What's Going on in the Markets: December 22, 2018

Paraphrasing a popular novelty Christmas song by Elmo and Patsy ... "Santa got run over by a rein-bear, walking out to Wall Street on Christmas Eve..."

Unless you've been on an island somewhere and blissfully disconnected, you probably already know that the stock market had one of its worst weeks since 2011. The S&P 500 index lost about 7% in one week, while the NASDAQ and Russell 2000 indexes lost over 8%. With the exception of bear market funds, government treasury bonds and cash, there was virtually nowhere to hide. It's the worst December to date since 1931.

The proximate "cause" of the market angina this week was the federal reserve's (the "fed") 1/4 point rate hike amid signs of growth slowing around the world. While odds heavily favored the well telegraphed December rate hike, it's puzzling why Wall Street traders often act surprised when it actually happens. Perhaps it was the fed chairman's steadfast insistence on two more possible rate hikes next year, and continued monetary tightening via $50B of bond sales per month.

Before the actual announcement at 2 PM ET on Wednesday, we could almost see glimmers of Santa's sleigh in the distance, as the market was starting to finally bounce after several days of selling pressure. Alas, that sleigh did a prompt U-turn as Federal Reserve Chairman Jerome Powell struck a hawkish tone during his press conference following the rate hike announcement. Powell may turn out to be the Grinch who stole the 2018 Santa Claus rally.

Raising interest rates is the fed's way of preventing an economy from overheating and leading to high inflation. Higher interest rates tend to slow the rate of corporate/company hiring and purchasing of capital goods and equipment. But many corporate executives were already complaining about trade wars, the political rancor in Washington, and of course, the end of lower interest rates.

In reality, the economy is showing some signs of growth slowing, but not contracting (i.e., negative growth). It's contraction in the economy that translates to a recession, something that the weight of evidence still points to no recession on the horizon. Of course, that could change at any time.

Regardless of the cause, the market has been on a great run (bull market) since March 2009, more than quadrupling since the 2009 bottom. With the average bull market usually lasting about 4-5 years, this one certainly deserves some rest in the form of a healthy pullback. Unfortunately, it always feels bad when it happens, no matter how prepared we are.

There are negatives and positives in our economy to push/pull on the markets:

Negatives:

1. The S&P 500 Price to Earnings ratio (P/E), a measure of stock valuation, was at a historically overvalued extreme earlier this year, which warranted caution. While overvaluation alone does not end a bull market, it does dramatically increase the downside risk in stocks. The recent market pullback has caused P/E valuations to come down, but at 19.9 they remain above the long-term average. At this juncture, it's too early to say if valuations will continue to subside as prices move lower, or if a drop off in earnings will keep them at high levels.
2.  Housing prices had/have risen too high, and these elevated prices were/are going to be incredibly hard to maintain if interest rates continue to increase. It’s too early to officially declare that U.S. housing is, or was, in a bubble. However, real estate is starting to unwind both in terms of prices and activity – with some of the highest-growth areas feeling the most pain. Housing is incredibly important to the health of the U.S. economy. If housing metrics continue to decline, this will have negative implications for the economy and the markets.
3. In the past, the combination of a declining growth outlook and a rising rate environment (called tightening) has generally had dire consequences. Out of the past 11 tightening cycles, nine have resulted in a recession, while only two led to an economic soft landing. Based on history, the current investment landscape is tilted towards a negative risk/return relationship as stock prices remain susceptible to future downward pressure.

Positives:

1. Consumer Confidence has rarely been more ebullient, with recent Conference Board survey results at the most positive level in 18 years. Although this indicator is
   considered to be leading, and usually rolls over before a recession, it’s interesting to note that past stock market peaks have frequently coincided with excessive levels of consumer optimism. Consumer confidence is essential to economic health, because a confident consumer isn't afraid to spend or invest in new ventures to keep the economy growing.
2. The Institute for Supply Management (ISM), which conducts surveys of business activity,  has also been persistently strong this year, and remains near the highest levels of this 9-year expansion. The Business Activity Index for the Service Sector, which accounts for about two-thirds of the U.S. economy, is back at the highest level since 2004. In manufacturing, the ISM Purchasing Managers Index is also hovering near its post-recession highs. Neither of these indexes are currently showing any signs of distress or hints of an impending recession. Whether the current steady outlook will continue to support this economy in the coming months is a critical question for 2019.
3. Jobless claims and the unemployment rate are both low by historical standards. Monthly job creation is strong, limited only by the number of available qualified candidates for many jobs. If there's one item that pressures the fed to raise interest rates the most, it's wage inflation, which we are starting to see as the demand for workers outstrips supply.
4.  The fed's steadfast insistence on raising interest rates, in the face of clear evidence that growth is slowing, is perhaps a sign that they see this as a temporary economic condition that can withstand further rate hikes. Why would the Federal Reserve still be tightening (with the 9th rate hike of this economic cycle made this week) if there could be major trouble on the horizon?
5. Signs of cooperation are emerging between the U.S. and China to end the trade wars and end the tit-for-tat tariff jabs. Both countries' markets would celebrate at least some resolution to this tiff.

Now What?

So what's one to do now that the market has taken a big tumble from new highs reached just this past September? The decline has been swift, brutal and almost immune to bounce attempts. In an algorithmic driven and high-speed trading market, risk happens faster than any time before. If you haven't lightened up on your holdings yet, it's probably too late to sell, but consider taking some chips off the table if Santa does come to call on Wall Street and rally after all. After more than a 9 year bull run, it's prudent to not give all your profits back and wait for the next bull market to get back to even. This is not investment advice, as I don't know your financial goals, your time-frame or your risk tolerance. But please feel free contact us to see if we can help you.

For our clients, we came into the market sell-off with lots of cash and hedges in the form of inverse funds and options. We have continued to add to our hedges as this market attempts to find a bottom, while also nibbling on some new positions that we expect to hold for the long term. So far, we have not been profitable on those nibbles, but we aren't buying them for the next week or next month. Buying a little at a time on the way down is the way it should be done for long term investors. Remember the old stock market saying: buy low, sell high.

What's Next?

My crystal ball continues to be in the shop, so it's tough to say what comes next. We are severely oversold, so a wicked and lasting bounce/rally could arrive at any moment. But while investor sentiment is awful, which is usually a contrary indicator to support the start of a market rally, so far there has been no price action evidence to support one.

Many hedge funds have had abysmal performance this year, and are forced to return billions of dollars to clients this quarter.  They are either closing and/or answering to client redemption requests that have to be met by year-end, so that could continue to pressure the market if their activities aren't done yet.

A lot of technical damage has been done to the markets, so I don't expect the next rally to be the one to ramp to new highs. Far from it.  Don't be the proverbial mouse to rush into the first market rally trap. Patience is essential--be the second mouse to actually grab the cheese. Any durable rally will last for weeks, if not months, you won't miss out.

Unless the next rally shows signs of a longer term durable bottom, I may be using any strength during the coming weeks to further lighten up positions and add more hedges in anticipation of a sub-par 1st quarter earnings season, and as all the people who didn't want to sell for tax reasons in 2018, decide to dump their shares in January.

That said, I'm starting to see some small signs of the potential emergence of a new bull market, sometime after the 1st or 2nd quarter of 2019. Any one spark could ignite this market to the upside (e.g., China trade agreement, signs of an interest rate pause, government shutdown resolved). So I wouldn't be cashing out of this market given that you could miss the big rebound that could start at any time. This is all speculation on my part, one that you shouldn't rely on for your own investment decisions. My outlook could be wrong, changes often, and could be different, even before the Christmas tree comes down.

Markets Got you Down?

If you're scared or stressed about the markets, here's some advice from Jim O'Shaughnessy, author of several books on investing, including the best seller, What Works on Wall Street:

"Take a deep breath, sit down, and write down how you feel about what is happening in the market. Be free-form, and be honest. If you feel a pit in your stomach, write about it. If you feel jittery, write about it. If you think this is the next financial crisis, write about it. If you feel like selling out and going to cash, note that too. Write about every worry, frustration and uncertainty you are currently experiencing. Then date it, and put it away.

Chances are very good that when you read it again 12-18 months from now, you'll be shocked you felt this way. Your brain will do somersaults to try to convince you that you *really* didn't feel everything you wrote, because things will have calmed down.

Corrections and bear markets are a feature, not a bug of the stock market. Without them, there would be no equity risk premium. Look back at EVERY OTHER market decline and remember, people were feeling like that was the end too. It wasn't then, it isn't now. This is actually a healthy, if painful in the short-term, action. Most important, remember, this too shall pass."

I couldn't have said it better myself. And as I often quote, Peter Lynch, legendary manager of the Fidelity Magellan fund said that "The stock market is a great place to make money, as long as you don't get scared out of them."

I'd like to take this opportunity to wish you very happy holidays and a grand New Year. I appreciate my readers very much.

"You can say there's no such thing as Santa, but as for me and the bulls, we believe."

Merry Christmas!

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.