It was another wild session on Friday as markets reacted to the mixed earnings.

While the overall market ended up down a bit over 1%, parts of the market, notably focused on the FANG related stocks, fell by more than 3% for most of the session.  October has been a tough month so far with just three trading sessions left.  The Dow is down more than 6%, its worst October since 2008.  The S&P is down over 8%, its worst single month since the Great Recession.  The NASDAQ Composite is down over 11%.  But with that said a correction from recent highs approaching 10% isn’t an abnormality within the context of a bull market.  What one can say, however, is that the structure of markets themselves have changed.  With new technology serving to increase the percentage of total volume done by automated trading systems, especially in times of expanded volatility, corrections have become significantly sharper and more compressed into shorter time periods.

That has to change investor behavior.  In baseball, there are hitters’ parks and pitchers’ parks.  Teams that play in hitters’ parks load up on sluggers while teams playing half their games or more in pitchers’ parks focus on pitching.  I like to think of the market in terms of a metronome that moves slowly from left-to-right and triple speed from right-to-left.  The changes this requires are increased discipline that requires investors to focus on asset allocation and valuation.  If stocks become extended, the temptation is to let profits run.  But one never knows when an event will stimulate a one-day price drop versus the start of a 10-20% correction.  When prices get too high, one has to take some money off the table. In asset allocation terms, one has to sell stocks and either buy bonds or increase cash.   Nothing requires sudden movement. If a 60-40 asset allocated portfolio becomes 65-35 because stocks increased in value faster than bonds, then selling one or two stocks within a diversified portfolio would return the allocation to normal.

The same holds true in market corrections.  Suppose you started with $100,000, $60,000 in stocks and $40,000 in bonds.  Next, assume that the stock value falls to $50,000 in a correction.  Your asset allocation now is 55.6% in stocks and 44.4% in bonds.  To get back to 60-40 would require the sale of $4,000 of bonds and the purchase of $4,000 in stocks.   One doesn’t have to rebalance daily or even weekly.  You should look at least annually although there are many who do this quarterly.  Certainly a sharp move as we have seen so far in October dictates revisiting one’s asset allocation.

Friday, I noted that the market correction was a combination of a reaction to higher interest rates and reduced expectations for 2019 enforced by a GDP report on Friday that showed a sequential decline in GDP and a sharp drop in the growth rate for investment spending.  While no one is forecasting an imminent recession, the consensus for growth next year is now back below 3%.  Furthermore, growth is slowing worldwide.   Add in a dollar that, if it were to remain at its current value going forward, would result in a 7-8% headwind to foreign revenues in the first quarter of next year.  For those companies active in emerging markets, the headwind could be even greater.  A combination of sub-2% growth and a very strong dollar led to a decline in corporate profits in 2015.  The same could be in store at least through the first half of 2019.   Estimates have been cut accordingly during this earnings season.  The combination of higher interest rates and lower expected profits accounts for the market’s correction.  The good news is that bond yields have fallen over the past two weeks and most of the adjustment to profit expectations by now have been built into models.  Thus, I think it is fair to assume that most of the correction is behind us.  But, as I always note, (1) in the short run, emotions trump facts, and (2) one can’t get too optimistic until we get two good days back-to-back.

With the end of October coming Wednesday, Thursday and Friday will bring us a flood of data about October.  The big number, as always, will be the employment report due to be released Friday morning. As always, a focus will be on wage rates.  Any sudden increase would spook markets.  The number of jobs produced is also important.   A very high number, while good for GDP, would suggest that productivity is not improving significantly.  The Goldilocks number would be something close to 150,000.

Futures point higher this morning.

Today Gabrielle Union is 46.  Wynona Ryder turns 47.

James M. Meyer, CFA 610-260-2220

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