“For every complex problem there is an answer that is clear, simple and wrong.” – H.L. Mencken
“You can’t predict, you can prepare.” – unkown
Many years ago I (Jon) had a client who started to lecture me on his perception of my job as his financial advisor. In this person’s eyes what we were to do for him was to “beat the market like the guys on tv do.” He started to explain to me how every Saturday he turns on the stock market shows on his favorite network and the gurus gush about all the money they have made with whatever the hot stock of the week happened to be. Of course, what said guru failed to mention were all the failed or stalled recommendations in the past weekend tv segment (pick up many an investment newsletter and you realize just how few of the recommendations turn out to be home runs). What this client was really saying to me was that he had failed to save enough at a younger age and he needed to “catch up” to meet his retirement needs.
This is not how investing works.
Investing is a long game. Over time the stock market moves from the bottom left to the upper right-hand corner; Bond yields move higher and lower. Over shorter time frames – be it this week, this month, or this year – returns can be erratic. As an investor it is important to make sure you are saving enough into an investment portfolio that meets the needs of your current situation. The smart investor asks how much risk they need to take then invests in an asset allocation designed to match the necessary risk. Tactical allocation can be effective in shifting a portfolio to take advantage of the investment by adding or subtracting from the risk taken.
Which leads us to reflect on the year that has passed and look forward toward the year ahead. As you may be aware 2018 was very different from the smooth ride of 2017 for investors. After 9 years of relative tranquility 2018 turned out to be more volatile than most predicted. The equity markets withstood two 10%+ corrections, including the worst December since the 1930s, as both commodities and bond yields fell. Last year there really was no place to hide.
In thinking about the markets ahead it is important to take some lessons from the year past. From there we will take a look at the economy to get a feel for where we are in the economic cycle.
Lessons from 2018
One becomes a better investor by learning from the past. 2018 handed us three big lessons:
Geopolitics matter: Around the office we can often be heard saying that global political issues don’t matter until the time in which the market decides they do. Tough US trade talk was in the background for the first 9 months of the year without an issue. Maybe it was talk of sales and earnings starting to take a hit, or the economic effect it was having on our global trading partners, or maybe the rhetoric became too much, but in October the market started to care about the perceived negative effects of tariffs and a trade war.
Rising short-term yields have made cash a viable alternative to riskier assets: It has been 10 years since money markets and short-term bank issued CDs paid anything close to what many would consider a reasonable interest rate. Investors can now make the choice to have some of their investment capital in “cash” and not feel like they are missing out on the ability to grow the nest egg. This pulls investable funds from stocks and bonds.
Portfolio Investments Matters: remember the mellow days of 2017 when the stock market moved quietly higher without a drawdown of more then 3%? Felt great, but an historic anomaly. In 2018 things were more normal with a 10% stock market correction in February and another significant drawdown in December. Quality of investment, once again, matters.
The Economy and Economic Cycle
Judging the economy and the markets is as much an art as it is a science. The economic cycle, while certainly following a pattern, is not precise. Simply put, no matter how clear and simple we may want to believe it is, the economy is affected by an innumerable number of factors – some are leading indicators as others do not move till later in the cycle. As an investor the economic cycle is important.
At the beginning of 2019 some leading indicators are showing signs of deterioration:
Housing: This is a very early indicator that generally will start to deteriorate while the stock market is still in a bull market and the rest of the economy continues to improve. While housing supply is nowhere near the peak of the Great Recession, we are seeing home supply start to move higher.
Labor Market: Deterioration is one of the warning signs of a weakening economy, historically with markets in bull mode. We are watching this closely but while the signs of deterioration are small, the fact that claims are so low is concerning. A flattening of claims generally occurs before the turn higher.
Heavy Truck Sales: While there is not enough recent data to confirm a downturn, this very early indicator looks like it has at least topped out, if not started to turn down. As the chart below clearly indicates, however, there is a lag between recession and receding truck sales.
Interest Rate Yield Curve: The spread between 2-year and 10-year US Treasury Bonds has come close to inverting but has yet to invert. Not necessary for a recession to happen, if the yield curve inverts it precedes a recession by about a year.
There are, however, a number of leading indicators which continue to be healthy, including Capacity Utilization, Personal Consumer Expenditures. Financial conditions are still very loose.
Overall we feel the economy is still in good shape, but after almost 10 years of expansion we believe the economy is approaching the back end of the business cycle. All projections we have seen call for economic growth in the 2.0-2.5% range for 2019. In other words, as we enter the new year economic indicators confirm that the economy is still expanding, albeit more slowly than the 3.0% rate in 2018. Without some major disruption we believe the chances of a recession this calendar year are small.
Of note: Consumer confidence peaks late cycle. When you hear talking heads use it as a panacea for good times to come take it for what it is worth.
Bond Market/Interest Rates
If you listen to some of the rhetoric surrounding the bond market you could become concerned for the bond market in 2019. Higher rates from The Fed; Corporate debt at high levels; Stress on the high yield bond sector. However, once you start to dig down a bit, things are not always as bad as they seem.
Just a few months ago the general consensus was that 2019 would feature three or four short-term rate increases. With the spread between long-term and short-term bonds tight, the thought was the expected increases would lead to an inverted yields curve (short term rates higher than long term rates), setting the economy up for a recession. Now we are in a reverse situation where “the market” is expecting rate cuts by the end of the year. Barring a major catastrophe, reality is probably somewhere between these two extremes.
Even if Chairman Powell and the Federal Reserve Board decide to not raise short-term interest rates in 2019, we expect there to be upward pressure on rates. We are entering unchartered territory with the combination of more than $1.2 trillion of new debt expected to be created, old debt that needs to be rolled over, and the loss of the Federal Reserve Bank as a buyer as they right size the balance sheet. That is a lot of supply in the face of losing a major buyer.
Moving onto corporate debt sector we are not concerned at this point in time. Debt levels are high but the interest cover ratios are low. Moody’s (Weekly Market Outlook 12/20/2018) see’s high yield default rate dropping in 2019 from 2.9% to 2.6%. They do also note, however, that the “unprecedented” $705 B of outstanding Baa3-rates corporate debt (the lowest investment grade bonds) could become a problem in an extended recession as downgrades could flood the high yield market with fallen-angel downgrades.
Given this as the background there will be some individual issues that are a problem for investors. This is the case even in the best of years. But in general, 2019 does not pose a threat to the corporate bond market.
Having an idea of where we have been is important for judging where we may be going when it comes to the stock market. The major pullback just experienced in the fourth quarter of the past year has taken a market that was getting a little expensive at 18x forward earnings estimates ($179 according to Wells Fargo Advisors) is now more reasonable at less than 15x earnings forecasts (as of 1/17/2019).
The S&P 500 (S&P) and Dow Jones Industrial Average (Dow) have moved higher in the long-term based on earnings growth. In the short to intermediate-term have been fluctuating based off of investor sentiment and what multiple said investors are willing to pay for current and forward earnings. Happy, confident investors will pay a higher multiple, while a more pessimistic tone leads to lower valuations. This leads us to ask one really important question:
What could be the catalyst to higher multiples in 2019?
There are a number of possibilities, including a trade resolution with China, Brexit, The Federal Reserve either curtailing their aggressive rate increase schedule or not raising rated in 2019, a return to more solid global growth trends, or some unknown issue that comes up during the year. There is a lot that can go well and move the equity markets higher. Yet these same issues can turn the other way on a single decision by a single person.
Unlike any other year we can remember, there are a lot of hot issues across the globe that do not present just one logical conclusion. We can make a solid argument for new all-time highs for the indices we follow just as easily as we can argue for a breakdown in stock prices if the world gets rocky. All of the aforementioned issues, in our opinion, will become more clear during the first half of 2019.
Looking at the charts we are at an interesting point that we feel should resolve itself in the fist half of the year. Looking at the daily chart of the S&P 500 it becomes evident that, from a technical perspective, the market has some work to do before it is back in true bull market status. Getting above the resistance at 2633 is a start, but the true test comes at the downtrend line that hovers around the 2700 level. A break through that level would be very positive for stocks in 2019.
If the S&P 500 cannot get through 2700 for whatever reason we believe that a probable scenario would have the market re-test the late-December lows around 2350. In this scenario we would expect the test to take some time to develop, and that it would develop around the world events previously mentioned. IF this is how the first part of 2019 plays itself out, we would expect the December lows to hold and a market rebound from that point. With valuations at reasonable levels and interest rates at reasonable levels we find it hard to see a scenario where markets do more than test previous lows.
Beyond the possible disruptors already discussed, there are a few other “normal” issues that the markets need to contend with. One is that the current economic cycle is now the second longest we have ever witnessed. The longest was 1991-2001 (10 years/ 120 months) and the second longest was 2001-post-recession recovery, which lasted 80 months. The average cycle since 1854 is 40 months and currently we are in month 114 of the current recovery, which is 2nd longest on record. It is not IF an economic recession is coming but WHEN it arrives. We don’t expect one in 2019 but 2020 is not out of the question.
Corporate earnings can also be an issue we have to deal with in 2019 – it’s not just about the numbers, but also expectations. With 2018 being an incredible year of earnings growth even good earnings will look and feel underwhelming. Most all of the forecasts we have seen show earnings growth slowing in the first half of the year then accelerating in the back half of the year. That is certainly a possibility, but not a guarantee. Either way it is hard to conclude with some reasonable certainty where earnings are headed for the full year.
What is clear to us is that there is nothing clear about the direction of the markets given the wide array of variables in play this year. Given the unusually large number of risks on the table this year an investor needs to adjust as the markets and investing environment dictate. Always remember that the stock market is a forward-looking entity that is more concerned with what the future will bring as opposed to the wonderful quarter that just ended. A big tell we watch for is the market reaction to earnings reports. Exceptional earnings that result in a selloff is bearish; modest or poor earnings that cause a rally is bullish. Simple but not easy.
There are years of change and years of trend that can be fairly easy to draw a picture of. In a year of change, while counterintuitive and uncomfortable, the right conclusion is a reversal of fortune. Perfect timing the end of a bull market run or a breakdown like 2008 is hard, but if you are looking without emotion you can see the change ahead. Trending years are even easier because it is basically more of the same.
How do you handle the year of uncertainty? Six words: Prepare, Stay Nimble and Embrace Volatility
On behalf of Magellan Financial we thank you for taking the time out of your day to read our thought on the markets. If you know someone who may be interested in these materials we encourage you to pass it along. If you have any thoughts or questions, please do not hesitate to contact us either by email or at 610-437-5650 during regular business hours.
Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.
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Robert I Cahill, Managing Partner Rob.Cahill@wfafinet.com
Jeffrey T. Bogert, Partner
Jonathan D. Soden, Partner Jon.Soden@wfafinet.com
Robert Sweeney, Financial Advisor Bob.Sweeney@wfafinet.com
Jay Knight, Associate Financial Advisor Jay.Knight@wfafinet.com