There’s something about another trip around the sun that makes us want to calibrate. The calendar turns and we all get busy measuring our body weight, exercise frequency, and portfolio performance. But calendar months are arbitrary. Taking stock of things during January is really no different than doing it in February… …except for this year. The Market December was the worst month for the S&P 500 in 10 years. From the December 3rd open through Christmas Eve, the index lost over 16%! Fortunately we rebounded the next week to close the month down only 10%, narrowly missing becoming the third-worst month of all time (behind only the crash of October 1987 and the financial crisis of October 2008, a dubious list). After years of the market grinding slowly higher we were reminded that it can and will go down. For the third quarter the market fell -13.58%, at one point brushing up against the ‘bear market’ threshold of -20%. As I stated in my 3rd quarter review: The market will react. No one is ever sure exactly when, but it will. Interest rates rising this much in a short time is rare, and will eventually have an impact, as people begin to trade their stocks for (now) higher-yielding bonds, and borrowing gets more expensive. Here’s a glimpse at just how bad the 4th quarter was compared to the rest of the year:
For the first time since 2008, the S&P fell for the year (-4.38% total return). Stepping out of the US and looking globally, it’s clear the damage was not limited to the US. In fact, we were the nicest house on an ugly block:
How bad was it overseas?
That’s a lot of red! For the past year-and-a-half, we’ve also seen a steady rise in long-term interest rates,…until December. As seen in the chart below, the channel starting in Sept 2017 through Nov 2018 was pretty clear and consistent…until November, when long-term yields started falling quickly:
This abrupt change was clear in the mortgage market as well:
The economy remains on solid ground, going on a decade of positive GDP growth:
Along with the continued generational low in unemployment…
…. the Federal Reserve will likely continue on their path of raising short-term rates we described in the Q3 summary:
With long-term rates now falling, and short-term continuing to rise, we saw our first yield curve inversion in Q4…
The above graph shows the difference between the 5 year and 2 year treasury yields. In a ‘normal’ market, interest rates are higher with a longer term, i.e. – you get paid more to tie up your money longer. We say the yield curve gets flatter and ‘inverts’ when the longer-term bond yields drop below shorter-term. As you can see above, it’s been a steady tightening between the 5-year and 2-year until December, when the 5-year yield officially dropped below that of the 2-year. Yield curve inversions are seen by many as a harbinger of recession. When longer-term rates get cheap, the narrative says that the bond market sees little growth potential in the future, so they are willing to trade into short-term rates to wait it out. Historically, inversions aren’t a positive trend, and are definitely seen as a late cycle occurrence, but are they predictive? We’re not here to make predictions, but you be the judge:
The above shows that same 5-year minus the 2-year yield going back 40 years. The green arrows indicate previous inversions, while the gray bars show recessions. If you had to guess, would you say a recession is coming? Changing gears away from the market for just a second, I wanted to focus on one very notable achievement from Q4. The United States passed Russia and Saudi Arabia to become the largest oil producer in the world! To put this in perspective, here’s a chart of the last 20 years of crude production, and you can see the explosive growth of the last decade:
That growth is due to fracking and other technological advancements that have made it easier and cheaper for us to produce oil. It’s impossible to speculate in this space what the future ramifications will be on foreign policy, energy markets, etc, but it’s safe to say this is a game-changing achievement (fun fact: if Texas were a country, it would be the #3 producer in the world). The Portfolios We saw above that long-term rates did an about-face in Q4, so did commodities:
And real estate:
We know the Fed is likely to continue to raise short-term rates in 2019, and most asset classes have broken their long-term trends to the downside. This is a market in transition. Using the trends above, we entered 2019 with minimal exposure to commodities, real estate, and lightened up on stock market exposure across the board. Cash was the best performing asset in 2018 – that’s right, if you had just put money under the mattress you probably did better than owning most assets. Here’s a look at one of our favorite charts, the ‘periodic table’ of market returns. This ranks the returns of assets each year, and is a good visual reminder at how silly it is to try to predict from year to year. Note the top right box, showing ‘cash’ as the winner for 2018:
Will that continue into 2019? If you’re just using color as your guide and nothing else, it’s clear that predicting the future is fruitless. What Does it Mean For You? Now that market volatility is back, what do we do as investors? If you need the money soon,…well you shouldn’t really be holding that much in stocks anyway. Get out. If you’re a long-term investor,…you take this opportunity to rebalance, use trends to help reduce risk, maybe harvest some tax losses, and thank the stars you get to buy things on sale! What you should definitely not do is panic. Markets go up and down, this is a normal part of investing. The market has told us to be cautious in the short-term but the economy is on sound footing. A recession will happen at some point, but it’s not imminent. This is an excellent time to revisit your downside tolerance; no stock is worth losing sleep! Part of a long-term investment plan is understanding that sell-offs will happen and should be baked into your overall return expectations. If you have a long-term plan in place, you can trust that market goes up and to the right over time.
Innovate Wealth aims to educate, inform, and provide perspective. We will not bombard your inbox with fluff. If you want to see more content like this, subscribe to our blog and follow us on social media!
All written content on this site is for information purposes only. Opinions are solely those of Innovate Wealth unless otherwise specified. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.