Year End 2018

Humpty Dumpty

The fourth quarter of 2018, especially the month of December, gave us a taste of how volatile the markets can get. At the end of the third quarter, the S&P 500 was up 9% for the year. By year’s end, it was down 6.2%. That’s a reduction of 15.2% in value over the course of three months. In addition to the stock market, almost all asset classes were down for 2018. Cash and U.S. Treasuries were exceptions to the downward spiral. In reviewing returns on bonds, I use the Barclays US Aggregate Bond Index which began in 1973. This index was negative every trading day during 2018, until the final trading day, 12/31/18, when it went positive to 0.01%. The S&P 500 index began in 1957. Since that time, the S&P 500 and Barclays bond indexes have never both been down. This year was almost the exception.

What caused the erosion of the markets? While various experts point to a wide variety of different factors, the key element was fear. Fear that the economy was going to stall. Fear that the global economy would pull down the U.S. economy. Fear that trade tariffs would disrupt the growth of the economy. The fears are too numerous to list. The facts were that the economy was still growing, consumer confidence was up, consumer spending was up, workers’ earnings were up 3.2%, and unemployment was at a record low. The culprit of the downturn might have really been the belief that stocks were priced too high, relative to future earnings.

Investment Outlook

With this backdrop, what does an investor do? We must begin by acknowledging that 2018 was a terrible year for most investors. Next, we need to consider the fundamentals both in the U.S. and abroad.

It is worthwhile to look at a couple of technical numbers that might give us a sense of the valuation of U.S. stocks. Two metrics I believe are good indicators are the overall dividend return and the price of a stock relative to the earnings of the stock, known as the price earnings ratio. The Dow Jones Industrial Average is comprised of 30 large company stocks. At the beginning of 2018, the anticipated dividend return, which is based on the actual dividend and the price of the shares, was 2.11%. At the end of 2018 the expected divided yield had risen to 2.43%. This rise of 15% makes the dividend yield on these stocks very competitive with bond yields. The price earnings ratio (P/E) went from 19.77 to 14.72 during the year. A P/E of around 15 is generally considered a good value for most stocks. If we look at the S&P 500, which is an index of 505 stocks, we see the dividend rate go from 1.89% at the beginning of the year to an estimated 2.15% for 2019. In a similar fashion, the P/E of the S&P 500 went from 20.02 to 15.25. These numbers would indicate that the overall pricing on stocks is reasonable. If earnings or dividends are better than expected, that would be a benefit. 

Bonds, which turned positive in December, are impacted by the move of interest rates. When rates rise, the value of bonds drops. When rates drop, the value of bonds rises. In 2018, the FED raised rates from 1.25% at the beginning of the year to 2.25 at year’s end. That increase had a negative impact on bond prices and also increased the cost of mortgages. The FED has now indicated that it will moderate the rise in the interest rate in 2019. This likely means that interest rates will be stable and should result in positive results from bonds.

As interest rates increased, the value of the dollar became expensive relative to foreign currencies. This signal by the FED, of stabilizing interest rates, has resulted in the dollar becoming weaker and foreign currencies becoming stronger. This will make U.S. products and services less expensive to foreign countries. It also means that foreign investments that were hurt by the rising value of the dollar should be in a better position for 2019. That may result in gains from foreign stocks.

Lastly, China, which makes up a big part of the emerging markets, along with Hong Kong, is loosening up the availability of money. This could result in an upswing to Chinese stocks and other Asian stocks in the second half of 2019. If a trade compromise with the U.S. is reached, emerging markets equity could be impacted positively.

Market Review

Let’s look at the numbers for the fourth quarter of 2018. The quarter began with the S&P 500 at 2914, and ended at 2507, with a loss of 407 points or -14%. For the year, the S&P 500 has gone from 2674 to 2507, down 168 points, for a loss of 6.2%. The mid-cap stocks, represented by the S&P MidCap 400, began the quarter at 2020, ending the quarter at 1663, for a loss of 357 points or -17.7%. For the year, this index has gone from 1901 to 1663, a loss of 238 points or -12.5%. Small stocks, represented by the S&P SmallCap 600, began the quarter at 1062 and ended at 845 for a loss of 217 points or -20.4%. For the year, they have gone from 936 to 845, a loss of 91 points or -9.8%. International markets, represented by the DJ Global ex US index, began the quarter at 253 and ended the quarter at 223 for a loss of 30 points or -11.9%. Since the beginning of the year, this index is down from 267 to 223, a loss of 44 points or -16.5%. Interest on the 10-year Treasury Note went down during the quarter from 3.055 to 2.684 for a return of 1.2%. For the year to date, the note has gone from 2.49 to 2.684 for a loss of 0.08%. The Bloomberg Barclays US Aggregate Bond Index went from a yield of 3.46% at the beginning of the quarter to 3.28% at the end, giving a positive return of 0.05%. The index was up 0.011% for the year.

The Overall Picture

Given what has been happening in early 2019, we are likely to continue to see volatility in the markets. There was a downturn in manufacturing in the fourth quarter, which appears to be from fear on the part of some manufactures that the economy was about to go negative. With the economic indicators showing continued growth, we should see a rise in manufacturing in the first quarter. We are not likely to see a growth rate of 3% as we saw in 2018, but with consensus showing growth of about a 2.5% for 2019, we should see positive results. We continue to highly recommend diversification in portfolios, since this helps to mitigate volatility over the long term. Investors should also make sure that their portfolios reflect their risk tolerance.

Ed Mallon