My F&M

4th Quarter Market Commentary

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2018 was a good year for the economy and a difficult year for stocks.  Actually, through the 3rd quarter, 2018 was fine for stocks, but the 4th quarter swoon was large enough that it set stocks back for the year.  Therefore, this review will consider both the year as a whole and the 4th quarter individually.

For all of 2018, US stocks (Russell 3000 Index) returned -5.2%, but in the 4th quarter alone, US stocks were down 14.3%.  Large US stocks (S&P 500 Index) were down 4.4% for the year and down 13.5% for the 4th quarter, while small US stocks (Russell 2000 Index) were more than 6.5% worse than large stocks in both the year and the quarter.  The full year loss for stocks, though only in mid-single digits, was still the worst showing for stocks in the past ten years.

Non-US stocks were considerably worse than US stocks for the year (-14.2% for the ACWI Ex-US Index) but declined less in the 4th quarter (-11.5%). With respect to emerging versus established international stocks, emerging market stocks were a little worse than established international stocks for 2018, but were down only 7.5% in the 4th quarter, which was much less than either US or established international stocks.

Our benchmark for global stocks consists of 70% Russell 3000 (US stocks) and 30% ACWI Ex-US (non-US stocks), and its return was -7.9% for 2018 and -13.4% for the 4th quarter.

We have also written a fair amount lately about the relative performance of growth stocks versus value stocks.  Growth greatly outperformed value for the first three quarters of 2018, but in the 4th quarter, that reversed and value outperformed growth by about 4%.  Much of that had to do with large drops by formerly high flying, expensive stocks like Amazon, Netflix, and Facebook, which we had not purchased for clients, and which as of 12/31/18 were down respectively 27%, 37% and 40% from their highs.  Still, for the full year, value lagged growth by over 6%.

The bond market produced nearly flat returns for the year and slightly positive returns for the 4th quarter (+1.6%).  REITs were down 4.0% for the year and a little more than that in the 4th quarter (-6.1%).  Private real estate on balance had a strong year.

Stocks experienced a sudden swoon in confidence in the 4th quarter (and especially in December) as concerns rose about trade, rising interest rates, the independence of the Federal Reserve, Brexit, political wrangling that has included a partial federal government shutdown, and more.  But market confidence bounces around in an unpredictable manner, sometimes with significant volatility.  It’s just part of the market landscape – short-term noise that is best ignored.  Much more important matters to keep our eyes on are the drivers of long-term returns including market valuations, economic growth, and inflation.

With respect to valuations, going into 2018, stocks were quite expensive as we have written repeatedly.  During the year, earnings growth was strong and dividend growth was solid.  With stronger fundamentals and lower stocks prices, valuations improved.  But unfortunately, valuations didn’t improve from bad to good, they just improved from bad to ... well, it’s a mixed bag.  Measured against earnings (both trailing and next year projections), stock valuations are OK now relative to history, interest rates, and inflation.  But by valuation as measured by many other ways (including dividends, book value, revenue, and 10-year smoothed earnings), stocks are still relatively expensive.  Of these various measures of valuation, 10-year smoothed earnings (the “CAPE”) has the best predictive record historically.

As to the economy, it has been quite strong in 2018 and while many expect a slowing in the pace of growth in 2019, few anticipate a recession.  We certainly don’t know (in fact, the timing of the beginning and the ending of recessions is not even determined until several quarters after the fact!)  However, most seem to believe the odds are that the economy will continue to expand in 2019, just at a slower but still a good pace, and we don’t see strong arguments against that view … unless recent market volatility and angst becomes a self-fulfilling prophecy.  If the sudden collapse in market sentiment causes enough consumers to defer purchases and causes enough businesses to defer hiring and investment, that in itself could initiate an economic contraction.

Is that likely?  On the consumer side, Visa and Mastercard report quite strong holiday spending, so that leg doesn’t seem to have crumbled yet.  But as to business expansion, we just don’t know and won’t know for a while.  On the other hand, outside the US, some economies are weakening, and a few are in contraction, and that could certainly impact earnings of companies with significant global presence.

Inflation continues to be benign and recent declines in commodity prices including oil appear likely to reinforce that trend.  However, as the labor market is close to “full employment”, wage pressures are certainly a potential factor for inflation in 2019 if wage gains outpace productivity growth.  With high levels of government and other debt, high interest rates would be particularly troublesome so high inflation (which would move interest rates up) would be quite problematic should it occur.  We don’t see evidence of much inflation now, but this is an area of concern that generally gets too little attention today and one that we focus on carefully.

What we do know, however, is that:
1)  in the long run, asset class returns are relatively predictable
2)  in the short run, they are volatile and highly unpredictable
3)  market setbacks (sometimes sudden and strong) are normal
4)  stocks are cheaper than they were a year ago (even if they are not yet cheap)
5)  the discipline of rebalancing is much preferable to the sometimes-substantial harm that can come to portfolios from selling into market losses

We don’t know if the economy will continue to grow, though that seems likely, and we don’t know if the stock market decline is over yet or if deeper lows are in store over the near term.  Nevertheless, we are confident that stocks offer better long-term prospects than bonds.  So, we are following our discipline, keeping our long-term view, and rebalancing.  Rebalancing is the way to take advantage of and benefit from market volatility.  Rebalancing means selling stocks when they have risen faster than other asset classes, and it means buying stocks when they have fallen faster than other investments.  We have been buyers of both US and international stocks and expect to continue in that mode unless markets snap back to new highs too soon.

As to current opportunities, we are embracing reduced exposure to traditional credit risk in bonds since the market is not sufficiently rewarding the taking of that risk now.  On the other hand, we think the best long-term returns are now offered by emerging market equities because of attractive valuations.