Despite being a difficult year in markets, 2018 was a strong one in the US economy and a reasonably strong year for many economies around the world:
- Worker productivity, the key driver of long-term economic growth and a higher standard of living, surged.
- Wage growth in the U.S. accelerated in response to a near-record low unemployment rate.
- US household net worth rose above $100 trillion for the first time ever, while household debt as a percentage of net worth remained at an historic low.
- And finally, earnings of the S&P 500, paced by robust GDP growth and significant corporate tax reform, bounded upwards by more than 20%
By any historic measure, it was a great year for the US economy, and certainly the best year since the 2008-9 financial crisis for many countries around the globe. And yet, it was a year in which markets of all kind—stock markets, bond markets, and commodities markets—struggled under the weight of a decade-long bull market and increasing worries about the prospects for slower economic growth. January opened the year on strong note, only to suffer a 10% setback in February, followed by a regrouping into the summer months. By late September, the Dow Jones had surged to a new high of 26,743, before running into the buzz saw that was Q4. During the final quarter, we saw stocks in the US and abroad fall by almost 20% from their intra-year highs, ending 2018 on an unusually sharp and disappointing down note.
While the Trump tax cuts and the rollback in business regulation certainly buoyed markets coming into 2018, there is little doubt the imposition of tariffs and the uncertainty surrounding trade talks has raised prices for many imported goods—and more importantly from the market’s perspective, has resulted in lower expectations for trade-related activity, which comprise nearly one-half of US S&P 500 earnings. Lower earnings expectations, along with anxiety around the Federal Reserve’s rate hiking path, were at the heart of last quarter’s global market sell-off. China’s slowing economy—and again, the risk of a further slowdown there due to a US-China trade war—added to the market’s worries. And, although the sell-off was not unusual in its magnitude, it still caught many off-guard given how quickly it unfolded and that it had been since 2011 since we’d seen anything quite so dramatic.
Fixed income markets, while not seeing volatility anything like what we saw in equity markets, also struggled. Most short-dated high-quality bond holdings, our more typical bond holding in client portfolios, saw meagerly positive returns, while longer-dated issues suffered losses of nearly 6% due to an increase in market-based interest rates during the year.
During December, we also saw the Treasury yield curve invert, with the five-year Treasury note yield dipping one basis point (a basis point is 1/100th of a percentage point) below the yield on the three-year Treasury. This so-called yield curve inversion has historically been a relatively reliable harbinger of an eventual recession, although not one without fail. More importantly, it’s questionable how actionable this signal is: when recessions have occurred following such an inversion, there has been an average lead time of 16 months. However, when looking at stock market performance, here and abroad, the value of such an indicator has been mixed, at best. Following a yield curve inversion, US stock markets a year later were higher 66% of the time, and globally, they were higher in 86% of the subsequent one-year periods. Over subsequent three-year periods following a yield curve inversion, US and global markets were higher 33% and 71% of the time, respectively. So, while the yield curve has historically been a useful indicator of recession risk, it’s been less reliable as a predictor of equity market performance, especially when looking at market performance that encompasses both US and non-US holdings.
Although the fourth quarter sell-off made for a painful holiday season for investors, the silver lining is that that all stock markets around the globe closed the year with valuations more in line with historic norms, with most major market valuations dropping by more than 15% on a price-to-earnings basis. As has been the case for some time, US stocks continue to be more expensive than international and emerging market holdings.
Putting last year into a bit of historical perspective and underscoring my earlier point that last year’s drop was in no way unusual, here is your statistical market fact of the day: Since the S&P 500’s inception in 1956, there have been eleven bear markets (with a bear market being defined as a 20% decline in stock prices). When such declines have occurred, the average temporary loss in S&P stock values has been 33% and lasted, on average, for 12 months. So, aside from the rapidity of last quarter’s decline, it was relatively mild by many historic standards.
A Few General Principles Worth Keeping in Mind
In the ten days since the quarter ended, global markets have rebounded a bit, with many markets having risen 10%. That welcome respite from the negative volatility of Q4 notwithstanding, there are a few general investment principles I’ll take a moment to review, as I think they provide a worthwhile context for thinking about what to do—or perhaps, what not to do—as it pertains to the goal-focused, long-term investor during rough patches like we saw last quarter.
Principle No. 1: I have always believed—and continue to believe— that investing should be goal-focused, planning-driven in nature, and undertaken with an eye on the appropriate investment horizon, which is often longer than many investors realize…even for investors in their 50s, 60s, and beyond. In my experience, successful investors are continually focused on and acting upon a plan; the unsuccessful investors I have seen became unsuccessful because they were doing exactly the opposite…namely, reacting to current events. Headlines in the news seldom—if ever—warrant a portfolio change; headlines in a client’s life may.
Principle No. 2: Plan don’t prognosticate. I have yet to see anyone reliably profit from speculating about what the economy, the markets, or the Fed might do or not do in the coming months. In almost every scenario, one would have to be right not once, but twice, in order to profit from such prognostication, and the odds of that happening are one-in-four, at best, and, realistically, even lower than that.
Principle No. 3: Portfolios shouldn’t fundamentally change unless plans change. While disciplined rebalancing, tactical tax loss harvesting, and adjusting a plan to changing life circumstances is entirely appropriate, my experience has been that long-term results are inversely correlated with the amount of portfolio tinkering one engages in. Higher investment activity generally produces lower investment returns. And, for those who are inclined to make market-based changes (e.g., opportunistically increasing stock exposure as prices and valuations fall, a difficult exercise if ever there was one), these changes should be thought out well in advance, with a documented plan, and executed in a disciplined fashion. Decisions made in the heat-of-the-moment are seldom good ones.
Ultimately, the primary benchmark an investor should be focused on is not whatever the hot market of the day is, but rather the “Am I on track to meet my most important lifetime goals for myself and my family?” benchmark. Chasing performance and/or measuring against an arbitrary benchmark will be playing a whack-a-mole with a moving target as today’s best performing benchmark is quite possibly tomorrow’s worst. Long-term, goal-focused, and planning-based investing is the process of matching portfolio construction with each investor’s most important lifetime goals, all within the context of minimizing the risk of a funding shortfall. That’s what successful investing is about, and the approach we advocate for each of our clients.
I hope the year has started off for you as well as it has for equity markets, and that 2019 is a year of improving health, happiness, and prosperity for you and those you care about. As always, please let us know if there is anything we can do for you. It’s a pleasure to have been of service to you this year and we look forward to another year of the same.