If the 2018 investment year ended on September 30th instead of Decembers 31st, we would be singing a different tune about the 2018 market experience. Up until September 30th, 2018, most major U.S. market indices were up 8-10%. Alas, 2018 still had three months to go, and what a final quarter it was!
Markets were hit with a series of negative events that caused investors to doubt future economic growth. What started out as a normal corrective period turned into a rout, possibly due to seasonal liquidity issues. This led to unprecedented levels of selling in December that looks to have been divorced from what we know about the economy. These events culminated in a two-day period around Christmas Eve where stocks lost about 6% of their value. Stocks have now more than recovered those December losses, although we’re still trading well below our most recent highs.
It is too soon to tell if we’ve hit the market lows for this cycle or if economic activity will warrant a bit more downside in the coming months. However, we believe much of the bad news has now been priced into stocks. Also, we don’t believe we are having a repeat of the 2007-09 bear market, namely because we are not in the midst of a financial crisis.
It’s likely that some of the overarching issues that led to the sell-off could be resolved this year. Modest earnings growth in 2019 would suggest that stocks are undervalued. If so, probability suggests markets have the potential to advance this year, nearing or exceeding last year’s highs.
What In Blazes Went Wrong With The Markets In 2018?
While this is a big question, we can sum it up by saying that markets faced concerns last year that ultimately led to their undoing. There were three principal issues, including a tightening money supply which led to higher interest rates, trade fears with China, and worries about a slowing economy.
The Federal Reserve has gradually increased interest rates for the past couple of years. However, we saw a spike in bond yields late in the summer. This caused investors to worry that the Federal Reserve would go too far with monetary tightening. This in turn it was feared could lead to stalling economic growth. The U.S. and China are still engaged in high stakes negotiations over trade issues and the markets have gained or lost based on perceptions of how these events might pan out. Finally, there were concerns that a slowing economy could lead to a recession. We can also add to this toxic mix that certain actions of the President late in the year, such as the Government shut down were not seen as market friendly.
On their own, these concerns may have instigated a decline, but all three combined turned many investors, especially short-term programmed traders, into sellers last fall. December’s sell-off likely had more to do with these programs and lack of liquidity than economic issues. The proof is that we have quickly rebounded from those December lows. If 2018 was a thirteen-month year, stocks would have traded with modest gains factoring in January’s advance and dividends. Stocks are probably trading now where they would have if you hadn’t seen that bout of illiquidity in December.
What About ETFs?
2018 was unique in that all asset classes posted negative returns except cash. ETFs were not immune to this swoon. ETFs are based on indices and will mirror the underlying index’s gains or declines. As such, ETFs have been whipsawed around just as badly as any other investment. However, an ETF portfolio has a much higher probability of recovery as markets find traction, compared to a portfolio of individual stocks, which may develop fundamental issues independent of the markets.
We continue to evaluate investments via our ETF process, where we believe we can find value. It is impossible to know if this will pan out in the next few months, but we believe value has been created in this decline as long as we see continued economic growth. Also, we find ETFs attractive in situations where market dislocations have brought prices down to levels where the dividend is attractive relative to long-term interest rates. Ultimately, dividends provide a cushion in market declines and, regardless of current events; you get to keep the dividends already paid out.
The Value Of A Long-Term Approach
We preach that investors need to take a long-term approach to equity markets. Here’s why. Since 2009, there have been a few years where stocks have flirted with losses, but for the most part, annual returns have been positive. That’s why the 2018 declines may have come as a surprise.
That being said, it is not uncommon for stocks to have a down year. There are 91 years of trading history for the S&P 500 and 30 of those years were declines. There is data on the Dow Jones Industrial Average going back 122 years and we can see that it has been down in 42 of those years. This makes the odds of a decline about 30% in any given year. It is rare to experience two down years in a row apart from a financial crisis or external issue.
Humans break time up into units like days, weeks, months, and years. Markets have no such calendar. They will rise and fall based on investors’ gauge of future economic growth. Thus, while seasonal characteristics and investor sentiment play an important role in the daily movement of stock prices, these will be trumped by investors’ longer views about the state of the economy. Investment cycles don’t begin or end on any set calendar date. On average, stocks will have at least one decline of about 10% during a calendar year. These declines often occur earlier in the year, usually from May to September. Unfortunately, investment concerns trumped seasonality in 2018 and stocks posted declines.
Stocks are long duration assets and their returns should be measured over longer time periods. Here then, are some numbers to keep in mind. From its lows in March 2009 through the end of 2018, the S&P 500 is up 273% without dividends. The Nasdaq Composite, an index of growth-oriented investment names, is up 431%, again without dividends. By our calculations, each of these indices has seen nine corrective periods equal to or greater than 10% during this nearly decade-long advance. Each correction at their worst felt like the end of the world and the investment punditry proclaimed the end of the bull market each time. They were wrong then, and I believe they will be wrong again for reasons we will discuss below.
Could We See A Repeat Of The Last Bear Market?
Economic scars sometimes never heal. While the Great Depression seems like ancient history, there are still those among us who lived through that dark period of history. One of the wealthiest men in my small hometown grew up in that era and once told me that his family was too poor to buy enough coal to heat their home. As a result, he would go out to the railroad tracks and pick up the coal that fell off the passing trains. Even as an adult, he would catch himself looking down at the tracks for coal, long after the trains had switched over to oil. That experience marked him for the rest of his life.
Similarly, the scars from the last recession (or depression, depending on your viewpoint) are generational and will have a lasting impact for many who lived through it. There is an underlying fear of and the desire to avoid another calamity like that. It is the ghost down the hall, so to speak. Everybody is constantly on the lookout for and proclaiming about how we're on the verge of the next "big one" - the next major market decline.
Well, to have the next “big one” you will need a large scale unexpected event or speculation that impacts a significant percentage of the population and causes significant damage to the financial sector. We have written before that you cannot prepare for most unexpected or unpredictable events, such as in the case of a natural disaster or some kind of foreign crisis. California could suffer a major earthquake tomorrow, or not for another 20 years.
Financial implosions need a catalyst. Right now, there is no evidence of an asset bubble that could take down the financial system. Bitcoin and cannabis aren’t big enough to count. Banks are currently reporting solid, if unspectacular, earnings and there is no hint of a systemic crisis in their commentary. Based on what we know today, we would consider this a low probability event.
Commentators who have constantly called for a new bear market have been wrong and have cost both themselves and others the opportunities this current bull market has afforded. We will have corrections, but declines are also a part of investing. Ultimately, this type of market behavior is healthy because it allows stocks to reset for a possible move higher over the next 12-18 months as long as the economic growth remains steady.
What Comes Next?
We think investors will need some time to rebuild trust. We’ve just seen the worst December since 1931 and that 20% decline ranks as the 11th worst in terms of percentage loss since 1955. You’d have to go back to the 14% decline we saw in 2015-2016 to find anything similar. (1) While the S&P 500 may have lost around 5% for the year, many other indices performed substantially worse. The average growth fund lost around 12%, which also mirrors the average decline of individual stocks in 2018. Declines like this usually take time to heal. My guess is that it could take anywhere from 6 to 9 months for stocks to approach the recent highs. While those would be welcome returns for 2019, we cannot exclude the possibility that we may retest December’s lows at some point. It is also possible that, if we hit a rough patch this year, markets could overshoot 5-7% to the downside before resuming an advance.
Irrespective of these near-term concerns, let me repeat my longer-term views on growth. I am unchanged in my optimism about the future, the economy, and the markets. The reason I’m so positive has to do with the pace of technological advancement, which is still increasing exponentially and is unlikely to slow down in the foreseeable future. Again, we are seeing fantastic advancements across many frontiers and disciplines. I’ll invite you to go back and read what I’ve said on this subject instead of listing examples.
Just know that these previously discussed trends are advancing more rapidly than before. Behind these ideas are new businesses, jobs, and economic advancement. I still think we may be about 40-50% through this secular bull market, one every bit as powerful and durable as the rally that lasted from 1982-2000. Noted investors who agree with me include Leon Cooperman, Warren Buffett, and most recently, Jeffrey Vinik. Vinik has stated that he thinks this current bull phase could run another 10-years. (2) I agree with his reasoning even if I’m unsure of the number of years we have left.
Markets are never a one-way ticket higher and corrections will happen. Even our previous bull market had periods where it paused to catch its breath. There were at least five declines in excess of 10% back then. Then, as now, there were also periods where stocks did not advance. I think we’ll review this period in the coming years as one of these pauses.
Final Thoughts
Our assumption is that economic growth will slow down in 2019 but the U.S. will not enter into a recession. We think the U.S. GDP growth will be around 2.4% in 2019. That should lead to earnings growth of between 5-7% this year. If that is possible, then stocks are likely undervalued and stocks have the potential to advance 10-15% this year. However, markets stalled in the fourth quarter on decelerating earnings growth. Stocks could come under pressure this winter if these concerns increase. That is one of the reasons I think it is possible for us at some point to retest December’s lows and possibly still correct 5-7% from those prices if sentiment becomes too negative. However, I believe that evidence of stronger than expected economic growth will occur in the back half of 2019 and that should ultimately put a floor under stocks, allowing them to advance as the year progresses. Thus, for me, the risk-reward equation is compelling. We will adjust portfolios as necessary to conform to this new reality.
Where Does That Leave Your Portfolio?
2018 was an extremely volatile year whose ending might have been different without a unique set of circumstances in December. It is highly probable that last fall’s correction in stock prices already discounts much of investor’s concerns. We think a friendlier Federal Reserve, some resolution to trade issues with China, and an economy growing faster than most pessimists currently expect could set the stage for market gains in the coming months. We do not believe the current expansion is dying but if we see evidence of such then we will take actions to become more defensively oriented in client accounts.
If you have questions about your portfolio and how market movements are impacting your accounts, call my office at 312.953.8825 or email us at lumencapital@hotmail.com
About Chris
Christopher R. English is the President and founder of Lumen Capital Management, LLC-a Registered Investment Advisor regulated by the State of Illinois. A copy of our ADV Part II is available upon request. We manage portfolios for investors, developing customized portfolios that reflect a client’s unique risk/reward parameters. We also manage a private partnership currently closed to outside investors. Mr. English has over three decades of experience working with individuals, families, businesses, and foundations. Based in the greater Chicago area, he serves clients throughout Illinois, as well as Florida, Massachusetts, California, Indiana, and other states. To schedule a complimentary portfolio review, contact Chris today by calling 312.953.8825 or emailing him at lumencapital@hotmail.com.
The information contained here is taken from sources deemed reliable but cannot be guaranteed. Mr. English may, from time to time, write about stocks or other assets in which he or other family members has an investment. In such cases appropriate disclosure is made. Lumen Capital Management, LLC provides investment advice or recommendations only for its clients. As such the information contained herein is designed solely for the clients or contacts of Lumen Capital Management, LLC and is not meant to be considered general investment advice.
*Long ETF’s related to the S&P 500 and various components of the NASDAQ in both client and personal accounts.
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(1) The Capital Spectator: “Ranking the Current US Stock Market Drawdown vs. History.” January 8, 2019.
(2) CNBC.com: “Hedge Fund Manager Vinik Says Bull Market Could Go Another 10-years.” January 10, 2019
