“I have two kinds of problems: the urgent and the important. The urgent are not important, and the important are never urgent.” Dwight D. Eisenhower in a 1954 speech to the World Council of Churches, quoting Dr. J. Roscoe Miller, the President of Northwestern University.
December’s market swoon came as a shock for many investors. After finishing the previous nine years with a positive return, December’s market selloff resulted in the first negative annual total return for the S&P 500 since 2008. The fourth quarter of 2018 also marked the fourth time in the last decade that the S&P 500 declined more than 10% over the course of a quarter. The other three times occurred in Q1 2009 (-10.9%), Q2 2010 (-11.4%), and Q3 2011 (-13.8%). There were numerous factors that seemed to contribute to investors’ fear. Among them were increasing concerns about a slowing global economy, the ongoing trade war between the U.S. and China, the Federal Reserve disappointing markets by raising rates 25 basis points in December and signaling an additional two rate hikes in 2019, uncertainty surrounding the impact of falling oil prices, and fears that corporate earnings may have peaked. Adding “agita” to the markets were comments by current Chair of the Federal Reserve Jerome Powell that the Fed’s ongoing unwinding of its balance sheet would continue on “automatic pilot.” Throw in selling pressure from investors engaged in year-end tax-loss selling and a lack of buyers over the holidays and you have the perfect recipe for a significant market correction. By Christmas Eve, the S&P 500 was less than one-half percentage point from entering a bear market (traditionally defined as a drop of 20% or more). However, equities rallied back following a Christmas break to narrowly avert an official bear market. U.S. small-cap stocks fared the worst of the major equity asset classes, losing 20.2% during the fourth quarter and bringing their year-to-date losses to 11.0%. Losses were wide spread across all equity asset classes and market sectors with virtually all equity asset classes finishing both the quarter and the year in the red.
As investors fled volatility in equity markets, many sought to allocate their capital to the relative safety of bonds. This flight to safety helped push interest rates lower in December, driving the benchmark 10-Year Treasury down to 2.69%, 55 basis points below its peak of 3.24% on November 8, and only 29 basis points above where it ended 2017. Despite interest rates mostly rising throughout the year, the December rate plunge moved broad fixed income indices back to the breakeven point or slightly into positive territory for the year. The Bloomberg Barclays U.S. Aggregate Bond Index, the broad benchmark used by many fixed income investors, finished the year with a return of 0.01%, which would be about as low as you can go and still claim a positive return. Shorter/intermediate-term municipal bonds, measured by the Bloomberg Barclays Municipal Bond 5-Year Index, finished the year up 1.7% after a strong fourth quarter rally.
Despite the pervasive pessimism that seemed to overcome markets in the fourth quarter, there are more than a few bright spots to consider as we look forward to a new year. The U.S. economy grew at an annualized rate of 3.4% in the third quarter of 2018, and growth in China is expected to be in the neighborhood of 6% in 2018. Inflation continues to be benign, with the latest report showing the CPI (Consumer Price Index) rising 2.2% year-over-year through the end of November. The unemployment rate is also low, coming in at 3.9% as of the latest report from the Bureau of Labor Statistics on January 4. Low levels of inflation combined with a strong and apparently stable labor market should continue to provide a counter to some of the worst market fears. And it seems fair to posit that investors are pricing in some fairly negative outcomes related to tariffs, trade wars, and other geopolitical concerns. Given these positive underlying economic indicators, any upward surprise in the areas with which the market has expressed so much concern could significantly improve investor psychology.
As we move into a new year, investors should continue to focus on what is important, their long-term investment plan. The investment plan should include contingencies for changing market conditions, such as portfolio rebalancing, tax-loss selling, and reassessing the asset allocation of the plan as conditions change. But we should all beware of devoting too much time to the tyranny of the urgent, never letting it distract us from that which is truly important.
What just happened?
Since 1990 the S&P 500 has declined more than 10% in a calendar month on five occasions:
- December 2018 -10.1%
- February 2009 -10.6%
- October 2008 -16.8%
- September 2002 -10.9%
- August 1998 -16.8%
U.S. and many foreign stock markets declined over 14% in the 4th quarter – the most in a quarter since the financial crisis of 2008. Because of recent declines, valuations of equity indices are nearing their long-term historic averages. Some sectors of the U.S. stock market, such as technology and financial stocks, traded 25-30% lower at year-end than they did earlier in 2018.
Interest rates increased for most of the quarter. However, over the last few weeks of the year intermediate and long-term interest rates declined as concern mounted over the prospect of slowing U.S. and worldwide economic growth. Despite the volatility surrounding the level of interest rates in 2018, high quality fixed income securities and other capital preservation strategies provided a positive return during the fourth quarter. The 10-Year Treasury yield peaked at 3.2% on November 8th before declining to 2.7% on December 31st. On the other hand, short-term rates continued to rise, due to the Federal Reserve hiking rates another 25 basis points in mid-December. This action reinforces the reality that while the Federal Reserve exerts significant influence on short-term interest rates, it is the market that sets longer term rates.
Markets appear to be going through a transition from an extended period of zero interest rates, low inflation and readily available credit to an environment of higher interest rates and more difficult credit conditions. In addition, there is a growing concern that Federal Reserve policies (raising short-term interest rates and allowing U.S. treasury securities/agencies to mature, thus reversing previous quantitative easing) over the coming year may add to the current volatility and potentially hinder 2019 – 2020 economic growth. While short-term interest rates have risen, and credit conditions are tightening, inflation continues to be benign, with the consumer price index rising at an annual rate of 2.2% as of the end of November. Low levels of inflation, along with low and stable unemployment, registering 3.9% as of January 4th, do not currently support the fears of a weakening economy, nor does the strong December jobs report of over 300,000 new positions created during the month.
Geopolitical tensions and uncertainty continue to be a driver of market volatility. Midterm elections changed the political party in control of the U.S. House of Representatives, increasing policy uncertainty going into 2019. Across the Atlantic, no viable path to ease Great Britain’s exit from the European Union, known as BREXIT, exists despite a deadline in less than three months. Additionally, tariffs and harsh trade rhetoric, specifically between the U.S. and China, escalated late into the end of the year, and are still unresolved. During what is typically a holiday-induced calm, these uncertainties played out in the markets, with significant year-end tax loss selling further pressuring equity prices.
How does the environment of 4th quarter 2018 compare to the environment of previously volatile periods?
The current level of stock market volatility, while difficult to stomach, is not that unusual. The extremely low levels of volatility seen in 2017 and other recent years are more the exception than the norm. The last time the stock market experienced this level of decline in such a short period of time occurred during the financial crisis of 2008 and, prior to that, in 2000 – 2002 following the bursting of the technology bubble market speculation.
While it may be tempting to draw parallels between the recent market sell-off and other prior sharp market declines, there are some significant differences in the circumstances surrounding each of these events:
- In 1999, the technology and internet bubble led to widespread overvaluation of companies with little, or even zero, revenue, much less profits. The entire sector was overvalued and driving the performance of the broader index. Today, the group of stocks driving the market are companies with substantial revenues, significant cash flows, healthy earnings and dominant market shares. While their valuations may be stretched, they are very different from the numerous dot.com companies and failed internet stocks that precipitated the bursting of the technology bubble.
- In 2007-2009, the financial system was extremely fragile which does not appear to be the case today. Banks and other large financial institutions are much better capitalized and the issues that led to the financial crisis do not appear to be as much of a current problem. Most analysts don’t believe a similar crisis is likely now because the financial and banking system appear to be on much firmer footing.
There are a few areas in today’s environment that are worth noting, despite the fact that some conditions that preceded previous bear markets, as mentioned above, do not appear as concerning today:
- High levels of debt on corporate balance sheets, particularly debt used for share buybacks as opposed to debt borrowed for investment and growth, may be a cause for concern in the event of a significant economic slowdown.
- Private market and asset valuations are now stretched as capital has poured into venture capital, real estate, and leveraged buy outs. In addition to elevated valuations, many of these companies/investments also carry significant amounts of debt.
- Debt levels on government balance sheets are higher than ever before. In a rising interest rate environment, this can lead to significant debt servicing costs, hampering government spending and leading to greater geopolitical uncertainty. This problem is not unique to the U.S. and has the potential to be a widespread problem.
Has the recent market volatility created opportunities for long-term investors?
In prior time periods, volatility has often provided opportunity for investors. After December’s selloff equities are trading closer to more normal historical market valuations. Some sectors, such as energy, technology, financials, and consumer staples, are becoming relatively more attractive. For investors adding to their portfolios, the entry point during this period seems to be more attractive from a valuation perspective than it has been in several years. While not all equity sectors are trading at attractive levels, some areas of interest are developing.
Investors not currently adding to or systematically withdrawing from their portfolio can rebalance and effectively take advantage of volatility while maintaining their asset allocation. And as stated, tax loss selling is an important strategy for investors in volatile markets and may contribute to the overall long-term after-tax portfolio return.
A lingering concern in the market revolves around predicting the next recession; however, US economic growth is currently running over 3% with other large economic powers such as China experiencing 6%+ annual growth rates. Given inflation levels are stable in the 2-3% annual range, the need for further interest rate hikes is diminishing.
Unemployment in the U.S. remains under 4%, a level which encourages consumer spending and should support economic growth further into 2019. Finally, U.S. median and average real incomes continue to rise at annual rates above 3%, which is well above historical averages dating back to the late 1960s.
What strategies does RGT recommend given the current environment and how are client portfolios positioned if a significant downturn occurs?
One of the guiding principles of RGT’s approach to portfolio management is that we are long-term and goal-oriented advisors. We are focused on helping our clients achieve their long-term financial goals, not simply on beating a benchmark or unmanaged index. Thus, a cornerstone of the investment process is to develop an investment policy statement and asset allocation for each client that we believe will maximize the probability of the client reaching their financial goals, while doing so in a manner that is aligned with the client’s personal tolerance for risk and ability to make sound decisions during periods of heightened uncertainty. The strategies mentioned below will be implemented in different ways throughout RGT’s client portfolios, depending upon each client’s personal circumstances. And as a result, all client portfolios will not necessarily perform in an identical fashion, particularly during periods of market volatility.
Another guiding principal that RGT utilizes in developing and managing portfolios is related to this long-term strategic approach. To achieve long-term success, we believe investors are best served by developing a broadly diversified asset allocation adjusted to best fit their particular risk tolerance. Well diversified portfolios typically maintain exposures across geographies, industry sectors, market capitalization, and investment styles. Maintaining these exposures over time through disciplined monitoring and rebalancing of the portfolio reduces the risk of portfolios becoming over allocated to any particular sector or investment style. During periods where particular investment styles or market sectors become richly valued relative to history or to other sectors or styles, maintaining this discipline helps limit exposure to these more expensive parts of the market.
Several of the strategies mentioned below are directly taken from the investment principals and long-term approach described in this section. RGT believes it is important to understand that periods of volatility, like the one experienced by investors in December 2018, are part of the normal course of events which we expect portfolios to encounter and are part of the long-term planning and strategy embodied in each client’s investment plan. Should there be any specific risks or opportunities that develop along the way, we still have the flexibility to adjust client portfolios and adapt if we believe other strategies are prudent.
The combined experience of RGT partners and employees includes over 60 previous equity cycles (“bull” & “bear” markets) dating back to the 1970’s and thus, we have experience managing through several previous volatile periods.
Prior to the most recent market decline – RGT purposefully de-emphasized and limited allocations to areas of investment which experience excessive speculation and higher risk. Thus, investment strategies which are perceived to be more “at risk” were naturally limited in portfolios.
During the current market decline – RGT continues to make progress in its due diligence efforts with managers focused on some of the most affected areas of global markets. We are starting to see some outside RGT equity managers find good buying opportunities in the latest period of volatility. Also, RGT portfolios are designed to be under-allocated to areas where valuations are high. Typically, as volatility increases, outside RGT equity managers find it challenging to outperform market indices due to “indiscriminate” selling across the board. Once markets correct for an extended period, RGT believes its managers will seek to take advantage of opportunities that have arisen during this difficult market.
If markets continue to be volatile – RGT consistently reviews areas for opportunistic investment. For example, if interest rates continue to rise, clients are able to earn more income from capital preservation/fixed income strategies given higher expected forward rates of return. Similarly, if stock markets decline further from current levels, more rebalancing opportunities will present themselves. Additionally, for the first time in several years, investors will be presented with the opportunity to consider shifting their overall portfolio allocation to a more aggressive stance at much lower valuations.
In the last 10 years there have been 4 other quarters when equities (both U.S. as measured by the S&P 500 and global equities as measured by the MSCI ACWI index) experienced similar declines as this past quarter – the 1st quarter of 2009, the 2nd quarter of 2010, the 3rd quarter of 2011, and the 3rd quarter of 2015. The recovery in equities after each of these declines was positive in the immediate twelve months following. While there are no assurances that this will occur again, the historical record points out the importance of having the discipline to remain committed to your long-term strategic investment plan.
Thank you for the opportunity to provide this information and analysis. Please contact RGT with additional questions.