2018 was perhaps the strangest year I’ve experienced in my career as an investment professional. Most importantly, it was one of the truly great years in the history of the American economy, and by far the best one since the global financial crisis of 10 years past. Paradoxically, it was also a year in which the equity market could not get out of its own way.
It is almost impossible to cite all the major metrics of the economy which blazed ahead in 2018. Worker productivity, which is the long-run key to economic growth and a higher standard of living, surged. Wage growth accelerated in response to a rapidly falling unemployment rate. Household net worth rose above $100 trillion for the first time, yet household debt relative to net worth remained historically low. Finally—and to me, this sums up the entire remarkable year—for the first time in American history, the number of open job listings exceeded the number of people seeking employment.
Earnings of the S&P 500 companies, paced by robust GDP growth and significant corporate tax reform, leaped upward by more than 20%. Cash dividends set a new record; indeed total cash returned to shareholders from dividends and share repurchases since the trough of the financial crisis reached $7 trillion.
But the equity market had other things on its mind. Having gone straight up without a correction throughout 2017 (a correction is defined as a 10% decline in price), the S&P 500 came roaring into 2018 at 2,674—probably somewhat ahead of itself, as it seemed to be discounting the entire future effect of corporate tax cuts in one gulp. There ensued in February a 10% correction, followed by several months of consolidation. The advance resumed as summer waned, with the Index reaching a new all-time high of 2,931 in late September. It then went into a savage decline, falling to the threshold of bear market territory: S&P 2,351 on Christmas Eve, off 19.8% from the September high. A rally in the last week of trading carried it back up to 2,507, but that still represented a solid six percent decline on the year, ignoring dividends. 2018 thus became the tenth year of the last 39 (beginning with 1980) in which the Index closed lower than where it began. At the long-term historical rate of one down year in four, that’s actually just par for the course.
The major economic and market imponderable as the year turns is trade policy, which in the larger sense is an inquiry into the mind of President Trump. I think it fair to say that Trump has managed to reduce tax and regulatory burdens in impressive fashion, but his tweets and his tariff threats have created unnecessary distractions and unfortunate uncertainties, not to mention higher prices for an array of imported consumer goods.
These and other uncertainties—perhaps chief among them Fed policy and an aging expansion—were weighing heavily on investor psychology as the year drew to a close. For whatever it may be worth, my experience has been that negative investor sentiment—and the resulting equity price weakness—have usually presented the patient, disciplined long-term investor with enhanced opportunity. As the wise and witty Sage of Omaha wrote in his 1994 shareholder letter, “Fear is the foe of the faddist, but the friend of the fundamentalist.” One good thing we can say about last year’s sell-off in stock prices is that valuations have become even more attractive. On a forward price/earnings basis, stocks are priced below their 25-year average.
At year-end, we rebalanced accounts to accomplish three things. (1) Bring portfolio weightings closer to their long-term targets in order to manage risk. (2) Increase the credit quality and reduce the interest rate sensitivity within the fixed income allocation. (3) Take advantage of tax-loss opportunities to reduce capital gains now and in the future. While nobody likes to see temporary price declines in their portfolio, tax-loss selling in the era of index funds is about the closest thing to a free lunch that investing has to offer.
Going forward, we’re confident that the market will continue to reward patience. While corporate earnings growth may slow, there’s no reason to believe that it will turn on a dime, or that a recession is imminent. The Fed will do what it can to avoid an inverted yield curve and a Fed-induced recession. As it is, they could raise the Federal Funds rate a few more times before monetary policy could rightfully be considered tight.
Tactically, we’re keeping an eye on the corporate bond sector, particularly low-quality (high-yield) bonds. This past October, the risk premium (the extra yield required by investors to accept the higher risk of owning junk bonds instead of Treasurys) reached its lowest level in 10 years. This tells us that high-yield investors are very accepting of risk, or perhaps ignorant of it. Should the economy slow or interest rates rise too quickly, the companies behind these junk bonds will be impacted more than their higher-quality competitors. As we saw in 2015-2016, demand for high-yield bonds would likely fall off, causing yields to rise and potential bargains to appear. We’re not there yet, but it’s starting to move in that direction. In the meantime, we will continue to hold mostly shorter-maturity, high-quality corporate and Treasury bonds.
If you have any questions, comments, or concerns, please let us hear from you. All the best wishes for a Happy and Prosperous New Year!
Ashley Vice, CFA, CFP®
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