Fourth Quarter 2018 Commentary – Turbulent Times

The preface to Benjamin Graham’s famous book Security Analysis contains the quote, “Many shall be restored that are now fallen and many shall fall that are now in honor.” It was arguably the most important investment book of all time but it never told us when.

The U.S. stock market got off to the fastest start since 1987 and finished with its steepest loss since 2008. In terms of value destruction, the market was agnostic, punishing everything and leaving cash as one of the lone asset classes to finish positive for the year. Former high flyers were forced to see what life was like on the other side of the mountain. A darling of recent past, Bitcoin, found itself down more than 80% from its late 2017 high. More prominent investments such as Netflix, Facebook and Goldman Sachs were all down more than 40% from previous highs. Even Proctor & Gamble, the maker of Pepto-Bismol, found itself down more than 20% at a point last year – consumer demand was unlikely the culprit.

As we catch our breath in the wake of turbulent times, we must separate the emotional aspect of seeing dollar values decline and prevent ourselves from running out of the store when the merchandise goes on sale. While it was painful getting here, global stock markets are cheaper today than 12 months ago. And while valuations alone are not indicative of the market’s near term direction, they do inform long term returns. And every investor’s long term returns will ultimately be woven into how they react when things get violent.

Any time the market is swaying too much in any direction, the unwinding of that is often painful. Without trying to draw an exact conclusion, it appears something like that played out in the final months of last year. U.S. stocks had a dreadful finish putting them in correction territory for the quarter and negative for the year. The S&P 500 snapped a nine-year streak of positive returns in the process. In non-U.S. stocks, the year was even tougher as international and emerging market stocks finished the full year down double digits. While both finished the year in bad shape, they held up better than U.S. stocks in the fourth quarter. At some point, all of the concerns around trade, tariffs and a stronger dollar will be fully baked into the prices investors are paying for international and emerging market stocks. If those fears aren’t fully incorporated yet, we are close.

In fixed income, bonds staged a strong rally in the year’s final 90 days, finishing in the green after teetering in negative territory for the majority of 2018. If not for the late rally in bonds, it would have been the first time stocks and bonds finished a calendar year negative since 1969. And with a measly +0.01% return for the Barclays Aggregate bond index in 2018, bonds were hardly the stabilizer investors needed. In short, 2018 was a disappointing year.  While negative equity returns globally draw most of the ire, the lack of buffer in bonds, and even more negative returns in the alternative category from the likes of real estate, reinsurance and others compounded the problem.  Diversification did not hold up its end of the bargain last year. Nobody likes the phrase “over the long term” but most people can at least accept its validity.

Diversification is like a patient offense trying to grind out an edge – it’s not trying to score two touchdowns on the same offensive series. For better or worse, diversification and patience go hand in hand. Patience isn’t naturally embedded into most people; it often requires power tools.  International and emerging market stocks have underperformed U.S. stocks drastically since 2009. There is historical precedence that will not always be the case. Nobody can say “when” but slow and steady will win the race.

As we close the final chapter on 2018, investors are left reeling from a turbulent year. Everyone understood that the bull market in stocks that started in March 2009 was not going to last forever. At the moment, nobody is declaring the bull market dead but it might be fair to say the stock market’s complexion has changed.  U.S. stocks are coming off of three consecutive quarters of record earnings growth, yet we have negative equity returns to show for it. Companies are no longer being richly rewarded for “beating earnings” – they have to also paint an exciting story about the future. For many reasons, that picture has gotten harder to create. The world’s largest company, Apple, delivered a blow in early January telling investors that their most recent forecasted earnings numbers were being revised lower as sales of iPhones, iPads and other accessories had cooled off.  If business is getting tougher for Apple, it’s a safe bet business is getting tougher for many other companies.

The good news is that markets are discounting mechanisms. And by that, we mean that markets try to look into the future and incorporate that future into today’s prices. In 2017, equity markets had a wonderful run – they saw a future where tax cuts flowed through to bottom lines and created record earnings growth. When tax legislation went into effect at the beginning of 2018, it was already embedded in the price of stocks for the most part. And when record earnings came knocking in three consecutive quarters this year, it was already in the price. During 2018, it appeared as if markets were pricing in a slower economy where consumers started to think twice before buying a $1,000 iPhone. But curiously, when Apple told investors to brace for a sales slowdown during the first couple of days in 2019, it came in the middle of a sharp rally during the early part of January.

Lastly, you never know “when.” The investment publication Barron’s invited ten forecasters to give their 2018 market projections prior to the start of last year. These forecasters walk the halls at large banks, research firms and money management firms. All ten predicted higher stock prices in 2018. All ten were wrong. And last year was not an anomaly; humans have never shown any consistent predictive powers for forecasting stock prices. The best economist to ever have lived is probably the stock market itself – when a storm hits the equity markets, it’s only obvious in hindsight. Isaac Newton always said that he could calculate the movement of stars, but not the madness of crowds. A simple way to avoid bear markets is to never invest, but we do invest and bear markets, recessions, and a 24/7 news cycle are part of that process. And keeping some Pepto Bismol lying around couldn’t hurt.

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