US Market Viewpoints: December 31, 2018

The markets delivered a Christmas gift that no one asked for this year, a bear market. Stocks capped a turbulent year with a steep sell off in the fourth quarter. 2018 was a tough year for almost all assets categories around the world. The best performing asset was cash beating both stocks and bonds. This is the first-time cash has been the best performing asset since 1994. This was the first negative year for the S&P 500 since 2008 and the quarter was the 10th worst quarter for stocks since 1950. A bear market is when stocks sell off 20% from their prior high. Most of the US markets reached bear market territory. The Dow Jones Industrial Average has managed to avoid one so far.

There was not one single issue that caused the market sell off, but rather a series of items that percolated to the surface. There are four key issues that are in focus; interest rates, future economic growth, trade issues and political uncertainty. Short term interest rates have been moving higher since December of 2016. The Federal Reserve raised rates twice this quarter, each time by 0.25%. Short term interest rates are now in a range of 2.5% and 2.75%. This is giving some investors an alternative to investing in stocks or bonds. Short term rates and long term rates are roughly the same. This is usually a signal that expectations for future economic growth are slowing. When short term rates are higher than long term rates this is called an inverted yield curve. We are close to seeing an inverted yield curve and this has been a good predictor of recessions, although it usually has a lag time of a few months to two years until a recession occurs.

Economic growth remains good in the US, but there are signs that growth is maturing. There is little to no signs that a recession is going to happen in 2019. International economies are decelerating at a quicker pace than expected. This is in part caused by uncertainty around trade issues. China is seeing their economy miss expectations because of tariffs place on goods by the US. Additionally, Europe and Japan are having a tougher time growing because China is a significant business partner for these economic blocks. US companies are seeing their international clients act more cautiously in this environment. Lastly, there is a higher level of political uncertainty than in the past. All of these factors contributed to the market moves seen this quarter.

The difference between the 3rd and 4th quarters could not be more staggering. In the 3rd quarter all sectors posted positive performance while this quarter all sectors were negative. Defensive sectors like utilities (-0.4%), consumer staples (-5.5%) and REITs (-5.7%) held up better than the broader market. The worst performing sectors were found in more cyclical industries. Energy stocks sold off 22.2% in the quarter largely because of the 38% price decline in crude prices. Industrials sold off 17.1% in the quarter and tech shares were off 17.0%. Larger companies performed better than small and mid-cap companies in the quarter. Value stocks did slightly better than growth in the quarter although growth performed much better through the entire year.

Strategy

In our last Quarterly Viewpoints, we borrowed a line that we need to prepare because we cannot always predict. We had no idea and were not predicting the results of this quarter, in fact we were positive. We did takes steps in October to limit the downside in your accounts. We added a low volatility exchange traded fund (ETF) to the accounts invested in our ETF model. This type of investment performed well during declines in the market. We increased your cash holdings slightly as well. For our clients near or in retirement throughout the year we have increased your cash holdings to make sure we had at least 12 months of your distributions sitting safely in money market funds. Our moves this quarter did reduce your losses compared to the benchmark.

Outlook

Now that we have entered a bear market let’s review a brief history of how markets perform during these sell offs. Since World War 2, we have seen seven bear markets. The average length is about 20 months, with the shortest being less than five months and the longest being 38 months. The average decline in a bear market has been 34.5%. The range of losses has been from down 22.5% to 50.5% (during the financial crisis). Bear markets are usually periods of increased volatility. You will see large positive and negative days routinely. The best percentage up days for stocks usually happen during bear markets.

Looking ahead, let’s start with some positive items. Stock valuations have gotten a lot more attractive. Valuation is never a short-term buying signal, things can always get cheaper. However, It is a good indicator of future long term returns. Forward P/E valuations for the S&P 500 are trading 14.2x. This is below the long-term average of 14.9x. Earnings growth is expected to be in the high signal digits for 2019. Lastly, the Fed is likely going to take the next few meetings off from increasing interest rates. The Fed is not going to be in a position to raise interest rates given current market conditions.

Investor sentiment is terrible right now. There is fear and caution in most investors’ minds. This usually leads to oversold market conditions. Looking back at periods when the S&P 500 has sold off more than 10% in a quarter stocks have performed well in the future. The 1, 3 and 5 year performance looks quite good with markets posting positive returns above the history averages. For investors with a long-term time horizon this is a buying opportunity.

The stock market is a forward discounting mechanism. With the moves of this quarter what is it pricing in at this point? For investors, the question we have to ask is, was this fall as good as it gets for the economy? The US economy is projected to grow in the low 2% range for 2019. This is slowing from an expected pace of 2.9% in the 2018. Unemployment is low which is good for employees, but is a headwind for businesses. Companies are having to make choices like paying employees more to retain them and in some cases forgoing growth opportunities because of the tight labor market. Weak energy prices are negative for US growth. The US is now a top 3 energy producer in the world. In the past, it has been good to have low prices because it was beneficial for consumers. Now it has a negative impacted on industrial companies who supply the energy space. Corporate earnings growth is expected to slow and year over year earnings comparisons will be tough because the tax cuts lifted earnings so much in 2018. We do not expect earnings growth to match expectations. Housing and car prices are likely to remain stable. Any weakness here could be a negative sign for near term growth. Lastly, there are a rush of IPOs expected in the first half of 2019 from many of the Silicon Valley “unicorns”. Companies like Uber, Lyft and Airbnb are rushing to go public. This is a cautious sign to us.

In the near term we are cautious and expect to maintain our current stance described above. We don’t intend to make any dramatic moves, either conservative or aggressive, but are looking for buying opportunity. There could be a short-term catalyst for stocks with a resolution to the US’s trade dispute with China. For clients with a long-term time horizon, this is not a time to pull back on investing. Stocks got a lot cheaper which means you get to buy them on sale!