January 2019

Last year was a tough one for investors with stocks, bonds and commodities posting negative returns. One of the few places to hide was in short term debt instruments primarily, U.S. Treasury bills.

Cash was King despite a strong economy, low inflation, strong earnings, low unemployment and record corporate profit margins.

The last quarter of 2018 saw stocks nose-dive on trade fears, a fourth interest rate hike by the Fed and drooping confidence about future economic activity at home and abroad. U.S stocks lost $2.05 trillion in value in just one week during December, according to Wilshire Associates.

The S&P 500 closed down 4.4%, with dividends included. After its Oct. 3 peak selling began in earnest. Between Dec. 3 and Dec. 24 the index fell 16.2%. The Russell 2000 Index lost 11% for the year.

International markets were even worse; Japan -13.8%, China -12.4%, Emerging Markets -14.9%, and Total International Stocks -14.5%. U.S. Aggregate Bonds, AGG -0.50% and the 10+ year U.S. Government Bonds -5% did not provide much ballast as most fixed income funds and asset classes lost money. U.S. 10-year Treasury Notes began the year at 2.41% and ended at 2.65%. S&P 500 earnings 21% rose on a revenue gain of 9%.

Given lower corporate taxes, tame inflation, historically low interest rates fewer regulations, high consumer confidence and 1969 unemployment levels why has the stock market dropped 20% from its market peak?

Significant declines mostly occur with an imminent recession or negative outside event. Sometimes an exogenous shock causes a sudden drop. This occurred in 1987 with Portfolio Insurance, in 1989 when Sadaam Hussein invaded Kuwait and again in 1998 when Wall Street bailed out the Long-Term Capital Management. If a meaningful shock is coming we have yet to identify it. A 10% downdraft is common in Bull Markets but 20% declines define Bear markets.

No doubt the stock market rose for nearly 10 years from SPX -666.79 on Mar. 9, 2009 to its peak of 2940.91 on Oct. 3, 2018. This climb occurred on the back of the second longest

economic expansion in modern times. Major concerns now center around trade wars, rising short term rates and a change in the political power balance.

The Fed in 2018 has slowed its purchasing of mortgage backed and government bonds. So called Quantitative Easing has become Quantitative Tightening. The ECB will also begin a liquidity drain in 2019. This is an all out effort to "normalize" rates after a decade of Central Banks keeping them artificially low.

Perhaps this combination of events unnerved market participants who fear another 2008- 2009 type meltdown. Can markets stand on their own with little or no help from Central Banks?

While this correction was fast and furious we do not see a meltdown or liquidity event unfolding in 2019.

We have better regulated and highly capitalized banks plus a growing economy. Friday's employment numbers surprised markets with their strength and continued to show strength in hiring.

A market level of 2554 for the S&P 500 gives us a forward P/E ratio of 14.6x on this year's estimated earnings of $173.94 according to Fact Set. Using the inverse calculation of 173.94 /2554, one derives earnings yield of 6.8%. Both measures point to an inexpensive stock market compared to historic 5 and 10-year P/E averages. Future stock market returns with a 14x-15 x P/E range are 12.7%, with 15x-16x P/E stocks return an average of 7.1% according to an America Funds recent study.

During the fourth quarter, analysts lowered estimates for companies in the S&P 500. The Q4 bottom-up EPS estimate, an aggregation of the median EPS estimates of all the companies in the index, dropped by 3.8% to $40.93 from $42.56 during this period. Fact Set still estimates earnings growth will exceed 15% in Q4 2018.

Foreign economies have slowed in 2018. Export dependent countries like Germany, Japan and China have been hit by trade war fears even as negotiations carry on.

Some developed economies have very low interest rates indicating snail like growth and fear of deflation. Switzerland -0.25% and Japan -0.03% have negative interest rates for 10 year government bonds. Germany +0.22%, France +0.72%, Spain+1.50% and the U.K. +1.25% all have lower rates than the U.S. out to 10 years.

In China, the second biggest economy, projects a decade low GDP of +5.3%. Tariffs have begun to bite as the U.S. demands trade concessions and an end to intellectual property theft. These realities make for nervous investors.

If trade uncertainties get resolved, markets will likely rally. However, if the Mar. 1 deadline passes without an agreement an additional 25% tariffs will be placed on Chinese imports.

Capital expenditures in the U.S. were set to rise substantially in 2018 but trade concerns have caused managements to stall on spending plans.

All of these uncertainties lower confidence and P/E ratios. Some are concerned that the U.S. economic cycle may have peaked. The key question for investors is whether or not share prices have peaked as well, even though earnings look likely to go higher.

If trade talks succeed, lower tariffs could put global economies back on a faster growth footing. Gold was down about 2% last year in U.S. dollar terms but rallied 6% in December. The dollar is up 5% over the past year vs. a basket of currencies, and is still king of the currency road. Rivals like Bitcoin and other crypto currencies crashed and burned in 2018.

In sum, stocks do not appear expensive here or overseas. Oil prices are down sharply from their October peak and investor fear has gone way up. Earnings have not likely peaked but their growth rate will slow. Volatility has surged with both Investors Intelligence and the AAII sentiment surveys showing more Bears than Bulls, a contrary indicator.

If we see tangible results on trade talks and the Fed slows its 2019 planned rate hikes investors will breathe easier. Last week, Chairman Powell indicated that the Fed is now data dependent and flexible about future rate rises. If necessary, he stated the pace of Quantitative Tightening could be altered as well.

We certainly preferred the low volatility, high return market we enjoyed in 2017. Now that 2018 is behind us, we expect fundamentals will begin to override emotions.

Fundamentals are still good, tax selling has ended and hopes have improved concerning trade negotiations. Earnings reports will begin shortly along with forward looking comments from corporate managers.

Stock markets generally drop rapidly but recover slowly. We have taken some defensive measures given the aforementioned uncertainties. We are also taking advantage of higher returns on T Bills and other fixed income investments that weren't available one year ago.

Please remember that over long periods of time stock prices rise and reward patient investors.

We wish you all a happy, healthy and prosperous New Year!

Disclaimer: These stock market observations are confidential and proprietary. They are for informational purposes only and are not intended to be used, and may not be used, as investment, legal, accounting, tax, or other advice. No express or implied representation or warranty is being made with respect to their accuracy or completeness. No obligation exists to inform the recipient when the information herein is no longer current or accurate. These observations do not constitute an offer to sell or a solicitation of an offer to buy any securities or interests in any investment vehicles managed by CFA or an associated person or entity, or to provide investment advisory services.