{"id":1586,"date":"2020-01-18T00:40:37","date_gmt":"2020-01-18T00:40:37","guid":{"rendered":"https:\/\/straussresearch.com\/?p=1586"},"modified":"2020-01-18T00:57:17","modified_gmt":"2020-01-18T00:57:17","slug":"year-end-letter-2018","status":"publish","type":"post","link":"https:\/\/straussresearch.com\/index.php\/2020\/01\/18\/year-end-letter-2018\/","title":{"rendered":"Year End Letter 2018"},"content":{"rendered":"\t\t
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Investment Review — Year End 2018\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0<\/u><\/strong>January 3, 2019<\/u><\/p>

2018 was a dramatic year in the financial markets, with a notable increase in stock market volatility.\u00a0 After a 10% correction in the first quarter, stocks recovered and climbed higher in the second and third quarters, but then experienced a sharp selloff in the fourth quarter.\u00a0 The S&P 500 finished the year with a price decline of -6.2%, or a total return of -4.4% including dividends.\u00a0 The NASDAQ declined by -3.9%, while the Dow Jones Industrials fell -5.7%, closing the year at 23,327.\u00a0<\/p>

In the bond market, long-term bond prices fell a bit, as the yield on 10-year Treasury bonds rose from 2.4% a year ago to 2.7% at year-end 2018.\u00a0 The dollar gradually climbed higher for most of the year.\u00a0 The price of oil rose to a peak of almost $77 in early October 2018, then plunged in the fourth quarter to close the year at $45 a barrel.\u00a0 Equity markets in both Europe and Asia generally saw even larger selloffs than the U.S. stock market, with many foreign markets showing declines in the range of 15% – 20% or more.\u00a0<\/p>

Figure 1\u00a0 \u00a0Perspective on the Stock Market, 2016 \u2013 2018 <\/u><\/p>\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t\t<\/div>\n\t\t<\/div>\n\t\t\t\t\t<\/div>\n\t\t<\/section>\n\t\t\t\t

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In this year-end report we will first summarize the major events of 2018, then assess the outlook for 2019.\u00a0<\/p>

Review of 2018<\/u><\/strong><\/p>

The year started off on a positive note as stocks rose strongly in January, driven by a continuation of the economic optimism of 2017.\u00a0 By late January the market had become overextended, and in early February, economic data showing higher inflation sparked a selloff which quickly turned into a 10% correction.\u00a0 The market weakness continued throughout March amid worries about President Trump\u2019s tariffs on imports from China.<\/p>

In the second quarter, stocks were supported by strong corporate earnings reports, good economic news, and the historic summit meeting of President Trump and Kim Jong Un, raising hopes for a peaceful resolution to the North Korea situation, a risk factor which had been hanging over the markets for months.\u00a0<\/p>

Stocks then continued to advance throughout the third quarter.\u00a0 The market rose in July as quarterly earnings reports were better than expected and the U.S. economy continued to show strength.\u00a0 August was another good month as investors were encouraged by news of a new trade deal between the U.S. and Mexico, and in September the market was flat.\u00a0<\/p>

However in early October the picture began to change quite dramatically.\u00a0 Bond yields spiked higher due to strong economic data, and Federal Reserve Chairman Jerome Powell stated that \u201cwe may go past neutral, but we\u2019re a long way from neutral at this point.\u201d\u00a0 This unexpectedly hawkish statement from the Fed Chairman implied that he was intent upon continuing to raise short-term interest rates for another year or two, meaning the Fed could make a major policy mistake by raising rates too far and throwing the economy into a recession.\u00a0 In late November Mr. Powell made statements that appeared to reverse his previous position, but markets then sold off again after the Fed meeting on December 19th<\/sup>, when the Fed\u2019s comments on future rate hikes were perceived as still too hawkish and out of touch with market expectations.\u00a0<\/p>

A related concern was the flat yield curve in the bond market.\u00a0 In early December, long-term bond yields dropped sharply to 2.85%, bringing the 10-year yield down very close to the 2-year yield, meaning that short-term and long-term bond yields were roughly the same.\u00a0 Historically a flat or inverted yield curve has been a leading indicator of a recession, so this bond market condition led to worries about the economic outlook.\u00a0<\/p>

Another factor contributing to the market selloff in October was the growing tension between the U.S. and China, and worries about large scale tariffs and a trade war.\u00a0 In early December, good news emerged from the G-20 summit meeting in Argentina, as President Trump and China\u2019s President Xi agreed to hold new trade talks, but shortly thereafter hostilities rose again when a top executive of Huawei, a giant Chinese telecom firm, was arrested on charges of selling U.S. technology to Iran.\u00a0 This international incident brought renewed attention to the ongoing problem of China\u2019s large scale theft of U.S. technology.<\/p>

Finally, another major development in late 2018 was the dramatic fall in oil prices, which tumbled to $45 a barrel in the fourth quarter, as mentioned above.\u00a0 This decline was due to increasing supply along with lower worldwide demand, and was interpreted as a sign of weakness in the global economy.\u00a0<\/p>

Thus, amid worries about a global economic slowdown, an overly aggressive Federal Reserve policy, a flat yield curve, and conflict with China, stocks sold off again in December.\u00a0 The S&P 500 declined by -9.2% in the month, with a decline of -14.0% for the fourth quarter as a whole. \u00a0As stocks plunged, Treasury bonds benefited from the \u201cflight to safety\u201d effect, with the yield on 10-year Treasuries falling to 2.7% by year-end.\u00a0<\/p>\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t\t<\/div>\n\t\t<\/div>\n\t\t\t\t\t<\/div>\n\t\t<\/section>\n\t\t\t\t

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Outlook for 2019<\/u><\/strong><\/p>

As we look ahead to 2019, many issues are likely to play a role in influencing the market\u2019s direction.\u00a0 The fundamentals of the U.S. economy and earnings have been healthy, but there are a number of major uncertainties in the environment.\u00a0 The most important issues include the political and geopolitical backdrop, trade with China, the economy, Federal Reserve policy, and corporate earnings.<\/p>

Domestic Politics<\/u><\/p>

The November 2018 elections resulted in a divided government, with each party controlling one branch of Congress.\u00a0 Traditionally, this situation of gridlock in Washington has been considered good for the stock market, because it means there will be no major legislative changes that will disrupt the economy.\u00a0 However recent events suggest that the political climate in Washington is becoming very contentious, as illustrated by the recent partial government shutdown over the issue of border security.\u00a0 In addition, there has been some discussion of issues such as impeachment of the President or a potential Constitutional crisis, which would be disconcerting for the markets.\u00a0 Thus the overall political backdrop presents some risks for the market in the year ahead.\u00a0<\/p>

Geopolitical Issues<\/u><\/p>

Various geopolitical issues have presented uncertainties for world financial markets in recent months.\u00a0 The Brexit negotiations have been disorderly and the recent riots in France have highlighted growing populism and unrest throughout Europe.\u00a0 Similarly the recent political turmoil in Italy has appeared to threaten the stability of the European Union and raised questions about the health of the European banking system.\u00a0 One of the risk factors for the year ahead is the possibility of unrest in Europe and\/or some type of European financial crisis. \u00a0<\/p>

On other fronts, growing tensions between Russia and Ukraine have been disconcerting, the sanctions against Iran remain an ongoing issue, and there is still a possibility of renewed problems with North Korea if it does not keep its promise to denuclearize.\u00a0<\/p>

Trade Negotiations with China<\/u><\/p>

The main geopolitical issue for the markets revolves around the U.S. \u2013 China trade relationship.\u00a0 For years China has been employing a number of unfair trade practices, such as stealing intellectual property, dumping goods into the U.S. market at artificially low prices, and imposing high tariffs on U.S. products in China.\u00a0<\/p>

The two countries are now engaged in trade negotiations that were started at the recent G-20 meeting.\u00a0 These talks will cover major issues such as China\u2019s theft of intellectual property and forced technology transfers.\u00a0 Some progress appears to have been made, as China has agreed to boost purchases of U.S. agricultural and industrial products.\u00a0 However if the issues are not resolved by the early March deadline, the U.S. could still raise tariffs from 10% to 25% on $200 billion of Chinese goods, and potentially place tariffs on virtually all goods imported from China.<\/p>

A trade war in which each country imposes high tariffs on the other\u2019s products would cause higher prices, disrupt global supply chains, and potentially cause a recession in the entire global economy, which would be very bearish for the stock market.\u00a0 However, there is still a chance that a major trade deal can be reached.\u00a0 If a deal is made which would stop the theft of U.S. technology and provide more access to the Chinese market for U.S. companies, it would be good news for the economy, create jobs, and be very positive for the markets.<\/p>

Economy and Inflation<\/u><\/p>

The U.S. economy accelerated to a very healthy pace in 2018, as the broadest measure of the economy, the gross domestic product (GDP), had a growth rate of 4.2% in the second quarter and 3.5% in the third quarter.\u00a0 Data for the fourth quarter has not been reported yet, but is expected to be roughly 2.5%, meaning growth for the full year of 2018 should be in the range of 3%.\u00a0<\/p>

According to presidential economic advisor Larry Kudlow, the reasons for this economic strength include the elimination of many job-killing regulations, along with a lower corporate tax rate.\u00a0 This competitive tax and regulatory environment has led to an increase in business confidence, meaning that companies have been staying in the U.S. and investing in the U.S., with a large increase in capital spending.\u00a0 Job creation has been very strong and the unemployment rate has fallen to only 3.7%, its lowest level in decades.\u00a0 Weekly unemployment claims have hit a 50-year low and there are labor shortages in some industries.\u00a0 Consumer confidence has surged, supporting a high level of consumer spending, for example retail sales were very strong in the recent holiday shopping season.\u00a0<\/p>

Despite all this good news, many are worried about a slowdown in the economy over the next year or two, or even a recession.\u00a0 This is based on issues such as the flat yield curve in the bond market (as discussed above), an overly tight Federal Reserve policy, a reduction in fiscal stimulus, and a slowdown in the global economy.\u00a0 Recent economic data from China and Europe has been weak, and the U.S. is the only bright spot in the global economy.<\/p>

Inflation remains low by historic standards, with most measures now showing an inflation rate of roughly 2.0%, in line with the Federal Reserve\u2019s objectives.\u00a0 One factor that may contribute to inflationary pressures is the tight labor market, as wage growth has accelerated to an annual rate of 3.1%.\u00a0 However, other factors suggest that inflation will remain low, including the recent sharp drop in oil prices.<\/p>

Putting all of this together, we believe that the U.S. economy is likely to show a moderate slowdown next year, with real GDP growth for 2019 decelerating to the 2% range.\u00a0 While this would represent a reduction in growth compared to 2018, it would still be a healthy economy with no recession.\u00a0<\/p>

Federal Reserve Policy and Interest Rates<\/u><\/p>

The Federal Reserve raised short-term interest rates four times in 2018, in quarter-point increments, with the most recent move in December 2018 bringing the target range up to 2.25% – 2.50%.\u00a0 However, inflation remains abnormally low despite the recent strength in GDP growth, and many believe that the Fed is moving too far, too fast, and should simply stop raising interest rates.\u00a0 The Fed\u2019s official outlook suggests two more rate hikes in 2019, but has stated that its policy will be \u201cdata dependent,\u201d meaning decisions will be based on incoming economic data in the months ahead.\u00a0 Many market participants believe that the Fed will not raise rates again for at least six months.\u00a0<\/p>

On a related note, the Fed has been selling government bonds at a rate of $50 billion per month to reduce the size of its balance sheet, in order to unwind the policy of \u201cquantitative easing\u201d that was undertaken after the financial crisis of ten years ago.\u00a0<\/p>

These bond sales, along with the large bond issuance by the Treasury to finance the budget deficit, have led to record levels of Treasury bonds coming into the market, which might be expected to drive up bond yields.\u00a0 However there is also a very large demand for Treasury bonds, both from traditional buyers such as U.S. pension funds and from global investors whose own countries have extremely low interest rates and who view U.S. Treasuries as a very attractive, safe investment.\u00a0 These factors have kept long-term interest rates at low levels by historic standards.\u00a0<\/p>

Earnings and Valuation <\/u><\/p>

Corporate earnings growth was very strong in 2018, with the past two quarters showing year-over-year gains well in excess of 20%.\u00a0 One of the main reasons for these very strong earnings gains was the recent tax law change which cut the corporate tax rate from 35% to 21%.\u00a0 For 2019, earnings are expected to show a more moderate growth rate of 5% – 10%.\u00a0 The consensus earnings estimate for the S&P 500 for 2019 is now around $172, which would be a gain of roughly 10% over the 2018 estimate.\u00a0<\/p>

In fact this slowdown in earnings growth has been one of the reasons cited for the market\u2019s decline in the fourth quarter of 2018.\u00a0 Bearish investors worried that we have seen the peak in earnings growth, so the best earnings news is behind us.\u00a0 Also a few other issues have been causing concern about earnings, such as the strong dollar and the slowing global economy, which is significant because many multinational corporations earn a large percentage of their profits overseas.\u00a0<\/p>

The fact that the stock market declined in 2018, while earnings rose strongly, has brought the market\u2019s valuation down to a very reasonable level. \u00a0Based on the S&P 500 year-end closing price of 2507, its price\/earnings (P\/E) ratio is 14.6 times estimated earnings for 2019.\u00a0 This is a moderate level of valuation, in the middle of the historic range.\u00a0 It shows that stocks are not expensive.\u00a0 In fact this valuation level is very modest given the low level of interest rates.<\/p>

Conclusion <\/u><\/p>

Despite a strong U.S. economy and powerful earnings growth, the stock market had a disappointing year in 2018 because of major issues such as the China trade relationship and Federal Reserve policy.\u00a0 The sharp selloff in the fourth quarter of 2018 has left the market in a very oversold position from a technical perspective.<\/p>

This sets the stage for a recovery and potentially a good year in 2019, especially since the decline has brought the market\u2019s valuation level down.\u00a0 As discussed above, the outlook for the U.S. economy is not bad and we do not expect a recession in the year ahead. \u00a0Earnings should grow by 5% – 10%, and inflation and interest rates remain abnormally low by historical standards.\u00a0 Thus, based on the economic fundamentals, the market outlook appears relatively positive.<\/p>

However, as discussed above, there are a number of significant risk factors and unknowns in the outlook, which could affect the market in either direction in the year ahead.\u00a0 These include the divided political climate in the U.S., potential turmoil in Europe, the risk of a trade war with China, a slowing global economy, and uncertainty about Federal Reserve policy.\u00a0 In this environment, market volatility is likely to remain high.\u00a0<\/p>

In any case, history shows that stocks remain the best performing asset class over the long term, so investors can focus on long-term investment objectives without undue alarm about short-term volatility.\u00a0<\/p>

\u00a0<\/p>\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t\t<\/div>\n\t\t<\/div>\n\t\t\t\t\t<\/div>\n\t\t<\/section>\n\t\t\t\t<\/div>\n\t\t","protected":false},"excerpt":{"rendered":"

Investment Review — Year End 2018\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0January 3, 2019 2018 was a dramatic year in the financial markets, with a notable increase in stock market […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"nf_dc_page":"","om_disable_all_campaigns":false,"_monsterinsights_skip_tracking":false,"site-sidebar-layout":"default","site-content-layout":"default","ast-site-content-layout":"default","site-content-style":"default","site-sidebar-style":"default","ast-global-header-display":"","ast-banner-title-visibility":"","ast-main-header-display":"","ast-hfb-above-header-display":"","ast-hfb-below-header-display":"","ast-hfb-mobile-header-display":"","site-post-title":"","ast-breadcrumbs-content":"","ast-featured-img":"","footer-sml-layout":"","ast-disable-related-posts":"","theme-transparent-header-meta":"default","adv-header-id-meta":"","stick-header-meta":"","header-above-stick-meta":"","header-main-stick-meta":"","header-below-stick-meta":"","astra-migrate-meta-layouts":"default","ast-page-background-enabled":"default","ast-page-background-meta":{"desktop":{"background-color":"","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""},"tablet":{"background-color":"","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""},"mobile":{"background-color":"","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""}},"ast-content-background-meta":{"desktop":{"background-color":"var(--ast-global-color-5)","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""},"tablet":{"background-color":"var(--ast-global-color-5)","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""},"mobile":{"background-color":"var(--ast-global-color-5)","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""}},"_jetpack_newsletter_access":"","_jetpack_dont_email_post_to_subs":false,"_jetpack_newsletter_tier_id":0,"_jetpack_memberships_contains_paywalled_content":false,"_jetpack_feature_clip_id":0,"_jetpack_memberships_contains_paid_content":false,"footnotes":"","jetpack_post_was_ever_published":false},"categories":[3],"tags":[],"class_list":["post-1586","post","type-post","status-publish","format-standard","hentry","category-monthly-letters"],"yoast_head":"\nYear End Letter 2018 - 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