Why Last Year's Market Meltdown Might Actually Be a Good Sign
February 11, 2019
By Michael Moreland
Vice President Investments
Can you tolerate one more article on how badly 2018 ended? If so, read on. The ending may surprise you.
The final quarter of the year was only the fifth time since the Crash of 1987 where more than 90 percent of U.S. stocks – large, small and mid-size – traded below their 200-day moving average. The broad markets went over Niagara Falls, without a barrel.
Similar times in the past were often associated with major events – the aftermath of the September 11 attacks and the onset of the 2008-2009 credit crisis are two examples. The fourth quarter, however, had no parallels. Tariffs? Yes, certainly important. Rising interest rates? We all pay attention to what the Federal Reserve says and does. Slowing economic activity? It is, but still solidly in positive territory and expected to remain so.
Are “Momentum Trades” to Blame for the Market Meltdown?
So why was the final quarter among the worst in the last generation? There were good reasons for a correction to occur, but its speed and magnitude were way beyond reasonable.
To paraphrase an old Oldsmobile commercial, ‘this is not your father’s stock market.’ Corrections that played out over weeks or months now take place in a matter of days or weeks. As shown below, mutual fund and retail sectors – traditional ‘buy and hold’ investors – now comprise only about one quarter of U.S. equity trading. The bulk of activity is through hedge funds, high frequency traders, and quant shops. A long-term perspective is not in their lexicon.
A big part of the trading strategies for these groups is the ‘momentum trade.’ In short, one buys what’s going up and sells what’s going down. An explanation I saw compared this strategy to taking a multiple choice test in school – if the first two answers are ‘B’, then the rest must be the same, and there’s a prize for finishing first. Longer term investors are just along for the ride. Fundamentals matter, but sometimes they are overwhelmed by entities shaving fractions of a penny per trade on huge volumes.
What Does This Mean for the Markets in 2019?
By now, it's pretty clear that December was not the beginning of the end. Prices have recovered sharply since the end of the year. Valuations are reasonable, and a sense of perspective has returned. Even with the uncertainties mentioned above, the outlook for financial assets is decent — particularly if the Federal Reserve sticks to its recent commitment to exercise patience in policy adjustments.
This view is also supported by history. In four of the five instances of declines mentioned at the start of this note, the markets were higher six months later. A year later, prices were significantly higher across the board — an average 12-month gain of more than 20 percent. We’ve already seen double-digit gains since the Christmas Eve trough. Perhaps the same factors that created the fourth quarter ‘melt-down’ are propelling the first quarter ‘melt-up’.
What’s the lesson from this? It’s the value of following the long game. Our clients’ portfolios are built to meet specific long term goals. We cannot avoid downturns, but we can help navigate through challenging times without losing sight of the ultimate destination. Please talk to us about how we can help.