Wall Street tendencies were dashed in 2018. "Sell in May and Go Away" didn’t work at all as the market rallied strongly over the summer. And the "Santa Claus Rally" we often get in December was replaced by the Grinch or Scrooge or some other unseemly character. During one particularly horrific period in December, chief–of–staff John Kelly and Secretary of Defense James Mattis both resigned. This was compounded by the Federal Reserve raising interest rates and Peter Navarro, Assistant to the President, voicing bellicose statements about a sustained trade war with China. The economy slowed at least slightly during the fourth quarter with autos and housing both on the weak side.
After trailing the U.S. all year, foreign markets were generally stronger than the U.S. in Q4. For the fourth quarter, Emerging Markets (VWO) fell 6.4%; China (FXI) fell 7.7%; Europe (VGK) fell 13.0%; and Japan (EWJ) fell 15.2%.
Q4, 2018 Review
The market peaked in the first week of October and fell steadily from there. The high–level concerns were: 1) Trade Wars – mostly related to China; 2) The Federal Reserve – expectations of multiple interest rate increases next year is a rough proposition for the markets; 3) Political uncertainty; and 4) Economic slowdown – growth is slowing almost everywhere in the world.
Despite President Trump’s pronouncements that trade wars are easy to win, history suggests this is untrue. Global supply chains are so complicated and so interconnected that the ripple effects of tariffs are significant and hard to understand. At a minimum, the trade wars have caused companies to pull back on investments until the situation becomes clearer. Stock markets hate uncertainty. President Trump seems to thrive on uncertainty. In Q4, this became a market problem.
As we entered Q4, the Federal Reserve had just raised short–term interest rates to 2.25% and was essentially forecasting one more interest rate increase in Q4, 2018 and three more increases in 2019. This would have moved short–term interest rates to 3.25% by the end of 2019. Investors are tuned in to thinking that when short–term interest rates exceed long–term interest rates (an "Inverted Yield Curve") that this is negative for the economy and the markets. Since the 10–year Treasury ended the year at 2.68%, the prospect of 3.25% short–term interest rates was very troubling for the markets.
Politics also contributed to the weak Q4 stock markets. Most of the "adults" that surrounded the President (Cohn, Tillerson, Kelly and Mattis among others) are now gone. Rumors abounded that the Federal Reserve Chairman’s job was at risk. Impeachment proceedings in the now Democrat–led House are likely in 2019. We enter 2019 with a government shutdown over a seemingly small issue of the Mexican Border Wall. All these issues combined for a crisis of confidence in the U.S. political scene.
Japan and Germany both had their economies shrink in Q3. There were some one–time factors to explain this, but it was a wake–up call. In the U.S., auto sales and housing starts are flat to slightly down. Economic growth for the U.S. was about 4% in the second quarter. This likely slowed to 3% in Q3 and 2% in Q4. How low will it go in 2019?
Corporate earnings were very strong in 2018 – in large part due to corporate tax cuts. Based on the data we use, earnings were up 16% for the year. Since the markets were down, stocks look cheap on their Price–to–Earnings ratio (P/E). As we entered Q4, the P/E ratio was 17.5. As we enter 2019, it is now under 15.
Healthcare stocks (XLV) were the best performers for the year gaining 6.3%. The only other sectors gaining were Utilities (XLU) and Consumer Discretionary (XLY). In our letter a year ago, we mentioned Energy (except for pipelines) and Industrials as two of the sectors we wanted to avoid. Energy (XLE) was the worst performing sector for the year falling 18.2%. Materials (XLB), Industrials (XLI) and Financials (XLF) were also relatively weak.
Foreign markets were weak all year. In 2018, Europe (VGK) declined 14.9%; Emerging Markets (VWO) fell 14.8%; Japan (EWJ) lost 14.1%; and China (FXI) declined 13.3%.
Interest rates fell sharply in Q4. Yields on the 10–year Treasury bond declined from 3.05% at the beginning of the quarter to 2.68% at the end.
After increases in 2016 and 2017, the Goldman Sachs Commodity index fell 15% in 2018. This was mostly due to the rapid fall in the price of oil that ended the year at $45 per barrel, a fall of 25% for the year. Metals prices were weak with Copper falling 18% for the year. Natural Gas and Corn were among the few commodities that rose in 2018, each gaining slightly in 2018.
After being a little weak in Q1, the US Dollar rose for most of the rest of the year versus other global currencies. For the year, the US Dollar rose 4.3%. A strong US Dollar is great for Americans that want to purchase foreign goods or travel abroad. It is not so good for companies that export, and it has led to some recent weakness in the economy
Q1, 2019 Investment Strategy
We have espoused caution for almost two years. Our caution has been based on being late in the economic cycle and high stock valuations. We are now almost 10 years into this economic expansion that began in early 2009. This nearly matches the longest expansion in the history of the U.S. We now have a slowing global and U.S. economy, and we think we are only one bad government policy decision away from a recession. Therefore, we remain cautious.
Before the market rallied in the last week of December, the market was down almost 20%. A 20% decline is the definition of a bear market. This alone is not much of a concern. We have studied market declines repeatedly. Statistically, after almost any prior observation, the market goes up about 2/3 of the time. After increases, after small declines and after large declines, the market goes up about 2/3 of the time.
Statistics give us hope. Another reason for hope is that there is no reason for the government to make a policy mistake. There is no reason for the Trump Administration not to strike a deal with China on trade. It’s absolutely in the best interests of both countries. There is no reason for the Federal Reserve to raise interest rates in 2019. As a matter of fact, Federal Reserve Chairman Powell has come out since year–end to soft talk the prospect of further increases, espousing "patience." Commodity prices are falling and wage increases are moderate, meaning future inflation is not an issue. If reason prevails and good policy results, we should not have a recession in 2019. In this case, markets will likely increase 10–15% this year.
If the trade war continues or if the Federal Reserve raises interest rates, we will likely have a recession in 2019 and the markets will likely fall another 10–15%. We simply don’t know which way the cards will fall, and therefore we must remain cautious.
We do think we will be sellers of stocks if they increase 10–15%. If this happens, we will still be late cycle and valuations would then be somewhat high again. In this case, bond yields will likely increase (bond prices lower), and we would be buyers of bonds where client objectives dictate. Cash invested in a money market fund yielding over 2’ is also a decent option.
Conversely, we also think we will be buyers of stocks if they are down 10–15%. At this level, stocks would be down 25–30% or so from recent highs, and this has always been a good buying opportunity. Even in the worst bear markets of 1973–74, 2000–02 and 2008–09, buying when the market was down 25–30% was a very good decision over the next 3–5 years.
Of course most bear markets are not as bad as the three cases stated above. In the average recession, the market falls about 30%.
We have no plans to make significant changes in our stock portfolios. The big technology stocks still seem to be very well positioned and now are reasonably priced. The big banks were relatively weak in 2018, but they have terrific balance sheets, low price–to–earnings ratios and relatively high dividend yields. Healthcare was the best performing sector in the market last year, and we still like many healthcare stocks. Energy Pipeline stocks were also relatively weak in 2018, but their finances are in better shape, demand is strong and the dividend yields are over 5%.
In a low interest rate environment like we are in there are a number of high yielding, low growth but stable businesses that offer good investment potential. Emerging markets were down significantly in 2018, but we continue to favor maintaining a position here due to the low valuation and the positive long–term growth profile.
IMPORTANT DISCLOSURE INFORMATION: Historical performance results for investment indices and/or categories are calculated including reinvestment of dividends and other income. These results have been provided for general comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your account holdings correspond directly to any comparative indices.
Regent does not hold itself out as providing, nor does it provide, financial planning services. Neither Regent nor any of its representatives serve as an attorney, and no portion of Regent’s services should be construed as same.