For lack of a better analogy, 2018 was a roller coaster of a year. Economic data was generally strong, yet concerns over rising interest rates, a slowing ‘rate’ of economic growth and trade with China have derailed the general optimism that had been with the market over the past two years. We believe investor confidence was fueled by pro-business and pro-consumer policy, such as de-regulation and tax cuts, and a broad recovery of the global industrial economy. Further complicating matters, the Federal Reserve has changed its rhetoric on monetary policy strategy multiple times. In response, the markets have become significantly more volatile and this volatility is expected to remain.
As we stated in our last communication, we believe we are entering a key inflection point in the U.S. as the Fed continues on the path of tightening monetary policy and we seem to be inching closer to a recession. We know that it is impossible to predict how the market will react to the steady flow of headline news throughout 2019, however, we believe that historical data provides the perspective and context to not overreact to the volatility.
Market Volatility in 2018 With a Historical Perspective
In 2018, the market eventually caught up to the Fed’s restrictive policy and began looking for signs that the ongoing 10-year domestic economic recovery was coming towards an end. Concerns over inflation and rising interest rates first spooked the market in late January, when the S&P 500 index fell roughly 10% over a two-week period. While the market recovered for most of the year, volatility persisted and picked up during the fourth quarter, leading to substantial declines. Concerns over a trade war with China, slowing global growth and constant turmoil in Washington D.C. added to the daily restlessness of the markets. Equity assets globally ended lower for the year, with international equities leading the declines. Fixed income assets in general outperformed most asset classes in 2018, while generating only modestly positive returns *.
Daily Market Volatility Returns in 2018
To provide some perspective around market volatility, we calculated the daily price movement of the S&P 500 index over the past 11 years. In the table below, we identify the number of days in which the price of the index had a positive or negative daily movement of 2% or more. There were 37 such moves in 2018, compared to zero in 2017 and an average of 86 per year from 2008-2011.
Following six years of an extremely calm market environment, the return of volatility in 2018 was unsettling for many investors. While we expect market volatility to continue for the foreseeable future, we want to remind you that the current level is certainly not unusual.
Annual Market Volatility
The following study compares intra-year market volatility and annual returns of the S&P 1500 index dating back to 1995 (the S&P 1500 index is a broad U.S. stock market index). In the chart below, we plotted the largest gain and decline of the index at any point during the year as well as the final performance of the index for each year. For example, in 2018, the largest intra-year gain was 14% and the largest intra-year decline was 20%, while the index lost 6.8% for the full year. Out of the last 24 years the S&P 1500 index finished the year higher 17 times (or 70% of the time), yet the largest annual declines averaged 11% during those positive years. Furthermore, the average of the largest intra-year declines for every year in this study is 15%.
Source: Bloomberg: S&P 1500 historical prices. Grey=largest gain/decline. Green=positive year; Red=negative year
While this is a small sample size and every year has its own unique circumstances, we attempt to illustrate that market volatility is not unusual when it comes to investing. Additionally, looking at the variability of annual returns alongside the variability of intra-year price movements; helps emphasize the extreme difficulty of actively timing the markets. As you know, we remain steadfast in our belief that the most important action to take during heightened periods of volatility is staying invested and committed to your long-term strategic asset allocation plan.
Expected Portfolio Return Volatility Narrows over Time
Expanding on the previous studies, we wanted to illustrate the benefits of committing to a long-term strategy as well as introduce the impact of portfolio diversification. In the first chart below, we look at the projected variability of S&P 500 index returns over time. The starting point for this study utilizes a 10-15 year forward-looking expected return projection of 5.25% for the large cap U.S. equity asset class. When applying a normal probability model to this asset class, based on expected standard deviation (measure of volatility), you can see the drastic reduction in expected return volatility when holding periods are increased to 3, 5 and 10 years relative to simply a 1 year holding period.
Based on this study, in any given year the expected return of the S&P 500 index ranges from down 15% to up 31%. When holding this index for 5 years, the projected variability of returns over that period narrow to down 5% to up 15%. After 10 years, the expected return probabilities further narrow around the projected long-term average.
Source: Mornigstar Direct: S&P 500 10-15 yr forward return & standard deviation. Log-Normal Distribution model
Benefits of Portfolio Diversification
Expanding on the previous chart, we include a more diversified portfolio to the study. The diversified portfolio in this case represents a 60% weighting to stock (S&P 500 index) and a 40% weighting to fixed income (Bloomberg Barclays Bond index). As you might expect the addition of a more conservative and uncorrelated asset to the stock portfolio, results in an overall reduction of expected volatility.
Based on this study, in any given year the expected return of the diversified portfolio ranges from down 7% (vs 15%) to up 19% (vs 31%). When holding this index for 5 years, the projected variability of returns over that period reduces to down 0.67% (vs 5%) to up 10.5% (vs 15%).
Source: Mornigstar Direct: S&P 500 (red) & Bloomberg Barclays Agg Bond index (blue) 10-15yr forward return & standard deviation
Portfolio diversification remains a core concept within our overall investment philosophy. As a reminder, the overall goal of diversification is to achieve lower portfolio risk and reduced variability of returns as compared to another investment with the same expected return characteristics. This applies to the inclusion of multiple equity and fixed income asset classes. Moreover, for many of you, fixed income assets play an important role within your specific plan. As interest rates reach more normalized levels, we believe fixed income will continue to serve as a core holding, providing income and portfolio stability during periods of heightened equity volatility.
Low Probability of a Recession in 2019
While we continue to see signs of slower economic activity, we believe that overall the U.S. economy remains strong. Gross Domestic Product (GDP) in the US is now projected to grow at an annual rate of 2.3% in 2019 (down from previous 2.5% estimate). GDP contraction to negative levels is one of the key indicators used to declare an economic recession and we do not expect to see negative year over year declines in GDP in 2019. Driving the U.S. economy continues to be consumer strength and many indicators suggest that this strength should continue in 2019. The Federal Reserve Bank of NY yield curve model is currently predicting a 21% probability of the U.S. entering a recession in the next 12 months. For reference, this probability reached 60% prior to each of the six most recent recessions **.
Risks to the Market
Rising Interest Rates and Market Disapproval - We have already seen how the market has reacted to rising interest rates and concerns remain on whether the Fed will raise rates too much too fast. After raising interest rates four times in 2018, the Fed has recently stated that it expects to raise rates two more times in 2019 (the market is actually anticipating the Fed to raise rates less than two times). Fed Chairman Powell recently put the market at ease with comments that they are open to a pause in rate hikes, leading to market advances in early January. We expect the market to remain extremely volatile during the Fed’s eventual long transition period from rate hikes to rate cuts.
Underwhelming Economic Data – We believe that two key economic data points to watch this year include U.S. GDP and the Purchasing Managers Index (PMI) surveys. As stated earlier, expectations are that GDP will be lower in 2019, yet the question remains, how low will it go? In December, U.S. manufacturing PMI fell to its weakest level in over 2 years. While the current reading of 54.1 represents expansionary levels, growth in new orders, production and employment fell sharply. Globally, the composite PMI in the world fell to a two-year low (52.7 in December). We expect the market to keep a close eye on these PMI readings as they approach 50, the neutral growth level. ***
Yield Curve Inversion – The spread between the yield on the 2-year Treasury bond and 10-year Treasury bond compressed to roughly 0.19% at the end of 2018. This flattening of the yield curve could continue in 2019 should the Fed raise interest rates as indicated. An inversion of the yield curve would occur when the yield on the 2-year bond exceeds the yield on the 10-year bond. Many economists believe that the odds of a recession significantly increase when the yield curve experiences an inversion.
Declining Earnings Estimates – Quarterly earnings will be closely watched all year long, starting with fourth quarter 2018 results in January. With increasing concern over slowing growth, we expect that the market will face heightened volatility during corporate earnings season. Company guidance and analyst earnings estimates are likely to be key drivers of overall market performance in 2019, as the impact to stock valuations will be scrutinized.
Study of Past Recessions
We prepared a study of the last 13 recessions in the U.S. following the Great Depression. On average, these recessions occurred nearly every 5.5 years, lasted for one year and resulted in an economic contraction of 4.2% (measured by a decline in GDP).
Additionally, in the table below, we measured the equity market sell-off experienced around these recessionary periods. Using the S&P 500 index, we calculated the peak to trough drawdown of the index as well as the performance of the index following the eventual bottom of the market. On average, the S&P 500 index declined 29% from its peak and recovered roughly 21% and 47% after 3 months and 1 year, respectively.
Currently, the S&P 500 index has declined roughly 20% from its most recent peak in September 2018. In slightly more than half of the recessions in this study, the index declined 21% or less (highlighted in the table below). Our take away from this is that it is conceivable that the majority of the ‘anticipated’ U.S. equity market decline due to a recession may have already occurred. We are not suggesting that market volatility is behind us or that further declines will not occur, but simply that a declared economic recession does not have to bring substantially more market declines along with it.
Source: Bloomberg: S&P 500 historical prices
If you have made it this far in the letter, we hope that you found the information helpful. 2018 was a rocky year for the market and navigating the headlines was certainly frustrating at times. While we expect more of the same in 2019, we want you to know that we are paying close attention and you should know that your individual plans were constructed with this environment in mind.
If you believe your financial situation has changed and/or you would like to discuss your plan, please do not hesitate to reach out to us in advance of your next review. As always, we look forward to speaking with you soon and we wish you a wonderful start to the New Year.
Gregory Slater, CFA, CFP®, CIPM®
Chief Investment Officer
Chart A) 2018 Total Return of Major Asset Class Indexes
Source: Bloomberg; 2018 year to date total return, International, emerging market, S&P 500, Barclays Agg indexes
* Source: Bloomberg: Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index.
** Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York and NBER.
*** TradingEconomics.com. ISM manufacturing PMI & JPMorgan Global PMI.
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