To say that 2018 ended on a miserable note would be the understatement of the century. The economy grew at roughly a 3% rate. Corporate profits rose in excess of 20%. Employment and wages had solid gains. Inflation was barely evident. Interest rates remained extremely low. Indeed, real interest rates were nearly zero. Admittedly, there was a mild reduction in excess liquidity, but that had been ongoing well before the collapse of stock prices in the 4th quarter. December was the worst year-end month for equities since 1931. Because 85% of trading volume is accounted for by algorithmic traders and ETFs the price moves have been magnified way out of proportion to economic and corporate fundamentals.
What happened? In a word: INCOMPETENCE. Incompetence at many levels of government, particularly the White House, the do-nothing Congress, and the Federal Reserve Board for starters. Trump and his misguided advisors started an unwinnable trade war with China, whose economic growth has now slowed enough to ignite a global economic slowdown from which the U.S. is not immune. In the meantime the Fed, which has raised the Federal Funds rate 9 times since 2015, seems oblivious to the disinflationary structural changes in the economy over the past decade and appears unaware that the economy is already slowing due to the lagged effect of its policy. One or two more rate hikes in 2019 plus its autopilot shrinking of its balance sheet could well tip the economy into recession. Together these two issues have terrified investors all over the world.
However, we strongly believe there will not be a recession in 2019. GDP growth will fall below 2%, but corporate profits should rise at a single digit pace, even without the incremental benefit of the 2017 corporate tax cut. A number of high growth sectors, many technology based, will increase earnings at double digit rates. Overall, equity valuations in the aggregate have fallen from about 18 times forward estimates to less than 14 times, implying a forward earnings yield in excess of 7.0 %, which is nearly 3% higher than the BBB bond yield. Indeed, numerous well situated, high quality equities are now valued at between 5 and 10 times profits. Once the fear among investors abates, today’s equity prices will be seen to offer the best opportunity in many years.
For that to happen, however, the misguided policy of the Fed must change, and the trade war with China must end. Until investors see daylight on these two issues, stocks will languish around current levels. That said, the worst of the sell-off will be over once tax loss-motivated selling ends and ETF outflows taper off. December 31st cannot come soon enough for all of us.
We are ending the year with large cash balances in our clients’ accounts, minimized tax liabilities, a group of undervalued core holdings, and a strong degree of caution and patience. We will commit cash reserves carefully as the macro- and political backdrops begin to show improvement.
There are 21 examples in recent history in which violent sell-offs not followed by a recession have quickly led to extremely large price rebounds. We thank each of our clients for their forbearance during this most difficult period. We have high conviction that 2019 will be a year of significant financial rewards.
