2018 Reflections and 2019 Horizons

We hope this post finds you knocking your New Year’s resolutions out of the park and enjoying the beginnings of a fresh year. The primary reason for this blog is to take some time to reflect on the past and use it to create building blocks for the future. Through the last couple of months in 2018, we experienced some violent and somewhat irrational movement in the stock market and it’s important to learn from those months.

 

First, we want to thank you for hanging in there, we know times like that can be stressful and it’s hard to keep emotions from driving decision making. However, we know that emotions very rarely make the best decisions for us. With regards to investing they will drive you into the market when things are up and drive you out of the market when things are down – this is a perfect recipe for losing money, and losing it quickly. We have yet to come across an authority on investing who says that making trades out of fear or greed is a smart idea.

 

Second, we have learned and affirmed several things through the past few months and feel it would be of value to our clients if we shared some of what we’re reflecting on and what steps we should take moving forward.

 

Let’s start with a quick review of 2018:

 

Tax Cuts – positive impact on company earnings across the board for the most part.

 

Trade Policies – a lot of progress was made with several countries. Negotiations with China got the most coverage and these negotiations provided great “uncertainty” throughout the stock market. It’s interesting to note that the Russell 2000 outperformed the majority of 2018 (excluding the last three months) – we believe this was primarily because of the reduced exposure to China and therefore less uncertainty about the outlook for those companies.

 

Interest Rates – the Federal Reserve raised rates four times in 2018, this is now nine times since the Fed began its course of raising rates from near zero levels about three years ago. (We will discuss further later on)

 

Volatility – we saw a real increase in volatility in 2018. This was startling to some as 2017 was a very calm and smooth ride. We know that calm and smooth isn’t always the case for the stock market though. Fortunately, volatility also creates opportunities that prudent investors can use to their advantage.

 

Overall in 2018 we witnessed many headlines that made the future a little murky. It becomes difficult to project revenues as well as expenses when the outlook is unclear. The main factors we believe took center stage were the trade war with China and interest rates. The uncertainty surrounding both of these topics resurfaced all throughout 2018.

 

Now let’s consider the 4th quarter of 2018:

 

What caused the initial selloff in October?

 

See our previous blog.

 

Why did the market continue to fall after initially selling off in October?

 

As we’ve mentioned before, there are a multitude of factors that play into the movements of the stock market. We believe all eyes were on Federal Reserve Chairman Jerome Powell. During 2018, there would be news that spooked investors, causing a leg down which always recovered once fundamental data came to light (economic data as well as company specific earnings reports). All of the data pointed to continued expansion for the U.S. economy. However, we believe there was a shift in how investors reacted to “positive” data. The narrative revolved around interest rates and if the Fed was raising too quickly and if this would result in a Fed induced recession. As a result, good news started to be viewed as bad news because the good news would give the fed cause to continue to raise rates and potentially raise them too quickly.

 

This fear was realized in December when the Fed raised rates for a fourth time (this was actually expected). However, the market did not expect Jerome Powell to come out and say that they would raise rates two more times in 2019. The market expected Powell to say something like “we will let the data guide our decisions in 2019” However, that is not what he was said, in fact, Powell’s remarks made it seem like the Fed was on cruise control and would raise rates no matter what happened. This was a real concern and in our opinion warranted real selling.

 

The Fed’s primary job is to keep inflation in check and inflation was under control. Sure enough, Powell came out in January and said basically the opposite of what he had said in December, he walked back the two rate hikes and said they would let the data guide their decisions. In particular, he mentioned that the Fed would take into account what the stock market is telling them. This was HUGE and is what he should have said in December. But at least he came out and said it in January. This allowed for good news to once again be viewed as good news as the market knows the Fed is looking at more than just a few data points to base its decisions on. Once again we are seeing positive numbers and buyers have been coming back into the market as the air clears.

 

So what did we learn and what did we affirm from the 4th quarter?

 

We learned that in the short term, it doesn’t pay off to fight against the market even when the market is acting irrationally, it does pay off to trust your trading rules and what technical analysis would indicate. We affirmed that fundamentals prevail over the long term. It’s fairly easy to see this – as the air has cleared in 2019, clarity returns, and fundamentals take the stage. That's why January was a stock pickers market. Top stocks have significantly outperformed the S&P 500 so far in 2019.

 

What can we expect from 2019?

 

 It would seem the Federal Reserve has moved out of the limelight at this point in 2019. Unless something drastic happens, we are expecting them to let the data guide their decisions, which is exactly what they should do and is the function of the Fed. Inflation continues to be stable thus far so we don’t expect any drastic change in Fed policy going forward. One new development is the discussion of using quantitative easing (QE) more regularly, not just as a last resort. They’re calling it “Anytime QE”. The goal of Anytime QE would be to help orchestrate a soft landing for the US economy, in the event that there is economic slowing or crashing in other economies across the globe. The world is so interconnected now that even if the US economy is humming along, weakness in other places could cause markets in the US to be dragged down along with it. Why? Because so many companies operate internationally, their profits would suffer from economic instability in any of the markets where they operate.

So why would the Fed consider Anytime QE? We believe the primary reason is because the Fed Funds rate is still relatively low. Meaning they don’t have much room to lower rates in order to stimulate the economy. So they are discussing the option of using QE more regularly, not just once the Fed funds rates is down at zero and QE is the last resort for economic stimulation. It will be interesting and important to follow where these discussions go throughout the year. Money supply impacts capital spending, which impacts a company’s ability to grow and expand profits, which ultimately impacts stock prices and dividends.

 

Trade Policy:

 

President Trump has spent much of 2018 negotiating new trade policies with many countries. What was the point? In a sentence, we believe the point was to create new trade deals that would be of benefit to the US. Our President took the hardball approach to negotiations by placing tariffs on goods from other countries in an effort to get them to the negotiating table. The US is easily the world’s greatest consumer, which gives the US an upper hand when it comes to trade – other countries need the US consumer more than the US needs other consumers.

Trade negotiations are ongoing, which means there is an element of uncertainty. There’s that word again – the theme of 2018 – uncertainty. From an investors perspective it’s difficult to estimate revenues, expenses, and ultimately profits when many variables are unknown. From a business’s perspective, decision making for capital spending becomes difficult. When operating in a global economy, companies weigh many factors when deciding where to build the next plant, open a new retail store, etc. Often it comes down to a cost benefit analysis – which new project will produce the greatest net present value. A cost benefit analysis becomes tricky when you don’t know if you’ll be facing a 10% tariff or a 25% tariff in the next year based on where you decide to direct your capital spending. Over the long run, tariffs tend to be a drag on economic expansion. We can see that clearly from the slowdown in China since the US has placed tariffs on various products. However, they have proved to be a useful tool for the President to negotiate new and more favorable deals for the US.

 

At the present time, we are waiting on the March 1st deadline for the US/China trade talks. President Trump has voiced that the March 1st deadline may not be set in stone if talks are progressing positively. However, should talks fall apart, we could expect to have further tariffs put into place against China. This will almost certainly cause pain to the global economy, including the US and the stock market will likely react sharply to the news. However, if a deal is reach or even solid progress is made, we anticipate further short-term rallies in the stock market. This has been the pattern for the past 12 months.

 

BREXIT – The UK’s exit from the European Union:

 

The March 29th deadline is quickly approaching. The process for Brexit was triggered on March 29th, 2017 – Article 50 of the Lisbon Treaty was invoked which provides two years for the EU and UK to agree to the terms of the split. That deadline is coming up, however, no deal has been made yet. Theresa May’s proposed deal was voted down on January 15th. Now there is speculation about pushing the March 29th deadline back while they continue to negotiate. This is relevant because again, it adds a level of uncertainty to the playing field. For more on Brexit, here is a useful article.

 

So how do you invest in this environment?

 

We have begun implementing several strategies into our portfolio with the goal of preserving profits and providing some protection against another downturn like we experienced in the 4th quarter of 2018. Although we are not anticipating anything to that degree for quite some time, we want to be prepared nonetheless.

 

What’s the good news?

 

Let’s discuss cause and effect. In the 4th quarter of 2018, headlines were overwhelmingly negative, stock markets were falling further and further every day, causing fear, increasing volatility, and sending many people out of the market. Why? Many of the reasons we discussed above. So what changed from December until now?

  • Interest Rates

  • Federal Reserve

  • Trade Policy

As you can see in the market’s performance this year, simply gaining clarity has its own effects on the market. Increased clarity from Jerome Powell, progress in trade negotiations – every step forward brings clarity to the market and with clarity comes confident decision making. We have witnessed a significant rally so far in 2019. With each tick of clarity, conditions in the market have improved. It will be important to ask ourselves this question when another day or week or month of selling happens – Is the market moving because of real fundamental risks or changes in the landscape, or is this merely a reaction to a bad headline which may not have a fundamental impact? We’ve learned and believe that headlines can sometimes win the battle, but fundamentals often win the war. Reacting to a headline can prove to be a costly mistake because emotions tend to take over rational thinking. So we always need to take a step back and look at the full picture before making a decision.

 

We hope this posting will give you some insight into what happened during the tail end of 2018 so that ultimately we can all learn from it as we move forward. At MFG we encourage you to stay the course with your new year’s resolutions, we hope you’re off to a good start! As always, we want to thank you for your continued trust and loyalty.

 

Authored by:  Michael McCracken CFP®, ChFC and Jeffrey Gardner, Financial Advisor The information presented above has been prepared for informational purposes only and the commentary represent the opinions of the author and are subject to change at any time due to market or economic conditions or other factors.

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