January 23, 2019
Dow Jones Average: 24,576
S&P 500 Index: 2,639
The stock market stumbled through much of the final quarter of the year and the decline
accelerated under a variety of stresses in the month of December. It was the worst
December on record since 1931, with the S&P 500 Index declining by 9.2% for the month.
Many observers labeled it a rolling bear market, meaning that there was no single industry
leading the decline, but a situation where all sectors took their turn going down. While
stocks were the weakest asset class in 2018, other assets also fared poorly, making 2018 an
unusually difficult year for most investment strategies.
In many past stock market declines, investors have shifted their money into more stable
assets, like Treasury bonds. This influx lifted the prices on those securities in the process.
In some punishing bear markets for stocks, longer-dated bonds have appreciated by ten or
even twenty percent. This past year was unique in that bonds declined for much of the year,
and only a recovery in December helped bring them back towards a neutral return. The
final result was still an average decline of 1.5% on longer-dated bonds. Gold, another asset
thought of as a safe haven, declined in 2018 by a similar amount. Indeed, when everything
was tallied around the world, the only major asset classes to post any kind of positive return
were U.S. cash and short-term bonds, and they barely broke above a 1% return.
While 2018 ended up being a year in which stocks, and so many other asset classes,
declined in value, the U.S. economy fared relatively well last year. Corporate profits
increased as a result of growing revenue and lower federal taxes on corporations.
Employment increased and wages started to rise at a faster pace than in recent years. And
critically, when the market reached its peak in the fall of 2018 many stocks were not
that expensive mathematically. The price to earnings ratio for the entire stock market, a
conventional measure used to judge how expensive stocks are, was certainly above average,
but nothing close to the peak reached during the tech bubble. It seemed a benign backdrop
for stock investors, but clearly something was amiss as stocks cratered at the end of the year.
One explanation for the stock market decline is that political turmoil finally began
to weigh on investor sentiment. The populist revolt in Europe continued to threaten the
stability of that economic union, with the Brexit process in chaos. The Trump administration
found no agreement with China on trade, even as a self-imposed deadline loomed that would
raise tariffs on hundreds of billions of dollars of goods. The President’s histrionics also
began to wear on investor psychology. When he openly mused about the possibility of firing
Jerome Powell, the Federal Reserve Chairman, markets collapsed to their lowest level of the
year on Christmas Eve. Finally, the Federal government shutdown that began in December
also weighed on investor confidence as it started to impair economic growth and portends
other battles to come.
All of this political turmoil partially explains why investors have disposed of more
volatile assets like stocks. Yet it still does not offer a full explanation for why returns were
so poor for all asset classes. That answer is far drier, but no less important in our view. For
the past decade, in response to the financial crisis, central banks around the world pumped
trillions of dollars into the financial system to stabilize and then stimulate their respective
economies. The Federal Reserve succeeded on both counts and changed course in 2017 by
raising interest rates. The Fed continued with this policy in 2018, and also began to shrink
the Fed balance sheet by selling bonds. The latter is a complicated process that effectively
removes money from the financial system. Both are important steps in warding off future
inflation, but they can pressure bonds and many other assets in the process as there is
simply less money available to support asset prices. Policy makers were hopeful that a
stronger economy would prosper without further monetary stimulus from the Fed, but it is
a tricky balancing act when the Federal Reserve changes course. Rising interest rates can
pressure stock, bond, and gold prices, which was certainly the case in 2018.
There were limited paths to positive returns last year for an investor with a diversified
portfolio. Our strategy involved holding significant portions of cash and short-term bonds,
but also committing to a stock portfolio with large representation in what we viewed as
defensive, non-cyclical companies. The first half of the strategy worked well, as cash
and short-term bonds were the only asset classes to post a positive return, as noted above.
However, when the market turned decidedly negative in December, even the likes of
Novartis, Johnson & Johnson, Walgreens and other conventional stalwarts turned and fell
with the rest of the stock market.
The bond market began to recover in December and the stock market has rebounded
in January. The Federal Reserve softened its position during its last communication,
indicating they may not raise rates as aggressively as previously forecast. China and the
U.S. both seem to be working towards a solution to the trade war in the new year. There
remain many unresolved issues for investors, but when stocks decline by 20%, which they
had by Christmas Eve, equity prices can recover even in a less-than-perfect environment.
We purchased a handful of new investments during the recent price decline and most of
them are faring well in this market recovery, alongside our older holdings.
Our bond strategy remains unchanged. It is not the right moment to commit generally to
longer-dated bonds. Cash and short-term bonds retain the same appeal they had at the start
of last year. Indeed, short-term yields are almost a full percentage point higher than where
they were to start 2018. We will continue to favor shorter-term bonds, unless conditions
change dramatically and offer income investors far higher yields on longer dated bonds.