2018 Market Review and a Look Forward

Reaching the peak of a mountain is the easy part. Once you’ve reached the top, you need to start planning for the descent. And that’s where things get tricky. While most metrics are pointing to a healthy economy for 2019, the stock market has continued to remain volatile for the first month of the year. That trend will likely continue.

Looking back, it appears that my market concerns were well founded last year. Stocks rose and fell depending on which headline captured the news cycle. Watching your savings fall back to Earth after a decade of growth is a reminder that investing will always hold risk. This article will briefly cover what was behind the turbulence and talk about my approach to investing. Hopefully this will give you some insight on how to handle the expected volatility in 2019.

Last year’s market movers

Last year started out following the previous year’s positive trajectory. After large gains in 2017, it appeared the promise of tax cuts may have unleashed the market’s animal spirits. My thought at the time was that tax reform could become nothing more than a short-term sugar high. As I reported during the first quarter, stocks reached their first peak of the year in early February. Most attributed the early year decline to President Trump imposing tariffs shortly after the new tax code came into effect.

The second quarter of the year was much of the same. There was a modest rebound despite continued worries over the trade war. At the time, markets were also concerned about the approaching yield curve inversion. An inverted yield curve is often a predictor of economic recessions, considering that almost all recessions begin within 6 to 24 months afterwards.

Risk in an investment portfolio is primarily driven by the asset allocation within the account. While I often discuss this with clients, I felt it prudent to update my client’s Investment Policy Statements mid-year. This document explained how accounts were structured and reminded them about the risks in their accounts. I followed up with semiannual reviews shortly after. Most felt comfortable with their portfolios despite the headwinds.

Over the next few months, I made allocation changes in anticipation increased volatility. Rather than focusing primarily on low cost index funds, I introduced a few actively managed ones. Index funds will simply follow the market downward during a decline unlike actively managed that can change holdings to reduce loses. Portfolios were also weighted more towards value and dividend paying stocks which tend to offer more stability during rough markets.

Given the tariff issues, investment in the Chinese market was reduced. An increase was made in the more stable European Union funds to balance out international exposure. Finally, there was an increase in bond fund durations. That change was made to take advantage of the higher yields from interest rate hikes.

In December, the stock market had given up all of the gains made during 2018. As expected, the yield curve had also inverted. On December 21st, the NASDAQ Composite index closed in a bear market (-22%) territory for the first time since the Great Recession. On Christmas Eve, the S&P 500 index closed in a bear market as well. It had declined 20.05% below the most recent peak.

inverted yield curve 2018

It was to be expected there would be a market correction given the fact that we were in a record-breaking bull run. Still, media outlets at the time were pointing to the fact that our economy was still on solid ground. Many technical analysts had charts showing upward growth heading into Q4 and beyond. What was to blame for the market drop at the end of year?

The simple answer is uncertainty. It’s the primary reason we’re in this seesaw market. Investors aren’t as sure about the benefits of the tax plan. Consumer confidence is down. Ill-advised trade tariffs are hurting the two largest economies in the world. The midterm resulted in divided government and a new direction for policy. The year also ended as it had begun… with a government shutdown.

These problems didn’t go away when the calendar flipped to 2019.

2018 Investment review

morningstar S&P 500 2018

Overall, the S&P 500 was down 6.24% for 2018. The Dow Jones Industrials Index declined 5.63% for the year. None of the investment portfolios the firm manages declined more than the broad market. This is due to the fact that a diversified portfolio is rarely invested in an equity only allocation. Bonds, which typically move in the opposite direction of stocks, barely broke even given the fact that interest rate hikes pushed values down.

Year-end statements will be a bit of a letdown after many years of steady gains. The good news is that the majority of funds I use for clients fared better than their benchmarks. A fund’s benchmark is the standard used to evaluate how a fund is performing relative to similar investments. For 2018, 70% of the funds I use performed better that measurement.

That doesn’t mean the funds had positive returns for the year. Instead, it means that ones I used held their value better than the asset class as a whole. Some funds beat their benchmarks by just a small percentage… but these small amounts add up over the years. The Matthews China Dividend fund, as an example, fell by almost 10% for the year. It’s benchmark, the overall Chinese market, fell 20% in comparison. A shallow hole is far easier to climb out of.

Looking over various investment sectors, ESG (Environmental and Social Governance) funds look to be the only outlier when it comes to performance. ESG funds consistently underperformed their benchmarks (which are often comprised of non-ESG companies). The reason for this seems to be that they have both a narrower list of companies to invest in as well as the companies often being smaller sized. Smaller companies seemed to struggle overall, which is to be expected when the market starts becoming volatile.

Moving Forward in 2019

Looking back at 2018, my concerns appeared to be well founded. For the next year, I’m cautiously optimistic about the direction we’re moving in. Many of the issues that dragged the markets down last year were entirely man made and should be tempered going forward. One such issue was the longest government shutdown in U.S. history.

As a result of the 35-day shutdown, 800,000 federal employees went without pay until the end of January. The economy slowed as the flow of funds into the economy stopped. The Congressional Budget Office is estimating $11 billion in losses after the longest government shutdown in history. While government employees will eventually earn back pay, government contractors lost out entirely.

The S&P 500 Index has been slowly rising since the start of the year despite the worries. This growth was happening even though periodic contributions into Thrift Savings Plans ceased for two pay periods. Now that back pay is on its way, we should see the market react to the flow of funds into these accounts.

2019 YTD S&P 500

As with other recent policy changes, there’s little way to anticipate what departures from the norm investors will have to deal with next. The issue of another shutdown still looms. As this is being drafted, President Trump is demanding Congress fund his signature campaign promise or risk another closure. Between the recent political defeat and poor public perception of the shutdown, chances are above average that some sort of compromise can be reached.

We should also remain hopeful about ending the ill-advised tariffs placed on Chinese goods. There are few positives when it comes to trade wars. One may be that China will most likely enact changes aimed at preventing a more sustained one in the future. If the trade war deescalates on March 1st, we can also count ourselves lucky that it took place during good economic times.

Resolving these issues cleanly would be the best-case scenario for investors. Unfortunately, we need to address the elephant in the room. Investors need to have a better picture of what future economic conditions will look like for the year. As long as the negative reports remain in the news, it’s hard to argue against playing it safe.

While tariffs and trade wars remain lead stories, they have all been eclipsed by the drama surrounding President Trump. No matter what your views are… we can all agree that he creates uncertainty. The information that we have after two years of investigations point to a future when we have a diminished executive branch in some form or another.

How much of a problem could this become? Most likely, it wouldn’t be the worst outcome. What would be the worst-case scenario, in terms of uncertainty for investors, would be the actual process of impeaching the President. I wrote a well circulated article researching the topic back in 2017 that you can review more in-depth if you’d like. What it found was that history shows large market swings took place during previous impeachment proceedings only to be followed by a relatively quick return to the previous trajectory.

All of this is conjecture, of course. No one can predict how the markets will move day to day into the future. At best, a fiancial advisor can only feel the currents building towards a trend. In mid-November of last year, most of the firms I spoke with during an advisor conference with were predicting strong results with near term volatility. That translates to rough seas followed by smooth sailing.

When it comes to managing investments, my philosophy for the year can be summed up with the following quote - Pray to God, but row away from the rocks. That means I’m going to stick with what I know and follow core investment principles. It also means that I’ll steer clear of known danger areas.

At the start of 2019, a thorough review of all funds was done to ensure performance was in line of the investment’s benchmark. Capital losses, which can offset future taxes, were harvested in December. Now that the wash sale period has passed, account rebalancing is being finalized. Most client’s have already met with me for their annual reviews as well.

All of these have been shown to have a positive impact on long term returns. In the near term, it can be difficult to quantify these results. Since human nature pushes us to focus on short term needs rather than our longer-term goals, changes need to be occasionally made in our portfolios to sooth nerves when volatility comes along. This is why I use a satellite approach to compliment my core diversification strategy.

My satellite approach has been to weigh portfolios more towards large and steady companies. I concentrated on companies with a track record of paying dividends as they often have the presence to weather most storms. I also split from my typical index approach for large companies and added actively managed funds. Those have fund managers who perform additional due diligence on the individual stocks that the funds comprise of. Finally, as a result of higher bond yields, I’ve planned changes that take advantage of the yield returns without adding much more risk in the accounts.

For your part, you should be making sure your emergency funds are properly funded this coming year. You’ll also want to spend time making sure your investment strategy fits with your overall plan. If you haven’t already, make sure to rebalance your retirement accounts. Finally, review your tax situation now that you can finally judge the new tax law’s impacts your family.

We can only speculate as to what will happen beyond 2019. Most feel that there is a slight chance of recession this year, though the odds grow in 2020. Longer term investors should view this as a buying opportunity. Those with more current needs should still hold equities since doing so helps prevent inflation for eroding purchasing power. Most importantly, stay focused. These are indeed strange times for investors, but don’t let today’s headlines sway you.

Trust me… you won’t even remember them a week from now.