In 2018, the U.S. economy experienced some of its strongest growth since the 2008 recession. Corporate revenues and profits soared, and dividend payments hit an all-time record. Consumer confidence and spending were boosted by the lowest unemployment in 50 years and the highest wage gains in a decade. Christmas retail sales were robust. CEO and small business confidence were very high, the dollar was strong, interest rates remained historically low and inflation stayed subdued.
And the stock market had a negative total return for the first calendar year since 2008. It was the first time since 1948 that the S&P 500 index rose in the first three quarters and then finished the year in the red. It was also one of the worst years on record for combined asset classes as foreign stocks and those of emerging markets underperformed the U.S. market. Rising interest rates produced negative returns for bonds while real estate and commodities also declined.
Despite the aforementioned positive fundamentals, stocks underwent a significant change in valuation metrics as investor confidence fell. In that last couple of months, the concerns of BREXIT, U.S. federal government infighting, slow European economic growth, slowing global economic growth, trade wars/tariffs and associated talk combined with the Federal Reserve’s outlook on 2019’s potential fed funds rate increases led to the stock market crashing down as many investors sold indiscriminately. The equity market’s price declines were exacerbated by the sales of broadly owned index-based exchange-traded funds by retail and institutional investors, particularly into a late December period historically known for lower market liquidity. The momentum fed on itself and was amplified by computer-based trading systems.
The Fed is trying to undo an unprecedented increase in its balance sheet while simultaneously raising interest rates. The Fed has raised rates from 0% to 2.50% in the past three years. But the Fed is also reducing the base money supply with “quantitative tightening” (QT) to get its balance sheet down from $4 trillion to $2.5 trillion by the end of 2020. Analysts estimate every $600 billion of balance sheet reduction is roughly equivalent to a 1.0% hike in the fed funds rate. So, in addition to the 3.5% of rate hikes from 2015–2020, there is another 3.0% of implied rate hikes from QT. A total of 6.5% of rate hikes (3.5% nominal and 3.0% from QT) in five years from a zero base is on of the most extreme examples of monetary tightening in the history of the Fed.
Nevertheless, by all measures, the U.S. economy is still growing, and profits and dividends are expected to increase at single digit rates in 2019. While we have for some time been telling clients to expect lower capital markets returns over the next several years, the current stock market decline has presented decent opportunities, and we are taking advantage of those at a measured pace. Given the heightened volatility in recent weeks and some further earnings adjustments (fourth quarter results and company guidance come in within the next couple of weeks), 2019 may get off to a somewhat rocky start. But unlike 2018, when valuations were stretched as the year started, this year some valuations are relatively cheap. As we get past the first few months, when Brexit is resolved one way or the other, tariff concerns become less fuzzy, and we see whether President Trump and Congress can find any common ground at all, prices should begin to reflect those better fundamentals.
History serves as a valuable tool and a great friend to the intelligent investor. All bear markets in history have been temporary phenomena, and investors who rebalance their portfolios on a regular basis--that is, buying stocks when their percentages of the total have gone down--tend to do better than investors who don't rebalance, and especially better than the many who lose their nerve and sell in a panic during the downturn.
Of course, you should always invest to the level of a peaceful night’s sleep while keeping a healthy sense of respect of the stock market’s inherent volatility. In the long journey of the stock of a high-quality business, the daily short-term price jumps that make people nervous are non-events. It’s the ability to handle good and bad times with equanimity and stay true to your investment process that matters because the critical element is the long-term growth of businesses, not short-term price fluctuations.
All of us at LVM extend our best wishes for a happy, healthy, peaceful and prosperous New Year!
Craig A. Vander Molen, CFA, CPWA ® Managing Director and Chief Market Strategist January 3, 2019