We have been sharing with all of our clients for at least 6 months that a technical correction in this market was long overdue. Our primary indicator was that normal volatility in the market has been very subdued and abnormally low. The chart below shows how low downside volatility has been recently compared to history.
Some of you may have heard about the largest point drop in the Dow Jones Industrial average on February 5th. Putting that number into context, the drop on February 5th was the 100th worst down day in terms of percentage declines for this index. The chart below shows the top 20 largest percent declines for the Dow Jones index.
We think this most recent price action will remove some of the concern about excess valuation in U.S. equities and potentially provide further legs for a continued bull market. The reason for this is because, fundamentally, the world economies are in the best shape they have been in years. Additionally, because of the recent U.S. tax law changes, corporate earnings consensus projections point to an increase of 20% in 2018.
We are still concerned about worldwide debt and the fact that the U.S. government is willing to increase debt dramatically to leverage the U.S. economy. If interest rates rise rapidly, this could impact prices of all asset classes. At this point in time, we do not think interest rates will rise rapidly in absolute terms. We have been expecting a 1% increase in interest rates in 2018, but whether or not we exceed that expectation will be directly impacted by U.S. inflation.
From a portfolio perspective, our thoughts are always focused on the long-term objectives of your financial plan. Your portfolio risk should reflect the risk necessary to achieve the goals in your financial plan considering any short-term cash flow need. D3’s client portfolios have been constructed accordingly, taking into account cash flow needs for life style maintenance and other short-term goals.
If your short-term cash flow needs have changed due to changes in your financial plan, or your long-term risk tolerance has changed, you should let us know and we will adjust your portfolio accordingly. As a reminder, we do not make short-term trading moves unless we have major convictions about the market (i.e. our recent reduction in U.S. equities in favor of international equities and the reduction in fixed income in favor of alternative income).
The reason why we avoid short-term trading is because we have demonstrated that taking a longer-term perspective increases the probability of success for our clients’ financial plans. If we tried to predict the daily changes in the stock markets, we would be considered traders rather than portfolio managers. If we or anyone else were good at predicting daily changes in the stock market, we would be retired billionaires.
In summary, we focus on increasing probabilities of success. By taking a longer-term view, we increase those probabilities. So, expect more market volatility as the stock market continues to digest higher debt, inflation, and interest rates.
We encourage you to give Don or Adam a call if you would like to discuss our perspective on market volatility in more detail.