Still Within Normal Correction Territory… Here Comes Goldilocks?

 In Strategy Updates

It is the speed of the recent decline in stock prices, not the distance that has been most disruptive to investors. When compared to almost all bull market corrections throughout history, this one is a “textbook” example in terms of absolute decline – most indexes are now down around 8-10% from the highs. It is the speed of the decline – about 3 weeks – that can be a bit unnerving. Historically, corrections within bull markets take 4-6 weeks, with the exception being the one we experienced earlier this year which also traded in similar fashion. Perhaps we are entering a newer, faster world order for market behavior? It appears to be the case. Will the market be able to recover from this (so far) normal, but quicker pullback? We think it is quite likely. However, investors should realize that the next leg of the bull market will be different than the last in terms of sector leadership.

In our 25 years of managing money for families and foundations, we have likened economic growth to “Goldilocks” a handful of times. For those of you who are newer clients, we reference the famous words of Robert Southey’s 19th century fictional character, Goldilocks, in relation to our view of the global economy over the next year. To quote the young lady with the golden hair, the economy will likely grow at a pace that’s “not too hot, not too cold…but just right. After an economic boom in global growth for the past few years, we see an economy that will cruise along at its current rate or a tad slower in the next year or so – not a recession or economic collapse that some prognosticators and the media seem to be suggesting in recent weeks. As mentioned in prior Strategy Updates, the global economy is too big and has too much momentum to stop on a dime. However, with the Federal Reserve continuing to nudge up interest rates, we expect that their purpose is to slow the economy a bit to prevent inflation (too hot), avoid a recession (too cold) and allow the economic cycle to last as long as possible (just right). If the Fed is successful, and our outlook coincides, this could spell great opportunities for us stock and bond investors.  Here is why:

An economy growing at a moderate pace will likely cause a significant rotation in market leadership – a rotation that we see as already in the works. The recent decline in stock indexes has been led by the winners of the last two years, namely financials, industrial and materials companies. The stocks that thrive on increasing economic growth have been the same ones that have declined the most in the recent correction. We think that this is a sign that the bull market will continue, but will include other sectors that have so far been ignored, including consumer staples, healthcare and even utility stocks.  It will not be the end of upside performance of select technology, financial and industrial stocks, but they will no longer be the only ones in the performance spotlight. As you can imagine, this type of market allows for more diversification of your stock portfolio and a bit more exposure to “recession-resistant” companies. We are already adding some now and will continue to do so.

The Fed is adamant about raising rates, which has caused some short term investor anxiety – we believe this will soon pass. However, this is an excellent time for those of us who buy individual bonds – not bond funds. Higher interest rates provide an opportunity to lock in higher yields as some of your bonds come due or if you have excess cash to invest.

As you know, we are always sensitive to the possibility that our outlook may be wrong or that something could happen that is unknowable to disrupt our view.  Therefore, we manage the risk of declines that are out of the “ordinary” by managing your portfolio’s asset allocation, sector management and the use of carefully placed stop loss orders.  Keep in mind that your stop loss orders are meant to protect you from declines beyond “normal.” They are not meant to mitigate short term normal volatility.

We hope this brief update finds you well. If you have experienced any significant changes in your financial situation please let us know.

Thank you for your continued confidence in our work.

Your Team at Main Street Research