Volatility defined 2018. The calm waters of 2017 were overtaken by waves of volatility, making it a stressful year for investors. The stock market had some highs in 2018 but could not sustain the momentum as investors struggled to navigate murky, uncharted waters. Stocks constantly wavered back and forth from excitement to gloom and doom, unable to find a clear path in either direction until the fourth quarter.
The S&P 500 started the year at a record pace and continued its momentum from 2017, but the euphoria quickly dissipated in February as the U.S. market had its first correction since 2015. Investors started to worry the economy would overheat due to huge tax cuts and force the central bank to raise interest rates faster than expected. Moreover, this correction had a secondary impact by shifting investor sentiment. Almost overnight, markets went from near euphoria to having seeds of doubt. This impacted markets and heighten volatility for the remainder of the year.
All attention quickly shifted to China and U.S. as the trade war began to take center stage. The rhetoric between the two countries intensified and tariffs began to escalate. The trade threat caused any excitement surrounding record earnings growth or above average GDP growth to be short-lived. Trade would become the elephant in the room as investors could not ignore the looming risk of a full-blown trade war. The tug of war continued all year long until the negative forces finally outweighed the positive ones.
December was a particularly painful month for stocks. Despite the strong holiday season, the S&P 500 was down 9%, making it the worst December since the Great Depression. At the end of the year, the S&P 500 was on the brink of a bear market (defined as -20%) as it was down over 19.8% from its prior peak in September. It did not satisfy the technical definition of a bear market, but it sure felt like one.
At the end of the year, we had to ask ourselves an important question. Did the fundamentals alone drive the markets down or was it something else?
Fundamentals were partly responsible for the drawdown, but not the main culprit. Domestic corporate earnings were strong, unemployment rate was below average, and inflation was contained, but global economic data did weaken. Much of this global slowdown can be attributed to tightening financial conditions and the uncertainty surrounding global trade as companies decided to pause on growth until there is some clarity. Currently, we do not see a recession risk in the short-term – there are no visible excesses in the economy (i.e. housing, credit) or systematic financial issues to cause a major collapse, but things can change quickly for better or worse.
We acknowledge there was some deterioration of fundamentals, but the magnitude of the sell-off was overdone. The market selling was exacerbated by computer driven models (algorithmic trades), momentum trades, and negative sentiment around risk assets. Yes, there are pockets of weakness and things are not as rosy as it was last year, but the underpinnings of the economy remain supportive for now.
As we enter 2019, it is likely volatility will persist. As volatility continues, it will create opportunities for patient, long-term investors. This is not the time to make drastic moves, but a time to be disciplined and consistent with our investment approach. At the end of the year, we were able to take advantage of the falling markets in many client accounts by selling bonds that maintained their value to buy stocks that sold off. The volatility also allowed us to tax loss harvest throughout the year. We will continue to look for these types of opportunities in the year to come.
To conclude, we will leave you with a quote from Warren Buffett reminding investors what it takes to sustain wealth during volatile times like we are in today. “During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively financed American businesses will almost certainly do well.”
As always, please do not hesitate to reach out with any questions.
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