While the third quarter ended with the S&P 500 Index near a record high, the fourth quarter brought about an extremely challenging environment with the index closing the quarter with a decline of 14%. The bulk of the equity market declines were experienced in the final month of the year resulting in the worst December since 1931 as well as the steepest annual drop since the financial crisis of 2008.
Selling pressure was driven by concerns that economic growth and profit growth are slowing down, the Federal Reserve may be raising interest rates too aggressively, and that trade disputes may not be resolved in the near-term. While all valid uncertainties, these issues have largely been present for some time. Political chaos also added to the negative sentiment with unsettling turnover in the administration’s cabinet, the President’s sharp criticism of the Federal Reserve Chairman, and of course the third government shutdown of 2018.
Full-year domestic equity results were certainly disappointing, and flattish fixed income returns did little to offset the declines. However, on a relative basis, U.S. equity markets held up much better than other asset classes that we have either avoided, maintained limited exposure to, or dramatically reduced throughout the year. These include areas such as small company stocks, emerging market equities, commodities, and global/international stocks.
Below is a summary of the full-year 2018 performance results for a broad range of asset classes. As the chart indicates, portfolios tilted towards U.S. large company stocks weathered the storm significantly better than a more global approach or one that included a significant amount of small and mid-sized company stock exposure.
With the benefits of tax reform and fiscal stimulus fading, and global growth slowing, it appears the U.S. economy is in the process of downshifting from the above-trend GDP growth rate of about 3.5%. Last quarter we outlined and discussed the slowdown in interest rate sensitive segments of our economy, mainly housing and auto sales. Also, the recent stock market correction has translated into a notable decline in household wealth levels, and this has dented consumer confidence to some degree. It remains to be seen if this will have a lasting impact on actual consumer spending and business investment.
Is it all bad news? No. The U.S. consumer still appears to be in good shape. In fact, Mastercard recently reported that holiday sales increased by an impressive 5.1%, which represents the strongest result in six years. Consumers are also benefiting from rising wages, a significant drop in gas prices, and limited inflationary pressures. Despite a very low unemployment rate, we continue to add workers to the payrolls, with monthly additions averaging roughly 254,000 in the fourth quarter.
While corporate earnings growth is still expected to be positive in 2019, analysts’ expectations are for a measurable decline in that growth rate from about 20% in 2018 to roughly 8% next year.
We find it difficult to fully attribute the recent stock market declines to the expected slowdown in GDP and corporate profit growth. The baseline assumption for 2019 was not that economic growth was going to continue to expand at such a rapid rate nor was it that corporations were going to be able to post another year of 20% earnings growth. These are not new revelations. Investor expectations have been for a slowdown in both categories for some time.
Thoughts on Q4 Volatility
We have outlined several catalysts for the recent equity market volatility. But we wanted to provide some additional commentary on a few of these issues.
China Trade Tensions
Investors were forced to grapple with the uncertainty around the China trade conflict for most of 2018. In early December it looked as though there was at least a temporary reprieve in the conflict as the U.S. and China agreed to a 90-day postponement of planned tariff increases to allow time for the two countries to negotiate the trade dispute. Investors initially celebrated the new development. However, the rally was short-lived after President Trump’s “Tariff Man” tweet which rattled investors’ optimism about the prospects for a near-term solution.
The outcome of this issue remains uncertain. However, we are encouraged to see both sides start the negotiation process with some tentative indications of progress. Economic slowdowns and equity market stress in both China and the U.S. could serve as incentives for some type of agreement.
Federal Reserve – Interest Rate Policy
Another factor influencing market volatility has been the Federal Reserve’s stance on interest rates. In December the Fed hiked rates for the fourth time in 2018 and the ninth time since late 2015. Investors are concerned that the Fed may be raising interest rates too aggressively given the backdrop of slowing growth in the U.S., weakness in many international economies, moderating inflation, and global trade tensions.
Recent commentary from various Federal Reserve members has indicated more of a “data dependent” tone given the headwinds mentioned above. The fixed income markets are also pricing in a very low probability of additional interest rate hikes in 2019.
Finally, we think it is a rational conclusion that market volatility has been amplified by computer-driven trading. Many short-term traders utilize computer algorithms and momentum strategies to generate short-term profits. These algorithmic trading strategies can have an outsized impact on equity markets during periods of less liquidity and lighter volumes, such as during the holidays.
We have seen these dynamics before, and they haven’t tended to last for an extended period unless validated by legitimate deterioration in economic conditions.
After reducing equity exposure in the second and third quarters, we entered the fourth quarter with portfolios positioned at a neutral or mid-point equity stance. We did some buying in late October after the equity market corrected by roughly 10%. However, by early December it became increasingly evident that given the mounting uncertainties, this decline was becoming more severe than the previous corrections that we have experienced over the past several years. We, therefore, moved to a more defensive position, reducing our equity allocations to underweight or more specifically to one-step below mid-point. The equity allocation reduction included an elimination of our remaining dedicated foreign stock exposure.
We also recharacterized a portion of our equity exposure away from more economically cyclical sectors and into more defensive stocks within the healthcare, utilities, telecom, and consumer staples sectors.
The equity sale proceeds are currently being held in cash. Those defensive cash balances range between 13%-15%. We view this cash position as an effective buffer against equity market volatility that could persist. The majority of the cash position has been allocated to a money market fund which offers a yield of roughly 2.35%.
We believe a prudent and somewhat defensive stance is warranted at present and are looking for some clarity on the plethora of uncertainties before shifting back to a more balanced stance.
2018 Performance Attribution
From a performance standpoint, 2018 could easily be described as the year when nothing enhanced bottom line results. This statement is very evident in the asset class performance summary chart on the first page. Given that backdrop, below is a summary of some of the things that benefited results on a relative basis as well as some notable detractors. With the U.S. equity market experiencing a peak-to-trough decline of 15% in December alone, many of our earlier-year contributors shifted into the detractor category.
Contributors to Performance:
- We entered the fourth quarter at a mid-point or neutral equity stance. We weren’t overly aggressive heading into the selloff.
- No direct exposure to small cap stocks, emerging market stock, commodities and a limited allocation to international stocks.
- Healthcare exposure was beneficial as it was one of the very few sectors that finished the year with a positive return.
- Our core fixed income strategies performed above expectations and better than the broad bond market in 2018.
Detractors from Performance:
- While we methodically reduced international equity exposure throughout the year, and some of our strategies held up better than broad international indices, any form of foreign stock allocation was a detractor in 2018.
- Cyclical stocks or stocks with performance profiles more sensitive to economic growth were particularly hard hit in the fourth quarter.
- Preferred stocks have been strong contributors to portfolio returns for years. We continue to like the asset class, especially with yields in the 6%-8% range. However, preferred stocks were also casualties of the selling pressure in December.
We fully recognize the multiple uncertainties that exist and have adjusted portfolios accordingly. However, we also recognize that equity markets currently seem to be pricing in very bad final outcomes for all these uncertainties and in our opinion, that is a pretty extreme view.
It’s difficult to really “value” stocks or know what they are worth unless you have a high degree of confidence in what those companies are going to earn in the future. But if estimates for next year are relatively accurate or in the ballpark, stocks are cheaper than they have been in about five years.
Saying stocks have been volatile is a huge understatement. Day-to-day market moves have been gut-wrenching. But we have seen these environments before. Each one feels different, but they all have something in common. They don’t last forever.
We haven’t had a recession in ten years and that’s a long time to go without one. But recessions don’t happen just because you haven’t had one in a while. They are generally caused by a severe and unforeseeable shock to the system, a surge in inflation, or excesses like we saw in the tech bubble or in the housing market before the great financial crisis. Obviously, you never see the unforeseeable shock coming because it is unforeseeable. But the other two, inflation and excesses don’t seem to be present. Therefore, we think a rationale baseline assumption is for slower growth in 2019, but still growth.
We provide a few visual aids and some additional commentary on these topics below.
The slide below shows the historical valuation level of the S&P 500 Index. After the fourth quarter decline, stocks are cheaper than 5, 10, and 25-year average valuations.
Sources: FactSet, FRB, Robert Shiller, Standard & Poor’s, Thomson Reuters, J.P. Morgan Asset Management.
Price to earnings is price divided by consensus analyst estimates of earnings per share for the next 12 months as provided by IBES since December 1993, and FactSet for December 21, 2018. Average P/E and standard deviations are calculated using 25 years of IBES history. Shiller’s P/E uses trailing 10-years of inflation-adjusted earnings as reported by companies. Dividend yield is calculated as the next 12-month consensus dividend divided by the most recent price. Price to book ratio is the price divided by book value per share. Price to cash flow is price divided by NTM cash flow. EY minus Baa yield is the forward earnings yield (consensus analyst estimates of EPS over the next 12 months divided by price) minus the Moody’s Baa seasoned corporate bond yield. Std. dev. over-/under-valued is calculated using the average and standard deviation over 25 years for each measure. P/CF is a 20-year average due to cash flow data availability.
Guide to the Markets – U.S. Data are as of December 31, 2018
A Look at Recent Volatility Spikes
This is a long-term chart of the “VIX” Index which is a proxy for the volatility of the S&P 500 Index. This index is commonly referred to as the “fear gauge.” Elevated levels represent market uncertainty and significant spikes correspond with periods of investor panic.
There have been many of these volatility spikes, but they eventually fade.
Sources: CBOE, FactSet, J.P. Morgan Asset Management.
Stock market returns are based on calendar year peak to trough declines experienced during VIX spike, except for J.P. Morgan acquires Bear Stearns, which is based on the calendar year peak to the acquisition date. Average is based on the period shown from 12/31/2006 to 12/31/2018.
Guide to the Markets – U.S. Data are as of December 31, 2018
Historical GDP Growth
The chart below shows GDP growth rates going back to the early 1970s. It also shows the average growth rate since the economic recovery began in 2009. GDP growth has averaged 2.3% since 2009. It seems unreasonable for investors to expect that the growth we experienced in 2018 would carry forward when that is so inconsistent with historical averages.
Expectations are for the growth rate to slow in 2019 and move back towards these trend-level averages. Those expectations seem very reasonable and are much different than a severe contraction or a recession.
Sources: BEA, FactSet, J.P. Morgan Asset Management.
Values may not sum up to 100% due to rounding. Quarter-over-quarter percent changes are at an annualized rate. Average represents the annualized growth rate for the full period. Expansion average refers to the period starting in the third quarter of 2009.
Guide to the Markets – U.S. Data are as of December 31, 2018