I am very glad to have 2018 behind us, as it was one of the most challenging markets that I have had to navigate in my twenty-seven-year career.
I don’t call it challenging due to the pullback experienced during the fourth quarter. It was challenging due to the complete disconnect between the negative share price movement and the positive things going on economically, and with most corporations.
Below you will see the price movement in the S&P 500 last year. If you remember, January was fantastic, with a 7% run-up in the index’s value. Our first correction occurred in February, due to investors’ concerns about wage increase data and concerns about its influence on inflation. The markets retested February’s lows a few months later and then slowly moved up to all-time highs in the fall. Fears about a global recession due to our trade war with China, a disconnected Fed, and slower expected domestic corporate earnings growth sent the markets plummeting. We experienced the 20th drop of at least 10% since WWII, with the S&P 500 losing 13.97%.
Historically, dividend paying stocks (also known as “Value” stocks) do better than non-dividend paying stocks during a market pullback. This was not the case in 2018. Below you will find how each style and asset size performed during 2018.
The VIX, the index which tracks historical volatility, spiked well above its historic level of 21 twice in 2018. Below is a chart tracking its rate throughout the year.
Market Pullbacks Are Normal
It’s never fun to lose money in the market. Declines are normal. The average inter year decline from 1983 to present has been 13.63%, while the S&P 500 has produced a 12.07% average annual return during this time period.
2019 Markets – What We Like
The Secular Bull Market is Still Intact
Our secular bull market began in 2013, when the S&P 500 broke above its’ prior highs found in 2000 and 2007. The average secular bull market lasts 14 years, while the shortest was 9 years. The last one was 18 years, from 1982 to 2000. We are 5 ½ years into our secular bull market, with many more good years ahead of us.
Current Economic Data Looks Good
We have reviewed the Chicago Fed National Activity Index many times with you. The lower red line shows the three-month smoothed national economic data. Zero represents average growth. Anything above the top dashed green line indicates inflation. Anything below the lower dashed green line represents a recession. As you can see, our economy is growing slightly above average.
Leading Economic Indicators Are Solid and Growing
The Index of Leading Economic Indicators (LEI) is a leading indicator intended to predict future economic activities. As you can see from viewing the blue line (and the arrows), the LEI has accurately predicted the last seven recessions dating back to 1970. The red line shows the actual growth in the LEI. As you can see, our economy is strong and growing.
We Have Virtually No Unemployment
Unemployment levels have continued to drop. According to the Bureau of Labor Statistics, December saw a slight uptick off of November’s 49-year low in unemployment. As a result of such low unemployment, we are beginning to see wage growth. This is very typical. As you can see from the chart below, there is an inverted relationship between unemployment and wage growth. Many investors became concerned that higher wages would result in high inflation, causing the Fed to raise rates to combat inflation.
As you can see from this next chart, inflation is under control.
The Fed Has Paused to Think
On January 6th, Fed Chairman Jay Powell announced at the AEA speech that “there was no preset path for policy.”, and that the Federal Reserve would give “pause” to think. Based upon January 11th Fed Futures, there is a 73% chance that the Fed will keep rates exactly where they are throughout the year. There is 14% chance of a cut in rates, and a 12% chance that they will raise rates once by December 2019. This is a drastic change from their stance a few weeks ago.
Record Earnings
Companies making up the S&P 500 reported record earnings. In fact, the S&P reported over 25% increase in earnings during the fourth quarter (Q3 earnings). And while earnings are not expected to grow at the same rate as last year (due to the tax cut), we are expecting strong, record breaking earnings during 2019.
Record Share Buybacks
We experienced record share buybacks during 2018, and near record dividend payments. This means that corporations saw no better place to invest their money than their own company’s stock.
The S&P 500 Index is Undervalued
Last year I expressed my concern that the markets were slightly overvalued. A simple way to look at the market’s valuation is looking at the historical P/E (price-to-earnings) ratios. As you can see from the chart to the right, the S&P 500’s P/E ratio was slightly above average going into 2018. Earnings went up significantly, and price dropped a little over 6%, driving our P/E ratio to 14.4. This is about ½ a standard deviation below normal.
At year end, all asset classes were undervalued.
The S&P 500 is Very Over Sold
The selloff that we experienced took us to levels we haven’t seen since March 2009. Typically, when a market is this oversold, it rebounds. The blue lines below show the points in the S&P 500 when it was as oversold as we were at the end of 2018. As you can see, within a few weeks the markets went up in value.
Sentiment Is Extremely Pessimistic
Sentiment is a contrarian indicator. When investors are overly pessimistic, it typically means the markets are at their lows. Just like the previous chart, when optimism is at extreme lows, the markets typically rebound.
Markets Typically Rebound After Large Losses
Q4 2018 represented the 20th quarterly correction of at least 10% or greater, since World War II. Of the 19 prior corrections, the market rebounded 78% of the time when looking out to the next quarter and the next year. The average recovery of the next quarter was a little over 5% and the markets recovered almost 16% during the following year. Our current circumstances are dramatically different than the four times the S&P 500 experienced negative returns. The markets were still significantly overvalued during 2001 and 2002, and the U.S. was in a major recession in 1973 through 1974. The likelihood of us seeing a major rebound is very high.
What We Are Concerned About in 2019
Conclusion
- We expect volatility will remain elevated as compared to the past few years.
- We expect a resolution in the U.S. vs. China trade wars.
- We expect markets to revert to proper valuations, which will provide a strong boost to general market performance.
- We expect record earnings, as the global economy stabilizes. This will further boost the U.S. stock market.
- We expect an above average return in the U.S. stock markets, a below average return in the European markets, an above average return in Emerging Markets, and potential negative returns in the domestic bond market.
