After all the ups and downs of 2018, the US Stock market, as represented by the Wilshire 5000 index, ended the year down -7.13%. Less risky bonds, as represented by the Barclays Capital Aggregate Bond Index, declined -0.18%. Since the year-end, the markets have been in recovery mode and moving up nicely with the US Stock market, gaining over 16.5% so far year to date (1-1-2019 to 4-9-2019).
When we reflect on the ups and downs of the stock market in 2018, nothing really surprised us. During our 2018 outlook letter, we warned that volatility would certainly pick up on the weight of interest rates, government spending, taxes, and trade policy. Then, on December 21st we addressed the decline in a special market update and explained how we believed the worst was likely over, and the near term future looked bright. This outlook has proven fully accurate thus far as markets have rebounded very aggressively since that December 24th low point.
So what does all of this really mean?
Not much, really. I suppose you could say our crystal ball was working well and we had good insight, but the simple truth is that markets are designed to rebound. Temporary declines after major run-ups are a normal and healthy part of the investment process. 2018 was a good reminder about the volatility markets can – and will – experience from time to time. However, when we take a step back and place 2018 in a greater context of history, the current fundamentals, the year’s events did little to surprise or change our thinking. The US Stock Market has gained over 150% during the past 20 years, 869% during the past 30 years, and 3,270% during the past 50 years. Current unemployment remains low, interest rates will remain reasonable, and the economy is still growing; all reasons that we felt the recent declines would be somewhat short-lived, and ultimately provide opportunity. With 2018 behind us, and markets/accounts again approaching high-water marks, here are our thoughts on 2019.
As a general rule, we are not big fans of giving market outlooks. Our view is simple: markets for securities are inherently volatile and capricious. Some days, weeks, months, and years, they go up and in others, down. The market is like a giant scale that constantly weighs information but can take years for the scale to accurately settle. Over 10, 20, and 30 year periods, the market will reflect the compounded profit and interest in a very effective manner, but the short-run is extremely unpredictable. Allowing the wonder of time and interest to work in your favor is the greatest advantage investors hold. Making sure we own companies with strong balance sheets and business models are the second great advantage we hold.
This does not mean we should ignore market activity. We aim to capitalize on short-term inefficiency created from the market bouncing around to capture and enhance the long-term effects of compound interest. Our job, in short, is to always keep emotion away and allow compounded interest to work its magic while constantly looking for small enhancements created from short-term volatility. With this opportunity-seeking mindset, we move forward with our 2019 outlook.
• Federal Reserve Interest Rate Policy and US/China Trade Policy will likely drive short-term movements and potentially set some long-term fundamentals.
It should be no surprise that the 2 major issues are interest rates and China trade policy. Rising interest rates are a wealth stripping effect. Loans become more costly, thus homes are more expensive, and investments less valuable. The other issue with rising rates has become the US Dollar. As rates rise faster to other countries than the US, the Dollar generally strengthens relative to the alternative currency. For example, in 2014 it cost about 6 Chinese Yuan to buy 1 US Dollar. Today, it costs around 6.76, which represents a 13% currency cost increase. This generally results in either fewer products being sold to China OR lower prices to offset the currency change. When you think about the amount of revenue companies generate internationally, a 10-20% decrease in sales or revenue can be a bit of a headwind to growth. We believe this global trade imbalance when coupled with the China trade tensions is making the Federal Reserve very nervous. We have already seen some cracks appear in the ISM Manufacturing index with a 4.5% decrease in December. Thankfully we saw a 4.2% bounce in January. While this is not overly concerning, the recent volatility may keep the FED from hiking rates too aggressively. Stable rate policy and stable trade would remove two of the biggest uncertainties of 2018 and possibly set some longer-term fundamentals in place that would serve as a tailwind for the economy. Thus far, the stock market seems to be expecting both of these outcomes. Confirmation would be a much-needed boost to the economy and markets.
Other elements of caution include fiscal tensions, corporate debt quality, age of expansion, consumer-spending habits, among others. These items currently pale in comparison to the rate and global trade policies discussed above.
Investments are generally valued relative to future earnings potential. You buy an investment for a future earnings/profits stream. Therefore, the valuation equation is comprised of 3 main thoughts. Will the earnings stream grow/shrink? What is the security of the earnings stream long term? What are my alternative choices? If you buy a rental property you will likely consider the earnings produced by rental income relative to price, the security of the renter to keep paying, and the ability for the property to appreciate and drive higher rents or a sale. Stock and Bond valuation is not much different. We must consider the earnings today relative to price levels, earnings in the future and our alternative choices. In aggregate, the S&P 500 earnings yield was 4.47% as of year-end 2018. The future projected 5-year earnings growth is around 9.82% (Y-Charts Data). When compared to alternative choices such as bonds and cash…stocks still appear the most attractive long term. 4.47% is much higher than a 10-year bond at 2.66% or savings rate at less than 1.50%. In addition, companies offer the potential for growing the earnings stream over the next 5-10 years, making stocks the obvious current favorite long term. In short, stocks still seem like the best choice long term, but we do not see them as significantly cheap nor do we feel they are overvalued.
Investment Expectations – Future Rates are Key
In 2018 we saw the effects of higher rates on stocks. As rates rise, the attractiveness of bonds as an alternative asset improves. At some point, investors are willing to take a little less return for the lower risk and certainty a bond offers. 2018 volatility was somewhat sparked by the battle between future alternatives. The idea that pretty soon an investor could get a 4% 10-year bond with very low risk gave stock investors reason to pause. As rates increase, the valuation and future potential of stocks will decline. If rates such as the 10-year yield stay below 3%, we believe the long term outlook for stocks is favorable and would not be surprised with a possible 6-8% US equity return over the next 5 years. If the Federal Reserve decides to pressure rates significantly higher, then we would expect closer to a 5% US equity return rate. Most likely we will see a slow move up in rates, an eventual recession, a reaction to lower rates and a solid market rebound over the next 5 years. History would lead us to believe the FED will likely push the envelope of rate hikes a bit too far, the economy will gradually slow down and a recession will take place. As the data of a recession hits, the FED will reverse course and likely cut rates to stimulate the economy once again. Our original base case scenario projected a likelihood of a recession in late 2019 / early 2020. However, the recent language of the FED has given us a sliver of hope that perhaps they have realized the folly of hiking rates, given the global economic uncertainty that currently exists. If, in fact, they decide to slow or stop hikes, we could see the bull market cycle extended. This is a good example of why we never time the markets. Things well beyond our control can really add to optimism or pessimism in quick order. We believe having a solid plan, focusing long term and being opportunistic will result in long term returns very satisfying to the investor’s needs.
Investment Action – Stay the Course
Everything mentioned above is a normal and healthy part of business cycles. The labor markets worldwide remain near all-time low unemployment. Interest rates are increasing and monetary policy is tightening. At some point, the weight of higher rates and reduced labor force capacity will tip the economic scales and reverse the cycle. Companies will need to start laying off employees to keep meeting profit expectations, they will stop issuing bonds for expansion, consumers will slow spending, profits will decrease and a recession will begin. As markets react, the opportunity will become obvious. We will have a chance to buy some wonderful companies at great prices. The cycle will stabilize, rates will decrease in response to less supply of bonds, homes will become cheaper to buy, consumers will start to spend again, companies will see profits and the recession ends. This cycle has played out many times and we are prepared to use the cycle to our advantage. Those who have a healthy understanding and emotional control stand ready to take advantage of opportunities. We have experienced a tremendous run-up in all accounts over the past 10 years. We are positioning in strong companies that will weather the next storm as we wait for the cycle to play out. We never know when the scale will tip, and desire all the upside we can get while the sun shines, but are well prepared to take advantage should the tide go out.
We remain cautiously optimistic, with an understanding that variables well beyond our control can play a large role in temporary results. Most importantly, we remain confident in the market over the long term (5, 10, 15+ years) and the ability for stocks and bonds to keep producing solid long-term results that can meet planning objectives. 2016 and 2017 offered solid returns in accounts that exceed our planning objectives. 2018 was a bit of a wash after 2 really good years. Markets appear to be optimistic for 2019 thus far and we believe that if interest rates remain stable, the Fed backs away from tightening, and trade policy talks are resolved, then we may have reason to be optimistic yet again. We look forward to the remainder of 2019, ready to take advantage of opportunity should it arise, but hope to see continued gains and/or income that meet or exceed planning goals.
Disclosure and References
Index results such as the Wilshire 5000 and S&P 500 do not reflect management fees and expenses and you cannot typically invest in an index
Evergreen Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.