The New Year is supposed to be a fresh start. We get to begin all over again with energetic resolutions and stalwart promises, putting last year’s disappointments behind us. Investors are all for leaving behind 2018, which was a particularly rough year. Most asset classes turned in negative performance while volatility punctuated the year at dizzying levels. Will markets turn over a new leaf in 2019? Or will we see more market angst?
Markets aren’t predictable – at best they hint at trends or tendencies with varying probabilities unfolding. Investment management is the art of protecting against the worst of these tendencies while seeking opportunities in the best. At StrategicPoint we study the economic fundamentals, technical analysis, valuations, sentiment and other factors to help formulate our strategy. Above all else, we look to where we are in the business cycle, as that can help determine whether volatility signals a longer term bear market or a shorter term correction in the midst of a continuing bull market.
Sometimes it pays to become more defensive early. At other times riding out volatility with a more aggressive portfolio will be the better choice. A third choice, and the one we are following this year, is to tweak around the edges of our portfolios until we have a better sense of where the markets and economy are headed in the coming year.
2018 was an exceptionally strong year for the economy (blockbuster earnings – thanks in part due to the tax cuts, low unemployment, continuing accommodative monetary policy, modest inflation, strong spending patterns and positive sentiment on the part of consumers and businesses alike.) It wasn’t a typical year for a major sell off. That may bode well for a more permanent rally if the next recession can be held off.
That said, there are concerns that could bring forward a downturn in the economy. Chief among them are: an ongoing and escalating trade war with China; US monetary policy that raises interest rates and tightens too fast; and continuation of the global slowdown, potentially magnified by Brexit in Europe and China’s internal fiscal policies. It is unlikely that we will develop firm convictions (positive or negative) of any of these potential pitfalls until after the first quarter.
Company earnings, too, may be a huge factor in 2019. As the immediate effects of the Tax Cuts and Jobs Act fade, year over year earnings comparisons could fall. The issue is how far they will retreat. Traditionally the most pessimistic earnings outlook comes right before the next quarter earnings report (end of March for Q1 earnings). When actual earnings come in, they traditionally surprise to the upside. If this pattern continues this quarter, then markets, which appear oversold even if still overvalued, could rally. Unfortunately, we won’t know if 2019 earnings will have rolled over or stayed buoyant on an after-tax-cuts basis until April of next year.
With the rise of computerized, algorithmic trading and passive investing, there are fewer active investors to step in when the markets tank or rally (JP Morgan Asset Management). With computerized trading, momentum often replaces analysis. Momentum strategies can cause markets to overshoot to both the downside and the upside when the remaining active investors step aside to let the bear run or ride a raging bull. Most recently, active investors appear to be on the sidelines watching the markets rather than leading them.
Those who follow technical analysis also look for tipping points to signal a bottom of any market collapse. Capitulation is one of those tipping points. Capitulation translates as “panic”. Analysts look for a sign that investors have exhausted their selling capacity. At that point those who are likely to be spooked into dumping their holdings are already out of the markets. What is left are buyers who can scoop up positions at relatively inexpensive prices. Currently, according to Ned Davis Research (NDR), market sentiment is falling, but it hasn’t turned pessimistic yet. NDR believes that we have not seen capitulation and volatility will likely remain until the bottom is technically reached.
Valuations also play a role in determining when a market is oversold and when an attractive entry point has been reached. Despite the dramatic increase in company earnings this year, valuations are still relatively high from historical standards, although not excessively, according to Ned Davis Research and BCA Research. Stocks might have fallen more this past year if it weren’t for companies spending their tax cut revenue to buy back their shares. And interest rate increases are still working their way through the system. Rising interest rates can take away from the attractiveness of stocks as returns from bonds increase. On the other hand, some of the best returns are made in the late stages of the business cycle (see below), valuations aside. Investors need to be in the market to benefit from a late stage rally. Which brings us to the overriding question of where we are in the business cycle.
Business cycles are reoccurring fluctuations that bring the economy from being above trend growth to below trend growth and back again. Recessions occur when low trend growth turns negative – unsettling employment, income, spending, investment and the like. The fluctuations themselves can be caused by internal factors (primarily consumer and business decisions) and external factors (government involvement and natural forces) and follow patterns that broadly tend to repeat themselves over time.
Arguably, the Federal Reserve has the greatest influence on business cycles. Its mandates are to control/tamp down inflation especially at a peak in the business cycle, and to stimulate employment during business cycle troughs. Currently analysts disagree over whether the Federal Reserve is moving too fast in raising rates, which could tilt the US into an early recession, or too slowly, which could prevent us from being able to effectively manage the next downturn.
At the same time, Congress and the President have stimulated growth through tax cuts and increased spending. These actions were designed to propel growth forward and keep the economy out of a recession as long as possible, and especially until after the next election. However, there is debate as to whether the stimulus will fade and require more actions by Congress and the President in 2020 to try to keep a recession at bay. If new stimulus gets bogged down in Washington, postponing a recession could become less likely.
So where does that leave us for 2019? For at least another quarter, we believe the equity markets – both in the US and overseas – could remain quite volatile as traders struggle with the uncertainties outlined above.
Beyond that point, there could be greater clarity on several of the outstanding issues and concerns. If it is deemed that a recession is not an immediate threat, the markets could experience a significant rally, characteristic of the late business cycle. If substantial uncertainty remains on a number of fronts, and there are increasing calls for an imminent recession, the outlook for the markets could be much less sanguine.
Our current belief is that a recession will be postponed until sometime in 2020 and that we are experiencing a bear market within a longer term bull market. That means we do expect the markets to rebound later this year and are holding adequate equities to benefit from this bounce. At the same time, we are making a few, select changes in certain portfolio models to hedge against the case that we are wrong.
So enjoy 2019. But we can’t wish the markets a Happy New Year just yet.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.