Wild swings in the stock market capped off a dreadful December for stocks. The violence of the moves, both up and down, left many investors grasping for some narrative to explain the volatility. MSCI’s All-Country World Stock Index was off 7.0% in December and finished down 9.4% for 2018. The US bond market, after struggling for most of the year, staged an end-of-year rally to finish essentially flat for the year.
Small stocks fared worse than bigger ones. The Russell 2000, an index of shares of smaller stocks, fell 20.2% in the fourth quarter to finish down 11% for the year. The S&P 500 index of large US stocks fell 13.5% in Q4 and was down 4.4% for the full year, including dividends.
Financial markets performed two acts in 2018. In the first, US stocks led international counterparts as domestic growth surpassed expectations. That sent the dollar rallying and interest rates higher. Foreign corporations and countries felt pressure as their currencies fell. Corruption and government policy errors in Turkey and Brazil exacerbated the effects.
The second act began in October. Global stocks sold off, led by markets in the US and other developed countries. Fed Chair Jerome Powell’s efforts to signal monetary policy flexibility appeared to spark the selloff. Investors scratched their heads; what did the Fed know? Were they bowing to unusual public criticism from the White House? Other signs of slowing growth, mainly from abroad, added to the uncertainty.
In the end, it took only a small deceleration in global growth indicators to spur a quick drop in asset prices.
Where Do We Go from Here?
Some warning signs popped up in the 4th quarter: part of the yield curve inverted, long-term trends broke down in stocks, and the high-yield bond market declined. Historically speaking, these moves suggest stock returns may be below average in the coming months. Yet, it is not a given that large declines will necessarily follow.
For stocks to fall further, the economy needs to enter a recession. Listen to the financial media, and you will likely hear that a recession is a fait accompli in 2020. If not 2020, then 2021. This is nonsense of course. If there was any confidence in these predictions, investors would dump stocks now, business would not invest, workers would be laid off, and a recession would start now instead of later. It’s best to ignore these headline-grabbing pundits.
Could 2019 be a repeat of 2008? It’s unlikely. The banking system is much stronger now. It could also be like 2010, 2011, or 2016 – all of which were corrections along the way of the decade-long rally. It is extraordinarily difficult to differentiate between normal corrections and deeper bear markets in real time.
While we don’t have a crystal ball (and don’t believe anyone else has one either), here are the positives:
While growth is slowing, the economy is still expanding. Economic expansions do not die of old age. The labor market is healthy and despite the current trade mess, business activity is holding up, with the economy adding 312,000 jobs in December.
Valuations on stocks are more attractive after the recent downturn. The forward-looking price-to-earnings ratio on the S&P 500 declined to 14.5 and now stands below the 25-year average of 16.1.
As we move into the year, more clarity on the Fed’s intentions should ease market concerns. Often, the fear of uncertainty is worse than the result.
There is no permanent damage from tariffs …. yet. While the US has some leverage over China, the financial markets have exerted some leverage over the White House. The pressure to ease trade tensions is higher than it was before the market correction. But a stroke of a pen can fix this.
And the negatives:
The uncertainty over ongoing government chaos, the stock market, and other unresolved global issues could weigh on businesses and consumer confidence. With everyone being extra vigilant, market weakness could be the tipping point. This is the case where financial market stress spills over into the real economy.
The Fed is often blamed for being too focused on inflation, choking off the economy with higher rates. The signs of this happening aren’t quite there in our opinion. But policy mistakes are not out of the question.
Of course, what worries us now will not be what worries us in six or twelve months. At the beginning of 2018, a nuclear showdown with North Korea was at the top of the worry list, a situation no one is talking much about now.
What We Are Doing
After recent market declines, stock allocations in most balanced portfolios are now below long-term targets. We are holding course for now as heightened volatility could persist. While we are finding more opportunities to reinvest in stocks, we are taking our time.
A defensive posture seems most prudent. We are focused on high-quality companies with strong balance sheets and consistent earnings. While not immune to the ups and downs, these firms can survive whatever the economy throws at them and offer growth on the other side.
Our bond portfolios hold shorter duration government and other investment-grade securities. With a flat yield curve, we see little reason to extend maturities. We hold no junk (high-yield) bonds, which often shadow movements in stocks. We structure our bond portfolios to ensure clients have access to liquidity and are not forced to sell stocks at inopportune times.
What It All Means
All stock corrections are worrisome, but these selloffs characterize equity investing. Over time investors who endure market swings have been well rewarded.
The right strategy is the one you can stick with through the ups and downs. Pay attention to your liquidity needs, reserving enough in liquid, stable-value assets to survive several years of poor markets.
Base your allocation to stocks and other risky assets on careful planning. Bonds and cash should total enough to provide three years of living expenses. Extend that to five years if you are not still working.
Now is a good time to take your risk temperature. Your ability to tolerate market drawdowns may change as you enter new phases of life. If the market is keeping you up at night, it may be time to reassess. Tweaking your allocation is not the same as full-bore market timing, which we do not recommend. Please call us with any questions or concerns.
For investors with a well-diversified portfolio fit to their lifestyle, a more significant downturn in stocks should have no major impact on life plans.
Contact us at 865-584-1850 or email@example.com
DISCLOSURES: The information provided in this letter is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy or investment product, and should not be construed as investment, legal or tax advice. Proffitt & Goodson, Inc. makes no warranties with regard to the information or results obtained by third parties and its use and disclaim any liability arising out of, or reliance on the information. The information is subject to change and, although based on information that Proffitt & Goodson, Inc. considers reliable, it is not guaranteed as to accuracy or completeness. Source information is obtained from independent financial data suppliers (Interactive Data Corporation, Morningstar, etc.). The Market Categories illustrated in this Financial Market Summary are indexes of specific equity, fixed income or other categories. An index reflects the underlying securities in a particular selection of securities picked due to a particular type of investment. These indexes account for the reinvestment of dividends and other income, but do not account for any transaction, custody, tax, or management fees encountered in real life. To that extent, these index numbers are artificial and cannot be duplicated in real life due to the necessity of paying those transaction, custody, tax, and management fees. Industry and specific sector returns (technology, utilities, etc.) do not account for the reinvestment of dividends or other income. Future events will cause these historical rates of return to be different in the future with the potential for loss as well as profit. Specific indexes may change their definition of particular security types included over time. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of Proffitt & Goodson, Inc. Past performance does not guarantee future results.