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« Q2 2018 Commentary | Main | Q4 2017 Commentary »

Q1 2018 Commentary

We entered 2018 holding more cash across all strategies than we have at any point in over a decade. 

Last quarter’s comments outlined a laundry list of excesses in the market – most of which were also at their most extreme levels of the recovery. 

Over the first three weeks of the year, virtually every extreme that had previously concerned us only grew further untethered from norms. 

Things changed rapidly.  It began with a 1000 point down week for the Dow – a fall in excess of 4%.    The decline was initially minimalized in the financial media, but only took a few more trading days for stocks to fall a total of 10% from their highs. 

The rapidity of the decline was notable but was widely framed as a “typical correction.”  This characterization, however, included a major, underreported oversight:  stocks fell this rapidly from all-time record highs – something that most serious market watchers would have told you doesn’t happen.  In fact, many seasoned market veterans, even those who believed markets valuations were stretched, found solace in this common wisdom early in the year.  There was a popular belief that once markets topped, there would be plenty of time to get out. 

The historical record was supportive of this belief, as virtually every major decline (1929, 1987, 1974, the tech and financial crashes) all began with more modest reversals.  The last time stocks fell this far this fast from record highs was in 1919.

This belies and important point: unique and unprecedented markets (like last year’s rise), coupled with unique and nearly unprecedented valuations were highly likely to be accompanied by unique and nearly unprecedented risks. 

The problem often lies in anticipating exactly what these risks are.  There is a common belief that the inability to predict and identify risks means that investors should not try to adjust their investments based on perceived risks.  History tells us, however, that there are many predictors of future market risk, including high valuations.  And while there is no precise tool for determining exactly when equity markets will peak or exactly what the risk-drivers will be, there is a blunt tool we can use to protect ourselves: cash.

Despite the pullback lasting nearly two months, we have only employed a limited amount of our accumulated cash positions.

Recommitting capital here is always a gradual process that requires the correct alignment of data and prices.  The volatile price action has meant that entry points have been short-lived, while other data sets, such as sentiment, have failed to fully support increased exposure.  Meanwhile, global accounts, which adapt to changing market environments, have raised their threshold for further investment in this market due to the volatility spike – preventing an accelerated entry.

There are plenty of technical reasons that we are being cautious getting back into the market in the short run, but they align with some longer-term concerns. 

First, of course, are valuations. Stocks have provided the perfect mix of rising earnings and falling prices to make equities their cheapest since July of last year (after adjusting for tax cuts).  Even with those adjustments, however, earnings multiples remain at historically unsustainable levels.

In addition to valuations, we are dealing with rapidly rising interest rates, which both slow growth and erode a primary argument for the high valuation multiples mentioned above.  In late March, 1 month Treasury bills were yielding nearly 40 basis points more than 10 year Treasuries had been yielding in July 2016, and were yielding only 30 basis points less than where 10 year yields were just last September. It is the fastest relative pace of tightening since 2007.

Finally, there is the fact that rapid pullbacks from record highs are not generally good buying opportunities.  Similar pullbacks in 2000 and 2007 proved to be great short-term trading opportunities, with stocks reaching new highs within months. But both drops ultimately presaged significant market tops.  In other words, even if stocks regain their January highs, it is not an all-clear for investors. 

Even if we are not in the midst of a major market reversal, corrections on the order of what we witnessed in the first quarter often take quite a while to sort themselves out.  Initially months, but often years before stocks are setting new permanent highs.

Though we added to our equity allocations in the first quarter, our investment activity was rather limited (domestic strategies targeting close to 33%, global strategies, 25%).

We were much more active in launching our options-supplemented domestic approach.  Options-enhanced accounts began trading in early February.  These first months of live-investing have gone as expected while alleviating some concerns with execution and options market liquidity.  We hope to significantly expand this strategy in the quarters ahead*.

Beyond our options strategy, we have expanded use of our Global ETF based approach, which outperformed domestic approaches for the quarter.  This strategy remains best suited for small accounts and as a great diversification tool for clients already employing our traditional approach.

We continue to look to ways to optimize client returns, while remaining prepared for what is likely to be a volatile road ahead.


Robert B. Drach

Drach Advisors LLC

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