In the course of 2018, the US stock market hit a high at the end of January, then immediately suffered a quick 10% correction. This was followed by many months of recovery to achieve a new high in September only to once again immediately fall 10% into another correction.

2018: Tired bull market or index fund/computer algorithm dominated market?

The year has been a roller-coaster of a ride leading us back to where we began.

I suggest that the path of the market in 2018 is worth noting. Is it a sign of a tired bull market that is having trouble holding new highs? Or is the pattern a reflection of a market that is now dominated by index funds and computer algorithms? Perhaps it may be both.

In either or both cases the prescription should be cautious stock selection and a somewhat increased allocation to cash.

Reflect on the past few years where high multiple, momentum stocks were the darlings. I think that game may be over.

As readers know, I have never been a fan of momentum investing and certainly one to stay away from high-fliers. In the market of recent years, prudent, traditional value investing has underperformed.

I have argued that the explosion of index fund investing has distorted the market, giving momentum to high multiple stocks.

I have also suggested that low-interest rates fueled growth and made suspect business models appear sound.

Cash helps during sudden market drops

If some rationalization of P/E multiples are underway and interest rates are higher, 2018 might prove to be a year where we see a change in the way investors approach the market.

The FAANG stocks may give way, allowing a broader set of leaders to emerge. If true, we could be standing on shifting ground. A lot of money has funneled into FAANGs and a repositioning takes time and is likely to be messy. After a long run, we forget that hot money flows out just as fast as it flows in, maybe even faster.

This is where cash helps. It provides dry powder to take advantage of sudden market drops where quality names go on sale.

Short-term Treasuries now offer some yield

Unlike a few years ago, short-term Treasuries at least now offer some yield.

The drop in stocks from the end of September is very uncomfortable. Leaders like Amazon have been taken down. Confidence has been shaken. The speed of the decline is un-nerving.

Worst of all, we are not out of it yet. The correction will be in place until the market makes a new high.

Despite the present negativity and maybe because of it, I still think the market goes higher before we have the next bear market. It will take time for new market leaders to emerge. During this period, investors should be combing over their portfolios, selling weaker names to buy quality ones.

Many stocks, country markets, and sectors have already been in bear markets and represent fertile ground to find bargains.

I wish everyone a warm, enjoyable holiday season and a happy, healthy, prosperous new year.

— Ian Green, Pendragon Capital Management

Subscribe to Pendragon's Newsletter

Note: This blog article is intended for general informational purposes only. Nothing in it should be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product.