It’s the first landmark you notice as your flight escaping Michigan’s cold and snow makes its final approach to the island. It encircles the spot of sand that will be your home away from home.

Once on the ground, you hear the sea upon it before you can view it. Then splotches of greens and bluish shades suddenly appear as a prelude to it, as if emerging from a tunnel into the daylight.

The waves thunder in, some topping 20 feet or more, and they crash upon it with a roar. The water foams bright white in the wake of a collision of earth and angry sea. Yet all this occurs not where the sand meets the water but instead distant from shore.

Once into the water, you snorkel high above it viewing a seemingly endless parade of colors. A slight kick of your fin transports you farther, over the schools of fish and the crenulated formations of coral that thickly populate its flanks.

Just 0.1% of Earth’s ocean surface is devoted to coral reefs. Yet these relatively rare structures of nature are home to 25% of the planet’s marine species. They help feed the world, boosting seaside economies and tourism.

However, back on land, staring out at the reef from the end of our dock, I’m hardly conscious of any of this. Instead, viewing the line of coral stretching in both directions to the horizon like the Great Wall of China evokes a sense of being protected. While the sea crashes furiously upon the structure built of billions of coral skeletons, a calm lagoon stretches in front of me as a result of the reef’s protective arms.

As a risk manager in the financial markets, the creation of such an environment for my clients’ portfolios is always on my mind.

Market update

The stock market, since it crested on January 24, has been delivering gale-like winds in all directions. It plunged for nine straight days into the correction territory we have been warning of since before Christmas. Losses in the many stock market indexes, which investors had been lulled into thinking could only move up, piled higher, topping 10%. Safe harbors in other asset classes seemed not to exist.

Then, in one week, it appeared that the storm had ended. Prices retraced 50% of their losses last week.

S&P 500: 2014-2018

Was it over? Or were we just in the eye of the hurricane, where killing winds die down to nothing, all is calm and risk seems not to be in sight.

I remain wary. We had almost two years without a 10% or greater correction. Could it really be over in just nine days? That would be one of the shallowest and shortest corrections since WWII!

Many market commentators are celebrating. They are calling it a V-shaped bottom. Yet, so often bottoms end up more W-shaped. Prices need to test the first low before reviving entirely their search for higher ground.

Sometimes it takes just a matter of days to etch out this pattern, on average about 60 calendar days. Other times it can take two years after plunging into a correction, as it did in 2011, before the stock indexes sail into new territory.

And occasionally, the second downturn continues lower. The storm surge breaches the barrier reef and the whole financial system seems engulfed. Studies tell us that 97% of wave energy is absorbed by nature’s seaside barriers. Over 200 million people are protected from most of Neptune’s wrath, but not all of it.

While I think the odds favor a retest, I do not think that we are in the eye of a hurricane but rather just a squall line of storms that could start and stop for a while. I expect the assault on new highs to begin again soon and reach its goal before early May.

Why the optimism? The stock market waves are grounded on earnings. As corporate earnings rise and fall, so go stock prices.

We are nearing the end of the reporting season for corporate earnings, and earnings are up over 15% on average from last year at this time. More than 70% of reporting companies have beat not only the analysts’ earnings projections but also, and this is rarer still, their revenue estimates.

At times, however, earnings gains can be an illusion. Like someone at a party who is the last to know that it has ended, earnings can top in the waning days of a bull market if a recession is in the wind.

However, there are no signs of a recession on the horizon. Interest rates, while higher, have not caused an inversion (low-duration bonds yielding more than longer-term bonds). And last week’s extremely positive housing start numbers are not showing the downturn that normally precedes a recession.

Housing Starts 1967 - 2018

Still, last week’s manufacturing numbers and dismal retail sales numbers continue a slowdown begun in December. The inflation numbers continue to move higher (although some measures still remain below 2% on an annual basis). When factoring in the negativity of the inflation reports, last week’s scorecard of economic reports can be viewed as six reports outperforming economists’ projections and 12 disappointing.

CPI rebounded and is ticking up

With the three-month core inflation rate of change being the highest since 2011, and the six-month rate growing the fastest since 2008, it seems time for some changes in most client portfolios. Not only does this favor non-bond investments (higher inflation drives rates higher and bonds lower) but also the attractiveness of alternative investments, like gold, and other commodities strategies.

These economic headwinds could continue to support the short-term market volatility to the downside that I mentioned. The quick return to bullishness by the average investor evidenced by the surging positive sentiment shown in the American Association of Individual Investors (AAII) report (a move from 37% to 48.5% bullish this week) also suggests a contrarian weight upon this market in the short term.

I don’t want investors to feel like the small motorboat that just struggled past me on the other side of the reef. The tiny craft rose to each wave crest only to plunge toward the Caribbean seafloor in the undertow. Every 2 or 3 feet of progress seemed to cost a loss of a foot or two. Yet, inside the reef, where the fisherman could have traveled, the sea remained calm.

This dichotomy persists in the financial markets. Buy-and-hold investors do indeed rise to the market’s heights as indexes soar. But they also plunge to financial depths as they seem to take one step backward for every two steps forward.

Dynamic risk management tries, instead, to keep investors sailing on the shore side of the reef. There may not be as much action in the lagoon, but it is easier to get where you want to go. It aims to do what marine biologists throughout the world work to accomplish: In the same way they seek to create the seaside protection and resulting serenity of the coral reef, the goal of dynamic risk management is to build a wall of protection for investors.

This can be a great tool when a financial storm is raging. By diversifying by asset classes and also by strategy type, you can create a portfolio that is like a reef: robust enough to survive, prosper, and protect.

Disclosure: No communication by Dynamic Performance Publishing or our employees to you should be deemed as personalized investment advice. Any investment recommended in this newsletter should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company. Dynamic Performance Publishing, its affiliates, and clients may hold positions in the recommended securities. Results are not indicative of holdings for clients of Flexible Plan Investments. Forwarding, copying, or otherwise duplicating this information for the use by anyone other than the intended recipient is expressly forbidden. These results are not representative of those achieved by clients of Flexible Plan Investments, Ltd. (FPI) due to differences in security selection, timing of trades, transaction fees, and FPI’s management fees.