Third Quarter 2018 Review & Outlook

“I don’t know when to buy stocks, but I know whether to buy stocks.” – Warren Buffett

Review

The major US stock market indices posted very strong gains for the third quarter. In fact, the recent quarter marked the best quarterly return for the S&P 500 since 2013. The broad market gains were led by the healthcare sector. Other sectors contributing to the strong quarterly performance were cyclical growth sectors – industrials, technology, consumer discretionary, and the newly formed communication services sector. Effective quarter end, the existing telecommunications sector was changed to the communication services sector. With the change, the new sector has transformed from an “income-focused” sector to a “growth” sector with the addition of well-known growth stocks such as Facebook and Alphabet (Google). In addition, the market weighting in the new sector is 10% versus only 2% when it was the telecommunications sector. The shifting of companies has resulted in technology and consumer discretionary sector weighting declines of about 5% and 3%, respectively.

In conjunction with the strong stock market, the US economy continued its broad expansion in the third quarter. This robust economic growth has continued while inflation has only modestly increased. US employment reports show both an increase in the total number of people working and strong growth in average hourly earnings. The widely followed Conference Board reported in late September that its Consumer Confidence index increased to the highest level in eighteen years. On October 1st, the Federal Reserve Bank of Atlanta increased their gross-domestic-product growth rate estimate to a stout 4.1% for the third quarter.

International stocks, and particularly those of emerging markets, continued to struggle relative to US stocks in the third quarter. In fact, emerging markets equities entered bear market territory during September. However, this is not uncommon, as emerging markets stock indexes have declined by more than 20% on seven different occasions since 2008. The main culprits causing this weakness in the international stock markets seemed to be the strengthening US dollar, trade tariffs, and the Federal Reserve interest rate policy.

The Federal Reserve, as expected, increased the fed funds rate by 0.25% at its September meeting. The increase brought the overnight lending rate up to a range of 2.00-2.25%. The 10-year US Treasury note yield finished the quarter at approximately 3.05%. The recent Federal Reserve rate hikes have continued to support higher short-term savings rates. An investor can now get over 2% pre-tax on a money market fund at Charles Schwab. This is substantially higher than many bank savings accounts. If you are holding a significant amount of cash at your bank, please contact your advisor to discuss your investment options.

Outlook

Market strategists and commentators continue to warn that the current bull market, which began on March 09, 2009, is due for a major downturn. A bull market is defined as a period since the last 20% or greater decline in the broad stock market. Contrary to the pundits, we think it is important to recognize this bull market has not advanced straight up. Although the S&P 500 has not had a text book bear market decline of 20% on a closing basis in more than nine years, there have been several statistically significant downturns during the period. The painful drawdowns experienced by investors since 2009 include (i) a 19.4% decline from April 29, 2011 to October 3, 2011; (ii) a 14.2% decline from May 21, 2015 to February 11, 2016; and (iii) a quick and sharp 10.1% decline from January 26, 2018 to February 8, 2018.

We believe the fears of an impending bear market do not seem warranted by the current positive corporate earnings outlook. Analysts project corporate earnings growth year-over-year for the third quarter to come in at 19.3%. Additionally, the full year 2018 earnings growth is expected to register at 20.3%. Earnings growth is projected to slow considerably in 2019 as compared to the strong periods of 2018, but still attain a healthy increase of approximately 10% for the full year.

Interest rate forecasters predict the Federal Reserve will raise short-term rates by 0.25% one more time this year in December, which will push short-term rates up to 2.50%. Beyond this year, forecasters are projecting three more rate hikes in 2019. The yield curve implication of this year’s rate hikes is that the gap between the 2-year and 10-year treasury bond yields stands at approximately a quarter percentage point, which is its narrowest margin in more than a decade. The yield curve is an important leading indicator about the growth prospects of the overall economy. Analysts continue to monitor this gap to see if the tightening yield curve persists and becomes inverted, which happens when short-term interest rates exceed the rate on longer term securities. Short term rates have exceeded longer term rates before each recession since at least 1975.

Despite the headwind from rising interest rates and the ongoing trade tensions, many leading indicators for the overall economy continue to exhibit positive signs. As mentioned before, consumer confidence is the highest it has been in eighteen years. Unemployment is low, and wages are rising. Both have supported strong retail sales numbers. Leading indicators typically begin to exhibit weakness for a year or more before a recession ensues. Current US economic growth remains positive and supportive of higher stock market returns.

Sincerely,

Marietta Wealth Management, LLC