A Wild Year, A Great Decade and a Market/Economic Disconnect

A Wild Year:

The year started optimistically with an expectation of continued synchronized global growth, benefits of U.S. tax cuts, and a forecast for 20% earnings growth.  Based on these optimistic assumptions, the markets shot up to an all-time high in January, then plunged in February, then set a new all-time high record in September, then cratered by Christmas Eve and then finished with a modest, belated year-end Santa Claus rally.  The year looked schizophrenic and December was the worst December since 1931.  The wild seesaw swings makes one wonder if the so-called investment pros have convictions that last longer than 10 minutes.  Through it all, it is hard to believe that the S&P 500 total return was only down -4.38%.

 

Major Benchmark Performance: Last
December Year-To-Date 10 Years
US Large Cap-S&P 500 -9.03% -4.38% 13.12%
US Small Cap-Russell 2000 -11.88% -11.01% 11.97%
Foreign Developed-MSCI EAFE -4.85% -13.79% 6.32%
Foreign Emerging Mkts-MSCI EEM -2.66% -14.58% 8.02%
US Bonds-Barclays Aggregate 1.84% 0.01% 3.48%
Long Treasury-20 Yr+ US Treasury Bonds 5.62% -1.98% 3.37%
High Yield-BA Merrill Lynch HiYld Bonds -2.19% -2.26% 10.99%
12/31/2018

Some Notable Highlights/Lowlights:

First, the FAANGs were De-Fanged.  Facebook, Apple, Amazon, Netflix and Google (the FAANGs) were darlings for many years.  Apple’s market value briefly exceeded $1 Trillion, but it took a tumble when iPhone sales and pricing didn’t match lofty expectations.  Facebook took the biggest slide (down over 39%) as the company faced slowing growth and increasing security/data privacy issues.

The “crypto craze” also imploded as BitCoin fell 80% from over 19,000 last December to 3,747 by year-end 2018.

Ultimately, most asset classes declined and there was nowhere to hide.  As interest rates rose and stocks declined, the decade-long stock mantra “There Is No Alternative”-TINA lost its luster.  By the end of the year, the cash is trash crowd was de-throned, and the cash is king stalwarts were rewarded.  Market psychology turned sour and the “buy the dips” trade was replaced by “sell the rallies.”

The Best & Worst Sectors:

U.S. economic growth exceeded expectations and resulted in the best growth rate in over a decade, but only two sectors were able to achieve positive performance:

-Health care was up 4.6% and utilities were up 0.5%.

Meanwhile the biggest losers were:

-Home builders which were down -35% as rising mortgage rates crimped housing sales.

-Energy fell -20.6% as crude oil fell -26% to $45/barrel by yearend.

The Best and Worst Regions:

Although most international markets were down, Brazil was a surprise winner with a 15.0% gain.  This was based on the election of President Jair Bolsonaro and the prospect of a more business-friendly environment.

The Chinese Shanghai Composite was the biggest loser at -24.6% due to the looming trade restrictions and a slowing economy.  Germany’s DAX was down -18.3% as tariffs hurt their automakers and other global exports.  Finally, Brexitmania uncertainty caused the UK FTSE 100 to drop by -12.5%

A GREAT DECADE:

Despite the December 2018 carnage, the current decade proved to be very respectable.  This is especially true when we think back to the intra-day low of 666 (yes, 666) in March 2009.  In reality, 2018 was the only negative year in the last decade for the S&P 500.  Moreover, the 10-year return was an above-average 13.12%.

 

A MARKET/ECONOMIC DISCONNECT:

The sharp December market decline was largely precipitated by a fear that the Federal Reserve was raising interest rates too quickly, and by a fear of an imminent recession.  A trade war with China was another wild card that could make any recession even worse.  The rise of algorithmic trading also exacerbated the downside volatility.  According to the Wall Street Journal, roughly 85% of all trades are now completed based on algorithms, quantitative models and passive trading.  These trades are on autopilot and they essentially sell more when markets are going down and buy more when markets are going up.  This amplifies both downside and upside market moves.  Historically, markets traded more on fundamentals of the economy and individual companies.  Finally, the lower stock prices caused a wave of tax-loss selling.

Meanwhile, economic data and corporate earnings reports were far stronger than what was happening with the markets.

-The economy is on track to grow at a 3% rate this year, the highest growth rate since before the Great Recession.

-Corporate earnings are on track to grow by a hefty 20% for 2018.

-Employment is at the highest level since the 1960s.

-Consumer spending is strong, and MasterCard just reported U.S. retail sales surged this holiday season (Nov. 1 through Dec. 24), rising 5.1% from last year’s level and the strongest growth rate in six years.

-Market valuations have become cheap.  Although stock market valuation levels were elevated at the beginning of the year, the combination of unexpectedly strong earnings and lower prices means that valuation levels are cheaper than average historic levels.

Looking to 2019, there are signs that growth rates are moderating:

-Europe and China are clearly experiencing economic growth rates that are slowing.

-Although 2018 corporate earnings came in at a blistering pace of 20 percent, earnings for 2019 are still projected to be a respectable 7.9% according to FactSet.

-GDP growth, meanwhile, likely will fall from its 3 percent pace this year, but most economists are still looking at gains in the mid-2 percent range for the year ahead.  If this growth rate turns out to be correct, then it would be the second strongest GDP growth in the past decade, after only 2018!

It is noteworthy that economic data and forecasts can be wrong, and a downside scenario is clearly possible.  Further, the talk of recession could be a self-fulfilling prophecy.  When the drumbeat of negative commentary becomes excessive, it impacts consumer and business confidence.

Finally, it needs to be said that Corrections (down between 10 and 20% from the previous high) and Bear Markets (Down more than 20% from the previous high) are normal.  The post-war period saw 31 corrections and 11 bear markets.  the average decline from the peak to the bottom has been 18.7%.  Within that context, the 2018 market decline was typical of the risk inherent in the overall stock market.

WHAT TO DO NOW:

No one knows for sure how the market will perform for 2019.  There are too many variables and too many unknowns to make precise forecasts.  Nevertheless, market/economic fundamentals and history provide guidance:

-History shows that large downdrafts like we saw in the 4th quarter are likely to be followed by above-average performance in subsequent 1, 3 and 5 year time periods.

-Current valuation levels are modestly below long-term averages, and these cheaper valuation levels are usually followed by periods of stronger performance.

-Although it is never easy, it is helpful to remember the sage advice from Warren Buffett: “Be fearful when others are greedy and greedy when others are fearful.”

So, don’t be a seller at these levels.  Do not abandon your long-term strategy based on these short-term price moves and headlines.  Rebalance your portfolio so that you maintain target weights for the various asset classes.  Finally, remember that the long-term averages were filled with numerous unforeseen declines and gains.

Jeff Johnson, CFA

January 3, 2019

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