2018 4th Quarter Update

Top Headline for Q4: Volatility Comes Roaring Back, U.S. Equities Tumble

The fourth quarter was a rough one for the US Equity markets as volatility spiked and all broad indices posted significant declines.  After running strong through three-fourths of a year, the equity markets began a brutal descent in October that culminated in large losses for the quarter.  For the quarter, the S&P 500 Index finished down 14%, the Nasdaq Composite fell 17.5% and the Russell 2000 Index dropped 20.5%.  The losses were widespread across sectors with all major categories, except for Utilities, posting losses on the quarter.  The volatility in December was particularly noteworthy as it is usually a quiet month for equities.  For example, it was reported on CNBC that we had the worst Christmas Eve performance in history, followed by the Dow’s biggest point gain ever on 12/26, along with one of the largest intraday turnarounds on 12/27.

General Market Update

Domestic Equities:  The difficult fourth quarter left the major indices in negative territory for the full 2018 calendar year.  For example, the S&P 500 Index ended 2018 down 6.2%, the Nasdaq Composite was down 3.9% and the Russell 2000 Index fell 12.2%.  The fourth quarter plunge came despite excellent earnings reports coming from Corporate America.  In fact, Factset reported that year-over-year earnings growth for 2018 is projected to exceed 20% which would be among the best growth reports over the prior 10 years.  Apparently, the positive earnings and economic news was not enough to overcome the fears stirred by tariffs, interest rates and a slowing global economy.

International and Emerging Market Equities:  The developed international equity markets also generally performed poorly in the fourth quarter.  The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was down 12.9% in Q4.  Surprisingly, emerging market equities held up slightly better during the quarter after falling faster earlier in the year.  For example, the Schwab Emerging Markets ETF was down only 6.1% in Q4.  Like the US equity markets, both developed and emerging international markets generally finished the year with double digit losses.  Our previously reported divergence between the international market and the US equity market did converge somewhat during the quarter as US equities fell faster than international markets.

US Bonds: The Federal Reserve continued, as expected, with another 25 basis point interest rate increase in December.  Although this move was widely predicted, it seemed to trigger a further sell-off in US equities.  Moreover, the fear seemed to spread to the corporate bond market, and corresponding bond ETFs, where longer-dated bonds saw a sharp decline after stabilizing in Q3.  Intermediate and shorter-term corporate bonds prices also fell though performance for the quarter was generally flat when factoring in interest payments.  The market fear helped the US government bond market as this investment is often seen as a “safe haven” in times of panic.   Government bonds of all maturities saw sharp price increases during the quarter leading to soundly positive returns for the quarter though still negative for the full year.  As previously reported, bank CDs, money-market funds and short-term fixed-income ETFs seem to be reflecting interest-rate changes more quickly making these more desirable “cash” options than bank savings accounts as rates continue to trend higher.

A Look Ahead

In our last update we wondered how much longer the great US equity market run could continue.  Perhaps the appropriate question now should be, “Has the bleeding stopped?”  Many of the fundamentals haven’t changed since our last update.  On the positive side, we continue to see great US equity earnings reports and near-term earnings projections remain at “top-quartile” levels relative to historical averages.  And, in theory, earnings should lead to growth in equity prices.  Unfortunately, it seems that the markets finally looked further into the future and panicked about longer-term earnings projections.  So, does the near future hold more panic and market drops or are better days ahead?

As we’ve previously commented, it’s easy to find something to panic about and we see further volatility ahead.  That is, despite high near-term projected earnings, the longer-term headwinds for businesses look scary.  Consider the following for Corporate America: we have unemployment at/near 40 year lows which will likely lead to increases in labor costs, we have rising interest rates and less risk tolerance leading to higher debt costs and we have escalating tariffs which are adversely affecting manufacturing input costs.  Moreover, we have significant uncertainly and, in our experience, the markets hate uncertainly above all else.  For example, we don’t know if the tariffs will get more restrictive and how long they will last.  It’s also unclear how immigration policy will affect the labor pool.  We are also now starting to hear some buzz about the large US budget deficit and how to get that back under control.  Could higher income taxes and/or a reversal of some of the recent corporate tax law changes be on the table?  It’s not good for the US equity markets to have these kinds of questions outstanding.

Lastly, although US GDP growth and corporate earnings are soundly positive, both appear to be slowing (i.e., growing at an increasingly lower rate) causing many economists to predict a recession in the next 12-36 months.  Also, much of the world is already seeing a macro-level economic slowdown which will be a further drag on the US.  In summary, the recent drop brought the US equity market to more reasonable levels but it’s certainly not at bargain prices at this stage especially given the headwinds.  It appears prudent to continue shifting toward lower risk equity sectors and investment grade bond market segments.  On the bright side for fixed-income investors, fixed-income and cash alternative yields continue to increase which makes them a much more compelling investment option going forward.  Best wishes for a happy and healthy 2019!
Sam Harris – Charlottesville           John Mumper – Richmond
(434) 214-0407                                 (804) 380-1050
Sam@PatinaWealth.com                John@PatinaWealth.com