4th Qtr Portfolio & Market Observations 2018

The year 2018 was a strange year in market history. Although the indexes all made new highs during the year they ended with the worst December performance since 1930. After nine years of investors making above average returns, they were shocked into the reality that the market doesn’t go straight up.

There will always be issues that investors have to worry about, but they tend to extrapolate the problem while keeping the solutions constant. We have weathered larger geopolitical issues in the past and while government policies can affect the economy, they cannot destroy it or make it any better than its underlying potential. The U.S. economy may not be a perfect system but it is the most successful economy in history.

After two years of steady growth, the U.S. equity markets gave way to volatility in 2018. September 2018 not only marked the 10th anniversary of the collapse of Lehman Brothers, but also served as a turning point in the current market cycle, as demonstrated by a historic collapse in the fourth quarter. The S&P 500 Index reversed its 10% year-to-date gain as of September 30, 2018 into a 4.4% loss by the year end, marking its worst calendar year since the financial crisis in 2008-09 and the most painful December on record. All the major market indexes posted double-digit losses for the last quarter, led by small and mid-capitalization stock benchmarks, despite the biggest ever single-day gains for the Dow Jones Industrial Average and the S&P 500 on December 26th . This decline spread throughout almost every sector of our domestic economy, leaving only the most defensive health care and utilities sectors with single-digit gains.

The global markets, as measured by the MSCI EAFE Index, have fallen 13% in 2018, as the gains of the first nine months of the year were erased and the index moved into negative territory in the final quarter.

The fixed income market’s performance through 2018 was largely a story of strengthening economic growth and rising interest rates. Wage inflation and a seemingly more hawkish Federal Reserve Chairman all contributed to persistent upward pressure on yields, and the significant 3% level on the 10-year Treasury bond was broken in September.  It remained at about that level until early December when risk aversion returned. As a result, the U.S. Aggregate Bond Index ended the year on the same level it started.

Despite the recent turmoil in financial markets, significant sectors of the U.S. economy remained healthy. After deleveraging in the wake of the 2008 financial crisis, household balance sheets remained robust, and savings rates continued to be high. Consumption, which makes up a sizable portion of U.S. GDP, continued to be supported by tight labor markets, lower energy prices and the recent tax cuts.

The U.S. economy grew at a strong 3.5% annual growth rate in the third quarter. While dipping from the previously recorded 4.2 %, our GDP growth had its best back-to-back quarters in four years, thanks to free spending by consumers and the federal government. On the other hand, home sales and housing starts were down and median home prices moved lower. The ISM Manufacturing Index fell in November, albeit to levels still well above the midpoint of 50, which separates economic expansion from contraction. Job creation ended 2018 on a powerful note with nonfarm payroll surging by over 300,000 in December. In addition to job gains, wages jumped over 3% from a year ago, posting the best gain since April 2009. The far bigger than expected jump in nonfarm payroll eased the market’s fears of an impending recession and indicated that our domestic economy still has considerable forward momentum.

As the U.S. economic data offered mixed signals, the tone of the Federal Reserve’s rhetoric became more dovish. Despite the fact that in October Jerome Powell said that the Fed was “a long way off” from the neutral policy rate, his more recent comments reflected some deviation from the aggressive path of the last few months. The Fed’s goal now is to engineer a “soft landing” with acceptable levels of GDP growth, inflation and unemployment levels.

So, what should we expect in 2019? We believe politics and policy out of Washington will continue to weigh on the markets, much like they did in 2018. Investigations and manufactured crises are likely to contribute to uncertainty. Trade tensions persist, though on a more positive note, relations between the U.S. and China seem to be improving. A commitment to keep negotiating would likely delay the March 1st increase of tariffs to 25% on $200 billion of Chinese goods. The Trump administration’s concerns regarding China’s industrial policy still stand, but the President, who is sensitive to financial markets and economic concerns over the trade tensions, may be more inclined to take a smaller deal in the name of a political victory.

The stock market entered bear market territory in December. The decline from the recent peaks to the lows recorded on December 24th and 26th has been sharp and steep, exceeding a drop of 20%. However, since Christmas, the market has turned around in a V-shaped recovery as risks from the Federal Reserve, China, and the White House have diminished.

Market sentiment is a fragile emotion that can turn on a dime, as the last quarter of 2018 has shown. The market is in a recovery stage, but that still doesn’t suggest an end to amplified volatility. At the same time, the big picture is favorable enough for stocks to be a more attractive financial investment during 2019 in our opinion.

Dumont & Blake Investment Advisors, LLC
December 31, 2018


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