Investment Strategy

Weekly market insights and possible impacts on investors from the Wells Fargo Investment Institute Global Investment Strategy team.

February 21, 2018

Chris Haverland, CFA, Global Asset Allocation Strategist

Anatomy of a Stock-Market Correction

Key Takeaways

  • On average, U.S. stock-market corrections occur every 11 months.1 Historically, they have not turned into bear markets a majority of the time.
  • During the latest correction, all asset classes were lower, but some declined by less than others. A hypothetical diversified portfolio outperformed equities and captured only a portion of the downside during the correction.

What it May Mean for Investors

  • Fundamentals remain unchanged, while equity valuations have become more compelling (cheaper). We believe that investors should be prepared to deploy excess cash as opportunities present themselves.

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After an extended period of low volatility, equity markets have experienced sizeable swings in the past few weeks. Stock-market euphoria over U.S. tax reform and global synchronized economic and earnings growth was abruptly replaced by concerns over budget deficits, rising rates, inflation, and volatility strategies that may have exacerbated the sell-off. Regardless of the cause, equity markets correct (at least a 10% decline) once every 11 months (on average). The last correction was nearly two years ago; however, during a secular bull market, the time between corrections can be longer than average.

Since 1928, corrections have transitioned to bear markets (at least a 20% decline) less than 50% of the time. Our view is that the latest decline is a normal market correction that does not signal the end of this bull market. Historically, stock-market corrections within bull markets have lasted approximately four months—with prices recovering over the following year. Given that it only took nine trading days for the S&P 500 Index to reach correction territory, this episode may have a shorter-than-average duration, which is not unheard of in recent bull-market history. We have had four corrections (prior to the current one) during this bull market, with an average length of 106 days and an average decline of 15.3%. The average return one year (12 months) after hitting the bottom has been 22.7%.

What worked while stock prices were falling?

The S&P 500 Index hit a record high on January 26, capping off one of the best starts to a year in recent performance history. That was followed by one of the fastest pullbacks on record that ultimately led to a 10.1% drop in the index from peak to trough. All equity classes were lower during this period; however, smaller-capitalization equity indices outperformed larger-capitalization indices and international stocks outperformed those in the U.S. (Chart 1).

Chart 1. Asset class benchmark performance during recent correctionChart 1. Asset class benchmark performance during recent correctionSource: FactSet, Morningstar Direct, Date Range January 29, 2018 –February 8, 2018 - . Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment. Please see the end of the report for the risks associated with the representative asset classes and the definitions of the indices.

No asset classes were spared, but there were varying degrees in the magnitude of losses. Even high-quality bonds (which often move in the opposite direction of stocks) declined in price. High-yield fixed income fell by 1.4%, with spreads widening modestly. Meanwhile, a hypothetical diversified Moderate Growth and Income (MGI)2 allocation captured only 57% of the downside in the S&P 500 Index. This is a good reminder of the importance of diversification during volatile times—as historically, it has reduced downside risk and allowed investors to recover from losses more quickly.

Where do we go from here?

Stock-market corrections can be viewed as an opportunity for investors who have excess cash to deploy. As stated above, we do not believe that this is the end of the current bull market. Instead, we believe that it is simply a temporary pause in what is still a technically uptrending market. Fundamentals are unchanged over the past few weeks, and earnings expectations are still rising across the globe. Valuations have been reset, with forward price-to-earnings multiples falling back to levels not seen since President Trump took office. In addition, we are not seeing the warning signs of a deeper market sell-off—such as high-yield spreads surging, an inverted yield curve, that is, when short-term yields are higher than long-term yields, (it actually steepened over the past month), or emerging-market stocks significantly underperforming developed-market equities. Although the lows may not be in place yet, and volatility likely will remain elevated in the near term, we believe that it makes sense to buy equities on meaningful dips and rebalance portfolios regularly to take advantage of asset-class prices that have gone on sale.

Equities

Sean Lynch, CFA, Co-Head of Global Equity Strategy

Cash and courage

As volatility increases in equity markets, investors that have cash—and courage—could be well positioned. The key is possessing them at the same time. I attribute this investment axiom to Berkshire Hathaway’s Vice Chairman Charlie Munger, although John Maynard Keynes offered similar insights during the Great Depression of the 1920s.

Having cash may signify that an investor is skittish about the market, or in a state of investment paralysis—not wanting to do anything. It is one thing to have cash, but the key is to have the courage to invest when the opportunity presents itself. Often, when volatility spikes and prices gyrate, investors hold off adding to equity positions until the markets calm down or become “more favorable.” Waiting for the “all clear” signal to ring usually happens after markets have regained much of their losses. This is why. In our opinion, truly successful long-term investors need to possess both characteristics in market corrections.

We believe that the recent correction offers a chance to add to equity positions based on three main factors. First, earnings continue to grow as estimates are increasing across the globe. Second, U.S. and global economic growth are improving. Finally, valuation has become more reasonable as earnings have risen and prices have declined. As the table shows, U.S. markets seemed to have fallen the most—but also have recovered more rapidly than international markets have. Our favored place to invest remains U.S. equity markets, followed by the emerging markets, and lastly, international developed markets.

Although cash and courage are important during market downturns, not every dip is buyable. However, we believe that this one is.

Key takeaways

  • As volatility increases in equity markets, investors that have cash and courage could be well positioned. In our opinion, truly successful long-term investors need to possess both characteristics following market corrections.
  • We believe that the recent correction offers a chance to add to equity positions.
2018 correction, drawdown and rebound2018 correction, drawdown and reboundSources: FactSet, Wells Fargo Investment Institute. Data range: January 15, 2018 – February 15, 2018. The returns and prices represented in the table are intra-day. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment. Please see the end of the report for the risks associated with the representative asset classes and the definitions of the indices.

Fixed Income

Brian Rehling, CFA, Co-Head of Global Fixed Income Strategy

Bond-market volatility—it’s normal

Last summer, the Merrill Lynch Option Volatility Estimate (MOVE) Index hit an all-time low. (The MOVE Index measures implied bond-market volatility.) In August 2017, we wrote “While this low volatility environment in the bond market could persist for some time, it will not last indefinitely. Significant volatility in the fixed-income market is not uncommon and often comes with little warning.”

In the past few weeks, the bond-market calm has been shattered. We believe that the recent fixed-income volatility is not unusual; rather, it’s normal.

The chart below displays the historical range of annual yield movements for the 10-year Treasury note. The 10-year Treasury note typically trades in a fairly wide yield range over the course of a year. Since 2000, the average calendar year trading range (the difference between the year’s highest and lowest yield) for the 10-year U.S. Treasury note has been 140 basis points or 1.40 percent.3

We expect a more volatile bond-market environment to persist. In 2018, it is likely that investors will face additional, meaningful yield volatility, both higher and lower. History supports our expectation.

Key Takeaways

  • During periods of bond-market calm, investors often can be lulled into taking added risk in their fixed-income portfolios. High-yield debt investments have produced double-digit returns over the past 18 months. We recommend that investors take profits in lower-rated securities and move to an underweight position in high-yield bonds.
  • By understanding that interest-rate volatility is a normal part of fixed-income trading patterns, investors can be less emotional (and more strategic) when the inevitable periods of volatility occur.
Yearly trading range of the 10-year Treasury yieldYearly trading range of the 10-year Treasury yieldSource: Bloomberg, Wells Fargo Investment Institute, February 13, 2018. Past performance is no guarantee of future results. Yields represent past performance and fluctuate with market conditions.

Real Assets

Austin Pickle, CFA , Investment Strategy Analyst

REITs hammered as rates spike

“The quieter you become, the more you can hear.”--Ram Dass

We just witnessed the real-life example of the main risk to our REIT (real estate investment trust) overweight—if rates rise too far, too fast. REITs have a history of surviving gradual rate increases, but quick bursts in bond yields have hammered REITs (as we have seen firsthand over the past few weeks).

For nearly all of 2017, 10-year Treasury note yields had remained within a narrow range between 2.2% and 2.5%. But, to date in 2018, the 10-year Treasury note yield has moved well past 2.5% and was eyeing 3% last week. The chart below illustrates how rate-sensitive REITs have been. The orange line is the 10-year Treasury note yield (inverted) and the blue line is the FTSE NAREIT All Equity REITs Index (which measures domestic REIT values). Recently, as rates spiked, many REIT investors jumped ship and values fell off a cliff.

The bottom line is that REIT fundamentals and valuations are largely attractive, but we are concerned about the potential for rates to continue climbing. We are listening to our fixed-income strategy team closely on their expectations for the rest of 2018. Should long-term rates peak near here, history says that REITs typically perform well for months thereafter. But if rate forecasts are revised higher, we may remove our overweight. Stay tuned.

Key Takeaways

  • The recent spike in interest rates has hurt REIT values.
  • REIT fundamentals and valuations remain attractive, yet if rate forecasts increase, we may remove our overweight.
REITs versus 10-year Treasury note yieldREITs versus 10-year Treasury note yieldSources: Wells Fargo Investment Institute, Bloomberg. Daily data: January 2, 2017 - February 13, 2018. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment. Yields represent past performance and fluctuate with market conditions.

Alternative Investments

Justin Lenarcic , Global Alternative Investment Strategist

Six key lessons from our Alternative Investment Symposium

Wells Fargo Investment Institute’s annual Alternative Investment Symposium took place in early February, full of candid insights from well-known industry leaders and investors. Below are six key themes that we identified at the symposium.

  1. Complexity versus simplicity. For several speakers, the investment playbook can be distilled into opportunities focused on complex securities or transactions, where specific expertise is required to unlock value. Other managers hinted at greater concern for market dynamics, specifically liquidity—and they are simplifying their portfolios. The general views were that returns at this point in the cycle require active management more than passive market exposure.
  2. Structure matters. As the cycle matures, the illiquidity premium becomes more important, and investment structures built to withstand increases in volatility and reductions in liquidity may be better positioned than other approaches. Attendees concluded that hedge fund managers need the flexibility to be buyers of stressed and distressed assets during periods of weakness. Moreover, private equity and debt strategies require patient capital to potentially unlock value. Understanding the structural differences between private placements and liquid alternative mutual funds is critical.
  3. Which inning? Nearly all speakers addressed the maturing cycle, but none felt comfortable pinpointing what “inning” we are in. While most agreed that we are in the latter innings of the cycle, they thought tax reform may generate enough economic growth to defer a recession, especially as global economic activity has accelerated. The idea of the game heading into “extra innings” was shared by more than one panelist.
  4. The return of macro. The removal of quantitative-easing-induced liquidity has begun, which means that macro factors such as interest rates, inflation, and volatility will have a larger influence on asset prices than in recent years. With the VIX (CBOE Volatility Index® (VIX®), which is a key measure of market expectations of near-term volatility conveyed by S&P 500 Index option prices) recently seeing its largest spike in history, attendees were acutely aware of the macro impact on investor sentiment and asset prices.
  5. Pivot point. Many of the managers spoke about the need to be agile in this environment, without getting stuck. Liquidity shocks are among the top-ranked market risks today, given the proliferation of passive vehicles and the removal of many banks’ proprietary trading activity, so the ability to change direction quickly, or pivot, is critical.
  6. Don’t market time. Several speakers noted the ineffectiveness of trying to time the market. Private equity, for instance, is extremely difficult to time, and evidence shows that the best investors are ones that remain disciplined about allocating across managers and strategies. Distressed debt is another area in which some investors try to time the market, to no avail. Opportunities within distressed strategies span the entire cycle, but it can potentially benefit one to “lean into” distressed debt when credit markets are at their weakest.

1 Corrections are declines of 10% or more.
2 Diversification is an investment method used to help manage risk. It does not ensure a profit or protect against a loss. See end of the report for the composition of the hypothetical Moderate Growth & Income portfolio.
3 One hundred basis points equal 1%.

Risk Considerations

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.

Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.

Composition of Hypothetical Moderate Growth & Income Portfolio: Moderate Growth & Income 3 AG model portfolio: 3% Bloomberg Barclays 1–3 Month Treasury Bill Index, 4% Bloomberg Barclays U.S. Aggregate Bond Index (1–3Y), 16% Bloomberg Barclays U.S. Aggregate Bond Index (5–7Y), 7% Bloomberg Barclays U.S. Aggregate Bond Index (10+Y), 6% Bloomberg Barclays U.S. Corporate High Yield Bond Index, 3% JPM GBI Global ex.-U.S. Index, 5% JPM EMBI Global Index, 21% S&P 500 Index, 9% Russell Midcap® Index, 8% Russell 2000® Index, 6% MSCI EAFE Index (USD), 5% MSCI EM Index (USD), 5% FTSE EPRA/NAREIT Developed Index, 2% Bloomberg Commodity Index.

Definitions

Emerging Market Fixed Income: J.P. Morgan Emerging Markets Bond Index (EMBI Global) currently covers 27 emerging market countries. Included in the EMBI Global are U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.

Developed Market ex.-U.S. Fixed Income: J.P. Morgan GBI Global ex-US Index (Unhedged) in USD is an unmanaged index market representative of the total return performance in U.S. dollars on an unhedged basis of major non-U.S. bond markets.

Public Real Estate: FTSE EPRA/NAREIT Developed Index is designed to track the performance of listed real-estate companies and REITs in developed countries worldwide.

The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is comprised of all eligible hedge fund strategies; including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage, and relative value arbitrage.

Small Cap Equities: Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.

Mid Cap Equities: Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe.

Large Cap Equities: S&P 500 Index is a capitalization-weighted index calculated on a total return basis with dividends reinvested. The index includes 500 widely held U.S. market industrial, utility, transportation and financial companies.

Developed Market ex.-U.S. Equities: MSCI EAFE Developed Market Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of 21 developed markets, excluding the U.S. & Canada.

Emerging Market Equities: MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of 23 emerging markets.

Frontier Market Equities (U.S. Dollar/Local). MSCI Frontier Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of 24 frontier (least developed) markets.

U.S. Treasury Fixed Income: The Bloomberg Barclays 1–3 Month Treasury Bill Index includes all publicly issued zero-coupon U.S. Treasury bills that have a remaining maturity of less than three months and more than one month, are rated investment grade, and have $250 million or more of outstanding face value. In addition, the securities must be denominated in U.S. dollars and must be fixed rate and nonconvertible.

U.S. High Yield Fixed Income: Bloomberg Barclays US Corporate High-Yield Index covers the universe of fixed-rate, non-investment-grade debt.

U.S. Investment Grade Fixed Income: The Bloomberg Barclays U.S. Aggregate 1–3 Year Bond Index is unmanaged and is composed of the Bloomberg Barclays U.S. Government/Credit Index and the Bloomberg Barclays U.S. Mortgage-Backed Securities Index and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of one to three years.

U.S. Municipal Fixed Income. Bloomberg Barclays U.S. Municipal Index is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least one year.

Commodities: The Bloomberg Commodity Index is a broadly diversified index composed of 22 exchange-traded futures on physical commodities and represents 20 commodities weighted to account for economic significance and market liquidity.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

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