“Politics is supposed to be the second oldest profession. I have come to the realization that it bears a close resemblance to the first.”

-- Ronald Reagan
 

Market Update
 
I hope everyone had a wonderful holiday season. Whether you reached your personal goals in 2018, faced challenges, or are looking for a 2019 reboot, let’s take a moment to hit on the key themes from the past year. 

January began 2018 on a firm footing, building on highs in the wake of tax reform, low interest rates, low inflation, and strong corporate profit growth. If stocks rise or fall on the fundamentals (and they usually do), the outlook was quite favorable as the year began.  However, while I will always believe no one can consistently time the peaks and valleys of the market, when there’s too much good news priced into stocks, any disappointment can create volatility.

A spike in Treasury bond yields tripped up bullish sentiment early in 2018. President Trump’s decision to level the playing field of international trade created uncertainty in the first half. Then, investors decided trade wasn’t important—until they decided late in the year that it was.  Another bout of selling began in October and the decline accelerated in December. Several factors contributed to the weakness, including fears that continued rate hikes by the Fed might stifle economic activity in 2019 and quash profit growth. 

As the year came to a close, the peak-to-trough decline in the S&P 500 Index totaled 19.8% (St. Louis Federal Reserve thru 12.24.18). Election uncertainty, trade wars, and rising interest rates made for a recipe of investor concerns this past year. As the saying goes, “there was nowhere to hide,” meaning all reasonable options to invest—from stocks to bonds to gold—suffered losses or showed sub-par returns.

If Christmas Eve marks the bottom of the sell-off, it won’t be the first time we’ve had a steep correction that side-stepped a bear market. We witnessed similar declines in 2011 and 1998. In both cases, a profit-crushing recession was avoided.

Overseas stocks fared quite a bit worse, as the global economy shifted into a lower gear earlier in the year, and trade tensions, which are more likely to rattle foreign economies, added to woes.

What’s in store for 2019?

While 2018 began with unbridled optimism, caution quickly entered the picture and most major U.S. indexes had their first downturn since 2008.In 2019, we have the mirror image. There is no shortage of cautious sentiment. But the fragrance that’s in the air today doesn’t always determine market direction throughout the year. As we’ve seen, markets can be unpredictable as investors try to anticipate events that may impact the economy and corporate profits.The stock market decline is being driven by fears that the decade-long rally since the 2008 financial crisis is over. But the economic backdrop is much stronger than it was in 2008. While economic growth and earnings will slow, they’re unlikely to collapse, which should help mitigate losses.
 
I’ve always found it interesting that some analysts hope to discern trends from various calendar-like indicators.  We’ve just entered a new year, and typically the so-called January barometer gets some play in that arena. Loosely defined, some say that how January performs sets the tone for the rest of the year.  Of course, if stocks perform well in January, the bulls already have a leg up on the bears. Throw in reinvested dividends and a natural upward bias in stocks, and it helps explain why a positive January usually results in a positive year.  However, that wasn’t the case for 2018, and by the same token, 2016’s weak start didn’t carry over into the rest of the year.

Then, there was this October 4th article in the Wall Street Journal: “Midterms Are a Boon for Stocks—No Matter Who Wins.” On average, the months of October, November and December have been the top-performing months during any year that included a midterm election (1962-2014). In 2018, though, there was a failure to launch. While there’s still time left on the calendar, history indicates that Year 2 Q4-Year 3 Q2 (where we are right now, October 2018 – June 2019) is regularly the best three-quarter performance period of the 16-quarter cycle that begins just after a president has been elected or reelected. That’s using data on the performance of the Dow going back to 1896.
 
Finally, we could hang our hat on one other midterm indicator. That is, the S&P 500 has finished in positive territory in every post 12-month midterm period since 1950. I say “could” because, while reviewing past election-year patterns to gain useful insights might make for an interesting conversation during New Year’s Day Bowl games or a family dinner, I must stress that it does not substitute for a well-thought-out plan that takes unexpected detours into account. 
 
Bottom line, looking ahead…
 
The stock market correction could get worse before it gets better. According to Ned Davis Research, the average decline for a short-term bear market without a U.S. recession tends to be -25% over 10 months. Earnings skyrocketed in 2018 on the back of tax cuts. In 2019, tax cuts will make earnings growth more difficult, along with higher wages and interest expenses. When earnings growth has slowed rapidly, the stock market has struggled. The market will need to work through the earnings slowdown before it can mount a sustained rally.  

Typically, as the market is correcting, expect lower-volatility sectors such as Utilities, Consumer Staples and Health Care to perform best.  Resource sectors, such as Energy and Materials, as well as oversold Consumer Discretionary and Industrials could perform well in the rebound phase.Later, investors are likely to turn their attention to sectors that can deliver solid earnings growth in a slower economic environment - Health Care, Energy, and Technology have potential.Increased bond supply and possible continued rate hikes should push Treasury yields modestly higher.
 
At the December 2018 meeting, the Fed made no commitment to future hikes but emphasized its continued desire to get the Fed Funds rate back to “neutral” which likely means a target of 2.75% to 3.0%. This means we may see a few more rate hikes from the Fed in 2019.  Of course, any additional hikes will depend on the outlooks for economic growth, inflation, and financial conditions at the time. 

With a tighter labor market, expect cost pressures to rise. The prospects of more tariffs and a likely rebound in energy prices raise the risk of higher inflation by year-end.  Higher inflation would put more pressure on the Fed to raise interest rates.
 
Based on the independent research we follow we are still likely to enter the “peak” or “boom” cycle of the economy sometime in 2019. This doesn’t mean a recession will begin in 2019.  What it means is growth will likely peak.  The economy could still continue to grow, but at a slower pace. While this is my hope, it is my suspicion that once we see slowing growth those who have been waiting for a shoe to drop in the market will have their “proof” the world is coming to an end which could then become a self-fulfilling prophecy spilling over into the markets further.  These forecasts will change based upon the facts changing. There is no doppler radar for the exact timing of market turns.  This is why we remain disciplined and diversified.  As you can see from the chart below, during the last big turn in the market diversified portfolios recovered, on average, 2-3 years before a non-diversified portfolio did.  Something that under performs today might just be a gem tomorrow.


 

Having said that, the fundamental economic indicators we watch, as of this writing, continue to indicate the economy is doing fine. The proof, as they say, is in the pudding.  In a few weeks corporate earnings results for the past quarter will start to be announced which will allow us to take the pulse of American business once again. Some disappointment is already priced in after Apple lowered their profit guidance from $91 billion to a “paltry” $83 billion. We know that stocks can be unpredictable over a shorter period and while sell-offs are normal they are also extremely unpleasant. But we take precautions to minimize volatility and, more importantly, keep you on track toward your long-term financial goals.  Contrary to what the media would have you believe, this time it’s not different. We have been through changes in economic and market cycles before and we will go through them again in the future.  As Warren Buffett opined a couple of years ago, “It’s been a terrible mistake to bet against America, and now is no time to start.”

If you have any questions or would like to discuss anything in this update or any other matter, please feel free to give me a call.  As always, I’m honored and humbled you have given me the opportunity to serve you.  As 2019 gets underway, I want to wish you and your loved ones a happy and prosperous new year!

Sincerely, 


Nick Toadvine, CFP®                                                                                                                
President

PUBLISHED BY NICK TOADVINE