After 10 consecutive quarters of gains, the S&P 500 index broke its impressive streak by giving back 6% over the summer. Its last negative quarter before that was a miniscule -0.38% pause in the fourth quarter of 2012 – as Congress barreled towards the Fiscal Cliff. Not since 2011 had the S&P 500 declined by more than 3% in a quarter. And prior to the August-September 2015 swoon, broad stock market indexes chugged along for more than four years without a garden-variety “correction” as defined by a 10% decline. That’s unusual to say the least. Historically corrections occur every 12-18 months within bull markets, so stocks were due for a pause.
When markets pull back, we all try to determine the root cause. If you’re a trader, the million-dollar question is always whether stocks are just starting to discount something much worse or simply consolidating recent gains within an ongoing bull market. It is always crystal clear in hindsight, but making that call on the front end is exceptionally difficult. Peloton structures portfolios so we don’t have to guess. Our approach is to maintain the right asset allocation for each client so we don’t have to make that call correctly (or at all) in order to do well by clients.
We own individual companies – not broad markets or economic growth – so we focus on company operating metrics in all market environments and sell stocks when we want to, not in a reactionary or emotional response to tumult. Amidst the recent volatility, people have asked us if we are buying or selling or just “sitting tight.” The answer is that we do all three all the time depending on the distinct investment. In any given climate we are moving away from some positions in favor of others we’re accumulating. Often specific rebalancing activity is necessary for certain client accounts, and sometimes individual stocks hit price targets even in down markets. Portfolio management is fluid, and we rely on our analysis and disciplines to dictate activity, not short-term market fluctuations.
There are plenty of proximate causes for the summer correction, including the slowdown in China, Fed rate hike waffling, and the possibility (albeit slight) of a government shutdown. All are perfectly good reasons for a pullback, but none appear to have teeth beyond some discomfort and ambiguity. Perhaps the single biggest uncertainty facing markets is the timing of the Fed’s rate hike. We at Peloton have argued that this should be a non-issue for markets, but it is nonetheless driving short-term volatility.
Recently, we happened across a new measure of unemployment known as the Z-POP ratio, which is a modified version of widely used models. Despite the headline unemployment rate of 5.1%, according to the modified Z-POP formula, the labor market has not yet healed fully from the recession. As far as we can tell, Z-POP is the only pertinent measure that could argue against raising rates. Numerous and varied other data series have regained and surpassed pre-recession peaks.
Recall that the Fed’s two mandates are full employment and stable prices (mild inflation). It is not responsible for Greece or China or currency exchange rates. Inflation is well under control, so if the Fed is truly focusing on its mandates (big IF), it must be worried about the employment picture – relying on the Z-POP readings to justify maintaining the extraordinarily accommodative stance. We at Peloton believe the Fed will still raise rates in 2015 (most likely at the December meeting) and that markets will handle the hike just fine. Mandates aside, the calamity that forced the Fed to undertake ZIRP is long gone, so the Fed should begin the process of normalizing interest rates sooner rather than later.