Following the worst performance for the S&P500 since 1931, the tone so far in these early weeks of 2019 is more hopeful. This is evidenced by broad and strong consecutive-day winning streaks; the S&P for instance was up +2.6% last week and +3.6% month-to-date. Even stronger are some areas of the market traditionally considered risk-seeking; the small-cap Russell 2000 climbed +4.8% last week and +7.4% in January. Key commodities viewed as a bellwether to economic growth including oil are also seeing their price recover notably off stressed December lows and international equities are participating in-line with the S&P. The cause? From a fundamental perspective, very little. But Fedspeak turned decidedly more dovish from the worrisome pre-disposed and not-so-data-dependent (toward additional hikes) tone that Chairman Powell conveyed with the rate decision in December.
Uncle Sam stole the year-end Santa rally. The worst December since 1931 and the worst Christmas Eve stock market performance of all time occurred this year. From my perspective, it is all politics this December. Yes, our great Uncle Sam “Scrooge” stole Christmas and a small positive investment performance for 2018. It traces to bad politics coming together in a “perfect storm.” A “perfect political storm” is the coming together of at least 2 bad events at the same time. We count at least 3 negative political charges right now: the Fed, Tariffs, and government shutdown (budget).
With just 5 trading days remaining in 2018, Santa is missing, failing to deliver any holiday cheer more familiar to investors at this time of year. Even a lump of coal might feel better at this point. Instead, the ill-behavior of financial markets would suggest that something very bad is happening to the global economy. On the heels of a -1.2% slide during the week ended December 14, the selloff intensified with the S&P tumbling another –7.0% for the week. It was the worst week for US equities in 10 years, and stocks are now off more than -12% for the month. Smaller-size US companies are generally faring even worse with the Russell 2000 small-cap index down -15% for the month and crossed the bear market threshold of -20% from its peak. The tech-heavy Nasdaq is also officially closed in bear territory on Friday (12/21) from its peak after leading the charge throughout most of the last two years. But regardless of size, US stocks are decidedly negative for 2018 to varying degrees.
Barron’s front cover over the weekend (12/15/2018) read “2019 Outlook: US Stocks Could Rally More Than 10%”; while the New York Times front page (12/15/2018) was “The Best Place to Put Money? Your Mattress” and in the Style Section (same paper/date) read “Are You Ready for the Financial Crisis of 2019?” Quite divergent headlines on the same day.
As we noted in these pages at the beginning of last week, we find it simply remarkable how quick the market’s mood can change against a fluid and stressed environment like the recent two months. Entering the week, the stars seemed to be aligning for those hopeful a more dovish Fed and collaborative tone between the US and China over ongoing friction about trade might develop. As recent as last Monday, optimists were starting to feel as if the storm clouds were receding during the final week of November, and a much longed-for Santa Rally in December might be starting to take shape. Then, with seemingly little warning, the bears were awakened again with declines throughout the balance of the week. The carnage began to unfold Tuesday, with blame by the media mostly being attributed to investors having second thoughts about the trade truce with China, although less recognized was a troubling development in Europe with British Prime Minister May suffering a setback in her government and undermining the Brexit proposals. We also believe that the inversion of the yield curve among some shorter maturities likely triggered indiscriminate and heavy risk-off program selling of US equities exacerbating any fundamental concerns. Despite the tail end of a strong multi-day rally on Monday, and the market being closed in honor of the passing of the 41st President Bush on Wednesday, the major US indexes still found themselves -4.6% in the hole to conclude the first week of December. From a psychological standpoint, the market backdrop is feeling increasingly pessimistic. Most challenging however is for investors to try and keep in mind how quickly the environment could take a turn for the better again seeing as how so many of the worries are “man-made” and policy-related.
In our November market commentary entitled “Shake or Break”, as well as periodic updates in recent weeks, we’ve spoke extensively about how the market’s October swoon and elevated volatility were not without justification. The sudden awakening by investors following conclusion of the 3Q can be linked to persistent worries that the economic strength being witnessed in the US for 2018 might be “as good as it gets”, set to fade as we anniversary tax reform; when paired with the lack of constructive progress between Trump and China over trade and the Fed communicating in a way that felt decreasingly data-dependent and instead on autopilot with respect to additional interest rate hikes it makes sense why so many market participants were in bad moods. We’ve stated throughout the duration of this corrective phase that the economic data in the US remained supportive and the probability of recession in the near-term would still appear remote. But the financial markets needed to quickly see a more conciliatory tone begin to develop from both Trump and Fed Chairman Powell before further psychological confidence damage and any meaningful stock market recovery could develop. That’s exactly what we received last week and financial markets responded strongly with their best week in two years.
Domestic equity markets remain up +1.1% in November, but the sailing is anything but smooth. The S&P500, along with most international markets, struggled for direction throughout most of last week. In fact, most days were characterized by sharp reversals – either beginning a session favorably but bleed throughout the day; or sharply negative only to bounce higher. Short-term intra-day reversals are just one symptom of a market that is uncertain how to reconcile still strong US data, against signs that same data may be peaking or is at risk if various policy stress points such as trade or interest rate policy do not diminish soon.
At the end of October, one could almost gather that a some modest relief was returning to the financial markets as the ugly but much anticipated US midterm election drew near and uncertainty over its outcome would be no more. As it turned out, election day generally went as predicted by political pundits – that Democrats would take back the house, but Republicans could hold their majority in the Senate. The fracture of Republican control renews what is often referred to as political gridlock. Citizens will often complain about gridlock or political dysfunction, but investors see it more favorably because the probability of significant policy changes are perceived lower when political parties are at odds with each other. In this day, it also mostly removes the possibility of Democrats pursuing impeachment of Trump or a wholesale rollback of policies implemented during his first two years (which would not in any way be market friendly). On the split-power result, US equities enjoyed a strong start to the week and post-election bounce on Wednesday. That bounce, which led some to cheer that a hoped-for 4Q rally might now get underway, were cooled Thursday and Friday as the Federal reserve reiterated its intent to continue raising interest rates. Still, the strength by markets early in the week was enough to help the S&P500 conclude firmly in positive territory for the week with an advance of +2.2% on the S&P500.
In recent days we executed several tactical adjustments in the fixed-income sleeve of client portfolios. We sold or reduced exposure to short-maturity bond funds and reinvested proceeds into position-traded money funds. These adjustments take advantage of attractive yields available on short-term money funds relative to the variable return potential on short-maturity bonds in a rising interest rate environment.
One word comes to mind when thinking of the drawdown endured in October: relentless. It was the worst month for US investors years with 16 of the 23 trading sessions during the month being negative. Worse than that, since the S&P500 made its last all-time high on September 20, 75% of all trading days were negative and the major US stock indexes flirted with technical correction – a term defined by a drawdown of -10% or more. The retreat was most severe in those areas of the stock market that to this point, performed the strongest. “FAANG” names (Facebook, Amazon, Apple, Netflix, and Google) were punished one after the next for either softer-than-hoped quarterly earnings or more sober forecasts of quarters to come. As bad as it was, perhaps the most discouraging development was that diversification provided almost no relief. Even the safest of bonds, which historically offered investors a destination of safety and could be counted on to rise during times of severe market stress, also forfeited ground during the month muting their benefit. International equities, of course more risky than bonds but experiencing troubled times throughout most of 2018 fared even worse than domestic (how much further can they fall?!). One story appearing in the Wall Street Journal went so far as to call diversification “dead”.