Q4 2018 Market Commentary: You’re A Mean One, Mr. Grinch


December 21, 2018

Written by Nathan Erickson, CFA®, CAIA, Managing Partner and Chief Investment Officer

To view and download a PDF of this commentary, click here.

Unfortunately for investors, December has not delivered the Santa Claus rally in markets that many hoped for. In fact, it’s been a bit of a roller-coaster ride in markets all year. The S&P 500 started the year up nearly 8% in January, only to give up all that return in February and move into negative territory. By the end of the first quarter, the S&P 500 was down just shy of 1%, with emerging market equities the lone bright spot in traditional asset classes:

The second and third quarters were much better for U.S. large cap equities, and while it is difficult to know for certain what drove markets higher, a second quarter GDP print of 4.2% and a third quarter print of 3.5% may have contributed to overall optimism in the U.S. Those GDP numbers were much higher than 2017 numbers, but likely the result of the stimulative tax bill passed in December 2017. By the end of the third quarter, traditional asset classes had diverged materially:

The peak of the U.S. market in 2018 occurred on September 21st, and through the market close on Thursday December 20th, the S&P 500 has fallen 15.4%. On a year-to-date basis through Thursday, the market is down 5.9%. If the S&P 500 finishes the year negative, it will be the first negative return since 2008 (on a total return basis). While a loss of 6% is never desired, it is a mild loss in comparison to history, and some might say a long overdue negative year.

Investors who pay close attention to markets may feel much worse. They likely feel a loss of 15%, and not 6%, because of the volatility in December alone. It doesn’t help that the financial media continue to highlight that the market is on track for its worst December since the Great Depression. This sounds similar to January of 2016, when the financial media were reporting the first ten days of the year as the worst start for a calendar year in market history. That year, the S&P 500 finished up 12%.  Sometimes headlines are just headlines, and they should largely be ignored.

Again, while we don’t know for certain why there has been volatility in December, there may be several contributing factors. Many economists believe the effects of the tax bill will be short lived, and that GDP numbers will return to under 3% in 2019. The Federal Reserve Board continues to raise rates, which is a response to a healthy economy, but inevitably increases borrowing costs and can slow the economy going forward. The current administration continues to engage in trade disputes with many foreign countries, and while tariffs have been mild to date, the threat of tariffs continues to loom over markets. Finally, ongoing political unrest, whether due to a potential government shutdown or turnover in the cabinet, fuels uncertainty which always drives volatility higher.

2018 results are likely to be disappointing, but a case can be made that 2018’s returns were stolen by 2017. Traditional markets were all much higher than average in 2017.

As we have said in the past, markets price on expectations. 2017 was the start of a new administration in the U.S., with Republican control in the White House and Congress. Optimism was extremely high, and markets responded to business-friendly and economy-friendly policies that were being discussed. While 2018 will likely be a disappointment, perhaps we should blame the Grinch of 2017 for stealing 2018’s returns. Indeed, if investors are willing to take a slightly longer-term view, two-year annualized returns in markets aren’t alarming:

In fact, three-year annualized returns look mostly normal:

In moments like this, it is helpful to remember that there are many forces working against a disciplined investment approach. The financial media inundate investors with information on a daily basis, and it rarely takes a long-term view. Behavioral economics has identified traits like loss aversion, which is the idea that investors feel losses twice as strongly as they feel gains. Investors who own diversified portfolios always have something that isn’t performing well, which can dampen the emotional benefit of a portfolio that is meeting long-term objectives. While 2018 has been a challenging year, investors must be careful not to react in the short term and derail the long term. The best investment plans and portfolios are designed to endure challenging markets, not avoid them. No one enjoys the risk required to earn a return, but risk is necessary to meet long-term objectives, and more tolerable if viewed over longer periods of time than shorter ones.

Written By

Mark Feldman

Nathan Erickson