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Market volatility returned in March, an unsettling development for investors hoping that February’s correction would prove to be a short-term interruption for the bull market.
During the week of March 19, U.S. equities fell the most over a one-week period since early 2016. Despite the largest one-day advance (on March 26) for the Standard & Poor’s 500 index since August 2015, equities resumed their slide.
Although the market may be entering a new phase in which volatility is returning to more normal levels, there are four important tips to consider before making major portfolio changes.
Don’t overreact to presidential tweets. President Donald Trump has posted thousands of tweets since taking office, many posted in the middle of the night or on weekends. The firing of Secretary of State Rex Tillerson was one of the major decisions first announced by a tweet from the president. Trump’s approach to communication is not likely to change, so investors need to adapt to a world in which policy is formed in 140- or 280-character increments.
Trump’s 1987 book, “The Art of the Deal” lends insight into his thought process, and provides context for investors trying to understand the future path of government policy. According to Trump, “One thing I’ve learned about the press is that they’re always hungry for a good story, and the more sensational the better. It’s in the nature of the job, and I understand that. The point is that if you are a little different, or a little outrageous, or if you do things that are bold or controversial, the press is going to write about you. … My style of deal-making is quite simple and straightforward. I aim very high, and then I just keep pushing and pushing and pushing to get what I’m after. Sometimes I settle for less than I sought, but in most cases I still end up with what I want.”
It’s important to recognize that Trump’s tweets are often an opening bid in negotiation, and he may moderate his more extreme policy demands during the course of the negotiation. Focusing on the most-likely endpoint in a negotiation may be more constructive than assuming that the most extreme outcome will prevail.
Worry more about trade wars than trade tensions. Trade tensions are rising, but tariffs and trade restrictions ultimately imposed by the U.S. government may fall short of the scope threatened in Trump’s initial announcements.
Trump is already scaling back plans to impose tariffs on steel and aluminum, and the same pattern may play out with proposed sanctions against China over intellectual property and market access. A trade war with China would be disastrous for investors and consumers, but an improvement in market access and intellectual property protection could actually be a positive development for the U.S. economy and equity markets.
The risk of escalation is a concern, as trade tensions could easily turn into a destructive trade war. It is a positive sign that China and the European Union are responding to Trump’s trade threats in a careful, measured manner, which raises the likelihood of negotiated settlements that are less destructive to global trade.
Expect interest rates and inflation to rise, but at a moderate pace. The Federal Reservehas signaled plans to raise rates three times in 2018, with the possibility of increasing rates four times if the economy shows signs of overheating. The market expects the Fed to raise rates three times this year, and for the 10-year Treasury to peak somewhere between 3 and 3.5 percent.
Despite the Fed’s plans, interest rates are reasonably low relative to history. Inflation is approaching the Fed’s target of 2 percent, but limited employee bargaining power, technology and global trade are factors that are likely to keep inflation in check for the next couple of years. Inflation may become more of a challenge as entitlements get closer to a tipping point in the mid to late 2020s, but for now there may be a limit to how high U.S. interest rates and inflation may go.
Some segments of the market may be more vulnerable to rising interest rates, notably bond proxies such as real estate investment trusts, consumer staples and utilities. Long duration stocks that are reliant on earnings far in the future, such as Tesla (ticker: TSLA) and Netflix (NFLX), are also vulnerable to rising rates. Earnings discounted far in the future are worth less in today’s dollars as interest rates move upward.
Intermediate and long-term government bonds are vulnerable to rising interest rates, so shorter-term government bonds may be a safer option in the near term. Longer-term bonds may become more attractive if rates rise a little higher, potentially providing a source of diversification if economic growth and inflation doesn’t accelerate as much as expected.
Don’t assume that technology will crash as it did when the dot-com bubble burst.Technology stocks have lost some luster in recent weeks, with several high-profile stocks suffering significant reversals.
Facebook (FB) is facing controversy over the privacy of user data and is experiencing dips in user engagement. The fatality resulting from Uber’s testing of a self-driving car creates uncertainty about the path forward for autonomous vehicles. Google (GOOG, GOOGL) and other social media companies may have to pay additional taxes on European revenue, if proposed digital taxes are enacted by the European Union.
Comparisons to the dot-com mania of 1999 are inevitable, as is speculation that there is a bubble that is about to burst. However, there are notable differences between today and 1999, reducing the likelihood that the technology boom will end in a meltdown. Contrasts between today’s technology sector and the dot-com era are significant, including differences in business models, growth prospects and valuations. Many of today’s top-performing technology companies are platform companies with an established ecosystem in which companies plug into the platform to add incremental value or gain access to a network of potential customers. Platform companies have far more sustainable business models than many of the darlings of the dot com era.
Benjamin Graham, who is considered the father of value investing, stated, “The day-to-day market isn’t a fundamental analyst; it’s a barometer of investor sentiment.” Sentiment may swing between extreme optimism and extreme pessimism, and sentiment often becomes disconnected from fundamentals.
Impatient investors can’t resist the temptation to time the market, a strategy almost guaranteed to be a losing proposition. Wise investors realize that time in the market is more important than timing the market, and devote their energy to separating fundamental trends from the emotional swings of the market.
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