1st Quarter 2019
Our Views on the Investing Landscape
Wall Street sometimes refers to the “Santa Claus rally” to describe a historical pattern of increasing stock prices during the end of December. This year Santa delivered coal to investors, culminated on Christmas Eve with a 654 point drop on the DJIA. The same day, the S&P 500 large company index declined 2.7%, making the total decline just over -20% since October before recovering slightly later that afternoon to close at -19.6%. The pundits will argue over whether the index entered “bear market” territory, which is commonly referred to for -20% declines but it is not clear whether this is on intra-day or closing values. Regardless of labels, the conclusion to 2018 will likely be one that investors would prefer to forget.
It is not all bad news. In this newsletter, we will explore:
- First, a review of 2018
- Second, a discussion on the major influencers of the markets and what we believe will be drivers in the new year
- Third, a review of specific actions we have or are taking in portfolios
Review of 2018
For some time now, we have been discussing with clients our belief that one of the major drivers of the markets has been Federal Reserve and other central bank monetary policy. Following the 2008-2009 financial crisis, central banks responded by creating enormous amounts of cash and pushing it into the global monetary system to stimulate the economy. More recently, the Federal Reserve led the way in reversing this trend, withdrawing cash from the economy in a steady and clearly communicated plan to return to normalcy. In our view, this implied that financial markets would experience greater volatility than investors have experienced in recent years. If the Fed no longer stepped in to stop big market declines, then investors bore that risk themselves.
Our expectation has so far played out. Stock markets started the year up strongly. Bond markets fell as interest rates rose, giving bond investors in June 2018 the worst 12-month return since 1994.
Volatility swings both ways. By the end of the year, the S&P 500 large company index closed out the year at -4.4% after flirting closely with bear market territory. The NASDAQ tech index, Russell 2000 small company index, and most of the major foreign markets also crossed into bear market territory before recovering. Interestingly, foreign markets generally held up better during the worst of the sell-off.
Yet again, the markets demonstrated why attempting to time short-term market moves is a long term losing strategy. On December 26, the markets returned from the Christmas holiday with their best day since March of 2009. The Dow gained 1050 points or 5%, on a percentage basis, the S&P matched it, and the NASDAQ climbed 5.8%.
As we frequently remind clients, these type of market swings are completely normal. In fact, this type of volatility is why stocks have historically generated higher returns than bonds and cash over long periods. What matters is how we manage them.
Stocks are not the only asset in a diversified portfolio. Bonds also had a very difficult period. The Bloomberg Barclays US Aggregate Bond Index was down most of the year before recovering to 0.0% return. Short-term bonds fared better. Real estate, cash, and short-term bonds were some of the only assets that delivered positive returns in this very challenging environment. The combination of these assets in diversified portfolios played their role and helped to control risk.
Major Market Themes and a Look Toward 2019
What remains for investors now is the question, is this a ‘little bear’ or a ‘big bear’ market, or is this a buying opportunity, or a time for caution?
There are a number of major themes in play. These help to create a framework for understanding the volatility of 2018 and to build expectations what might play out in 2019.
Trade: Global trade remains a risk for the global economy. China and the United States are the current focus. While the tariffs are the most present impact, this is part of a long-term struggle between economic powers as China attempts to secure a dominant role in the world via its Belt and Road Initiative (“all roads lead to Beijing”) and Made in China 2025 Initiative (“so we can cheaply buy your commodities and sell you our goods”). The renegotiation of NAFTA is another example of uncertainty on global trade that has spooked investors.
Political impasse in the US: The November election put the Democrats in charge of the House of Representatives and delivered a split government in Washington. Major legislation seems very unlikely, and investigations and subpoenas may prove a distraction to the White House. In the past, markets have liked divided government because companies prefer regulatory environments that are stable enough for them to invest long-term without the rules changing.
Concern about a slowing economy: We think that trade is the biggest risk here, as most other indicators are flashing green. Some of the handwringing is the result of how one looks at the data. For example, job growth may slow, but this must be mathematically true as the country gets closer to full employment. Similarly, US corporate profit growth will slow down from its 2018 numbers because the impact of corporate tax cuts is not repeatable. However, a slowdown in growth is not the same as decline. Meanwhile wages continue to climb as companies compete for workers, the unemployed come back into the work force, consumer confidence remains solid and personal savings rates remain good implying people have money to spend. On the balance, it seems unlikely to us that a recession is lurking in the near term.
Geopolitical uncertainty: In addition to the US China rivalry, the uncertainty over outcome of Brexit in March is a cause for concern. A no-deal or hard Brexit would be quite negative to both the UK and Europe, and by extension for the global economy.
Our impression is that the stock markets in December discounted the worst-case scenario, particularly on political themes. We think the markets had too negative a view and that on the balance it seems unlikely a recession will begin in the near term. There is always the possibility of negative surprises. There is also the possibility that the worst-case does not come to pass or that we have positive surprises.
Implications for Investors and Portfolios
What should investors do? Long-term investors may want to look at valuations. As of December 31, 2018, the S&P 500 was priced 14.4 times earnings, or about 10% below its 25-year average.1 Short-term market movements are too unpredictable to use this as a reliable indicator, but for long-term investors these moments have historically provided good buying opportunities.
While we like this opportunity, we remain cautious, reviewing portfolios for opportunities to rebalance by buying stocks at favorable prices, but not becoming overly optimistic. There is no way to predict with certainty when a bad market will stop falling. Investors need to remain disciplined now. During times when everything seems right, disciplined investors need to lean against the wind and manage risk. They should maintain sufficient liquidity in cash and bonds to ride through the inevitable uncomfortable periods. Conversely, when fear prevails disciplined investors should not permit emotion to rule their actions and thereby miss opportunities.
We monitor all of our managed portfolios’ asset allocation on a regular basis. When markets do well, being disciplined means selling stocks to control risk. For the past year when we sold stocks, we held increased positions in cash and short-term bonds in client portfolios, in part due to our longstanding concern that bond interest rates were too low to take on additional risk in long-term bonds. Managing risk can prepare portfolios to deal with volatility such as the markets recently experienced.
Challenging markets are also opportunities. We have been using the market drop to review every portfolio that may be underweight stocks to increase those allocations. US equities are now at relatively cheap valuations relative to historical averages. Overseas valuations are even cheaper. The markets can and have fallen farther in past events. For disciplined investors willing to tolerate this volatility and hold high quality diversified stocks in their portfolio, this may lead to higher long-term returns. Holding sufficient liquidity in other parts of the portfolio to be able to withstand these swings is critical, and why we counsel clients to remain disciplined in good times and bad.
We used the market drop in December to review all taxable portfolio accounts for loss harvesting opportunities. The market drop presented the opportunity to sell securities that may have declined in value and replace them with a similar investment. The investor can then use this resulting tax loss to offset gains in other parts of the portfolio. The tax savings of performing these activities on a regular basis can be substantial.
The short window between the late-December market fall and the end of the 2018 tax year created a tight timeframe for our team to complete this review. We were pleased that our continued investments in the people, processes, and technology made it possible to complete this relatively intense workload before year-end.
News and things you should know
Dwayne Tyril recently passed his Series 7 and 66 licenses. Congratulations, Dwayne!
For those receiving a social security benefit, your benefit will rise by 2.8% in 2019 due to the cost of living adjustment. Spend it wisely.
The United States became a net exporter of oil for the first time in decades in 2018.
Yale University is making major changes to its retirement plan, which will affect many of our clients. We will be working individually with those affected to manage this ahead of the March transition.
Wishing you a happy, healthy, and prosperous 2019.
With warm regards,
|Charles F. Kreitler, CFP®
President, Kreitler Financial
|Robert P. Kreitler, CFP®
Founding Partner, Kreitler Financial
1Source: J.P. Morgan-Guide to the Markets® U.S. 1Q 2019 as of December 31, 2018This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of Charles and Robert Kreitler, CFP and not necessarily those of Raymond James. The information has been obtained from sources considered reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Diversification and asset allocation do not ensure a profit or protect against a loss. Investing involves risk and investors may incur a profit or loss regardless of strategy selected. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. The Bloomberg Barclays US Aggregate Bond Index is a broad‐based flagship benchmark that measures the investment grade, US dollar‐denominated, fixed‐rate taxable bond market. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index. The MSCI EAFE (Europe, Australasia, and Far East) is designed to measure developed market equity performance, excluding the United States & Canada. The EAFE consists of the country indices of 22 developed nations. The MSCI Emerging Markets is designed to measure equity market performance in 25 emerging market indices. The NCREIF Property Index is a composite total rate of return measure of investment performance of a very large pool of individual commercial real estate properties. RJFS does not provide tax advice. You should discuss any tax matters with the appropriate professional. International investing involves special risks, including currency fluctuations, differing financial accounting standards, and possible political and economic volatility. Prior to making an investment decision, please consult with your financial advisor about your individual situation.