It feels strange to start this post with a New Year salutation as we are now officially three weeks into 2019. For a variety of reasons, we held off on an update until now. We were hoping to see a resolution to both the ongoing trade talks with China and the government shutdown. Neither has happened, but if it’s any consolation, the market is up over 8% since he government shutdown started. This is now officially the longest government shutdown in US history.
2018 Recap & Outlook
2018 will be remembered not only as the first negative return calendar year in the S&P 500 in a decade, but also for the return of volatility throughout the year. We experienced two bouts of volatility the likes of which we’d rarely seen since 2011 (Chart 1). If you remember, 2011 was the year ratings agency, Standard & Poors, downgraded the credit worthiness of the US government which (with the memory of 08/09 still very fresh) led to “double-dip recession” fears.
By the slimmest of margins, neither the Q4 2018 or 2011 pullbacks technically registered as a bear market (i.e. 20% decline) on a peak to trough market close basis. On December 24th, 2018 the market closed down 19.8% from the September all-time high. However, both episodes saw markets pullback more than 20% when intraday levels are considered. For our intents and purposes (and certainly for our clients and investors in the market), that was a bear market. For the calendar year the S&P 500 was down a more modest 6.2% (4.4% inclusive of dividends). While it has been a while since investors sustained losses, there is of course an understanding that equities can and do lose money from time to time. Normally, we count on our bonds to act as a shock absorber during times of market turbulence, but that didn’t happen in 2018. For the year, the Barclays US Aggregate Bond Index ended the year effectively flat. Below is a list of years in which the S&P 500 Index was flat for the year or negative and the corresponding returns of the Barclays Agg. On average, bonds have returned just over 6.0% when equity markets are weak over the last nearly 40 years. Those days appear to be behind us, and this reality has significant implications for risk and return expectations.
To give ourselves a frame of reference for what might happen next, we looked at the last 50 years’ data and asked: “what does the market return one year after a quarter ends in a correction (i.e. down 10% of more)?” There have been 16 instances of a quarter ending in a correction (prior to Q4 2018), and the average market return over the next 12 months was 16.0% (excluding dividends). If you narrow the set of data to exclude correction quarters where we were neither in a recession nor heading into one (recession in the next 12 months), the market notched an average gain of nearly 20%. We weren’t in a recession in Q4 2018, and we (and the market) do not believe we will be in 2019. That could certainly change, but as of now there are no signs the economy is in imminent danger of a recession. Thus far in 2019 the market is up 6.5%.
So, what happened? In this particular case there was no one catalyst. Q3 earnings were very strong coming in more than 24% above the same quarter in 2017, and sales were up 8% YoY. However, the market started to get concerned that growth had peaked. International markets showed signs of slowing throughout the year. After the Federal Reserve hiked rates in late September, it left little doubt they were going to hike four times in 2018 (more on interest rates below). Trade rhetoric hit a fever pitch and the government went into shutdown in late December. Expectations for earnings over the next twelve months have come down modestly, but consensus is that 2019 EPS will be up over 6% YoY. As a result, stocks look much cheaper now. In September, stocks were trading just shy of 17x forward earnings. On December 24th, they closed at 13.5x forward earnings – the cheapest level since 2013. Valuations have since rebounded to the mid 15’s. Looking forward, earnings and guidance over the next two weeks will be critical as the bulk of companies report.
On interest rates – the pace of rate hikes in 2018 appeared to be too much for market participants who had become accustomed to easy money. The Fed Funds rate is currently at 2.27% – nearly a full percentage point above the average Fed Funds rate over the last 15 years. It has always been our view that it’s not the absolute level of rates that matters, it’s the delta (i.e. change). Every rate feels high relative to zero. The Fed stuck to their guns and hiked rates for an eighth time this cycle in December. It appears they have gotten the message from the market, and the Federal Reserve members who have spoken publicly since the last hike have toned down the talk of future hikes. We expect one hike this year with an outside chance the Fed sneaks in a second in December. Whether we get one or two more, we believe we are very close to what will become the Fed’s long-term neutral rate. One of the best recession indicators – the spread between the 2yr and 10yr US Treasury – tightened to 10bps, but never went negative. For a brief period in late December and early January the 1yr Treasury yielded more than any point on the curve except the 10yr and 30yr. Looking forward, we expect the 10yr to trade in a tight range mostly between 2.75-3.00% for the remainder of 2019. We also expect the front end to be anchored with the prospect of Fed rate hikes now reduced.
A Note on the Passing of Jack Bogle
Much has been written about the life and legacy of Jack Bogle since his passing last week. While we can’t do justice to his legacy in this short passage, we don’t want this event to go unmentioned. The financial media coverage has been mostly positive and respectful, but it has also fallen short of capturing the true impact Mr. Bogle had on the average American. This makes sense given that he singlehandedly diverted billions of dollars away from Wall Street and back into the pockets and retirement accounts of every individual investor in the country. Whether you ever have or ever intend to own an index fund (and regardless of whether that fund is a product of the Vanguard Group, the multitrillion dollar institution he created), you were the beneficiary of his life’s work; he brought down fees for everyone. If you invest in anything other than individual equities and bonds, your fees are lower today than they otherwise would have been because of him. Thank you, Mr. Bogle, for all that you did.
The views expressed in this newsletter represent the opinion of Custos Family Office, a Registered Investment Adviser. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment or services. The information provided herein is obtained from sources believed to be reliable, but no representation or warranty is made as to its accuracy or completeness. Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results. Investments are not a deposit of or guaranteed by a bank or any bank affiliate. Please notify Custos Family Office if there have been any changes to your financial situation or investment objectives or if you wish to impose or modify any reasonable restrictions on the management of your accounts through Custos Family Office.