Note: To view recorded webinar where Zach discusses market volatility and reviews 2018 market activity, please visit: Understanding Market Volatility and 2018 Market Review
Each year, summarizing events of an entire year in the global markets is a challenge, even though many times there is a constant theme that continues throughout the year. 2018 can be a year remembered by the volatility experienced in the markets. Having written my fair share of market reviews over the last six years, it is hard to not be struck by the good overall returns we have experienced during this time period. While that isn’t much of a concession for some, broadening the time frame even longer is generally even better across every investment type … a fact that shouldn’t be ignored. There are many lessons embedded each year and I have expounded on a few that were top of mind in 2018 in a piece called A Few Lessons for the Investing “Playing Field” that some may find helpful for the upcoming year. The following is meant to summarize the events of 2018 and provide some of our current ideas about positioning portfolios in 2019.
2017 was marked as a record year, with positive returns in every month (first time in 90 years!) and almost no volatility. I hope we conveyed that this was not normal. 2018 started strong with the S&P running up over 7% in January, only to fall over 10% in 11 days in February on fears of inflation and rate hikes. Strong company performance throughout the year had markets shaking off most negative news and grinding higher until the end of the 3rd quarter with the S&P 500 up 9.57% and small companies represented by Russell 2000 up 10.46%. This is not to mislead one to think that all companies in the S&P 500 were performing equally, as there was a strong divergence between the “growth” sectors of the market (technology, healthcare, consumer discretionary) and “value” sectors.“Growth” stocks propped the averages up, outperforming “Value” stocks by as much as ~7%. Quarterly earnings growth was 27% (1st quarter), 27% (2nd quarter), and 32% (3rdquarter), which is remarkable! However, as the 4th quarter kicked off, fears of a trade war with China, falling oil prices, rising interest rates, and a slowing global economy arrived and spurred a steep sell-off of ~10% in October. The market rallied back 6% in a week, only to fall again and rally again, fall again to a low of -10.6% (S&P 500) with a last-minute rally with the biggest point move in the DOW in history to end the year down -5.35%. For an explanation of why the market can move so dramatically, please read A Few Lessons for the Investing “Playing Field”. A few takeaways: First, the U.S. economy by all objective measures is stronger than it has been in quite a while. Companies have posted record earnings and profits. However, the market is responding to what could be coming…is the economy slowing, are we headed for a recession, etc.? Without a doubt, the lack of a trade deal with China is weighing on the US, Chinese, and worldwide growth expectations. Companies have recently projected lower growth estimates, and sentiment has turned decidedly negative. Before we put a nail in the coffin for the economic expansion, we should consider a few points. One is that a trade “deal”/compromise is unlikely to get resolved in some grand fashion in the next 90 days, but it is also unlikely to not get some movement and provide some clarity to markets. Secondly, if the U.S. economy is slowing, with low oil prices leading to low inflation, Fed rate hikes are likely to be fewer or stopped entirely, which could provide some needed oxygen to the markets. We believe that it is wrong to assume that whatever the current assumptions are will always remain unchanged. Central banks, politicians, company management, and markets respond to what is happening and assumptions can and do change. Today the assumptions and sentiment espoused by many are full of pessimism, but the fundamentals don’t provide such a grim picture. The valuation of U.S. stocks are now “cheap” relative to history (P/E of 14.4 vs. 25 year average of 16.1), interest rates are less likely to rise, and the economy is still strong. If a trade deal/trade truce occurs in some fashion soon, stocks and the U.S. economy are likely to respond positively. Longer-term, we still believe stocks will reward investors and are an important part of most investor portfolios.
International stocks mimicked US stock returns until mid-May at which point negative sentiment combined with an increasing dollar started to cause a sell-off overseas. Developed international stocks are far more sensitive to a slow-down in trade, and the trade dispute between the US and China has had a chilling effect on global growth forecasts. Other idiosyncratic political issues, including BREXIT uncertainty, likewise has soured investor optimism. However, like U.S. stocks, valuations of international stocks are historically very cheap (P/E of 13.5 vs. 25 year average of 16.1) which is a key ingredient for good future stock returns. Additionally, if the U.S. dollar decreases relative to foreign currencies, international stocks could fair better in the coming years.
2018 can be remembered as a “risk off” year where investors got skittish and sold all risk assets, with cash/money markets providing almost the only positive return, and international and emerging market stocks being part of this sell-off. As you can expect with all the talk about trade with China, the Chinese stock market fell —22.8% (MSCI China Index) in 2018. The overall Emerging Market index which encompasses China, Korea, India, Brazil, South Africa, Mexico, to name a few, fared a bit better down -16.9%, so still holding on to some of its 37.28% return in 2017. Like the other stock indices, Emerging Market stocks are inexpensive relative to history as well and growth prospects are much higher than their developed market counterparts. If you are familiar with reading our previous market reviews, you will know that we do suggest maintaining a small position in these stocks and rebalancing them as needed; with their volatility, we have ample opportunities to do that.
The Federal Reserve raised rates four times in 2018 and the Fed Funds rate now stands at 2.4%. This is often a significant headwind to bond returns as the structure of yields at different maturities is heavily influenced by what the Fed does. However, as we have often stated, the bond market is bigger than the Fed, and global demand for bonds of different types is ultimately what determines performance in a given year. This year the aggregate bond index lost value early in the year as inflation and rate fears emerged, but as the global equity markets sold off later in the year, money flowed into bonds and raised prices (lowered yields). So amazingly, early in the year the stock market sold off due to interest rate fears and the bond market went down with stocks while late in the year, bonds provided the more familiar cushion to a stock market decline. Because of economic uncertainty, low and probably declining inflation expectations, and volatility in the stock markets, the Fed has reduced its forecast for rate increases from three to two in 2019, but many expect that we might get even less. If more volatility is to come, bonds will continue to play that key role in reducing that volatility at the portfolio level.
Let’s clear the air and admit that we all hate negative returns, whatever their cause. Diversification helped dampen losses but nearly every asset class beyond cash/short-term bonds was negative in 2018, and the daily volatility was unnerving for many, especially on the heels of a long period of very low volatility and good returns. If any comfort can be had, it is in the fact that we have been through many periods in the market like this where the future was unclear and challenges seemed to outnumber the positives. Like a pilot who must depend on his gauges when flying with limited visibility, we must rely not on what we can’t see, but what we can. Our investment principles, along with a reliance on fundamentals, is the best path towards staying on course in 2019 and beyond. We thank you for your trust in us as a steward of your capital and we will remain vigilant in that role in 2019.
Zach Ivey, CFA, CFP®
Chief Investment Strategist
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of April 5, 2018, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by Bridgeworth, LLC to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.
Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass.
Reliance upon information in this material is at the sole discretion of the reader.
Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal, and potential liquidity of the investment in a falling market.
International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments.
The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments.
Any securities, indices, and other financial benchmarks shown are provided for illustrative purposes only, and reflect reinvestment of income, dividends, and other earnings. They do not reflect the deduction of advisory fees. Investment products are subject to investment risk, including possible loss of the principle amount invested. You cannot invest directly in an index.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.
The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of the following developed country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the UK.
The MSCI EM (Emerging Markets) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the emerging market countries of the Americas, Europe, the Middle East, Africa and Asia. The MSCI EM Index consists of the following emerging market country indices: Brazil, Chile, Colombia, Mexico, Peru, Czech Republic, Egypt, Greece, Hungary, Poland, Qatar, Russia, South Africa. Turkey, United Arab Emirates, China, India, Indonesia, Korea, Malaysia, Philippines, Taiwan, and Thailand.
The Bloomberg Barclays U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.
Barclays 1-3 Year Government Bond – Barclays 1-3 Year Government Bond Index is a market value-weighted performance benchmark of investment grade government and corporate bonds with maturities of one to three years.
The Markit iBoxx USD Liquid High Yield Index is designed to reflect the performance of USD denominated high yield corporate debt. The index rules aim to offer a broad coverage of the USD high yield liquid bond universe. The Markit iBoxx USD Liquid High Yield Index is rebalanced once a month at the month-end (the “rebalancing date”) and consists of sub-investment grade USD denominated bonds issued by corporate issuers from developed countries and rated by at least one of three rating services: Fitch Ratings, Moody’s Investors Service, or S&P Global Ratings.
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