Quarterly Economic Update

Fourth Quarter 2018

After a long period of respectable market returns, many investors in equities experienced losses during the fourth quarter of 2018, in spite of the third quarter’s strength. The root cause of these losses was growing uncertainty, which is the equity market’s least favorite sentiment. Specifically, interest rate hikes and trade wars caused major concerns for many investors. As a result, U.S. equity markets responded by posting their worst October numbers since the financial crisis of 2008, a time most of us would prefer to forget. And while this November saw equity markets begin to calm down, the month of December disappointed by racking up much of the quarter’s losses. In fact, all three major U.S. indexes dropped at least 8.7 percent in December. The Dow Jones Industrial Average (DJIA or Dow) and S&P 500 also recorded their biggest monthly losses since February 2009.

For the quarter, the S&P 500 and NASDAQ dropped 14 percent and 17.5 percent, respectively, their worst quarterly performances since the fourth quarter of 2008. Not to be outdone, the Dow recorded its worst quarter since the first quarter of 2009, falling nearly 12 percent. As bad as they were, the final numbers do not fully explain just how crazy and wild a ride December really was for investors. Based on the lowest levels of the S&P 500 on Christmas Eve, the index was down over 20 percent from its record high on an intraday basis, briefly meeting the requirement for a bear market. The stock market would then come roaring back in the next session, with the Dow gaining over 1,000 points in a single day, making December 26th its biggest ever point gain.

Many market analysts felt the declines were driven by concerns of an economic slowdown and fears the Federal Reserve might be making a monetary policy mistake. In December, the Fed raised interest rates once again by 0.25%, elevating the U.S. Federal Funds rate range to 2.25% – 2.50%. The Fed has also forecasted additional rate hikes in 2019 and that was not helpful for equity markets.

The continuing concern over ongoing trade negotiations between China and the U.S. also pressured equities this quarter.

While a correction (defined as a drop of over 10%) in equity markets is not uncommon, there was one interesting characteristic of the fourth quarter market: intraday volatility. During the fourth quarter, the Dow had a record number of sessions with intraday 500+ point swings. That is roughly 2% of the current level of the Dow. Additionally, the Dow had five consecutive sessions with 500+ point swings from December 4 to December 11. This unusually high intraday volatility attracted a lot of media attention and it seemed as if the stock market was one of the main discussion topics every night on the news. (Source: Seeking Alpha 12/2018)

A Review of 2018

Looking all the way back to 2017, you may recall strong equity returns and an environment of very low volatility. 2018, on the other hand, tested the commitment of long-term investors. The S&P 500 and Dow fell for the first time in three years, while the NASDAQ broke a six-year winning streak. 2018 was a year characterized by the return of volatility, record highs, and sharp reversals. Interestingly, it also saw the first ever overall decline of both the S&P 500 and the Dow after the indexes saw rises during the first three quarters of the year.

How did international investors fare in 2018? According to Morningstar Research, it was “even worse for those invested in markets outside the United States”. The MSCI EAFE Index (an equity index which captures large and mid-cap representation across 21 developed markets not including the US and Canada) plunged about 14% in U.S. dollar terms. Morningstar noted that a variety of concerns caused pain in international markets. These included local political issues and troublesome economic data. Many other stock markets abroad also posted deeper losses than those in the U.S. For example, China’s Shanghai Composite entered a bear market in June and declined nearly 25% in 2018. The Shenzhen Composite (which includes many of the country’s tech firms) dropped by over 33% for the year.

Further, a variety of problems affected foreign-stock funds. Economic growth in the U.S. was much stronger than that of Europe, where the trends that finally had moved in a positive direction reversed course, with growth rates down to near zero or even dipping into negative territory in some countries. Europe’s biggest market, the United Kingdom, has been stressed by uncertainty over the details of its path to exit the European Union (Brexit). Political difficulties in Italy and other European countries didn’t help matters either.

For the past decade, income investments’ returns have been significantly lower than equity returns, and cash equivalents have provided very little growth opportunity with near-zero interest rates. Although they generally add less return that equities, cash equivalents and income vehicles can provide less volatility and stress than risk-based assets. Because of persistently low returns in the safer assets, many investors abandoned diversification and fully allocated into potentially higher returning stocks. This strategy can be advantageous when markets rise, but dangerous when they fall. Sometimes, investors are emotionally driven to change their allocations, but doing so has the potential to add substantial risk.

After almost a decade of strong equity returns, 2018 was a confusing and difficult year for investors. After the sour year-end close, it’s easy to forget that the Dow recorded 15 new highs in 2018, (ahead of the annual average of 11 new highs per year since inception). While the Dow comparatively reached more new highs in 2017 (71 in total, more than any year in history), there have been 53 calendar years when the DJIA notched at least 1 new high and 70 when none were recorded. For most investors, 2018 fully tested their commitment and patience. (Source: Seeking Alpha 12/2018)

2019 Outlook

Stocks may be coming off their worst year since the financial crisis of 2008, but for 2019, many analysts feel that equity markets will head higher. Over 65 percent of 29 respondents to CNBC’s exclusive ‘Halftime Report Stock Survey’ said their overall stock market outlook is positive. Over 58 percent feel that equities look cheap at current valuations. CNBC noted that no one responded that he or she believes equities are overvalued at current levels. About 41 percent believe stocks are correctly valued, and nearly 60 percent felt current valuations look cheap, which indicates an overall bullish sentiment. (Source: CNBC 1/7/2019)

“Let’s pull out all the down years from 1926 through 2017, of which there were 24. The average return in the year following a down year was 10 percent, the same as the overall average.” They also shared, “Uncertainty about the future course of stocks is large, so investors should fall back on a few fundamental principles. Diversification of investments reduces risk.” (Source: Forbes 1/5/2019)

Barron’s 2019 Outlook reported that investors will be happy to bid good riddance to 2018, a stressful year marked by two stock market corrections, rising interest rates, an ugly trade battle, and growing fears that a bear market lies just around the corner. All 10 market strategists Barron’s consulted in late December had 2019 targets for the S&P 500 index finishing the year higher. (Source: Barron’s 12/14/2018)

Seeking Alpha notes that, “Forecasting how 2019 will play out may be pure guesswork under the current circumstances.” They also add that as we begin the year there is a shutdown of important U.S. government services and a new political landscape (a Democratic Congress). They also report that although the Federal Reserve has raised rates and the global trade war is far from being resolved, current economic indicators are not pointing to an immediate recession. They cite that on the employment front we now have a tightening labor market with unemployment down to 3.7%. They share that, The Index of Leading Economic Indicators (which consists of ten forward-looking variables such as; unemployment claims, manufacturing shipments and orders, housing starts, interest rate spreads, M2 money supply, the S&P 500, and consumer sentiment) is still in expansion territory as of 1/1/2019.

Interest Rates are Still Critical

Three years ago, the Fed moved away from the near-zero rate that had been in place since the days of the global financial crisis. In December, the Fed raised interest rates for the fourth time in 2018 to move the target range for its benchmark fund to 2.25 percent to 2.5 percent. As of that session, Fed officials forecasted two more hikes in 2019, down from three rate raises previously projected. This is because Gross Domestic Product (GDP) was seen as rising 3 percent for the full year of 2018, down one-tenth of a percentage point from September, and forecasted for 2.3 percent for 2019, a 0.2 percent point reduction.

While investors wanted rate hike uncertainty to end, the Fed included in its statement that further “gradual” rate hikes would be appropriate. Charlie Ripley, senior investment strategist for Allianz Investment Management said that, “while this was a dovish hike from the stance that the Fed was in before, this is somewhat not as dovish as many participants probably wanted.” He also added that, “It would have been a difficult move for the Fed to completely remove some of the 2019 hike expectations, but I think they’re making the message clear that they’re going to remain more data dependent as we go into 2019.” The Fed’s official meeting notes described economic growth as “rising at a strong rate” and therefore the door is still open for further rate hikes. (Source: CNBC)

Besides potential rate hikes, further trade wars with China may keep markets quite volatile in 2019. Trade wars and signs that China’s economy is slowing have added to global investing uncertainty. Interest rates, trade wars, and worldwide growth rates should all be on an investor’s watch list for 2019.

Federal Funds Rate

In December, the Fed raised interest rates for the fourth time in 2018

Conclusion

What should an investor consider?

While numerous analysts remain optimistic, investors should not expect a straight-line uptrend. Corrections and bear markets will always be a part of the investment sequence. Although the old Wall Street joke can remind us that 10 out of 9 analysts can correctly predict the next recession, predicting exactly when equity markets will start back upward is near impossible. Investors with very long time horizons of 10-20 years or longer can often accept more risk than those with shorter horizons. While past performance is no indication of future performance, it still gives us data to consider. For example, based on the DJIA, 10-year returns since the index’s inception have averaged over 83%. Despite 2018’s negative performance, the 10-year return is still an impressive 165%. How is that possible? Well, remember this most recent 10-year period began after the DJIA was beaten up during the financial crisis. Since then, the DJIA has risen from approximately 8,800 to over 23,000! (Source: Seeking Alpha 1/4/2019)

CNBC reported on January 1st that some strategists are saying if the stock market’s two worst fears are resolved in 2019, that it could be a good year for stocks. While strategists see volatility continuing in 2019, they felt that the biggest worries for investors are still trade wars and the Fed’s interest rate movements. While many analysts remain optimistic, investors should prepare for continued volatility and not a straight-line uptrend.

Knowledge is Powerful

While the nightly news and financial tabloids like to use harsh and scary language to attract viewers, oftentimes their quick views of equity market performance include media magnification, which is the act of making something look larger or more important than it really is.

Currently, equity markets are volatile and have experienced a correction (some are even in bear market territory), but not a crash. As our chart shows, most corrections are not market crashes. If you’ll recall the October 19th, 1987 market drop of 508 points (a 22.6% decline), that clearly is a market crash. The same percentage decline for the Dow, if it happened on January 2nd, 2019, would have been over 5,000 points (which clearly did not happen).

It’s well known that emotions can work against an investor. An informed and knowledgeable investor, however, can often be less emotional. Differentiating between a correction (with a frequency on average of once a year) from a bear market (with a frequency on average of once every three years) can help investors when making decisions. (Source: NASDAQ)

What Should Investors Do?

Completely avoiding market risk may not be appropriate for most investors, and today’s traditional fixed rates might not help you achieve your desired goals. Most investors attempt to build a plan that includes risk awareness. Often, this can lead to safer but lower returns. Traditionally, bonds have been a nice hedge against market risk, but with interest rates projected to rise, investors must be extremely cautious.

For 2019, let’s focus on YOUR personal goals and strategy.

We focus on your own personal objectives. During confusing times, it’s always wise to create realistic time horizons and return expectations for your own personal situation and to adjust your investments accordingly. We work hard to understand your personal commitments so we can categorize your investments into near-term, short-term, and longer- term selections.

Now is the time to ensure you’re comfortable with your investments.

Equity markets will continue to move up and down; they’re supposed to. Even if your time horizons are long, you very likely see some short-term downward movements in your portfolios. Make sure your investing plan is centered on your personal goals and timelines, not those of other people. Peaks and valleys have always been a part of financial markets and it is highly likely that trend will continue.

CAUTION in 2019 is still the principal notion for investors. Investors need to be prepared. Market volatility has caused concern, but panic is not a plan. Market downturns happen and so do recoveries. This is the ideal time to ensure that you fully review and understand your time horizons, goals, and risk tolerances. Looking at your entire financial picture can be a helpful exercise in determining your strategy.

Discuss any concerns with us.

Our advice is not one-size-fits-all. We’ll always consider your feelings about risk and the markets and review your unique financial situation when making recommendations. If you would like to revisit your specific holdings or risk tolerance, please call our office or bring it up at our next scheduled meeting.

A skilled financial advisor can help make your journey easier.

Our goal is to understand your needs and then work together to create a plan to address those needs. We continually monitor your portfolio. While we can’t control financial markets or interest rates, we keep a watchful eye on them. No one can predict the future with complete accuracy, so we keep the lines of communication open with you. Our primary objective is to take the emotions out of investing. We can discuss your specific situation at your next review meeting or you can call to schedule an appointment. As always, we appreciate the opportunity to assist you with your financial matters.

Volatility brought the S&P 500 its best week in seven years, when the index rose 4.8% during the week of November 26. Shortly after, during the week of December 17, the S&P 500 had its worst five trading-session period over seven years, falling 7.1%.

The S&P 500s biggest single-day point gain came on December 26, up 177 points, or 5%. That made up for the nightmare before Christmas, a half-day trading session on December 24, in which the S&P 500 fell 2.7%.

The average Wall Street strategist thinks stocks will rise in 2019.

We Welcome Questions

While no financial professional can guarantee any type of specific return, we strive to continually oversee your situation and our recommendations.

We pride ourselves in monitoring the market environment and offering all clients a financial review when necessary. If you have any questions or items you would like to discuss, please contact us and we would be happy to assist you!