“There’s something happening here. What it is ain’t exactly clear.” — Buffalo Springfield
This seems an appropriate line for the financial markets over the last few months.
Through the third week of September 2018, the stock market was at an all-time high and the US economy was humming along at roughly 3+% GDP. Since that all-time high on 9/20/18, the S&P 500 plunged almost 20% into Christmas Eve, before bouncing back a bit to close down 6.2% for 2018. The steep selloff didn’t just affect the S&P 500. In fact, the only asset class that made money for all of 2018 was Cash. Even bonds, which usually see gains when stocks see declines, finished 2018 dead flat for the year.
The decline in the market at the end of the year was typical of what we expect at the beginning of a recession or other economic downturn. A decline of -20% or more is technically considered a bear market, which is something we haven’t experienced since 2011. Not all big market declines have signaled a recession, but once a market decline reaches 20 percent, the odds are higher, according to Bespoke Investment Group. Of the 13 bear markets for the S&P 500 since World War II, eight of them overlapped with some part of a recession. They also looked at ‘near bear’ markets where the S&P falls 19 percent but it doesn’t fall 20 percent … there have been five of those so far … only one occurred in conjunction with a recession. While we didn’t “technically” hit a bear market (S&P drop was 19.8%), it was too close for comfort.
What was different about 2018, compared to most significant downturns, is that economic fundamentals have been very positive all year. Previous instances where the market declined while earnings performance was still very positive were almost always driven by externalities such as: government budget fights, debt ceilings, or tariff wars. In 2008 it was the housing crisis. The 2010 and 2011 downturns were driven by non-valuation issues like 2010’s flash crash, and the fiscal cliff. In 2016 it was Brexit (Britain leaving the EU). In 2018 it was the combination of the Federal Reserve raising interest rates and the trade war instigated by Washington.
“And now we welcome the new year. Full of things that have never been.” – Rainer Maria Rilke
I spent the last three days in meetings and on calls with Chief Investment Officers and economists from JP Morgan, Fidelity and several other firms. My goal was to get as much input as possible in order to guide my approach going into 2019.
The general consensus was that the US economy is “still growing but slowing.” The range of estimates for GDP is from 2% to 2.5% for 2019. Basically, the US economy is moving into the late stage of an extended economic expansion, as is most of the developed world. One concern is that both China and the United Kingdom are close to or in a recessionary stage. The two biggest risks for 2019 are policy errors on trade and monetary policy. If the US and China can’t come to a trade agreement, higher tariffs will lead to higher costs to consumers and likely job losses at manufacturers. There is a saying that ‘economic expansions don’t die of old age, they get killed by the Fed’. Whether the Fed is able to navigate keeping employment solid and inflation in check, without going too far and choking off growth remains a significant question. Offsetting these risks are continuing positive effects from the 2017 tax cuts, perhaps increased fiscal spending on infrastructure, and deregulation that helps corporate profits.
Barring a policy misstep, there are no signs of an economic recession on the horizon. Employment remains very strong. Wages have started to rise. These are both positive for consumers and consumer spending makes up roughly 67% of the US economy. Interest rates and inflation, while both rising, are still low by historical standards.
The diagram above is a hypothetical illustration of the business cycle. There is not always a chronological, linear progression among the phases of the business cycle, and there have been cycles when the economy has skipped a phase or retraced an earlier one. * A growth recession is a significant decline in activity relative to a country’s long-term economic potential. We use the “growth cycle” definition for most developing economies, such as China, because they tend to exhibit strong trend performance driven by rapid factor accumulation and increases in productivity, and the deviation from the trend tends to matter most for asset returns. We use the classic definition of recession, involving an outright contraction in economic activity, for developed economies. Source: Fidelity Investments (AART), as of Nov. 30, 2018.
From an investment point of view, the bull market that started after the housing crisis in 2008/2009 remains intact. And while almost 10 years old, it is far from the longest bull market in history.
One thing is certain – volatility is the theme of the markets for the foreseeable future. 2018 saw 64 trading days where the S&P 500 moved up or down by 1% or more. There were 21 trading days with greater than 2% moves +/-. Of those 21, 7 happened in December alone. 2019 is going to be no different – we opened the year with a flat day followed by a 2+% down day. Today, January 4, 2019, the third trading day of the year, the S&P 500 is up 3.3% as I am writing this report at 2:15pm. (2017 saw just 8 trading days with 1% +/- moves and no trading days in excess of 2% +/-)
In many ways, the market is at a make or break point. On the one hand, valuations have come down a lot and economic growth remains stable in the US. If the negative risks I have discussed in this report are resolved positively, 2019 could look a lot more like 2017. A positive outcome is therefore dependent on the resolution to the trade situation and how the Fed proceeds. The alternative is that economic fundamentals continue to deteriorate in Asia and Europe, trade continues to slow, and investors start pricing in a recession. I still believe that, if for no other reason than political expediency, there is a high probability that the trade war will be put on hold or ended in the short term. If I’m right about that, then I think the market fundamentals are very supportive of higher prices.
I hope this note provides useful information. Please feel free to share it with family and friends.
January Calendar of Events (comments and additions for future months are always welcome)
- January is National Blood Donation Month. I’m donating on the 18th. How about you?
January 5th My granddaughter Isys turn 13. God help my daughter and son-in-law.
January 10th My better half, Eloise’s birthday.
January 15th the 9th anniversary of my independent practice – thank you to all my loyal clients.
January 21st Martin Luther King Day. Let’s pray for more racial tolerance and understanding.
Sources: Morningstar, Fidelity Investments, Bespoke Investment Group, Investopedia, Raymond James & Associates
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