The third quarter of 2018 was the best quarter for stocks since 2013, and all of the major U.S. equity indexes reached all-time highs during the quarter—the S&P500, the Dow, the Russell 2000, and the Nasdaq 100. At the end of the second quarter of 2018, the momentum signals Stillpoint follows had pointed to higher prices for stocks. As a result, we positioned portfolios to reap the expected benefits, and we did reap them.
Because we are momentum investors at Stillpoint, our plan was to continue to invest in equities for the fourth quarter of 2018. Correspondingly, one of the central tenets of momentum investing is that an object in motion stays in motion. Higher prices lead to higher prices. Of course, however, nothing goes up forever, and taking risk off at specific intervals is a wise move if the market has changed.
That is precisely what happened in October 2018. The equity indexes plunged in the neighborhood of 7%, approximately the same amount they had risen in the third quarter. This occurred after the equity indexes had already corrected 10% in February before recovering and reaching all-time highs. This environment was nothing like 2017, which saw a maximum 3.8% drawdown the entire year in the S&P500.
For these reasons, we thought it prudent to cut equity risk in portfolios for November and December, shifting equity allocations from 100% to 50%. This move minimized the ensuing drawdown in December, which was worse than in October. In all, the S&P500 index corrected just under 20%, while Stillpoint portfolios corrected on the order of 12-15%, depending on client investment plans.
What happened in the fourth quarter of 2018 illustrates a principle that investors should always keep in the back of their minds—probabilities are not certainties. While it was probable that the best allocation for the fourth quarter was equities—just like it was for the third quarter—it was not a certainty, and lower probability events can and do happen. As a girls' softball coach, I tell the same story to softball players. We play the probabilities to increase our chances of winning, but there are no guarantees that we will win every time we play the probabilities.
What's important is that investors and advisers have a plan in place to deal with an undesired low-probability event, while continuing to embrace the probabilities. That plan should almost always involve minimizing exposure to lower prices and greater volatility, which is precisely what we saw in the fourth quarter. Sometimes it rains, and when it rains, it sometimes storms. If it does, it helps to have a sturdy umbrella handy.
By the end of 2018, momentum signals that Stillpoint follows were flashing red while they had flashed green just three months prior. For this reason, Stillpoint portfolios are defensive as of mid-January 2019, mostly in U.S. treasuries and partly in gold. These assets performed well in the fourth quarter.
However, the equity markets have rallied since Christmas Eve, forming a temporary bottom. As of mid-January 2019, equities have performed very well since this bottom. But it's important to see the bigger picture, too. A three-week rally does not make for a bull market. That is especially true given that a key measure of the health of the stock market remains bearish. The S&P500 index remains well below its 200-day moving average.
As of the time of writing, the S&P500 index is a smidgen above 2600, while the 200-day moving average is at 2741. The index would need to rally more than another 5% to cross this all-important threshold. Additionally, researchers like Laurens Bensdorp have noted that the zone of 2% above and below the 200-day moving average is particularly noisy, meaning that when prices merely cross above or below the average, no clear signal emerges. As a result, it would take a rally of more than 7% for the index to enter bull territory again under this approach.
I hope that it does, and true to form, some of the indicators I monitor suggest that the next six months could be bullish for stocks. But these are expectations, not facts. The facts indicate that the most commonly used barometer for the health of the stock market continues to flash a red warning sign.
It would be a dereliction of duty not to respect this warning sign. One of the cardinal rules of trading and investing is not to take a big loss. Smallish losses can be managed, and a drawdown of 20% or less falls into the category of losses that can be managed. But losses greater than 33% do not. A drawdown of 20% requires only a drawup of 25% to break even, while a drawdown of 40% requires a drawup of 67% to break even. These are different sorts of problems, and we would rather face the problem of dealing with manageable drawdown than an unmanageable one.
Regardless of whether the markets rally in the next six months, it is also worth considering expectations beyond six months. There are reasons to believe that that the economy is beginning to deteriorate. Real estate peaked more than one year ago, and the 10 yr/3yr yield curve is close to inverting, suggesting that a recession and bear market could be about one year away. To that end, the return on 1-3 month T-bills over the past year (+1.72%) has greatly exceeded return from the S&P500 over the same time frame (-5.62%). Investors have become risk averse.
But never fear. What I have been describing is the ordinary progress of the business cycle. There is no question that we are late in the business cycle, when downside risk begins to overwhelm upside potential. Managing that downside risk is crucial, not simply for the reasons I've already mentioned. On the other side of a bear market is a new bull market, where upside potential overwhelms downside risk, and new opportunities abound. We want to seize those opportunities and not be licking our wounds from the last bear market.