1st Quarter 2019 Market ReviewSubmitted by Karstens Investments on April 17th, 2019
By Michael D. Karstens, CFP, AIFA
Last January we wrote the following:
“There wasn’t as much as a single 3% pullback in all of 2017 and we are currently in the longest period ever without such a minor correction, over 420 days and counting...Obviously declines of at least 8% to 12% are expected and 15% plus declines aren’t all that common...So what could go wrong? Some areas of concern:
1. Extreme valuations of financial markets. U.S. stocks currently trade at over 18.5 times next year’s projected earnings, the highest in the last 15 years.
2. Worsening U.S. fiscal financial position. The fiscal budget deficit for 2017 was approximately $700B and for the first time total public debt surpassed $20 trillion, only nine years after it hit 19 trillion, a level not exceeded in 200 years.... In addition, for each 1% increase in interest rates, the deficit would rise by $140 billion. Since 50% of the debt matures in less than three years, the impact of higher interest rates would hit fairly quickly.
3. Rising inflation. There are already important signs that inflation is on the rise, signs that are not being measured by the CPI.
4. Slower government money printing. Some would call this quantitative tightening (QT) as opposed to quantitative easing (QE). The European Central Bank (ECB) has been buying 60 billion Euros of bonds per month. The Bank of Japan, meanwhile is acquiring Japanese government bonds in sufficient quantities to keep its 10 year yield near 0%.... We’ve said for some time that government money printing was helping stocks and bonds. As you can see in the chart, global government money printing (balance sheet expansion) peaked in 2017 and is set to decline substantially.
5. High investor sentiment. Investors Intelligence recently stated that nearly 2/3 of investor newsletter writings were bullish on stocks in mid-December, a nearly three -decade high. Such readings are not usually conducive to high-intermediate term results.”
With that said, U.S. stocks continued their march higher and to new record highs. Not a lot went wrong the first eight months of 2018. Yes, foreign stocks began to drop in late January and the bitcoin bubble burst, however economic growth continued at a strong rate.
The market seemed to shrug off bad news and all the negativity surrounding the geopolitical environment. Then, in our third quarter newsletter we wrote:
“Little attention is being paid to quantitative tightening, rising interest rates, massive government debts, and rising corporate and consumer debt. Among all of this, valuations of almost all U.S. stocks are at historically high levels, using virtually any historic metric.”
In September, the markets reacted to worries about higher interest rates, trade tariffs, and the polarized U.S. government and stocks turned down sharply.
The fourth quarter was a real doozy with the S&P 500 dropping 14%, its worst quarter since 2008. Eighty seven percent of the stocks in the index fell during the quarter. Share prices with more than 3/4 of their sales abroad lost more than 20% based on tariff concerns. Stock market darling Nvidia lost 51% for the quarter while Apple fell almost 30%. Economically sensitive stocks like auto and home builders were also hammered. Not even Santa Claus could stop the decline with the DJIA closing down over 650 points on Christmas Eve, a nearly 3% decline and the worst Christmas Eve performance on record.
Most indexes in the United States had been positive through September but the fourth quarter losses wiped out all those gains and more. For the year, the S&P 500 index dropped 4.38% and the DJIA gave up 3.48%. The tech-heavy NASDAQ lost 17.29% for the quarter, which dragged it down 2.84% for the year.
Overseas markets, while not performing quite as poorly in the fourth quarter, had an abominable year as well. Tariffs and debt concerns drove Chinese markets sharply lower, with losses of 25%. The third and fourth largest economies in the world, Japan and Germany, saw their stock markets fall 12% (Nikkei) and 18% (DAX) respectively. The UK’s FTSE 100 Index fell 12%, Korea plunged 8% and emerging market stocks in general were down 17%. Gold actually performed well during the quarter gaining 7.8% but still lost 1.5% for the year.
It’s often been said that stocks go up like you are riding an escalator (slowly) and fall like you are riding an elevator (quickly). That was the case in the fourth quarter. What did go wrong? Most in the press would argue that concerns regarding trade tariffs and the slowing global economy were to blame. These are certainly valid points and major contributors. Many believe tariffs to be one of the causes of the Great Depression back in 1929. However, we believe two other major factors were at play as well - extremely high valuations and the end of money printing. After almost ten years of government money printing and the resulting historically low interest rates (in many cases below zero percent), prices of virtually all assets from real estate to crypto-currency to risky bonds and stocks had been highly inflated. As government slowed, ended, and in some cases began to unravel their QE programs, interest rates started to rise, and stocks began to fall. The 10-year Treasury note rose from an all-time low of 1.37% in July 2016 to a recent high of 3.24%. As the market decline accelerated, the Federal Reserve softened their position. Almost immediately, interest rates moved lower and the stock market stabilized and recouped some losses. To us, that is somewhat of a conundrum. If economic growth remains solid, i.e. not too hot and not too cold, and interest rates stay low along with inflation, stocks and real estate could do well. If the global economy slows or falls into recession, corporate earnings would fall and drag down stock prices. Highly indebted companies, which there are many, would likely fare the worst.
Perhaps the least talked about potential outcome would be that tight labor conditions and excess money printing would lead to higher inflation rates. This would probably force The Fed’s hand into raising interest rates, and would create a whole different set of winners and losers. Given the long list of concerns and potential outcomes, the obvious question is what to do as investors. In some ways, it may help to determine what not to do. Owning long-term bonds with rates this low still worries us, given the large potential losses should rates rise sharply. Buying bonds of highly indebted low-quality companies with single-digit interest rates does not seem at all appealing. With the sharp fourth quarter stock decline, stock prices are at more reasonable levels, although certainly not cheap. We still think it makes sense to own some equities for not only growth, but inflation protection. Even so, some caution is warranted. In that regard, it certainly strikes us that international and developing markets are cheaper than their U.S. counterparts, and it would not surprise us if they happen to outperform over the next three to five years.
Over the past year or so, we have owned, by far, the highest amount of cash, CDs, and Treasury bills that I can remember in 34 years. It’s hard to be excited about earning 2% to 3%, but it worked out well last year, and still makes some sense to us today. Finally, we’ve included an insert of some charts that we think you’ll find interesting.