4th Quarter 2018 Market ReviewSubmitted by Karstens Investments on October 26th, 2018
By Michael D. Karstens, CFP, AIFA
On the surface, it was a strong quarter for U.S. stocks. The S&P 500 gained 7.7% in the 3rd Quarter, its best performance since the end of 2013, while the Dow Jones Industrial Average (DJIA) climbed 9.6%. The NASDAQ Composite Index rose 7.1% posting its 9th consecutive quarterly gain. All three indexes finished the quarter within 1% of their all-time highs. Below the surface things were not quite as rosy. Although the S&P 500 is up 10.6% for the year, most of those gains were driven by a small number of stocks. Actually, shares of about 200 companies in the index are down for the year and many have fallen over 20%. Markets around the world posted much lower returns and many markets are down for the year. The MSCI EAFE (Europe/Asia/Far East) index gained 1.4% in dollar terms for the quarter but remains down 1.4% for the year. Emerging markets have suffered from a stronger dollar, trade tariff fears and rising interest rates. The MSCI Emerging Markets Index lost -1.5% (in dollar terms) for the quarter and is down -8.2% for the year. The Chinese stock market is down almost 20% from its peak and trades close to its lowest level in four years. Rising interest rates continued to put pressure on the bond market and intermediate and longer term bonds are mostly down for the year. The silver lining is that we can finally earn some interest on short-term treasuries with rates in the 2-3% range. In summary, while headline returns posted a very rosy picture, actual returns for a globally diversified portfolio have been much less robust.
As we look ahead, there are three different topics that seem timely:
1. The end of QE (quantitative easing) and the effects of QT (quantitative tightening).
2. Global diversification – does it still make sense?
3. Bull versus the bear – good news versus bad news.
Over the last 8 years we have written often about quantitative easing, a process in which central banks around the world created “new” money and then bought trillions of dollars of bonds. This process artificially lowered interest rates, encouraged the use of debt and likely played key roles in raising stock and real estate prices. Today, the process is beginning to reverse, yet surprisingly, not much is being mentioned about this. A year ago, on October 1, 2017, the Fed first began to shrink their balance sheet by allowing $10 billion of bonds to roll off each month. In early October, 2018, the monthly pace was slated to increase to $50 billion/month. While the U.S. began reducing their balance sheet, other countries continued to print money albeit at a slower pace. In late September, the European Central Bank (ECB) cut their money printing in half to $15 billion/month. In January, the ECB is slated to end their QE program altogether. You can see in the chart above how much money has been created in the last several years. Money growth peaked in 2017 and the rate of growth has been slowing each month since. In early 2019, global money printing is slated to go negative. That begs the question, if money printing (QE) fueled growth in the economy and asset prices, what will quantitative tightening (QT) bring? Will it have the opposite effect?
We have had a very prolonged period of out performance of U.S. stocks (especially large U.S. stocks) as compared to International stocks. As a matter of fact, by most measures U.S. stocks have outperformed International stocks over 1, 3, 5, 10 and 15-year periods. Those numbers seem to raise the question, does it still make sense to diversify internationally? Our answer is a resounding yes, and perhaps even more so today. Looking back in time, U.S. stocks seem to have performed the best over the long term, but only because they have done extraordinarily better in the last several years. It is easy to forget that the U.S. was amongst the worst performing markets in the 1970’s, and the decade of 2000-2010. It also earned lower returns than the average international market in the 1980’s. When I started my career in 1982, the DJIA had fallen from 1,000 in 1966 to about 700 in 1982. U.S. blue chip stocks, with dividends, averaged a low single digit return during this time frame. Meanwhile the Templeton Growth Fund (invested mostly internationally) compounded at nearly 14%. Some of my earliest comments from investors were “I don’t want to own any blue chips.” Of course, blue chips and large U.S. stocks made up almost all of their under performance in the next 10 years. Our belief is that over very long periods of time, say 25-year rolling periods for example, U.S. Large Cap, U.S. Small Cap, and International stocks will likely generate fairly similar returns. During these periods, however, there will be stretches when one sector greatly outperforms or underperforms. For example, from January 1, 2001 the cumulative return for foreign stocks as measured by the MSCI ex USA Index was 103% versus just 31% for the S&P 500. At that time, everyone seemed to be on the international bandwagon. Another recent example would be January 1, 2013 through the present in which the S&P 500 had a cumulative return of 130% versus just 35% for international markets. Now, everyone seems to be on the U.S. bandwagon.
Obviously the best outcome would be to identify those markets in a period of outperformance and invest in just that market. It sounds easy in practice but is much harder in real life. With that said, allocating more money to a market after a long underperformance and reducing exposure to those that have outperformed makes sense to us. For the record, the U.S. has outperformed for a very long period of time. By most measures, U.S. stocks are trading at the highest valuations on record, and trade for almost twice as much as their international counterparts.
Optimism vs. Pessimism
Given our contrarian bent, when thinking about what is next after nearly 10 years of positive stock market returns, we tend to think first about risk. Unfortunately, today’s risks do not constitute a short list. Investors seem very complacent today, sticking with stocks that worked in the past, i.e. FAANG stocks (Facebook, Amazon, Apple, Netflix, Google), growth stocks and index investments. Little attention is being paid to quantitative tightening, rising interest rates, massive government deficits, and rising corporate and consumer debt. Amid all of this, valuations of almost all U.S. stocks are at historically high levels using virtually any historic metric.
On the positive side, there are certainly some reasons for optimism. The U.S. economy continues to demonstrate strength, corporate profits have been growing rapidly, unemployment levels are at record lows, and inflation and wages seem to be growing at a manageable pace.
In weighing the positives and negatives, it certainly does not seem to be a time to take outsized risks. Foreign stocks, especially developing markets, seem fairly cheap relative to the U.S. and we would not be surprised if they outperformed in the long run. You could certainly say the same for gold and natural resources. Unfortunately, each of these areas could decline more than other areas in the short run if interest rates rise, the dollar stays strong, and the economy falters.