Stock markets around the globe fell sharply in the fourth quarter with most major indices declining into bear market territory. At its lowest point for the quarter, the S&P 500 Index had declined 19.8% from its September all-time closing high. (A bear market is generally defined as a 20% decline from a market peak. The current market decline rounded to a 20% loss and was greater than 20% using intra-day pricing.) Many other U.S. and international indices suffered even greater losses.
The table below shows the performance of major equity indices for various time periods.
Equity Performance for Periods Ending on December 31, 2018
|Total Return Index||Market Sector||Decline from high to low||Quarter||1-year||3-year||5-year||10-year|
|S&P 500||Large U.S. Companies||-19.8%||-13.5%||-4.4%||9.3%||8.5%||13.1%|
|Russell 2000||Small U.S. Companies||-27.2%||-20.2%||-11.0%||7.4%||4.4%||12.0%|
|MSCI EAFE||Developed Int’l Markets||-22.7%||-12.9%||-16.1%||0.1%||-2.1%||3.4%|
|MSCI EM||Emerging Int’l Markets||-26.6%||-7.9%||-16.6%||6.7%||-0.8%||5.5%|
Bear markets usually develop in anticipation of a recession, which sometimes materializes, but sometimes does not. The economist, Paul Samuelson, was quoted in 1966 as saying, “The stock market has forecast nine of the last five recessions.” His clever observation has held true numerous times in the 52 years since it was made. In fact, since the last recession, which ended in June 2009, the S&P 500 has had four previous corrections of more than 12%, each on worries regarding a slowing economy. However, no recession occurred and markets eventually recovered.
With the current U.S. economic expansion almost 10 years old, it is likely the U.S. will experience another recession at some point (though some major economies, such as China and Australia have gone more than 25 years without a recession). At this time, we do not see clear signs that a U.S. recession is imminent. Interest rates, job creation, inflation trends, credit performance, and corporate earnings growth all continue to point to economic growth for 2019. Growth is likely to moderate from 2018, which was bolstered by tax cuts, but most current estimates for GDP growth in 2019 are still in the range of 2% to 3%.
In light of the positive economic data, the Federal Reserve increased interest rates to a range of 2.25% to 2.50% in December. Prior to the Fed’s interest rate decision, President Trump had made it clear that he was opposed to the Fed raising its key rate. While the market historically reacts negatively to rising interest rates, Trump’s criticism of Federal Reserve Chairman Powell and the Fed’s interest rate policy seemed to exacerbate that reaction and add an extra degree of uneasiness to an already skittish market. Although it went ahead with its planned rate increase in December, the Fed adopted a more accommodative and flexible posture for 2019. It is now signaling two interest rate increases for 2019, rather than three. In addition, it lowered its target “neutral rate” to approximately 2.75%, which is the rate that the Fed considers neither loose nor tight.
The other major concerns for the market included the lack of significant progress on trade issues with China and slowing economic growth in Europe, Japan, and China. In early December, the U.S. agreed to delay additional tariff increases for 90 days, and China committed to buy a substantial amount of agricultural, energy, and industrial products to help reduce America’s huge trade deficit with China. We are optimistic that the U.S. and China will work to resolve their trade issues in a way that is beneficial to both economies. In the face of challenging demographic trends, it seems that slow economic growth in Europe and Japan have become the norm. These economies are expected to grow less than 2% in 2019.
While no one enjoys seeing their portfolio decline in value, we believe the recent drop in stock prices makes equity investments relatively more attractive. The 2019 price-to-earnings (P/E) ratio of the S&P 500, a primary measure of value for stocks, declined from 16.8 to 14.3 over the last quarter. For mid-size and small companies, which have suffered even greater declines, the P/E ratios stand at 13.3 and 14.1, respectively. For each market capitalization segment, these are the lowest valuations in more than five years.
We also believe that the Trump Administration will be more likely to take actions that will support stock prices over the next two years. The President has been clear that he views the stock market as an important barometer of his administration’s success. He has been highly critical of the Fed for raising interest rates and at least partially blamed the Fed’s monetary policy for the market’s recent decline.
Although it might sound cynical to say that President Trump may attempt to pump up stock prices, it seems that most presidential administrations have historically adopted a stock market friendly policy in the third and fourth years of the presidential cycle, most likely in an effort to remain in power. Since 1949, the total returns of the S&P 500 in the third year of the presidential cycle have averaged 19.9% - almost double the average for the other three years. In addition, since 1949 there has not been a loss in the third year of the presidential cycle.
S&P 500 Index - Presidential Cycle Calendar Year Performance since 1949
|First Year||Second Year||Third Year||Fourth Year|
|Average Total Returns||10.5%||9.8%||19.9%||10.3%|
|Number of years with a loss||7||6||0||2|
|Percentage of years with a loss||39%||33%||0%||12%|
While we are generally positive about equity markets as we begin 2019, we acknowledge that it is virtually impossible to predict the short-term direction of the stock market. Although short-term market volatility can be disconcerting, it can provide attractive buying opportunities for long-term investors. In managing portfolios, the primary tool for controlling risk is to establish an appropriate asset mix of equities and fixed income investments, based on a client’s objective and risk tolerance. If the equity exposure of a portfolio decreases due to a market correction, the process of rebalancing the portfolio will result in buying additional equities at lower prices. The rebalancing process imposes a discipline of buying low and selling high. When the market correction is ongoing, it is sometimes difficult to see the rewards of this strategy, but the longer-term payoff eventually materializes as the market recovers.
In periods when equities decline, fixed income investments usually contribute positive returns as many investors shift funds to safer investments. This occurred during the fourth quarter, as the Bloomberg Barclays Aggregate Bond Index generated total returns of 1.8%. During the quarter, the yield on the 10-year Treasury Bond declined from 3.05% to 2.69%, reflecting greater demand and higher prices for high quality bonds.
We offer you our best wishes for 2019. Please feel free to contact us if you have any questions regarding your portfolio.
John D. Frankola, CFA Lawrence E. Eakin, Jr. Matthew J. Viverette
Vista Investment Management, LLC is a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.