Market Update: Q1 2019

As bloody as the fourth quarter of 2018 was, the beginning of 2019 has almost erased all the damage. The S&P 500 is only a couple points off the early Q4 high, and global stock indices are following in lockstep.

So does that mean we should expect stocks to continue rocketing upward? Probably not. Economic data has slowed somewhat, and if the market continued at its current pace to start the year, stocks would be up 65%. Which is…..unlikely.

The Federal Reserve is still signaling several rate hikes throughout the year, but has relaxed the pace somewhat after some weaker economic numbers. This quarter’s market update will dig into what’s going on in the economy, and how that could affect stock and bond markets both here and abroad.


U.S. Economy

None of the economic & market analysts I pay attention to are ready to predict a recession quite yet. But they all agree that the U.S. is slowing. One data point that these analysts pay attention to is an index of leading economic indicators. Basically, it’s a composite of 11 individual leading indicators:

  • Average workweek

  • Initial unemployment claims

  • New orders for consumer goods

  • Vendor performance

  • Plant and equipment orders

  • Building permits

  • Change in unfilled durable orders

  • Sensitive materials prices

  • Stock prices

  • Real M2 (money supply)

  • Consumer expectations

A leading indicator means that positive changes are often followed by economic strength, and negative changes are followed by economic weakness. For example, when more building permits are issued, that’s usually a good sign of things to come. Typically, three consecutive monthly changes in the same direction for the index suggest a turning point in the economy.

Looking at recent readings, the index of LEI (leading economic indicators) peaked in September, and has declined in two of the past four quarters - including last month. On top of this, existing home sales (which tend to impact consumer confidence) fell 1.2% in January to the lowest level since November of 2015.

That doesn’t necessarily mean that a recession is around the corner, though. There seems to have been positive progress made in the U.S. / China trade dispute, including an extension of the deal deadline after President Trump reasserted his desire to come to terms. That would be ideal, as a continued escalation of tariffs on goods imported to both countries would be increasingly harmful.

On top of this, the Federal Reserve has turned “dovish” in the last few months. Remember that the Federal Reserve Bank has two jobs. In order of priority, the bank has a mandate to:

  1. Promote price stability (combat against inflation)

  2. Promote full employment & economic growth

There are two terms often thrown around to describe the actions of the Fed. “Hawkish” means that the bank is concerned about rising inflation, and is taking actions that might slow the economy but protect against rising prices. “Dovish” is the opposite, where the Fed is comfortable with current inflation levels & takes action to boost the economy.

In its January meeting, the Fed communicated that it’s very aware that the economy is slowing down a bit. The minutes added that there are currently no added inflationary pressures. This is bank-speak for “we’re turning dovish”. Whereas we will still probably see interest rate increases throughout the year, I’d expect the pace of raises to decrease. This will provide some cushion if the economy continues to slow.


U.S. Stocks

If you’ve read many of our quarterly market updates, you may recall my position on value stocks vs. growth stocks: value tends to outperform growth on a risk adjusted basis over the long term.

I hold this position because everything we do at Three Oaks Capital relies on academic research and empirical evidence. Our objective is to lead our clients to the best possible investing outcome. When investing our clients’ money, I never want to be in a position where we’re guessing what’s going to happen next in the markets. Because of that our philosophy uses research and evidence backed by historical data as a guide.

Based on the historical data, value shares just tend to outperform growth shares over long periods of time, very consistently. Could that turn out to be different in the next 30 or 40 years? Of course! But I’m not betting on it. Rather than step out on a limb and predict that the markets will behave differently in the next 100 years than they have in the last 100 years, the more conservative approach is to use historical data to shape investment decisions. This is why we tilt our portfolios slightly toward value shares.

Looking at the last few years, growth has crushed value here in the U.S. stock markets. This makes sense to me, as we’re toward the tail end of the economic cycle. I can’t confirm this with research, but it’s logical that growth shares would outperform value in the 5th to 9th innings of a cycle. As the economy heats up, high valuation companies with grand aspirations (think Facebook or Amazon) seem to stand a better chance. More reasonably priced value shares would then perform better during downturns and recoveries.

This is exactly what we’ve seen in the markets recently - including the rough fourth quarter of 2018. Large cap U.S. stocks fell 13.82% on the quarter in total. Value shares led the way with a loss of 11.72%, while growth lagged with a loss of 15.89%. International stocks are seeing the same disparity, with value down 11.25% and growth down 12.81% in Q4.

As I suggested in the introduction, the first quarter of 2019 is off to a stellar start. Going back to the beginning of the fourth quarter of 2018, the early run up in 2019 has erased nearly all the losses. Looking at the chart below, the S&P 500’s total return between 10/1/18 and 3/5/19 is only -2.92%. World markets are keeping up in lockstep, returning -2.9% over the same period.

S&P 500 Total Returns ( Source: Kwanti )

S&P 500 Total Returns (Source: Kwanti)

MSCI World Stock Index Total Returns ( Source: Kwanti )

MSCI World Stock Index Total Returns (Source: Kwanti)

So what should we expect going forward? Say it with me now: ”I have absolutely no idea”. I can tell you that we shouldn’t expect stock markets, here or abroad, to keep plowing ahead without any significant pullbacks. Interest rates are on the way up, the economy is starting to slow mildly (although it’s still strong), and we’re overdo for a major market event.

As investors, we should be focused on our asset allocations and appetite for risk. If you’re in a situation where a 25% market drop negatively changes your life, you’re probably invested too heavily in stocks. As I’ve said many times before, your financial plan should accommodate for market calamities. They happen from time to time we’re long overdo for one.


U.S. & Global Fixed Income

Ordinarily, strong rebounds in risk assets (stocks) are accompanied by retreats in safer asset classes like bonds. This has been the case thus far in our Q1 rebound for U.S. Treasury securities, but not quite so for government bonds elsewhere in the world. The 10-year U.S. Treasury bond began the year trading at an annual yield of 2.56%. This yield has increased since then, and currently sits at 2.72%.

10 Year U.S. Treasury Yields ( Source: cnbc.com )

10 Year U.S. Treasury Yields (Source: cnbc.com)

Remember that when interest rates rise, bond returns fall. Picture this: you purchase a U.S. treasury bond that pays you annual interest (in 6 month installments) of 2.5% per year. You pay $1,000 for this bond. The following day, the market rate of interest increases to 3%. If you’d waited for just one day, your $1,000 investment would yield 3% per year, rather than the 2.5% you locked in the day prior.

If you decided to sell your bond on the open market, you’d find that it’s market value would be less than the $1,000 you paid. Why would another investor buy your 2.5% bond for $1,000, when they can purchase a 3% bond with the same credit risk for $1,000 elsewhere on the open market?

While rates on U.S. treasuries have risen, rates on bonds issued by other governments fell in the first six weeks of the year. Before rebounding over the last two weeks, the 10-year Germany bund and U.K. gilts both fell to new lows, which is somewhat confusing given the strength of their local stock markets.

10 Year German Bund Yields ( Source: cnbc.com )

10 Year German Bund Yields (Source: cnbc.com)

10 Year UK Gilt Yields ( Source: cnbc.com )

10 Year UK Gilt Yields (Source: cnbc.com)

Why the disparity? There appear to be two related reasons. First, inflation is falling in the Eurozone. Rising inflation really harms bond returns, and falling inflation makes them a more attractive investment. Because of this, local and international investors have poured money into the asset class. According to the Ned Davis Research Group bond inflows in German and UK government debt are the highest in months. And with greater demand to buy bonds, the governments don’t need to pay as high an interest rate to issue them. Hence lower yields.

Since then yields have bounced in both economies, as well as elsewhere in the EuroZone. If you’ve been following the news, it’s not hard to understand why: Brexit. Basically, the news has suggested that there’s a greater chance that Britain’s exit from the EU will come in the form of Theresa May’s deal (if it happens at all). Rather than a “hard” exit, where the country cuts off all free trade agreements, a “soft” exit would some connectivity, and likely be less damaging to the UK’s economy long term. And with brighter long term economic prospects, long term interest rates tend to rise.


2018 World Asset Class Returns

Below is one of my favorite charts that comes out across a variety of research & new outlets every year. What you’re looking at is a ranking of returns by asset class, color coded, on a year to year basis.

Notice any patterns in this chart?

That’s because there are none. While this time period doesn’t capture a ton of different market cycles, it does capture more than one boom and a major bust. I like this chart because its a great reminder to remain diversified, with a consistent asset allocation, regardless of the environment.

Capture7.PNG

Its often tempting to boost your allocation to bonds when you think the economy is on tenuous footing. Or reduce exposure to the emerging markets when you hear bad news come out of Russia or China.

By maintaining a portfolio consistent with your longer term financial objectives, you can use the benefits of diversification to your advantage, as demonstrated above. Have at least a small portion of your assets in each of the asset classes above, and they tend to work together to improve long term risk adjusted return. The individual risks of each asset class tend to offset each other.

This idea is second nature to seasoned investors, but still serves as a good reminder to stay the course.

three-oaks-capital-attorneys.jpg

Subscribe to Investment Insights

Subscribe to the blog and receive a free copy of Living the Good Life: 5 Ways a Relationship with a Financial Planner Can Help You Live a More Fulfilling Life.