What Did We See?
- The US equity markets experienced some of their worst quarterly declines in many years.
- For all intents and purposes we can call it a bear market.
- Emerging Markets and Asia (ex-Japan) had the best returns for the quarter.
- Japan had the worst returns with the US, Europe and the UK faring slightly better.
- Volatility and fear have reached levels not seen since late 2011 as trade tensions continue.
Where Do We Stand?
- Clearly this is the worst environment we have seen in some time.
- Earnings growth expectations are slowing but not likely to go negative from here.
- The Fed will continue to normalize rates but has the ability to slow the pace as the environment dictates.
- The market is discounting a recession but the economy is on relatively solid footing and the odds of a deep recession remain low.
- We continue to rebalance your accounts accordingly and have been impressed with the protective power of the asset allocation strategies we employ.
Grin and Bear It…
An often cited maxim in investing circles is that the markets tend to take the stairs up and the elevator down. Nothing could have been more true about the fourth quarter of 2018 than this. Equity markets experienced some of their worst declines in many years and now stand at “bear market” territory. A bear market is described as a negative 20% return from recent highs in any one given market.
On September 22, 2018, the S&P 500 closed slightly higher than 2930. By December 24th that same index was 19.7% lower. For all intents and purposes we’ll call it a bear market. The same index ended up being down almost 15% for the quarter.
Since 1946 the S&P 500 has had 19 quarters where the return experienced more than a 10% drop. All but 4 of the quarters following that result were positive and the average return in the next quarter was up more than 5%. The average return over the next 2 quarters from that drop was up more than 11% and over the next year up almost 16%. As with anything in the markets, there have been outlier years that ended lower. In fact, two of them. In 1973 and during the 2001/2002 period we saw significant declines continue after a steep quarterly loss. I would posit that we are not in 1973 or 2001. We are structurally different than 1973 and the 2001 dot-com bubble was just that, a bubble with no earnings support.
So where are we, how did we get here and where is the exit?
Clearly, this is the worst equity environment we have seen in some time. Granted, we have been spoiled with a consistently higher market with little to none of the volatility that we usually experience. Either way, it just felt like an old-school bear market with buyers on the sidelines and no catalysts to drive stocks out of their “funk”. It also felt different in the relentlessness of the selling. Was it the algorithmic trading everyone likes to blame? Hedge funds? Nowadays, the pundits need to blame someone so pick your poison. I prefer to try to understand what is happening within the market’s fundamentals and then use that information to determine where we are going from here.
Earnings
Earnings growth is slowing from extremely high levels. The tax cut of last year was a boon to many corporations driving 25% or more growth in earnings in 2018. That is unsustainable growth. So we knew it had to come down. However, things that are already known don’t drive stock prices. Potentially the market is looking through to 2020 and beyond and seeing higher interest rates, tariff wars continuing, rising wages and global slowing. And so the estimates need to come down, and that drives stock prices lower. A slowing global economy also drives down oil prices which helps further lower earnings. You’ve just watched a negative feedback loop being formed. They tend to continue and overshoot reality, until they don’t anymore.
My conclusion, we may have a little more to go before this settles. That doesn’t always mean lower. It could mean just more volatile.
The Fed
The Federal Reserve has been on a campaign to “normalize” interests rates for the past few years. This is a normal activity and what is required according to their mandate and the lessons of the past. In the past the Fed did little to ease the air out of bubbles (see 2001, 2007) and the results were damaging. Slowly letting the air out of a bubble is a significantly better outcome than allowing a bubble to continue and eventually burst. The time to do this is when inflation is OK, unemployment is low and stock markets/housing are high. That is today, regardless of what the politicians think. Can they adjust their course? Absolutely!
My conclusion, the Fed will get out of the way if it gets really ugly but a market that is down 20% after having gone up almost 300% since 2009 is not going to scare them. I expect them to continue to be data dependent and raise rates through 2019 but possibly at a slower pace or with less removal of liquidity.
The Economy
Global stock markets appear to be discounting a recession. This has happened many times before. The old joke around Wall Street is that the market has successfully predicted 9 of the last 5 recessions.
The economy grew at a strong 3% +/- pace in 2018. That is a pretty good number. Up until 2018 the economy had been muddling along at around 2%, sometimes higher, sometimes lower.
However, today we are looking at political risk in Washington D.C., a continuing trade war, slowing global growth and the potential for an overly aggressive Federal Reserve.
My conclusion, the trade war might diminish in 2019 but the longer term (2 years or more) political environment won’t change. The globe may stop slowing but what will make it grow again? The Federal Reserve is the real wild card here which is why the markets have been trading on their every word.
Where do we stand at Shorepine Wealth Management?
From a short term perspective (3 – 6 months) we will likely see a rebound, and a pullback, and a rebound and then a pullback, etc… (I’m not sure what the order is going to be.) The point is, volatility is likely to be the norm for a while. For clients with more than 10 years left in their investing life this episode will be a blip on their historical radar. For clients with a shorter horizon, your asset allocation should reflect that risk profile. It’s never great to experience negative returns within your portfolio. Much worse is doing longer term damage to your outcomes by trading too much when this happens. I can cite a plethora of studies that show the detriment one can do in these environments.
Earnings are projected to reach $157 in the S&P 500 for calendar year 2019. With that index closing at around 2506 for the year we have a projected P/E of just under 16. That’s not overly aggressive. The economy may not grow at 3% this year considering the headwinds. That doesn’t mean it will grow at -3% either.
I can easily see an environment where earnings grow 10% from 2018 to 2019. If the P/E remains the same that would bring us a flat market for the year. Add in the potential for a world where trade wars diminish and the Fed is more cautious and we could see higher levels from here.
We continue to take a cautious view on the markets but do not want to subject our clients to missed opportunities. Thus, we continue to rebalance your accounts opportunistically and keep you invested according to your risk profile and unique circumstances. As always, we wish you well for the coming quarter and look forward to talking about your investments soon.
If you have any questions or have experienced any changes in your financial situation please do not hesitate to contact me.We appreciate your being a part of the Shorepine Wealth Management family and wish you all the best!
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