economic and financial system.” Buoyed by the Fed’s statement, the Dow closed up over 100 points on Tuesday and added another 187 points on Wednesday. Interestingly, since stocks were up sharply in the months preceding October 19th, those who were invested for the entire year still had gains even after the crash. Investors who bought into the market in the month or so before the crash, needed two years to recoup their losses. In retrospect, most blame the crash on computerized selling coupled with portfolio insurance which at the time was a new-fangled hedging technique. Asian markets fared worse as futures fell over 50% in a single day. The computer driven sell off on October 19, 1987 resulted in several new rules and regulations. Today, regulators and exchanges have instituted rules that are designed to arrest bouts of unchecked selling, with trading halts imposed when the S&P 500 falls 7%, 13%, and 20%.
Unchecked selling has not been a contemporary problem since the S&P 500 has not suffered a 3% decline (peak-trough) since November 7, 2016 which is the longest such stretch ever recorded. The lack of volatility has resulted in a sustained bull market that resembles a long upward flight of stairs. This past quarter, stocks recorded solid gains bringing up all the major US indices to record highs. Year-to-date, the NASDAQ has posted a stellar 21.67% return. The DJIA and the S&P 500 are up 15.45% and 14.24%, respectively. Small caps, as measured by the Russell 2000, have lagged slightly but still posted double digit returns of 10.94%. Despite geopolitical concerns, foreign markets outperformed the US by a wide margin. Driven by strong global growth, emerging markets were up 28.15% and the MSCI EAFE (Europe, Asia, Far East) has gained 19.96% this year to date. After a long period of underperformance, the strong growth overseas is welcomed.
Bond yields were uneventful with the 10-year treasury note ending the quarter at 2.33% after starting the period at 2.31%. The 2-year note finished up slightly at 1.47% which is the highest rate since November of 2008. Back then, money market yields were close to 5%, still a far cry from today’s low levels.
While we enjoy the current market rally, we cannot help but wonder how long it will last. There is little question that stocks are currently trading at very high valuation levels. By some measures stocks have only been this expensive twice in history – 1929 and 1999. We would also argue that much of the current run up has been driven by a very accommodative Fed and global money printing which has driven interest rates to very low levels (still negative in some cases) and has caused a rise in the value of almost all assets. How will markets react as the Fed begins to shrink its balance sheet and continues to raise rates and when will Europe and Japan curtail their money printing? Historically, money printing has not ended well and often resulted in inflation.