The S&P 500 had a somewhat volatile ending to January, falling 2% in the last week of the month. That left the index flat on the year after rallying to start 2020. The main headline driving the recent volatility is the coronavirus outbreak. However, as is usual with financial media headlines, this is most likely a short-term event. Not something with much of a long-term impact on the economy.
The S&P 500 is flat on the year
The fact that the S&P 500 initially went up but then declined is not that surprising. As we noted at the beginning of the year, risks for a short-term downturn were higher than usual. This isn’t because of worsening economic data or poor earnings, but rather because markets simply do not go straight up. And that was the set up to start the year after the S&P 500 rallied 15% from an October low. The long-run average return for the S&P 500 is about 7.2% per year. 2019 quadrupled that.
After 1 month, the S&P 500 (VOO) is flat but there are some interesting returns elsewhere. The NASDAQ 100 (QQQ), a tech-heavy index, is up 3% on the year. However, small-caps (IJR), a “risk-on” proxy of sorts, finished January with a 4% loss. And yet, most perplexing, is that long bonds are the best performer, already up 7% to start the year!
Long bonds, as shown above via TLT, have gained 7.28% annualized for the last 10 years. 2020 accomplished that return in the first month of the year. This can be interpreted in a number of different ways. The most popular reason would probably be that the bond market is pricing in another fed rate cut soon. And as such, long bonds are rallying.
More rate cuts coming?
Sure enough, futures markets are implying a greater than 50% chance of two more rate cuts this year, per Charlie Bilello:
If we believe that the bond market is rallying in anticipation of more rate cuts, we also have to believe the economy is slowing down. Either that or you subscribe to the idea that the fed is in the President’s back pocket. We’d rather assume that the fed is not at the political beckon of the President. Either way, we’re watching closely to see if the 2-year and 10-year yield curve inverts as it did in August:
It quickly snapped out of the August inversion, boosting equities in the process. In fact, the inversion in August marks a 6 month low in the S&P 500. While there is still an 18 bps spread between the 2-year and the 10-year, it’s testing 3-month lows. Furthermore, the closer it gets, the more attention it will get, which could dampen sentiment on its own. Lastly, we should note here that the 3-month and 6-month bill have already inverted with the 10-year, albeit only slightly (data from Bloomberg):
Non-US remains a headache
The overseas bond market is strong, much like it is in the US. BNDX, an international bond market ETF, and EMB, an emerging bond market ETF, are up 1.89% and 1.24% so far this year. But unless you think emerging markets stocks are on track to lose 10-15% this year, we see a buying opportunity developing.
Speaking of a 15% drop, the ETF, EJAN, has a 15% buffer built into it for 2020. And with the fund down 2.79% so far YTD, it’s attractive right here. That’s because, if by the end of the year, Emerging market stocks are not down more than 15%, EJAN will trade back to its 2020 starting price of $26.80. This ETF has very similar characteristics to BJAN, an ETF that we highlighted a few weeks ago. The main watch out on EJAN is the lack of liquidity plus its wide trading spread.
If you allocate across multiple market segments, you can find prices that are 2-6% lower since 2020 started. Ultimately, we do not expect the coronavirus to morph into the type of market-changing event that impacts market returns meaningfully this year. But we would not be surprised to see the stock market drop another 2-5% from here. And if it does, rest assured that the fear-mongering surrounding the coronavirus will reach a deafening pitch.
But just remember, if it wasn’t the coronavirus getting the headlines it would probably have been something else. When the market goes up as much as it did in 2019, it becomes easier for the market to find a reason to move lower. And that’s what’s happening now. This is all just normal ebbs and flows of the market. But be prepared for more volatility in the short-term. February is historically one of the worst months of the year.
2019 set a very high bar for the market and 2020 will almost certainly not be able to reach it. It may not even be able to reach half of it. But that’s not the market’s fault, 2019 was just that good. Therefore, being able to buy certain market segments when they are negative on the year is an appealing opportunity for us. Especially as we’re getting better than expected returns from various segments of the bond market.
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