2019 Market Outlook: Looking Ahead As we Say Goodbye to 2018
What a difference a year makes! This time last year as we reflected on market performance of 2017 and looked ahead to 2018, the overall enthusiasm for risk-taking was entirely different from today. The FAANG’s (acronym for the high flying momentum favorites) steady ascent to market caps that are followed with twelve zeros came and went just as dramatically as Facebook’s popularity. The VIX Index, which is a commonly referred measurement of market volatility, reflected the markets mood of uncertainty as positive economic fundamentals were neutralized by the growing political divisions and interest-rate angst.
Looking Back on 2017
The business friendly tax changes seemed to spark a furious rally that brought forward much of the anticipated gains before they became reflected in corporate earnings. Broad equity markets here in the US and overseas finished the year up double-digits but with elevated P/E ratios by years-end that signaled overbought territory. In fact, the S&P 500 was trading roughly 18.5x forward earnings heading into 2018. Fast forward 12 months, virtually no asset class finished in the black in spite of corporate earnings that ended the year more than 20% higher. One positive outcome is the markets valuations falling back in-line with historical norms to roughly 14.5x as of year-end 2018.
Speaking of contrasts, the 4th quarter of 2017 was as memorable as 2018 was forgettable. December alone, with the S&P 500 declining 9%, was the worst such monthly decline since 1946. The two biggest macro events, by far, that impacted returns and the overall gloomy sentiment was the ongoing Trade Disputes and Interest Rates. The trade disputes began in February with tariffs against our closest trading partners: NAFTA, Europe and China. Reconciliations have been made but future tariff adjustments and retaliations are still on the table. Additionally, the Fed has been cutting back on economic growth by increasing interest rates for short term lending to 2.5%. December 19th marked the 9th increase during this tightening cycle since 2015. As a result, the most economically sensitive sectors like Energy, Materials, Financials and Industrials have been impacted from a potential slowdown ahead. The more defensive areas like Health Care, Utilities and Real Estate have held up comparably better for the year.
So how are we positioning portfolios and absorbing the data points and anxiousness?
The first way to answer that question is by taking an objective view of the economy and the likelihood of Recession. We are currently in the midst of a cyclical bear market. Stocks have experienced a decline from the intraday peak on September 21st to the capitulated-selling on Christmas Eve, resulting in a 20% pullback. This decline does not necessarily mean that the secular bull market is over, but the ability to avoid Recession will likely determine which secular market we are in (bull or bear). Regarding the state of the economy, we are operating at peak employment with the unemployment rate at 50 year lows of 3.9%. Although core inflation (CPI excluding food and energy +2.2%) and interest rates are moving higher, they are still well below historical averages. Wages have been steadily increasing and are up over 3% year-over-year. This bodes well for consumer spending, especially as prices at the pump decline into 2019. Corporate earnings are estimated to fall back in-line with typical projections but are still expected to be up in the 7-8% range with revenues growing mid-single digits.
What Triggers a Recession?
Recessions are typically triggered when the Fed tightens too much or from other policy blunders. Risks on both fronts are relevant today but improvements could also lead to a sustainable recovery. As mentioned earlier, the Fed has been in a league of its own as it has been the only notable Central Bank unwinding the unprecedented measures that were taken in 2008. Not only have they been on a course to raising interest rates, but they have been reducing the size of their balance sheet, which is an additional contraction in monetary policy. The catch phrase that was used so frequently last decade, Quantitative Easing or QE, has been replaced with Quantitative Tightening. The markets have taken notice and yields of marketable bonds have fallen in response to the restrictive approach of a hawkish Fed. Trade policy, meanwhile, remains a bugaboo and has been weighing on global growth. Indeed, China’s growth rate has been slowing considerably and the corresponding strength of the dollar has been damaging to international markets. Trade wars are clearly impacting local economies and businesses and can be felt on earnings calls from global shipping giants like FedEx to global consumer products giants like Apple.
Our sense is that the volatility that ended 2018 will be carried into the new year as we continue with a diverging path of performance between financial markets and the economy. The Trump Administration is now in a 2-year election cycle that may be incentivized to deal with China. The Fed, after witnessing credit markets tighten and volatility spike may tone down the hawkish policy stance. These two headwinds which led the downturn in 2018 could lead to a resumption of the bull market in the second half of 2019. We acknowledge that these are two big unknowns and progress on one or both fronts is far from guaranteed. However, the recent weakness, as painful as it has been for account values, was necessary to flush out the excessive risk-taking and set-up a more favorable environment for stocks. Warren Buffett preaches to “be fearful when others are greedy and greedy when others are fearful.” This recent market swoon would imply that long-term value exists if you can tune out the daily noise.
Regarding relative valuations, the equity risk premium is currently approaching 4%. This is one of the highest levels in recent memory, suggesting that stocks are relatively more attractive than bonds. Cash is the ultimate asset class during downturns like this so we would also favor that over bonds. But caution is still warranted in this volatile market environment. We would suggest taking a very high quality approach towards evaluating potential businesses to buy. We favor businesses that generate cash instead of accounting profits, high earnings visibility and positive secular industry trends. In our experience, being able to control the urges to sell from fear is important to long-term financial success. As markets decline, the risk of investing each incremental dollar is actually less than when markets were rising, because you are buying in at cheaper prices.
So stay the course and focus on what you can control.
We here at The Popovich Financial Group appreciate your continued support and wish all a very Happy New Year!
Planning for the next year? We're here to help, so feel free to reach out.