“I spend about half of my time wondering why I have so much in stocks and about half wondering why I have so little.”
--Jack BogleWe can finally put 2018 to bed. The two stock indexes we follow most closely were the Dow Jones Global Stock Market, down -12.3% (WSJ) and MSCI ACWI (all country world index) down -9.42% for the year, even writing it is frustrating. This was on top of over 90% of the 70 tracked investment assets classes finishing negative for the year (the worst in history). While our portfolios held up as they were designed (which our team is proud of), we are not in business to lose money and even well designed portfolios don’t “feel” successful when performance is down. We started to get extra defensive in November as we saw the next 6-24 months being a challenge with slowing growth. Unfortunately, in what seemed like the blink of an eye the 4th quarter S&P 500 return was down -13.80% (see chart for Q4 returns) as we had the worst December since the Great Depression. While we did and do see the environment being difficult, we thought the decline was overdone and we have seen a small bounce back rally since Christmas.
Year-ahead outlooks have long been standard fare at investment houses and market research firms, despite economic, index, and commodity price predictions that for the most part end up being incorrect or incomplete. Strategists have a 53% chance of accurately predicting if markets will be up or down each year— about the same odds of calling a coin flip. However, while these predictions may be relatively useless, the analyses underpinning them can be valuable if strategists accurately identify underlying drivers of economic and market performance and connect the dots in a compelling way. It is certainly a worthwhile exercise, but it is best done on a running basis, using flexible portfolios as conditions evolve all year round. Nevertheless, on to the outlook.
Key Takeaways --US: We continue to believe the U.S. economy is late cycle, but that it will continue to see strong momentum. With volatility rising and valuations elevated, selective investing will be key in 2019.
--International: The outlook for international equities remains mixed as attractive valuations are balanced against rising political, economic and market turmoil.
--Fixed Income: Rising interest rates are breathing life back into bond income after years of rockbottom yields. Bonds can again offer stability to balanced portfolios.
Macro-Economic: We expect markets to continue to be unsettled as quantitative easing is removed and the Federal Reserve hikes rates. China and Europe are slowing faster than many expected, and threats of tariffs fan the uncertainty. All eyes will be on China in 2019 to offer guidance for the global economy. This busy calendar of events in global trade and politics will likely continue to unnerve markets; however, because your portfolios are properly positioned for your long-term goals, you should see this volatility as just noise. Moreover, we see it as an opportunity if valuations continue to fall.
Equity: We do not expect too much from U.S. equities given lofty valuations; however, companies with large addressable markets could still provide growth for investors able to find them. We will keep a bias towards Large Caps over Small Caps and continue to move from Growth towards Value. We will also remain patient with international stocks even if 2019 is another rocky year for overseas markets. There are unique opportunities where companies in Europe and in emerging markets have attractive valuations, especially compared with the U.S.
Fixed Income: We must remember that fixed income investments not only offer income amid rising rates but also protection from equity volatility. Safe-haven and municipal bonds may be especially attractive if equity markets gyrate. We will also pay close attention to core fixed income as it will be critical as the global economy is in a late cycle. We will be intently watching for unintentional risks in our core bond strategies as hard-hit emerging markets debt may offer opportunity for us as long-term investors.
Don’t let Volatility derail your Plan
After years of relative calm, market volatility is back with a vengeance. There are many contributing factors, but the three T’s are among the most impactful: tightening, trade tensions and too much debt. Those powerful forces are combining to disrupt global markets at times and put investors on edge. Expect it to continue, and potentially intensify, in 2019 as interest rates move higher, global trade disputes mount and debt levels rise. The U.S. Federal Reserve’s tighter monetary policy is reverberating around the world. Reacting to a strong U.S. economy, a tight labor market and moderately rising inflation, the Fed is expected to continue raising short-term interest rates in 2019. This is happening at a time when government, corporate and consumer debt are all dramatically on the rise. It was one thing to borrow when rates were at historically low level, but it is a whole different environment today. At the same time, global trade has taken center stage as the U.S., China, Europe and others seek to rewrite the rules of world commerce in their favor. It’s important to note that these trade skirmishes may continue for a long time. It’s a highly fluid situation that we will be monitoring closely throughout the year.
Recessions feel horrible; there’s no doubt about that. Companies pull back. People lose jobs. Stocks often decline, sometimes sharply. But how bad are recessions really? How often do they come around? And how much damage do they inflict, relative to more prosperous expansionary periods? Taking a step back and looking at the big picture can be helpful, especially nine years into the current U.S. economic expansion. Since 1950, the U.S. has been in recession during only 13.5% of all months. Many of those months included positive equity returns. And some of the strongest rallies occurred as stocks bounced back from those recessionary periods. The lesson? Trying to time the market to avoid recessions can cause investors to miss some of the biggest rallies and end up with lower overall returns than those who stayed fully invested in good times and bad.
There’s just no getting around it. U.S. stocks have gotten expensive. Even after bouts of unsettling volatility in 2018, the Standard & Poor’s 500 Composite Index has advanced 400% since the March 2009 start of the bull market. Although company earnings in recent years have soared along with stock prices, valuations have expanded considerably. As of November 30, the forward price-to-earnings (P/E) ratio for the S&P stood at 15.3 — hardly nosebleed territory but elevated by historical standards. And while past results are not predictive, history suggests that investors may want to temper expectations for returns going forward. That said, a small handful of innovative technology and consumer companies have driven much of the market return (online retailer Amazon has soared about 2,700% since the end of the last bear market) leaving valuations in other areas of the market at more modest levels. Of course, given that many other companies have more modest growth prospects and the likelihood of elevated volatility, selective investing will be critical.
It often pays to think big. Technological advancements and shifting demographics are transforming global industries, creating massive new markets for innovative and nimble companies; think cloud computing, biopharma and global air travel. Start with cloud computing, software and services that run on the internet. In a little more than 10 years, the cloud has grown rapidly, slashing infrastructure costs for companies and transforming business models. By 2021, cloud spending will rise to $300 billion, nearly double the $153 billion spent in 2017, according to industry researcher Gartner. The movement of IT workloads to the cloud is boosting demand for the services of Amazon Web Services and Microsoft’s Azure, the two leaders in cloud computing services. Advances in biotechnology are bringing us ever closer to a cure for cancer. Companies like Abbvie, the maker of rheumatoid arthritis drug HUMIRA®, and Gilead Sciences, developer of treatments for HIV and hepatitis C, have invested heavily in the development of potential cancer therapies. Barriers to entry are high in biologics, which cost billions to develop and many years of trials and approvals to get to market. It’s human nature: we want to travel. In 2017 more than 100 million people in Asia boarded a plane for the first time, reflecting rising affluence in the region. Worldwide, air passenger traffic is expected to reach 7.8 billion by 2036, sending demand soaring for new aircraft. Boeing and Airbus, effectively a duopoly, have backlogs totaling more than 13,000 planes, or eight years of production. With this type of market share and dominance, assuming reasonable valuations, these businesses could be investable for many years to come.
It’s a truism of investing: market downturns are inevitable. But while they can be unnerving, a closer look at seven major market declines shows that broad market index results don’t tell the whole story. Through each of the declines some sectors held up better than others. Even when the S&P 500 plummeted 55.3% in 2007-09 during the sell-off of the global financial crisis, consumer staples lost about 29% and health care fell 38%. Small comfort to be sure, but while history is not predictive of future returns, the record shows that selectivity and diversification can help add resilience to a portfolio when markets are sliding. Many of the areas that have held up during prior declines have paid meaningful dividends. Dividends offer steady return potential when stock prices are volatile and can be a hallmark of a disciplined, conservative management team. But not all dividend payers are equal. The key is to identify companies with strong balance sheets, good cash flows and the discipline to maintain dividend payments during declines.
Rates and The Fed
Should bond investors fear the Fed? The prospect of rising yields as the Federal Reserve forges ahead with rate hikes may continue to spook some investors. But maybe it shouldn’t. While unemployment was around 4% for much of 2018, recent inflation has been weaker than widely anticipated. Late in 2018, market pricing indicated a single Fed hike is in the cards for 2019, although expectations have jumped around a lot amid volatility. Crucially for bond investors, however, shortterm Treasury yields already have climbed significantly. Credit markets are a whole other story. Spreads — the gap between the yield on credit and Treasuries — have remained narrow by historical standards. For bond investors, that means the compensation for taking on credit risk is relatively low, and the upside from here could be quite limited.
I thoroughly hoped you enjoyed the outlook on 2019. I am honored and humbled by the trust and confidence you have placed in Auctus Advisors, and our team looks forward to continuing to earn it every day. As always, please contact us with any questions!
David B. Miller
Managing Partner | CIO