Market Update 12.31.2018

The U.S. stock market was down an astonishing -14.08% for the fourth quarter of 2018, and down -5.05 for the year.  The fourth quarter was the worst quarter for U.S. stocks since 2011 and the first down year since the financial crisis of 2008.  The U.S. market was down double digits for the year in late December before gaining nearly 7% during the final trading days.Following a strong first nine months of 2018, the end of the year was disappointing.  A myriad of issues overwhelmed investors and overshadowed the health the U.S. economy: divided Congress, trade disputes, monetary policies, Brexit and low oil prices.

The selloff was reminiscent of market fears during the financial crisis a decade ago.  However, the comparison is unreasonable because today the stock prices of many successful companies, across most sectors, are trading at significant discounts.

Computer driven trading programs, which account for approximately 85% of all trades, play a role in the extreme volatility.  Their trading formulas are closely held secrets, but the algorithms react to stock price movements.  When stock prices fall below certain support levels, the algorithms automatically initiate the sale of stocks.  This also occurs in the reverse, as we saw when the Dow Jones Industrial Average rallied on the Wednesday following Christmas gaining over 1,000 points in a single day!

The trouble all started in October when Fed Chairman Powell stated current interest rates were a long way from neutral, leading investors to believe that many more interest rate hikes were coming.  Investors are very wary of the Federal Reserve raising interest rates too fast and causing a recession, which they have done in the past.  At the end of December he changed his tone considerably, indicating there is no policy to continue raising rates and that the Fed will be patient as they watch how the economy evolves and that they are prepared to adjust policy quickly and flexibly, as needed.  Now experts expect interest rates to remain at current levels through June.

In addition to lowering interest rates during the financial crisis, the Federal Reserve, through quantitative easing, purchased $4.5 trillion in U.S. treasuries and mortgage backed securities to infuse liquidity (cash) into the economy and stock market.  Last year they began the process of reducing the balance sheet by letting the bonds mature to the tune of $50 billion per month.  This process reduces liquidity which is not good for the stock market.

The main driver of the volatility at the end of the year is the fear that economic growth will slow.  The economy and all natural things move in cycles.  Currently the U.S. economy is late in the business cycle, and at peak cycle.  We are experiencing full employment – meaning there are more jobs than workers.  The natural cycle for the economy means it will slow as we move out of the current peak.  That does not mean the economy will fall into recession, as many in the media constantly opine.  To the contrary, there is no evidence a recession is coming.  The current environment of low unemployment, higher wages and lower fuel prices is not consistent with a recession in the near to intermediate term. 

Global economies are slowing, including China.  But the government in China is taking action to bolster their economy.  Economic troubles are the norm for the EU where economic growth has always been minimal.  The latest troubles: Italy and Brexit will hamper growth, but should have only a slight effect on our economy.

The trade dispute between the U.S. and China appears to have moved into the negotiations stage.  Threats of new tariffs and tough talk have been replaced by talks of negotiations.  We are requiring China to significantly change the way they treat U.S. companies in their country.  That type of change won’t come all at once or right away.  But when the two countries begin to create meaningful agreements, the U.S. stock market will soar.

Corporate earnings announcements have just started.  This will have a big impact on the market because corporate earnings drive the stock market.

Economic highlights for the quarter…

GDP: Real GDP growth grew 3.4% annualized in the third quarter.  Consumer spending and private investment were the main contributors to real growth, while government spending increased slightly.  Businesses grew inventories significantly during the quarter, adding more than 2% to economic growth.  The Fed projects GDP growth of 2.3% for 2019.

Interest rates: The Treasury yield curve inverted by year end in the short to intermediate range, while yields fell across most maturities.  For the past year, however, yields are up, particularly in the shorter end of the curve.  The 10 year Treasury yield decreased by 37 basis points during the quarter, finishing at 2.69%.  The Federal Reserve raised its benchmark rate by 0.25% during their December meeting, but decreased their projection for 2019 to only two rates increases instead of three.

Note: an inverted yield curve is a typically an indicator of an upcoming recession.  However, we are in uncharted territory.  The Federal Reserve held interest rates at historically low rates for almost 10 years and through quantitative easing purchased $4.5 trillion in U.S. treasuries and mortgage backed securities.  Now they are raising rates and rolling off $50 billion bonds every month.  Both of these actions are causing the yield curve to invert.

Inflation: Consumer prices continued to exhibit modest increases during 2018.  The Consumer Price Index was up 0.4% for the three month period ending November 2018 and was up 2.2% for the trailing one year period ending November 2018.  The 10 year breakeven inflation rate fell rather dramatically during the fourth quarter, falling from 2.14% in September to 1.71% in December, the largest decline in three years.

Employment:  Jobs growth has been solid during 2018, with total nonfarm payrolls increasing by an average of 170,000 jobs per month during the three months ending November 2018.   The unemployment rate remains below 4%, a mark not seen since 2000.

Housing:  Home prices continued to move higher during 2018, with the S&P Case-Shiller 20 city Home Price Index up 0.9% for the three months ending October 2018.  During the past 12 months, the index is up 5.1%.

The recent market drops have given all 401(k) participants the opportunity to buy amazing companies at super discounted prices.  Some of the world’s largest, most profitable companies are on sale for 20% off.  That is the best deal I have seen in a very long time.

If you have any questions, please contact me.