Review and Outlook
In our October outlook we warned of more volatility to come. As it turned out, we got even more volatility than we expected. The market declined 13.5% during Q4, putting the S&P 500 at -4.4% for the year. The average stock in the S&P did even worse as the equal weighted S&P 500 was -7.8% for the year. US Mid and Small Cap fared even worse at -9.8% and International continued its disappointing performance over the last few years at -16.4%
We do not feel we are entering a mega-bear market like 2000 or 2008 as the fundamental precept for a decline of those magnitudes just isn’t in place. We have come very close to the definition of a bear market (a -20% decline) from the high on September 20th of last year, to the lows on Christmas Eve. The market has moved up dramatically since then, and while we cannot rule out a retest of the lows in December, our view is that the fundamentals do not support a move much worse than this. Moreover, the market became very oversold in December, and then we saw significantly large breadth in buying on the rally since then. Historically, this combination of oversold levels and broad buying rarely results in the market to do materially worse in the coming months. So, based on both the fundamentals and the technical patterns, we are modestly positive in the near term.
However, that doesn’t mean we have let our guard down! We also believe it is quite possible, in the intermediate term, that the market becomes much more volatile with less upside than we have had over the past few years. We also can’t rule out the possibility that the fundamentals will worsen later this year, creating even more volatility. We are highly focused on the yield curve, Fed monetary policy and US Fiscal policy. Each data point we receive on the economy, and earnings, is what will ultimately drive stock prices.
The Economy, Monetary and Fiscal Policy, and Earnings
Our outlook for the US economy is that it will continue to move forward. We see few signs at the margin that suggest a material slowdown. Most broad economic measures (CFNAI, ISM and Fed Surveys) show an economy that continues to expand, albeit at a slower level. Our favorite indicators “under the hood” are also not showing problems: Unemployment claims have yet to bottom and start higher, consumer sentiment isn’t moving lower (however it is showing signs of moderating), and housing has yet to turn lower in a meaningful way.
There is little doubt that the Fed is tightening monetary policy. They raised rates four times last year and the Fed balance sheet continues to be reduced. After the recent pullback in the market, the forecast is for the Fed to only raise rates once this year. The result of all this is a flatter yield curve that has yet to invert, and even if it did, an inverted yield often leads economic weakness by months, if not years.
We are concerned that US Fiscal policy could be a risk going forward. The current administration’s tariff “war” is causing apprehension over the future path of our economy. It’s hard to know how or when the tariff issue gets resolved and what the result will be. Everything could end up being fine, but in the meantime, the market does not like uncertainty and is anxious that this may become a headwind.
We are seeing few signs of an earnings recession, like in 2015, but we will have to be watchful as 4Q earnings are going to reported soon. Our concern is that CEO’s may issue conservative guidance in an effort to beat lowered expectations later this year. We will be watching how this plays out over 2019.
Sentiment and Technicals
By almost any measure, sentiment reached historic levels in December. Mutual fund redemptions and stock and ETF selling was as broad is it has been in the last 10 years. Investor sentiment also reached very low levels. Unless there is an economic recession, these kinds of oversold levels usually result in better equity markets over the next few months. This is especially true when significant buying comes in after reaching an oversold state, and we got that in spades. Breadth – meaning the volume and percentage of stocks moving higher – was highly positive in the post-Christmas rally, and this almost always also points to better markets. We may yet zig-zag in the near term and retest the lows, but it would be very unusual to go significantly lower over the next few weeks/months than where we have already been.
The 200-day moving average is declining, and this is usually not a healthy development. The 200-week moving average acted as support in the December decline, so that is presently a positive. Our models are still showing technical potholes that we will need to work through and that It is the primary reason we expect a more volatile market environment in the coming few years. The market is in the business of guessing when the next downturn will happen, and while we see few signs of this, there are many issues that the market will have to work through. The technical picture reflects this mixed, semi-positive environment and we will be watching for changes to this backdrop.
Equity and Fixed Income Strategy
While our stock selection process – which features high-quality companies with good growth at a reasonable price – slightly underperformed last year, this is atypical as our long-term returns are still solidly ahead of the S&P 500. If our outlook for a future of increased volatility develops, that should benefit our stock picking process and a resumption of longer-term outperformance. We are actively looking for new bargains which will develop from the increase in volatility.
Our ETF strategy has outperformed its benchmark (Int’l, Small and Mid-Cap) as we have largely moved away from these areas in the decline last quarter. We have since initiated new positions in these higher beta areas, but it’s unlikely we will go overweight here as more volatility will likely make it a difficult environment for higher beta areas.
Our Long /Short strategy may be a source of protection if volatility picks up significantly. It had a very good year, posting positive returns and doing much better than our peers. This is exactly what you want from an alternative strategy – to be a buffer and provide protection in difficult markets.
Our fixed income approach has been quite conservative given our view for higher rates. The equity market correction has put a lid on interest rates in the near term, but we are still looking for higher rates. We have also significantly upgraded credit quality in the portfolios as we did not feel we were being rewarded for holding lower quality bonds this deep in an economic cycle with a flattening curve. We are looking for opportunities to improve income as yields move higher by extending duration, especially if we get weaker economic news at the margin.