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2019 Market Outlook

For the first time in almost 3 years, our Risk Odometer turned Defensive! This is a substantial change and does not happen often.

Summary

  • Risk Odometer’s outlook downgraded to defensive for the first time in 3 years
  • Making sense of a very challenging investment environment in 2018
  • Our outlook for 2019 and where we see opportunities

Screen Shot 2019 01 14 at 2.15.30 PM

We recommend investors use caution in these environments and carefully review their risk.  The timing of our downgrade occurred mid-month, providing us the opportunity to allocate away from risk assets such as equities and increase our position in Treasuries and cash.  The timing of our Odometer proved valuable as December 2018 became the worst December since the Great Depression!

The causes of this downgrade are the result of negative changes in technical indicators (Technical Price Action, Breadth and Volatility). Fundamental indicators (Leading Economic Indicators and Earnings) remain positive. Although there is currently a disconnect between the two, we still advise taking caution in these environments. Technical indicators are better timing tools than fundamentals. They give more false signals but are also early warning signs for changes in fundamental signals. 

2018 Review

Equity Indices (2018 Returns)

Fixed Income Indices (2018 Returns)

Index

Return

Index

Return

S&P 500

-4.4%

Aggregate Bond

0.0%

Russell 2000

-11.0%

Investment Grade

-2.1%

MSCI EAFE

-13.8%

High Yield

-2.1%

MSCI Emerging Markets

-14.6%

US Treasury

0.9%

All indices are total return indices and include reinvested dividends. Index performances are provided as a benchmark but not illustrative of any particular investment. You cannot invest directly in an index. The source of the bond indices is Barclays. Data courtesy of YCharts.

2018 was a very challenging year for investors. Nearly all asset classes on a global basis finished the year negative. The S&P 500 turned in its first negative return since the Great Recession in 2008 (-4.4%), and international equity markets performed even worse (-13.8%). Fixed income markets also performed poorly and unfortunately did not provide their tradition safe-haven status. The aggregate bond benchmark was in the red all year until a strong December turned it flat for the year. Investment grade and high yield bonds were down over 2%, and treasury bonds barely showed any gain at year’s end after being in the red for the first 11 months. The GSCI Commodity Index and the Dow Jones REIT Index (Real Estate Investment Trusts) were down 8.6% and 7.8% as well. The year’s challenges climaxed in December when the S&P 500 experienced a rapid 16% correction, leaving it as one of the worst December’s ever! It was truly a difficult place to find positive returns anywhere.

Trying to make logical sense of what happened in the 4th quarter of 2018 is difficult. Many pundits point to a variety of reason such as; interest rate hikes, trade war disruptions, a global economic slowdown, and elevated equity prices. It’s very possible one or a combination of all of these led to the 4th quarter correction. However, we tend to think the larger macro investment theme of mean reversion was also a significant contributor. 2017 was one of the best years on record. Volatility sunk to an all-time low as investors had a love-affair with stock markets all over the world. Investors flooded global equity markets driving prices to unsustainable levels. 2018 was the reality check where markets reset the bar in equity prices. The capital markets are one of the greatest wealth generation mechanisms, but it is not always easy.

Silver Linings

The rapid corrections experienced in 2018 helped alleviate several of the lingering risks we discussed all year.

  • High Valuations: Less of a concern now. Following the 20% correction in the S&P 500 and earnings which are still strong, elevated valuations are less of a concern now.
  • Rising Rates: Less of a concern now. Following four rate hikes this year and slowing growth, the Fed has signaled they will slow down the pace of rate hikes. They may likely raise rates again in 2019 but they are signaling a slower pace and data dependency, a net positive for the markets.
  • Trade Wars: Still a concern. With the power in Congress shifting to Democrats, an unresolved government shutdown, and the president’s political cabinet constantly changing, I would now classify this risk as political instability. This one is still outstanding.

The silver lining from a challenging 2018 is it alleviated many of the concerns we had. The reduction of our biggest concerns should make for a better investment environment for 2019. The big question, now, is whether the economy can maintain the growth trajectory it has enjoyed for the better part of the past 10 years. 

2019 Outlook

Most economists and market analysts are calling for a continued slowdown in growth but not a recession. They are predicting a positive return in global markets; however, the returns will be slightly below historical averages. There seems to be an unusually strong consensus among these pundits as we enter 2019, which immediately gives us caution. We often take these outlooks and predictions with a grain of salt. Many of them are written by analysts who work for companies who sell investment products. Typically, those companies make their money by keeping you invested, and there is no better way to keep you invested than to make you feel good about the outlook for next year.

Our outlook for 2019 is more cautious than the consensus. We believe the rapid pace of selling experienced in the 4th quarter of 2018 is largely behind us in the short-term, but we are not convinced we are in the clear for the longer-term. Over the short-term (3-6 months) Markets may likely recover some of the losses for the first half of the year. The S&P fell 20% from the highs even though the economy is still growing, and companies are reporting strong earnings. The strong underlying fundamentals should help contain any additional significant selling pressure. We believe we would need to see additional signs of a slowing economy to change this opinion. Average stock market corrections in recessions are ~35%. Given that the market already corrected 20%, global fundamentals are still positive, and the probability of a recession remains low, we envision the markets stabilizing over the near-term.

Our more cautious outlook comes in the second half of 2019. It is likely the markets will oscillate back and forth in the first half of the year, working to find an equilibrium between the bulls and the bears. The second half of 2019 should give us more clarity about the Fed’s intention with rates, a resolution to trade wars and more information about whether the current economic slowdown we are experiencing is only temporary or the beginning of something more. We are not as convinced as the consensus that this slowdown is temporary, but we are also able to be more objective than most.

Our primary concern is not an economic one at this point. There is little evidence the economy will slow substantially (Federal Reserve models show low probability for a recession in 2019). Our biggest concern though--markets tend to move in trends. The US has not experienced a recession in 10 years. The average time between recessions is about 8-10 years (depending on your start dates). Although the length of time between recessions is not a sole reason why one should occur, it does put us at odds against the probabilities. During the current cycle, the economy has experienced several slowdowns (2011 and 2015). Those slowdowns proved to be temporary, and the market correction proved to be a short-term opportunity. What concerns us during this current slowdown is interest rates are no longer 0% as they were in 2011 and 2015. This could prove to be the difference maker this time.

As for now, the market correction appears to only be technical. The fundamentals of the market, such as earnings and economic indicators, remain positive. Strong fundamentals are the basis for the pundits who have unquestionable optimism for 2019. We too place a high value on fundamentals but understand that timelier technical signals should be considered when making investment decisions. Remember that most bear markets start with the erosion of technical indicators (like the present) and then advance to an erosion of fundamentals. The second half of 2019 should be very revealing.

Opportunities for 2019

Despite our cautious stance on markets for 2019, we believe there are still pockets of opportunity for investors. Those opportunities we like are in the following assets:

  • Commodities
  • Emerging Markets
  • Value stocks over growth stocks
  • Fixed Income

Commodities

We believe commodities should be a bright spot in 2019, as they remain historically undervalued. Commodities were one of the best performing asset classes in 2018 until they took a sharp correction at the end of the year. We believe we are in the later stages of this economic cycle, as evidenced by rising rates, elevated valuations and risking inflation. During late stages of an economic cycle, there is little spare capacity left due to prolonged growth. This tends to drive up the cost to produce and sell goods and increase inflation. This is a type of environment when commodities should outperform.

What may also be a catalyst for commodity strength is a weaker US dollar. Since commodities are a global asset but priced in US dollars, any weakness in the US Dollar should move commodities higher. The economic slowdown has already caused the Federal Reserve to reduce its outlook for further rate hikes, a negative for the US dollar, all else equal.

Emerging Markets

Emerging Markets are another area of opportunity. Emerging Market equities are trading at the lowest valuations relative to all other equity asset classes. The chart below shows the relative price-to-book ratio (a common valuation metric) of the Emerging Markets Index versus the S&P 500. The relative ratio is significantly lower than its long-term average, showing the cheapness of this sector.

chart outlook 2019

Chart courtesy of JP Morgan. Data source: FactSet, MSCI, Standard & Poor’s

During the early part of this period, the relative ratio was less than the historical average (1999-2004), and Emerging Markets dramatically outperformed the S&P 500 (108% cumulative return versus 8%[1]). The ratio dropped below the average again in 2012, yet Emerging Markets dramatically underperformed during this most recent period (9% cumulative return versus 105%[2]). The dramatic underperformance, most notable in 2018 due to trade war fears, has furthered the relative attractiveness of Emerging Markets. Low valuations are not always great timing tools over short periods (1 year), but there is considerable evidence that they are good predictors of long-term returns (10+ years). For investors willing to look through near-term volatility, these could be significant opportunities.

Value Stocks

Value stocks should be another area of opportunity. Value stocks have dramatically lagged growth stocks over the past decade. This has created the value factor to look very inexpensive relative to other factors. Growth stocks tend to generate their value by future cash flows. Rising interest rates are a factor which could bring value stocks back into favor. This is due to discounted future cash flows looking less valuable now than when interest rates were zero.

Fixed Income

Finally, today’s environment may provide a long-awaited opportunity in fixed income. With overnight rates now at 2.25% and a Federal Reserve still signaling more to come, fixed income yields look attractive in a volatile equity environment. Couple this with the fact that the Barclays Aggregate Bond Market Index, a proxy for the overall bond market, has never had two consecutive losing years, should make fixed income a viable solution for many investors.

We want to say thank you to all our loyal clients and readers. We truly value your relationship. 2018 was a challenging investment year. It is never easy and there will always be bumps along the road, but we continue to believe the capital markets are the greatest way to build wealth over the long-run. Stay focused on your goals rather than the market’s volatility and stick with your long-term plan. If you ever have questions or concerns, please communicate them to us. We love to provide advice and help in any way we can. 

[1] Data Source: YCharts. Dates are 12/31/1998 – 12/31/2004

[2] Data Source: YCharts. Dates are 12/31/2012 – 1/8/2019

About the Author

Michael Fickell

Michael Fickell

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