Thumbs Up or Down for 2019?

Looking in the Rearview Mirror

Let’s go back in time for just a moment to the first week of January, 2018:

  • The tax cuts had just been passed.

  • The S&P 500 had returned over 21% during the prior year and had a price to earnings ratio of over 24 (the highest in over a decade).

  • During 2017, there was virtually no volatility in the stock market. The worst drawdown was less than 2%.

  • Most market commentators were predicting another strong year for the US markets and a great year for international and emerging markets.

Now let’s recall what happened in 2018:

  • The S&P 500 broke out to all time highs on January 26th, with a quick increase of 7.5%.

  • President Trump put tariffs on some Chinese imports and the market quickly dropped 10.1% bottoming on April 2nd.

  • For the next 6 months, the S&P 500 gradually gained back all its losses and on September 20th once again posted a new all time high.

  • For the rest of the year, the market went on a roller coaster ride which saw a lot of scary declines and a few half-hearted advances. By the end of a short trading day on Christmas Eve, the S&P 500 had fallen over 20% from its September high.

  • In one year, market psychology had gone from euphoria to utter despair. By December 31st, investors were liquidating their mutual fund portfolios in record amounts, sentiment surveys were at their lowest point in years, and recession talk was blaring from the headlines.

Using index exchange traded funds (ETFs), here are the 2018 returns for major asset classes:

Virtually all investments lost money in 2018. A diversified portfolio with 60% equities and 40% bonds probably would have lost between 5% and 7%. Those losses are painful, but they are nowhere near the magnitude of losses incurred in 2008. Now, let’s consider likely scenarios for 2019 and how you might want to position your portfolio.

2019 Challenges

There were many causes for the dramatic declines we saw in the 4th quarter, but I think there were three underlying issues: the China trade war, the Fed’s attitude towards raising interest rates, and the high valuations for many stocks. How will those issues affect the market in 2019?

  1. China’s economy is suffering badly from the tariffs. Their GDP is falling and manufacturing is weak. The US economy is also weakening with many CEOs stating that their costs for raw materials are rising and demand for their products are declining. The administration is in talks with China to resolve many trade issues. It is doubtful the US can solve everything to its liking, but very possible an accommodation can be reached with China that will benefit both economies. I put the chance of a positive deal at 60%.

  2. In late 2018, the Fed seemed to suggest that they were going to continue raising interest rates regardless of inflation or economic weakness. The Fed chairman, Mr. Powell, was criticized for the perception his remarks made. On Friday, January 4th, Mr. Powell softened his stance greatly and suggested that the Fed would not raise rates unless the economy was strong and inflation started rising, “With the muted inflation readings that we’ve seen coming in, we will be patient as we watch to see how the economy evolves.” I think the risk that the Fed drives the economy into recession has been reduced to 20%.

  3. Stocks were at very high valuations for most of 2018 even though earnings increased by more than 25% for the year. With the decline in stock prices of 20% coupled with the increased earnings, the valuation of the S&P 500 as measured by the price earning ratio has decreased from over 24 at the beginning of 2018 to under 18 by the end of the year. The average PE ratio of the S&P 500 for the years 2009 to 2018 was 19.97. Stocks are not “cheap” now, but they are much more fairly valued than a year ago. The odds of high valuations contributing to another large decline are small.

Strictly based on my opinion of the key issues for 2019 and their probable impact, I think there is a good chance of a healthy rebound in stock prices for 2019. My assessment is that the China trade issue is the key variable.

So, 2019 might be very positive, but could have another decline if China is not resolved. How should an investor position their portfolio? I think that if you are in retirement or within five years of starting retirement, you have to be a little more cautious than you were in the past two years. That probably means an extra 5% or so in cash or short-term bonds. Otherwise, I would not change your normal allocation. If you do hold some extra cash, you can always deploy it if the China issue has a positive resolution.

 

The Big Picture

When evaluating major issues and allocation decisions, I always like to look at the big picture of the market to make sure I am not on the wrong track. Below is a monthly chart of the S&P 500 from 2009 to the present.

No doubt you have heard grave predictions for both the economy and the stock market. The chart helps to bring those predictions into focus. Clearly stocks became overvalued in 2018 when they exceeded the top line of the rising channel. We have had serious corrections twice since 2009. In 2011 we had a 21.58% pullback and in 2016 we had a 15.21% pullback. In both cases, the uptrend resumed with large gains following. I am not certain that our current pullback will have the same results, but at this point, we are still in the uptrend from the great recession.