“A market downturn doesn’t bother us. It is an opportunity to increase our ownership of great companies with great management at good prices.” – Warren Buffett
Review
During the first three quarters of 2018 the S&P 500 stock index rose by a strong 9%. But every calendar year has four quarters. In the fourth quarter of 2018 the S&P 500 slumped badly, giving up all the year-to-date gains and more to finish the full year down 6.2%. This was the worst annual performance for the index since 2008. However, there were some significant milestones reached in 2018, with Apple and Amazon becoming the first companies to exceed $1 trillion in market capitalization. Unfortunately, each of them subsequently declined well below that threshold before year-end.
Stock volatility rose sharply in the fourth quarter. The S&P 500 was down more than 1% in a day nine times in December alone, compared to just eight times during the entire year of 2017. Further, there were 17 days of more than a 2% swing, positive or negative, in the S&P 500 throughout 2018. In comparison, 2017 did not have a single day when the S&P 500 moved more than 2%. Somewhat surprising though, the annual average over the last twenty years is 20 days of 2% swings. Overall, a stressful year for investors was marked by a historically weak fourth quarter for the markets, two significant corrections, an ongoing trade battle with China, and a Federal Reserve that seemed to be out of step with financial markets.
A recent insightful article in The Wall Street Journal reported that approximately 85% of all stock trading is controlled by computers. There are large market moving quantitative hedge funds relying solely on algorithmic computer models to make their investment and trading decisions rather than traditional fundamental research and analysis. Many of the inputs programmed into these algorithms are focused on momentum alone, which tends to create a piling-on effect when there is significant buying or selling. Many believe this is likely part of the reason we see such dramatic moves up or down in the markets on a daily or even hourly basis.
Despite the significant increase in volatility, Fidelity Investments reported a greater number of stock buy orders than sell orders from October 1st through December 31st across their retail brokerage customers. This should be encouraging news to all individual investors, as it shows there is confidence in the market among non-institutional investors. And we agree that investors should be confident going forward as noted in our outlook below.
A big surprise in 2018 was the relatively low rates for the benchmark 10-year US Treasury Bond. The 10-year US Treasury yielded 2.41% at the beginning of 2018, reached its peak of 3.24% in November, and subsequently declined to 2.68% by the end of 2018. The decline in rates that we have seen over the last couple of months has occurred in conjunction with a lower than expected inflation rate of slightly below 2.0% and concerns about the economy slowing in 2019. However, some good news on the interest rate front is the lower 10-year US Treasury yield has resulted in lower mortgage rates, which can make new home purchases more affordable.
The Federal Reserve has received a great deal of blame for the stock market weakness during the fourth quarter. The Fed induced problems began on October 3rd when Chairman Powell said the Fed was “a long way from neutral” on its interest rate policy. The Fed further confused the markets on December 19th when it forecasted raising rates two more times in 2019, which was out of step with the collective expectation of one or fewer rate hikes. Not surprisingly, investors in the stock market did not like the hawkish comments and were surprised that the Fed was not more in tune to the message the financial markets were sending with lower stock prices and market interest rates in November and December. The futures market is projecting the Fed will not raise rates even once in 2019 due to a slowing rate of economic growth, contained inflation and weakness in the stock market.
We have listed several overall themes that have plagued the stock market recently:
(1) Economic Growth – Growth has slowed markedly throughout the world including China, Japan and Europe. The United States growth rate has also slowed from a robust second quarter real GDP of 4.2% to 3.4% in the third quarter.
(2) The Federal Reserve – The Fed raised rates four times in 2018. As a result, investors can now earn a decent return on cash or cash equivalents. For example, money market funds are now returning 2% to 2.25%, versus close to zero just a couple of years ago. These higher short-term rates now represent a viable investment alternative to risk assets.
(3) Corporate Profits – The rate of growth for corporate profits is projected to decline in 2019 from the elevated levels achieved in 2018. The strong 2018 profits were due in part to the corporate tax rate cuts that took effect at the beginning of the year. That impact is now rolling off the comparable periods.
(4) Tariffs and Trade – The United States continues to renegotiate trade agreements with multiple foreign countries, the most important of which is China. The United Sates and China are by far the two largest economies in the world. The tariffs imposed by and between the US and China are having a meaningful impact on world economic growth and are also disruptive to worldwide manufacturing supply chains.
(5) European Union – The United Kingdom is negotiating complex terms with the European Union for its “Brexit” from the EU. Separately, Italy’s nationalist party is working through contentious issues of austerity around its budget with the European Union.
(6) Politics – In the past year we have seen an increasing amount of political divisiveness and governmental disfunction that has not been supportive to investor psychology. As a result of the change of party control of the US House of Representatives and the ongoing Mueller investigation, we are likely to see even more polarizing news headlines out of Washington that consumers and the stock market will need to digest in 2019.
Outlook
As a result of the market decline in the fourth quarter of 2018, the stock market began the new year trading at a modest 15 times forward corporate earnings, which is a reasonably attractive market valuation historically. Fourth quarter corporate earnings projections were steadily revised down from 14% to 12% over the last three months. For the first and second quarters of 2019, earnings growth is expected to increase 3.6% and 4.25%, as the benefits of the corporate tax reform begin to wane. The consensus is the U.S. Gross Domestic Product will increase 2.25% – 2.50% in 2019. While that GDP rate would be lower than what we experienced in 2018, it would still be higher than what we saw in 2016 and 2017.
Despite the ongoing trade tensions, many leading indicators for the overall economy continue to exhibit positive signs. Consumer confidence remains high with robust holiday retail sales recently reported. Many economists are not forecasting a US recession in 2019, as the prevailing trend continues to be for relatively low interest rates, low inflation, and low rates of unemployment. A prominent economist we follow notes once profit growth peaks, an economic recession is usually three to four years away. With corporate profit growth likely having peaked in 2018 at 25%, that would push the likelihood of a recession out to 2021-2022. Current US economic growth is still positive and remains supportive of higher stock market returns going forward.
A few notable historical results to ponder for 2019 are as follows:
(1) Since 1926, when stocks fall 10% to nearly 20% from a recent high, stock returns during the next 12 months are up 34%.
(2) Following all negative years since 1926, the next year has an average return of 12.4%.
(3) A rare occurrence happened in 2018 when cash had a better return than stocks and bonds. This has happened only four times in modern years. When this has occurred, average returns for stocks over the next twelve months was 15.7%.
(4) The third year of Presidential terms are historically strong. During those years the stock market has only been negative twice, and not once since 1939. The average return for the third year in a Presidential cycle is 17.8%.
Of course, none of these historical events and returns mean they will repeat again in 2019. However, we believe there is potential for positive stock market performance in 2019 if these important outcomes take place: a) the Federal Reserve decides to only raise rates once this year, or not at all; b) the trade war with China reaches a successful conclusion; and c) the economies of China, Europe and emerging markets stabilize. A successful trifecta of these events could result in a big up year for stocks that would more than make up for the negative returns in 2018.
Sincerely,
Marietta Wealth Management, LLC