Market Commentary: Year-End 2018

By: Matt Garrott

What Happened in 2018

Hail to the King – Cash was king in 2018, up 1.87%.  Chances are your savings account outperformed your portfolio this year, as 2018 was a highly unusual year where virtually every other broad asset class lost money.  Keep in mind that inflation probably outperformed your savings account, so cash is still not a good long-term protector of your capital.  Speaking of cash, have you shopped around for a higher-yielding (about 2%+) savings account?

December ended with a Bear Kiss.  The S&P 500 dropped 19.4% from its all-time high.  While not officially a bear market drop of 20%, watching the market’s daily moves (not recommended) left many investors wiping off bear slobber.  This was followed by a sizable post-Christmas rally.  If you were asleep all year and just woke up to look at 2018’s numbers, you might think it was a sleepy year for US Large Cap stocks (down 4.4%), too.  Day-to-day, the markets were much noisier.  The S&P 500 dropped over 10% twice in 2018, once in January/February (followed by a 15% rally) and once from September through Christmas Eve.  Domestic Small Cap stocks dropped 10.3%.  Taxable bonds ended the year flat while Municipal bonds were slightly up.  International anything had a rough year.  International bonds were down 0.9%, Developed International stocks dropped 13.8%, and Emerging Markets were off 14.6%.  Real Estate was down 4%.

Like every year, 2018 was supposed to be a stock picker’s market…especially with the pickup in volatility.  Like most years, however, the S&P 500 beat the majority of active managers, this time outperforming 78% of the competition.  The ‘stock picker’s market’ pitch is similar to the shows on the Discovery Channel where they’re looking for Bigfoot.  They’re always on the cusp of catching a sasquatch, but return empty handed each time.

With a drawdown of 19.4% from all-time highs, the S&P 500 experienced a greater than average-sized drawdown (14%) for the first time since 2011.  Is the market in extreme distress?  Extreme volatility?  No.  Volatility is high relative to last year (the VIX never rose above 20 in 2017), but that’s because last year’s volatility was historically low.  We aren’t complacent or dismissive of risk.  However, we recognize that corrections like we’ve recently seen are a normal, necessary trade-off for the returns provided by stocks long-term.  As such, it just makes more sense to maintain perspective than panic.

2018’s Buzzwords:  Trump, Tariffs, Neutral Rate, Jay Powell, Populism, Gilets Jaunes/Yellow Vests, Fortnite, Marijuana, Cleveland Browns

Outlook for 2019

There are few calls for a correction this year, but remember that on average the market experiences a correction of about 14% every year.  Rather than fear a correction, expect one and welcome it as an opportunity to rebalance and harvest losses. One thing that we agree with the experts on for 2019 is that it will be important to remain disciplined in the face of extreme headlines.

If you want to get booked on TV, you need to predict an extended period of lower returns. Don’t get bewitched hearing these “experts” pound their chests on how right they are; many of these same prognosticators have been making these bearish predictions over the last 10 years, a period when the S&P 500 was up 13% annualized.  As Warren Buffet said “I have no use whatsoever for projections or forecasts.  They create an illusion of apparent precision.  The more meticulous they are, the more concerned you should be”.

As is consistent with our philosophy, we continue to focus on controlling what we can control, embrace an open architecture approach, and create customized, simple, yet elegant portfolios for our clients.  Portfolio rebalancing and tax loss harvesting will continue to add value without having to be “right” about any predictions.  A portfolio diversified across asset classes continues to be the most prudent way to protect against risks in the market.  While much of our attention is on risk, we are also looking for opportunities.

Both developed and emerging international equity markets look compelling from a valuation standpoint.  Growth stocks have outperformed value stocks for several years now.  It makes sense to check that portfolios have an appropriate value/growth mix.  Deeper value stocks have underperformed relative to “shallow” value stocks and may be poised to rebound.

The Federal Reserve hiked rates 4 times in 2018 from 1.25-1.50% to 2.25-2.50%.  The US 10-year Treasury yield is 2.68%.  Comparable government yields are generally lower across the globe.  Germany’s 10-year is 0.15%, Japan’s is 0.01%, and Switzerland’s is actually negative (-0.23%).  Some riskier government bonds have yields similar to the US.  Italy’s 10-year is 2.68% after a spat with the EU over their budget.  This is a sign that the rest of the world is still catching up to the United States in recovering from the financial crisis.  International was a drag on portfolios in 2018, but we expect it to add value over the long-term.

Most commentaries from our trusted sources of information see two main risks in 2019: the Federal Reserve and trade with China.

There is worry that the Federal Reserve will continue to tighten as it is focused on the economy (dual mandate of stable inflation and maximized employment) rather than the stock market.  The “neutral rate” where the Fed would stop hiking seems closer than initially expected and Fed commentary has turned dovish (or less hawkish), returning to the data-driven narrative of former Federal Reserve Chairwoman Janet Yellen.  This sets up a sort of “good news is bad news” situation.  If the economy continues to run above 3% with unemployment not seen since the 1950’s, the data may justify additional hikes.  The stock market would rather see no action from the Fed.

Vanguard has perhaps the best perspective on the issue of Chinese trade.  They see this as a political issue more than an economic one.  The leaders of both countries are taking fire for the impasse and that is what is most likely to move talks along, fueling a compromise that will allow both sides to claim victory.  This may be a case where resolution of the issue could bring a relief rally regardless of the actual terms.

The biggest risk we see in 2019 was not mentioned by any institutional investment firm: Investor Behavior.  The actions of investors themselves are the most consistent source of success or failure.  Every year there is a temptation to tweak portfolios away from what didn’t work to what worked last year.  This buy high, sell low strategy gives a feeling of control, but is a wealth leech.  One reason institutional investment firms don’t mention behavior is that it is in their best interest to get investors to DO SOMETHING, regardless of the investor’s best interest.  Pitches from these firms during a market drawdown promise safety while participating in upside – structured notes, various flavors of high yield bonds, options trading, illiquid securities, gold – beware of them all.

Fairway Scorecard 12-31-2018