It’s about the time of year where all sorts of ‘best of’ lists are being created and distributed. It’s in that spirit that my 2018 end of year market summary will be in this format. Not really a ‘best of’— as that wouldn’t be fitting in the one of the worst years in financial markets history from a breadth standpoint—but a ‘top ten’ list of what was learned in 2018. So, here goes:
1. Stocks are volatile. Sure, we already knew this. But, after 2017 where the volatility fell below the 1st percentile of historical experience, it took a splash of ice-cold water to the face to remind us of this fact. Call it the ‘recency effect’, but now that we’re awake we should be mindful of another fact: in order for investors to capture the long-term performance of an asset class that bests any other, they must be able to endure some real pain.
2. How much pain? Thresholds vary by region, but here are the 2018 performance numbers for stocks (through 12/27):
a. S&P 500 (large cap U.S. stocks)—down 7% year-to-date (YTD) and almost entered a Bear Market as it was recently off 19.6% from its October 3rd high;
b. Russell 2000 (small cap U.S. stocks)—down 14% YTD and down 27% from a recent high;
c. MSCI Emerging Market—down 18% YTD and was down 27% from its January high;
d. MSCI EAFE (developed international stocks)—down 17% YTD and fell 24% from its January high;
e. Vanguard Europe—European stocks are off 19% YTD and fell 26% from its January high.
3. The death of uncorrelated investments. Historically, certain asset classes like gold and bonds have tended to zig while stocks zagged. In fact, over the past quarter of a century there has never been a year in which both stocks and bonds were down in the same year. This was the case even in the Great Recession of 2008/2009 when stocks got clobbered and bonds maintained a positive return.
But 2018 will deviate from tradition as both stocks and bonds will finish the year in the red. In fact, as depicted in the chart below, 90% of the 70 asset classes (all types of stock, bond, commodities and currency classifications) followed by Deutsche Bank will have a negative return in 2018. This marks a record share of asset classes posting negative returns. The second worst year based on this metric was in 1920 when 84% of asset classes were negative. In 2018 there has been absolutely no place to hide!
4. The correction in stock prices has made the U.S. market cheaper, yet still above historical norms. Relative to other geographies, the U.S. market is downright expensive. This makes sense as the S&P 500 is up 125%+ from 2010 while emerging markets stocks are down 25% and developed international stocks are down 10% over the same time frame. In comparing valuations, the cyclically adjusted price-earnings (CAPE) ratio for emerging-market stocks is less than half that of the S&P 500.
A golden rule of investing is based on the belief that valuations will “revert to the mean”. Timing, with exact precision, is a fool’s game. However, as the chart below demonstrates, international stocks are overdue to take a lead in performance.
5. The Fed caused this recent downturn. At least this is the consensus view from market pundits and stems from the notion that the Fed has been too ‘hawkish’ (not willing to keep rates low) in recent comments. But it’s too easy of an explanation and defies rational sense, in my mind. Sure, the Fed’s communication has been awful. But, like I argued in a blog post in October, they will only raise rates based on continued economic growth. It’s always been the case that stocks don’t like higher rates (“don’t fight the Fed”), so it doesn’t present an ideal time for stock investment (see point #10 below). But, it makes absolutely no sense to me that a Fed would act on a forecast to raise rates if the market continues to precipitously fall and economic data shows stalling growth.
I’ll have more to say about the Fed in a post that I’ll put on this site in a week or so—please check back.
6. Tariffs and trade wars are not good for the market. Personally, I feel that there are valid reasons for a trade war with China. However, Mr. Market isn’t asking my opinion on the matter. That’s because on a fundamental economic level, tariffs are potentially inflationary. What’s more, the level of uncertainty brought on by this type of indefinite ‘war’ has a negative impact on investor psychology. What readers of my posts certainly already know is that Mr. Market hates uncertainty.
I find it almost impossible to game the outcome of the trade war. What I do think is that the market is negatively correlated to successful U.S. negotiations. This, in my view, is true because it’s well documented that the administration looks upon the Dow Jones as a metric of approval. With each tick lower in the Dow I feel that it places the U.S. more squarely over the barrel. We have presidential elections, the Chinese don’t. Therefore, the Chinese might have greater incentive to wait it out, which would act as a continued cloud over the market.
7. Self-inflicted continued uncertainty is equally as bad for the market. Such actions as Treasury Secretary Mnuchin raising liquidity issues, presidential tweets questioning whether Fed Chairman Powell will remain in his position, and all other attempts to spike the market are counterproductive. At this point, we’re going through a garden variety correction. Political capital must be saved for an actual crisis.
8. Growth is slowing. Or, is it? The Fed spooked markets by recently forecasting “further gradual” rate hikes in 2019. The market didn’t even bother to listen to Fed Chairman Powell as he said, “From this point forward we are going to let the data speak to us and inform us,” which meant that the Fed would not be on a preset hiking course and be data dependent.
Powell—and his 700 PhD economists—are slightly more optimistic because that’s what the data is telling them. The U.S. is stronger than the rest of the world—no doubt about it. Its nominal growth is strong at 5%+, although real growth in only 3%–give or take. U.S. leading economic indicators (LEIs) remain strong (still green in the chart below) and are not close to turning negative, which would signal a recession.
But the certain parts of financial markets are telling a different story.
- Rising rates had helped push the yield curve toward inversion, with short-term rates higher than long-term rates. At least the five-year and the two-year Treasuries have inverted; the classic recession warning is when yields on 10-year and the two-year securities invert (which was close to happening, but hasn’t as of yet);
- High-yield spreads have widened by only 100 basis points and need another 100 basis points to give a convincing signal of a recession;
- Oil prices are down 40%;
- Cyclical companies such as FedEx, Mohawk Industries, Auto makers, and home builders are all getting clobbered and have forecasted more pain to come.
Are the academics or the traders right? Time will tell, but whether we enter a global recession or not the risk remains that an earnings or liquidity recession is possible. Such is the ‘boom-and-bust’ cycle which we’ll review in the next section.
9. Economies are cyclical, and the U.S. has gone almost a decade without a recession, roughly 2x longer than the average interval between slowdowns. That implies we are overdue for a slump. As we mentioned above, none of the usual signs of an imminent recession are present, but the market–through the yield curve and certain cyclical companies–are telling a different story.
From a stock market perspective, Bear Markets (down 20% or more) have occurred every 4.8 years on average (see the chart below). Technically, the S&P 500 is down 19.6% from its Oct 3rd high, so not exactly in a Bear Market. The last Bear Market was in 2009, even though we experienced a 19.4% drawdown in mid-2011. Any which way you slice it though, the domestic stock market is due for a protracted Bear.
Rest assured, this is not the end of the world. On average, “garden variety” Bear Markets achieve full recovery in about one year.
10. This last point is a forecast based on the developments of 2018: the market is now oversold, falling too precipitously as if a depression is coming. A bounce is warranted as there are no indications that financial conditions are that dire. However, the health of the market is still not good. Domestic stocks, albeit much cheaper with the selloff, are still expensive. Growth is slowing—at least to more normal levels, maybe worse. Uncertainty with trade tariffs will undoubtedly remain. All of this within the wrapper of a Fed that wants to pull the trigger on higher rates. The Fed is ‘in a box’. And if the Fed is ‘in a box’, so is the market. In other words, if we happen to avoid a recession and agree to a trade deal with China then stocks will rally for a sustained period, economic conditions will improve….and the Fed will raise rates. Stock markets dislike rising rates so there will be a ceiling on stocks price appreciation even given the rosiest of scenarios.
Yep, there’s no need to add to long stock exposure at this point. But no need to panic, either. The base case for the market is that it’s adjusting to slower global growth with the threat of higher interest rates. All late cycle stuff. A continued rough patch for stocks over the near term will ultimately be healthy for portfolios over the long term. Until then, diversification will matter once again. Foreign stocks are cheap and non-stock investments such as bonds, commodities and even cash will once again anchor portfolios–just like they have proven with decades worth of evidence.
As usual, feel free to write or call with any questions…and have a Happy New Year!