Fourth Quarter Recap:  What a difference a quarter can make. The S&P 500 was up 9% through September but then declined 14% in Q4 to end (6.2)% for the year. Many other U.S. stock market measures were down more. And volatility raged throughout the quarter. According to The Wall Street Journal, about 85% of all trading is on ‘autopilot’; that is, controlled by machines, models, and formulas that often trade in unison at blazing speeds. The remaining traders include ‘zombie’ investors that cling to whatever information they can obtain; good one day, bad the next. They stumble around feeding on the latest bit of economic nourishment. Their time horizon is short. But like it or not, expect the volatility to continue.
Key themes for 2019: We will start with the three themes most responsible for the recent plunge into near bear market territory, and then consider three more:

  • Worldwide economic growth, including China and the Eurozone, is slowing. Recent reports out of China show more of a manufacturing slowdown than was previously expected. And U.S. GDP growth in 2019 is also expected to slow (but to a still robust 2.7%). However, the stock market is pricing in more than a slowdown and will not be swayed until there is a stream of stronger data. We do not currently see a recession on the horizon and think the economic cycle has more room to run. Interest rates have not risen to levels that will choke the economy.
  • Concerns remain about Fed policy and the likely course of future rate hikes. Fed Chairman Powell stated in December two rate hikes are likely this year which pushed the stock market into a tailspin. With a slowing economy and well-behaved inflation, we disagreed with their decision to hike rates in December and question whether any further hikes are necessary. Other investors feel the same way. According to the CME, fed funds futures now show a 91% probability that the central bank will not raise rates this year.
  • The trade tiff with China will not be easily resolved. Although talks are in progress, little is getting done. President Trump may increase tariffs from 10% to 25% on March 1st, which would increase the likelihood of slower growth here along with higher inflation–a wicked combination called stagflation. Will this be the tipping point leading us into recession? We don’t think so, but many investors are bracing for the worst.
  • Earnings growth will slow from last year’s torrid pace but is still expected to be a very respectable 7.9% in 2019 with revenues rising 5.3%. Profit margins are still near peak levels at 11.8%, but concerns center around recent company comments about rising costs including wages, transportation, and raw materials. And Apple announced on Wednesday lower than expected iPhone sales in China which will crimp earnings. Earnings expectations are usually marked down as the year progresses, but we still expect mid-single digit increases. We will get a better indication when Q4 earnings results are released later this month along with company outlooks.
  • Valuations are much improved but remain a mixed bag. Here are two of our favorite measures: First, the forward P/E on 2019 estimated S&P 500 earnings is now an attractive 14x. Not bargain basement levels, but much better than last January’s 18x. The other measure, S&P 500 market cap ÷ U.S. nominal GDP is flashing caution at 95% compared to an average 59% reading. Only once in the last 60 years has this ratio been higher (127% in 2000) which preceded a dismal decade for equity returns. Our conclusion is that the stock market is starting to offer good value to investors with many quality stocks now selling at 10-12x expected earnings.
  • Investor sentiment is horrible which is positive as a contrarian indicator. Although improved somewhat from the December low, most sentiment indicators are very bearish or at panic levels. For example, Citi’s model is in panic territory, and CNN’s fear/greed indication is at an extreme fear level. Other surveys show that managers’ net exposure to stocks has plunged (source:  Drach Market Research). As we have discussed before, when investor sentiment gets lopsided, markets tend to reverse course.

Our Forecast:  Wall Street strategists are expecting, on average, a 19% rise in stocks this year (source:  Barron’s). A rise of that magnitude would reintroduce valuation problems and over optimism in our view. Our expectation is for more modest but positive returns. Lately investors have been assuming a lot of potential bad news will actually occur, but sometimes investors forget that good things can happen, too.

Macro Trends Become Unsettling

Over the past several months we have focused upon the growing importance of several macro-economic trends including rising rates, declining financial market liquidity, falling commodity prices, excessive debt, and resurgent nationalism. These trends have contributed to a dramatic shift in market sentiment and a repricing of risk. Let’s take a look at each of these trends.

  • Rising rates. On December 19th markets witnessed the fourth quarter point rate hike of 2018 and the ninth rate hike of this cycle. Rising rates along with expanding credit spreads have further compromised overly indebted individuals, corporations and governments. Declining rates on longer-dated T-notes may soon cause inversion (short rates above the longer-dated). The 10 year minus two year spread recently narrowed to 10 basis points. Yield curve inversions do not always result in recession, but all recessions in recent history have been preceded by an inverted yield curve.
  • Quantitative tightening. The gradual unwind of the Fed’s balance sheet (QT) now threatens market liquidity for challenged borrowers including emerging market, junk bond, and leveraged loan issuers. Further, massive U. S. federal deficit spending may be “crowding out” less resilient borrowers. In December, issuance of junk and leveraged loans slowed dramatically.
  • Excessive debt. Servicing high debt loads diminishes the capital available to support economic growth and consumption. Artificially low rates over the past decade contributed to overzealous borrowing among individuals, corporations and governments. As rates rise, servicing this new debt may become difficult making default a real possibility for many.
  • Deflationary commodity price action. Price declines across most precious metals, base metals, and the energy complex all suggest the onset of a deflationary economy. Deflation is a scourge as asset values decline while debt service remains. Deflation may be the more threatening of all macro trends currently.
  • Resurgent populism and nationalism. Collapsing globalization, Brexit, protectionist policies and tariffs are all contributing to a breakdown of confidence in capitalism and free markets among investors. A diminished middle class and sluggish income growth over the past 35 years may have been a prime contributor to this trend. While in its early stages, the outcomes are unlikely to support free trade.

Transitions can be challenging and this long overdue repricing of market risk (or normalization) may be especially painful. The decade of uber accommodative monetary policies and the spectacular returns that followed appears to have ended. While short rates may be approaching a more neutral, sustainable level, the Fed’s ongoing effort to unwind its balance sheet, an experiment without precedent, could take a decade. Macro trends suggest a bumpy ride. 


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