The market finished 2018 the same way it began, with steep declines and wild volatility. Following a smooth rally in the third quarter, which brought the market to new all-time highs, the fourth quarter began with a sudden and steep drop, which reached its crescendo on Christmas eve. The dramatic decline dragged the S&P 500 to a –4.4% return for the year, the largest decline for the index since 2008. International stocks also performed poorly with the MSCI EAFE falling -13.8% for the year. Bonds were flat for the year with the Bloomberg Barclays Aggregate Bond Index returning 0.0%.
S&P 500 Performance
After nearly a decade of mostly positive returns, many investors were beginning to feel that we were due for a correction. But the decline suffered by the markets in the 4th quarter came very suddenly and seemingly out of the blue. At its worst, the market’s fall was reminiscent of the decline that occurred during the financial crisis in 2008. But in sharp contrast to that event, there isn’t a crisis unfolding. The economy remains quite strong, corporate earnings have been spectacular, interest rates remain well below historical averages, and stocks are currently quite inexpensive.
Despite all of the positives in the economy, last quarter’s market volatility has brought about a cascade of negative headlines. However, not much has actually changed in recent months, other than the market has declined. We will address the most frequently cited concerns here:
Trade War/Negotiations with China
President Trump began his campaign to renegotiate trade terms with China in early 2018. While both sides appear to be entrenched in their positions, we believe they will eventually strike a deal that benefits both countries. In recent days, there have been reports of progress in the negotiations.
Fed Raising Interest Rates
The Federal Reserve began raising their benchmark Fed Funds rate in 2015 with the goal of eventually normalizing their monetary policy. In December they raised rates for the 4th time in 2018 to a range of 2.25 – 2.50%. This remains well below the long-term average for the benchmark rate. They have indicated that they expect to raise rates two more times in 2019, but that will likely depend upon developments in the economy.
Slower Expected Growth in 2019
As expected, the tax reform bill that passed in 2017 resulted in exceptionally strong growth in the economy and in corporate profits. Following this surge in growth for 2018, growth is expected settle back to 2.6% for GDP and 10% for corporate profits. Most economists do not think there is significant risk for a recession in 2019.
There was much hand wringing as the mid-term elections approached in early November, but the results came in mostly as expected; the Democrats regained the majority in the House and the Republicans maintained control of the Senate. This results in a divided congress, which typically has been a positive for the stock market.
Flattening Treasury Yield Curve
The yield curve describes the difference between long-term and short-term Treasury yields, typically measured by the difference between 10-year and 2-year Treasury bonds. Currently, this stands at 0.16%, down from 0.54% at the beginning of 2018. Historically, an inverted yield curve (when long-term rates are lower than short-term rates) can signal that an economic slowdown is coming. However, an inverted yield curve does not always indicate a looming recession, and when the recessions occur, it is typically a year or more after the inversion.
When the U.K. voted in 2016 to break away from the European union, the consensus was that the U.K. would suffer the biggest economic impact and then, to a lesser extent, their trading partners. Not much has changed in these expectations and the negotiations for the specific terms of their departure are slowly progressing.
As of this writing, we are in the midst of the longest U.S. government shutdown in our history. The central issue is President Trump’s desire to build a wall along the southern border and the Democratic controlled congress’s desire to block its construction. Historically, government shutdowns (there have been 9) do not have much of an impact on the economy or the stock market.
Perhaps one, some, or all of the concerns above contributed to the second worst quarter for the market since the financial crisis. After nearly ten years of mostly positive gains, we were probably due for a worse than average pullback. But this one came out of the blue, and none of the concerns mentioned above can adequately explain the severity and relentlessness of the decline.
On a brighter note, due to the decline, stocks have become quite inexpensive. At the beginning of the quarter, the price-to-earnings ratio (P/E) for the S&P 500 based on expected 2019 earnings was 16.8x, compared to the long-term average of 16.1x. At the end of the quarter, the P/E has declined to 14.4x, quite low in historical terms, and as the chart below suggests, other valuation metrics, such as price-to-book and price-to-cash flow, are also below historical averages.
S&P 500 Index: Forward P/E ratio
Another positive to consider is that since 1950 there have been 19 quarters where the S&P 500 has declined 10% or more on a price only basis. As the table below shows, the average returns following a drop of this magnitude tend to be quite good. The average 1-, 3-, and 5- year returns following a quarterly decline of 10% or more are 17%, 37%, and 62% respectively. So if history provides any guidance, we are hopeful that the short-term pain will lead to better than average gains to come.
S&P 500 Quarterly Returns
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Horizon Wealth Advisors is a Houston based fee-only wealth management firm. Horizon is a fiduciary advisor. We specialize in helping successful individuals and families understand, organize, and manage their often complex financial situations. Horizon offers integrated financial planning and investment management services.