Could a Bad 2018 Yield a Better 2019?

The final quarter of each year is often a seasonally strong period for stocks, but not so this year, as the market found itself in a seemingly endless freefall. This culminated with the final month of the year being the worse December since the Great Depression, a rather unnerving fact.

But is it possible there’s a silver lining to 2018 that could, in the long run, actually be a net positive? Using some mental gymnastics (which I’m quite good at), I think the answer may actually be yes.

Let’s start with some interesting trivia. Now that 2018 is in the books, it registered as the first down year for the S&P 500 since the financial crisis (looking at performance including dividends). What’s more, the large-cap index has a history of rarely notching back-to-back declines; it’s only happened four times since 1929.

Why is this important? Because it suggests that the market often has a habit – as most of us know – of overshooting in both directions. When things are good, the market rises too far, and when investors run for the exits, it often falls too far as well.

The nature of this behavior means that adjustments up or down often exceed their fundamental justification, which is why the market will, for example, gap substantially lower in a short period of time even though economic justification for the move takes much longer to play out.

In other words, the market has already discounted a substantial amount of bad information that may or may not come to fruition. A perfect example of this is rate hikes.

Part of the cause for the 4th quarter’s plunge had to do with renewed worries about the Fed being on a preset rate-hiking schedule and committing the same mistake they’ve made many times historically. The market reacted sharply to that, and now, at least as of last week, the Fed has done an about face.

In case you missed it, at a conference in Atlanta, Fed Chair Jerome Powell went out of his way to communicate that the Fed is not on a “pre-set” path to move rates higher and “will be patient as we watch to see how the economy evolves.”

What’s perhaps more interesting to consider is what would have happened had the markets not thrown their 4th quarter fit. Had the markets complacently rallied through the end of the year (as they did at the beginning of the year), perhaps the message wouldn’t have been as clear to the Fed. They may have continued to push rates higher at a frantic pace until it was too late.

Part of what I’m getting at here is the market acts as a strong signaling mechanism and can itself be a cause for change. Maybe a down 2018 has breathed new life not into just simple metrics such as P/E ratios, but also into the collective thinking of important policy drivers such as Mr. Powell and those in charge of our trade negotiations.

It’s no secret that our economy moves in cycles along its long-term growth trend. The bigger these oscillations are, the better the boom times and the worse the bust (recession) times. While we’ll never get rid of these cyclical swings altogether, the smaller these oscillations are, the less of a roller coaster ride we have to sit through as investors.

So while 2018 may seem like a big disappointment, it actually may have paved the way for some positive developments that could ultimately dampen some of these oscillations. I think most investors would rather see a market that traded sideways for a couple of years than one that falls through the floor shortly after going through the roof.

But even if the benign fall during 2018 did give us some breathing room, it’s still a very mixed picture out there, so let’s walk through some of the data.

First, as you probably know, the December jobs report came in strong and well above expectations. Not only were 312K jobs created, the previous two months’ figures were revised higher by a combined 58K jobs.

A strong jobs report and a simultaneous relaxation by the Fed on rate hikes … ? That’s definitely a recipe for a market rally, which we’ve seen. What makes the situation even more palatable is that the unemployment rate rose from 3.7% to 3.9%, as 419K new workers entered the workforce.

In case you’re wondering why that’s a good thing, it’s because it signals continued slack in the labor market, which in turn signals less upward pressure on prices, which portends a more dovish Fed. We’re actually getting the best of both worlds right now as more Americans find work each month but inflation remains subdued.

But of course none of that necessarily means the worst of this correction is behind us. As has been frequently pointed out recently, the VIX futures curve remains inverted with front month contracts more expensive than longer dated ones (see image below).

VIX Futures Term Structure

In a normal market this curve slopes upward because there is inherently more uncertainty (volatility) associated with longer timeframes. (This is the same reason we expect the yield curve to slope upward during normal times.)

The current downward slope of this curve is an indication that many big players expect heightened levels of volatility over the beginning portion of this year. That’s probably not all that surprising, considering we should get more clarity on things like Brexit and trade talks with China as the year progresses. But at any rate, it’s a sign that we could still see some sharp moves ahead.

Also on the semi-bearish side, recent readings from the ISM manufacturing and ISM services indexes showed a deceleration in growth. The manufacturing index fell to 54.1% from last month’s 59.3% (recall that anything above 50 still signals expansion). The main issue here was the new orders component, which itself sank 11 points to 51.1. Manufacturing accounts for roughly 20% of the economy.

On the other side, the arguably more important (since it constitutes 80% of the economy) services index also declined to 57.6% from 60.7%. Both indexes are still in expansion territory and some variability is quite normal, but it’s another sign that overall growth is decelerating.

Liz Ann Sonders, the chief strategist over at Charles Schwab, has a habit of saying something along the lines of “better or worse matters more than good or bad.” I think there’s a lot of truth in that statement and also believe it’s a fitting representation of where we’re at now. The economy is still “good,” but it also appears to be worse than it was recently. Hence some of the declines we’ve seen.

The big question, then, is will the economy get better or worse from here? And therein lies the rub. While we can sometimes extrapolate longer-term trends to get an idea of what’s in store, other times binary events tend to get in the way of forecasts. This trade saga is one such event.

Over the last couple of years I’ve maintained the belief that Trump uses the stock market as an indicator of his performance and will do everything in his power to help it rise. I still believe that to be the case, and that idea underpins my assessment of his behavior moving forward.

I think at the end of the day this trade issue will resolve itself simply to avert more harm to both economies. Whatever each side has to say and do to save face, they will. No one seems to care about the real truth these days anyway, it’s all about manipulating the perception of truth.

That said, one fly in the ointment is that a lot of damage to the underlying economies, and particularly sentiment, may have already been done. Playing chicken is an exhausting game and can leave all of those involved frustrated and tired. It’s possible that this trade war has already impacted the behavior of commerce in a way that will have lasting effects.

All of that is simply to say, don’t necessarily expect everything to go back to being rosy immediately upon a final trade agreement. There will be an ongoing process of adjustment.

Finally, I had been searching for a well-drawn chart that showed the relationship between yield curve inversions and stock market tops, and finally found one, courtesy of Schwab.

In the chart below we can see the 10-year minus 3-month spread in purple, and the MSCI World Index in blue. As the chart itself notes, inversions align closely with stock market peaks.

Yield Curve Inversions and Stock Market Tops

Because both the stock market and the yield curve are leading indicators, they tend to move in sequence. We haven’t seen the 10-year minus 3-month spread invert yet, but if and when it does, we could be very near to a market peak (if we haven’t seen it already).

For now, I think the right stance is one of caution and conservatism. Those still looking to reduce exposure should probably wait a bit longer as we appear to be in the midst of a renewed short-term uptrend, but also keep in mind that scaling back in a series of smaller moves is the preferred way to go, since it’s never possible to time things perfectly.

Ultimately, I do think the market stands a good chance of putting in a better performance this year than last, and ending the year in positive territory, but those of you who have followed me for long enough also know that I think long-term forecasts are worth less than the paper they’re written on. So as always, we’ll take this on a month by month, and week by week case moving forward.

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