Quarterly Commentary: 4th Quarter 2018Submitted by Integras Partners on February 4th, 2019
Financial markets around the world faltered in the 4th quarter, not entirely due to economic realities but largely in response to “noise” over geopolitical events, trade concerns, rising interest rates, slowing growth of corporate earnings and global economies.
From the market’s closing high on Oct 3rd to its trough on Dec 24th, the S&P 500 gave up 19.8% of its value, narrowly missing the 20% definition of a bear market. While declines of this magnitude occur, we don’t normally see them when underlying fundamentals are strong. This slide was triggered by Fed Chairman Jerome Powell on Oct 4th stating the Fed was nowhere close to being finished raising interest rates. His comments sent the market down 10% (a typical correction) in just three weeks.
The real tempest was investors over-reacting. In today’s computerized markets, selling begets selling and Investor Sentiment (i.e., emotions) collapsed to the lowest levels since early 2016. The market transitioned from correction to panic in December, at its lowest point down 16%. Once the support level of the February lows (2,603 on the S&P 500) were broken, we were compelled to take considerable equity risk off the table. A decision we do not take lightly made more difficult with economic fundamentals still quite strong.
The carnage was widespread as equities continued to decline. The S&P 500 Index® was down 13.5% for the quarter, bringing 2019 performance to -4.4%. Small caps (Russell 2000) lost 20% in Q4 (-11% YTD). Foreign developed markets (MSCI EAFE) lost 12.5% (YTD -13.8%) and emerging markets lost 7.5%, almost doubling the year’s decline -14.6%. Only in a flight to safety did bonds (Barclays US Aggregate Bond Index) finish the quarter up 1.6% to finish the year flat. Dismal to say the least.
We stated in our October Commentary that 2019 corporate earnings would not keep pace with 2018’s 22% growth rate, trade negotiations with China would take time to resolve, the Federal Reserve would continue raising interest rates, and global economic growth would likely slow.
Thinking this was all common knowledge, we believed these detractors were already priced into the markets. Everyone we speak with, read and listen to was taken aback by the depth of this correction. Now the fundamentals themselves are weaker as a result of this volatility and uncertainty.
What does all this mean going forward?
Slowing growth rates and slowing growth are two very different things. Economic growth should slow towards the trend rate we’ve experienced throughout this expansion: +/-2% GDP vs. 3% GDP in 2018. Earnings growth will slow from the tax-induced 20+% growth of 2018 to the 8%-10% range in 2019. Interest rates are likely to remain somewhat constrained as the Fed is now (belatedly) more sensitive to its policies sending the economy into recession. US-China trade negotiations have targeted a March agreement. Job growth is strong, inflation is subdued, households have more income and debt costs are very low. Investors simply became disconnected from reality during December and markets suffered.
The market realizes the end is not here. Not yet anyway. In the wake of the selloff, equities are much cheaper now than they were. Entering Q4, the price/earnings (P/E) ratio of the S&P 500 was 16.8, or 4% above its 25-year average. This is a widely used barometer, measuring how many times annual earnings is the market willing to pay for stocks. On Dec. 31st, it was all the way down to 14.3, 11% below its long-term average. So, the market is significantly cheaper now and supported going forward.
Therefore, we believe the market will recover much of its losses during 2019, perhaps even setting a new high in the process, yet several risks must first abate. Foremost is the trade dispute with China. China is the world’s second largest economy and the key to global economic growth. The Chinese economy has suffered disproportionately in the tariff war and slowed significantly over the past year, taking global growth down with it. Both will suffer further if no settlement is reached. The U.S. has the upper hand at the moment and China knows it. Yet forecasting and valuing a resolution to this risk is impossible today.
The Fed must recognize the lower trajectory of economic growth and respond accordingly or risk causing a recession. It is walking the tightrope of attempting to normalize interest rates while not choking the economy. Chairman Powell’s Oct 4th comments sent chills through the market. Just two weeks later he was walking them back. In these recent statements, he indicated there would be fewer increases going forward than previously telegraphed. This is good news but the Fed must demonstrate its newfound concern.
Corporate earnings forecasts for 2019 had declined somewhat going into the 4th quarter. During the quarter, analysts reduced them significantly, further spooking the markets. While much criticism can rightly be placed at the feet of analysts, much of their forecasting data comes directly from the very companies they analyze. Corporate managers always want to beat expectations, so guide analysts down to make it easier. Investors overreacted to this practice in December. We expect earnings beats will remain quite high (around 60%) for the current reporting period. But now, it’s future guidance that will matter more than current earnings.
How will Integras Partners position investments going forward?
As of January 15th, the S&P 500 had just broken above its February low of 2,603, closing at 2,610. This was the technical (chart) line of demarcation for us on the way down and is approaching the next resistance levels on the way up. Should it hold above 2,603 and not retest the lows of December, it would be a rather rare occurrence. As in early 2018, a pronounced move lower is typically retested within a few weeks or months. We expect it will happen this time as well and watch the technical picture to indicate a safer point to redeploy dry powder.
Recognizing that a retest is likely we are cautious not to become greedy, though we readily admit that new lower valuations are highly attractive. With earnings season now underway we are watching the market response to companies guiding future expectations lower. Of the roughly 30 companies to report as of this writing, those who have lowered expectations have been hammered. With most companies reporting in the next 2-3 weeks we’d like to gauge market reactions before committing to higher equity exposure.
The Benefit of our Time Horizon Philosophy
Take comfort that you are not drawing income from across all investments. We strive to insulate near-term income needs from cycles of market dislocation like the one we’re experiencing. If your friends are fretting that some of each investment is sold monthly; let them know that IntegrasPartners has a better paradigm.
We know it’s not fun seeing values decline, and we shoulder this weight for almost 200 families, but in almost all cases, we’re not selling depressed stocks to meet immediate cash needs.