December 2018

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Similar to an athletic competition in which a lead is squandered in the final quarter, the past year’s stock market was noteworthy for posting the worst monthly performance in December since 1931.  Twice during 2018, the stock market climbed to low double digit returns only to relinquish those gains in sharp corrections characterized by surges in volatility.  In the 11% market decline of February 2018, we felt economic fundamentals remained intact and that the market correction reflected structural imbalances that, once resolved, would no longer impede the market’s advance.  We were vindicated by the stock market’s quick recovery.

The S&P 500 posted its first negative annual return since 2008 after peaking in late September 2018 when several negative catalysts prompted the S&P 500 to retreat to levels last seen in Q2 2017.  Those catalysts include a more hawkish posture by the Federal Reserve; ongoing trade tensions, particularly with the Chinese; weakening economic growth in parts of Europe and emerging markets; collapse in crude oil prices; Brexit negotiations in the UK; faltering housing starts data in the US; and concerns over the state of China’s economy.  Of these, we believe the most significant remain trade uncertainty and the relative contribution of China’s economic activity to global growth.  The markets weathered similar concerns during the late 2015 – early 2016 period in which the S&P 500 suffered a near 15% correction and oil prices fell nearly 60%.  At the time, we argued that the US economy was continuing to improve, and we advocated remaining invested.

There are myriad interpretations of the current correction, including the end to a long running bull market and an imminent recession.  We are not yet prepared to accept either conclusion.  Instead, we believe that heightened market volatility is primarily a reflection of geo-political uncertainty, as opposed to economic uncertainty.  Further, we expect resolutions to several uncertainties during the First Quarter 2019.  First, we are encouraged by recent news of constructive progress on trade negotiations with China prior to the end of the truce on March 1.  Second, the Fed has retreated somewhat from the aggressive posture toward future monetary policy announced in October 2018.  The bond market, in fact, is highly skeptical that the Fed will raise rates further, notwithstanding commentary from Fed officials.  The market has begun to price in a higher probability for a rate cut in late 2019.  Third, for better or for worse, investors will understand by March the future relationship of the UK to the European Union.  Finally, the Mueller investigation is expected to conclude with delivery of its report to Congress in mid-February.

We acknowledge that resolution of several lingering uncertainties could prove highly unfavorable.  However, some resolutions could also serve as positive catalysts for market advances.  The volatility of the markets reflects, in part, positioning by investors ahead of these outcomes as they react to shifting probabilities.  Volatility also reflects the impact of computer-driven trading strategies that seek to capitalize on short-term market gyrations.  By way of contrast, our focus is long term and based on understanding economic fundamentals.  In that regard, we believe market behavior and the economy have become disconnected.  This seems to be the result of a divergence between Wall Street and Main Street.  Low unemployment and rising wages have buoyed spending among lower and middle income households.  Retail sales and consumer confidence data support this contention.  This is a welcome development as much of the recovery since the Great Financial Crisis excluded these cohorts.  On the other hand, confidence among high income households and those who depend on continued gains in financial markets has declined as volatility has spiked.

Market volatility will likely characterize the First Quarter of 2019, and we are concerned that volatility could have a negative “spill-over” effect into a loss of business and consumer confidence.  As support, however, valuations for equities have retreated to levels that are more attractive.  We would also note that insider buying has increased recently.  As of this writing, it is our view that generally solid fundamentals in the US economy support higher equity values.  We acknowledge that geo-political uncertainties, as they persist, could temper our view significantly.  We look forward to discussing our outlook in detail at the Tenth Annual Symposium on Thursday, February 28, 2019.  Please save the date.  We hope that you can join us.