Friday February 2nd Selloff


February 5, 2018

In a sobering reminder that stock prices can move in both directions, the Dow Jones Industrial Average plunged more than 665 points (2.54%) on the last trading session of the week (February 2nd), while the S&P 500 skidded 2.14%. The week as a whole was awful, with the Dow tumbling 4.11%, the S&P 500 sinking 3.82% and the Russell 3000 dropping 3.78%.

Not surprisingly, the massive point drop on the Dow (the largest one-day move since December 2008) brought out plenty of superlatives from the financial press, even as the percentage magnitude of the change has been seen 16 times previously just since the end of 2009,…

…while the single-day decline of the broader market, as measured by the S&P 500, has been endured nearly 700 times previously over the last 90 years. Looked at another way, given that there have been 22,629 market days since the start of 1928, more than 3% of all trading sessions have suffered a loss equal to or greater than what was witnessed on Friday. Happily, there have also been 638 days where the S&P 500 gained more than 2.14%, with far more winning sessions overall no matter the magnitude.

We are not suggesting that folks should ignore the pain endured by their portfolios, and we recognize that the traffic has been flowing only in the northerly direction for quite some time, but we offer the perspective that volatility is not an unusual aspect of the investment process. Indeed, the drop from the highs set on January 26 hasn’t even made it onto the list of 294 previous setbacks of at least 5% for the S&P 500,…

…with the 10.6% to 13.4% annualized returns for Dividend-Payers and Value Stocks illustrating the ample rewards for putting up with the sometimes disconcerting gyrations of the equity markets. Of course, it is periods like the present that we believe investors should remember that the secret to success in stocks is not to get scared out of them, especially as big downturns spark all sorts of sensationalistic media headlines.

Like clockwork, this weekend our good friends at Marketwatch.com served up a column warning that there have been “long periods of misery when the market remained in a downward spiral or moved sideways.” The author informed readers, “It took 25 years for the market to recover from the 1929 stock-market crash,…

…and 16 years for stocks to bounce back from the combined effect of the Vietnam War, the 1973 oil shock and the resignation of President Richard Nixon [1].”

Yes, the Dow Jones Industrial Average showed no price appreciation over those periods, but the S&P 500 managed TOTAL returns of 6% or so PER ANNUM during both those supposed dismal spans. The reason for the gigantic gap in performance is dividends and their reinvestment. Alas, it would seem that many journalists do not grasp the concept of total return, though we respect that one would actually have had to reinvest their dividends to enjoy the solid equity market gains.

Of course, leaving dividends out of the equation and focusing solely on capital appreciation is a fatal mistake when evaluating the merits of equities, just a it would be to leave bond coupons or interest payments out of the fixed income conversation. On that subject, Morningstar’s most recently available SBBI Annual Yearbook shows that Long-Term Gov’t Bonds have had total capital appreciation (i.e. ignoring the income and its reinvestment component of total return) over the last 90 years of 36.9%, while Intermediate Term Gov’t Bonds have had capital appreciation of 68.3%. Those figures are NOT annualized and encompass nine decades, meaning that if one measured bonds like many seem to measure stocks, there would be no way they could ever be held.

And speaking of bonds, a spike in interest rates received the lion’s share of the blame for last week’s carnage as the yield on the 10-Year U.S. Treasury soared to 2.84% on Friday afternoon, up sharply from 2.66% a week earlier. Certainly, we recognize that higher rates should arguably make stocks less appealing, but investors did not seem to mind a week ago that the yield on the 10-Year had nearly doubled from 1.38% on July 8, 2016.

The main reason for the increase in rates had heretofore not been a problem is that they were rising on more favorable economic data. Hard to complain about a healthier domestic economy, given the boost it provides to corporate profits, and we were happy to see a continuation last week of the release of generally positive numbers,…

…including statistics on the all-important jobs picture.

To be sure, many are now worried that interest rates will rise faster, given that wage growth for January jumped 2.9%, the largest year-over-year increase since June 2009. While good for workers, higher employment costs have heightened worries about inflation, even as some of the increase in compensation was due to the one-time bonuses doled out by many companies in response to the cut in corporate taxes.

That said, we do note that the Federal Reserve was also more upbeat in the statement that accompanied last week’s decision to maintain the Federal Funds rate at 1.25% to 1.50%. Outgoing Fed Chair Janet Yellen & Co. said, “Information received since the Federal Open Market Committee met in December indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate. Gains in employment, household spending, and business fixed investment have been solid, and the unemployment rate has stayed low. On a 12-month basis, both overall inflation and inflation for items other than food and energy have continued to run below 2 percent. Market-based measures of inflation compensation have increased in recent months but remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.”

Of course, San Francisco Fed President John Williams, a voting-member of the Federal Reserve’s interest-rate committee, suggested in a speech on Friday that the U.S. central bank should remain on a course of gradual rate hikes this year. He added, “For the moment, I don’t see signs of an economy going into overdrive or a bubble about to burst, so I have not adjusted my views of appropriate monetary policy.” Mr. Williams concluded, “I expect continued moderate growth, with no Herculean leap forward.”

The futures market still seems in general agreement with the Fed (two to three rate hikes this year),…

…which stated last week, “The Committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”

That last comment is important for investors to keep in mind as interest rates remain extraordinarily low by historical standards,…

…which continues to be a strong support of equity prices by our way of thinking, both in terms of the income produced versus competing investments…

…and even in regard to valuation.

And, for those who truly fear the inflation bogeyman, we think healthy perspective can be provided by looking at the historical evidence of equity returns and changes in the inflation rate.

All of the above is not meant to say that equities will resume their climb this week, especially as there has not exactly been a lot of pain suffered by stock market investors in 2018, given how well the major market averages performed over the first four weeks of the year,…

…while the contrarian in us didn’t like the report last week from Bank of America Merrill Lynch that there were massive inflows into U.S. stock funds over the first four weeks of the year. As we like to say, the only problem with market timing is getting the timing right!

[1] 02.03.18. Source: https://www.marketwatch.com/story/the-dows-tumultuous-120-year-history-in-onechart-2017-03-23

Disclosure Information

No guarantee of investment performance or dividend payment is being provided and no inference to the contrary should be made. Past performance may not be indicative of future results. Investing involves risk, including possible loss of principal. Diversification does not
protect against loss in declining markets.

As of 2.2.18. TBV = Tangible book value. EV/EBITDA = Enterprise value to earnings before interest, taxes, depreciation, and amortization. FCF Yield = Free cash flow yield. Please see last page for additional information.

Opinions expressed are those of Al Frank Asset Management, a division of AFAM Capital, Inc. They are subject to change without notice,

and are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Please note that figures and illustrations herein are not intended to be representative of any individual product available through AFAM Capital, Inc.
CHART: Delta in Inflation & Value/Growth
The capitalization and factor-based (book value-to-price) portfolio data is from Eugene F. Fama and Kenneth R. French. The dataset is broken into four groups: large value, large growth, small value and small growth. A large value stock is a type of large-cap stock investment where the intrinsic value of the company’s stock is greater than the stock’s market value. A large growth stock is a growth stock of a company with a market capitalization value of more than $5 billion. A small value stock is a value stock of a company with a relatively small market capitalization. A small growth stock is a growth stock of a company with a relatively small market capitalization.

CHART: Ups & Downs, But Equities Win
From 02.20.28 through 1.26.18. price return series. We defined a Declining Market as an instance when stocks dropped the specified percentage or more without a recovery of equal magnitude, and an Advancing Market as an instance when stocks appreciated the specified
percentage or more without a decline or equal magnitude. SOURCE: Al Frank using data from Bloomberg, Morningstar and Ibbotson Associates.

From 06.30.27 through 12.31.2017. Growth stocks = 50% small growth ans 50% large growth returns rebalanced monthly. Value stocks= 50% small value and 50% large value returns rebalanced monthly. Dividend payers= 30% top of dividend payers, 40% of middle dividend payers, and 30% bottom of dividend payers rebalanced monthly. Non-dividend payers= stocks that do not pay a dividend. Long term corporate bonds represented by the Ibbotson Associates SBBI US LT Corp Total return index. Long term government bonds represented by the Ibbotson Associates SBBI US LT Govt Return index. Intermediate term government bonds represented by the Ibbotson Associates SBBI US IT Govt Total return index. Treasury bills represented by the Ibbotson Associates SBBI US 30 Day TBill Total

Return index. Inflation represented by the Ibbotson Associates SBBI US Inflation index. SOURCE: Al Frank using data from Professors Eugene F. Fama and Kenneth R. French and Ibbotson Associates.

CHART: Dow Went Nowhere 1929 to 1954
Growth stocks = 50% small growth ans 50% large growth returns rebalanced monthly. Value stocks= 50% small value and 50% large value returns rebalanced monthly. Dividend payers= 30% top of dividend payers, 40% of middle dividend payers, and 30% bottom of dividend payers rebalanced monthly. Non-dividend payers= stocks that do not pay a dividend. Calculator: http://dqydj.com/sp-500-return- calculator/

CHART: Dow Went Nowhere 1966 to 1982
Growth stocks = 50% small growth ans 50% large growth returns rebalanced monthly. Value stocks= 50% small value and 50% large value returns rebalanced monthly. Dividend payers= 30% top of dividend payers, 40% of middle dividend payers, and 30% bottom of
dividend payers rebalanced monthly. Non-dividend payers= stocks that do not pay a dividend. Calculator: http://dqydj.com/sp-500-return-calculator/

CHART: Down (in 2018) Under Bargains
Price-to-earnings (P/E) ratio: Divides the stock’s share price by its trailing 12-month earnings per share to show how much an investor is willing to pay per dollar of the company’s net income. Price-to-Book (P/B) Ratio: Divides the stock’s share price by its book value (assets minus liabilities). Price-to-Sales (P/S) ratio: Divides the stock’s share price by its annual sales. P/B refers to the price to book ratio which compares the stock market’s value to its book value. EV/EBITDA refers to the enterprise multiple which is the ratio used to determine the value of a company. The price to tangible book value (P/TBV) is a valuation ratio expressing the price of a security compared to its hard, or tangible, book value as reported in the company’s balance sheet. FCFY (Free Cash Flow Yield) is an indicator that compares free cash flow and market cap. The debt-to-equity ratio (Debt/TE) is a financial ratio indicating the relative proportion of shareholders’ equity and debt used to finance a company’s assets. Dividend yield is a ratio that indicates how much a company pays out in dividends each year relative to its share price. Market Cap is the market value of a company’s outstanding shares.

Any investment recommendations provided herein are subject to change. Those recommendations are provided for informational purposes only and are not provided as a recommendation to buy or sell any one security. Past and current recommendations that are profitable are not indicative of future results, which may in fact result in a loss. See https://theprudentspeculator.com/investment-reports/ for a list of all past specific investment recommendations. The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ. The Russell 3000 index measures the performance of the largest 3,000 US companies representing approximately 98% of the investable US equity market. The Standard & Poor’s 500 index (S&P 500) is a broad market sample based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. NASDAQ is a global electronic marketplace for buying and selling securities, as well as the benchmark index for U.S. technology stocks.

It is not possible to invest directly in an index.

Nothing presented herein is, or is intended to constitute, investment advice, nor sales material, and no investment decision should be made based on any information provided herein. Information provided reflects AFAM’s views as of a particular time and uses data from independent sources believed reliable. However, accuracy is not guaranteed and has not been independently verified.

AFAM Capital, Inc. is registered with the Securities & Exchange Commission, is editor of The Prudent Speculator (TPS) newsletter and is the Investment Advisor to certain proprietary mutual funds and individually managed client accounts. Registration of an investment advisor does not imply any level of skill or training.

047-AFAM-2/5/2018

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