In the final quarter of 2018, the economy and the markets downshifted, as several economic cracks surfaced in areas like housing and auto loans, while concerns over Fed tightening and Chairman Powell’s persistent hawkish rhetoric spooked investors. In December, the markets experienced a full “risk off” decline, which was exacerbated by the ongoing trade skirmish with China and the looming government shutdown. In response, Chairman Powell softened his rhetoric at the December Fed meeting, which quieted markets and contributed to a muted Santa Claus rally during the last few trading sessions of the year.
Circumstances abroad were no better. Great Britain continued to struggle with the mechanics and politics of their Brexit from the European Union, Italy’s debt crises mounted, and hints of a further slowdown in the German economy became apparent.
For the quarter, the S&P 500 fell 13.52% while U.S. small cap equities (Russell 2000) moved into bear market territory down 20.20%. Real estate (REITS) declined a more modest 6.61%. Overseas, the developed markets (MSCI EAFE) fell 12.54% and emerging markets (MSCI EM) dropped 7.47%.
Despite recent Fed tightening, fixed income (BarCap Aggregate) had a positive return for the quarter up 1.46% due primarily to the flight to safety from stocks to bonds.
The U.S. has been in an economic recovery and a bull market for over ten years now. For the most part, the ride to the present has been relatively smooth for investors. There are many reasons for this, but perhaps most significant has been the sheer magnitude of the prior economic decline and the unprecedented monetary stimulus perceived necessary to lift us out. Throughout this recovery, it seemed that every time the markets showed any signs of weakness, the Fed would be there to buoy them, a phenomenon referred to as the “Fed Put”.
At Wealth Dimensions, we’ve been struck over the years by the lack of market volatility as a result of this Fed enhanced rebound, which is historically atypical for the markets. For instance, in 2017, there were only eight days in which the S&P 500 was up or down more than 1% for the entire year. This has only happened three times since 1928! The markets experienced another period of unusually low volatility in the 3rd quarter of 2018 where the S&P 500 did not experience a single session in the quarter where it closed with more than a 1% move up or down.
When Jerome Powell became the new Fed Chairman in 2017, he changed the tone at the Fed, embarking on a combination of steady rate hikes and a reduction of the amount of debt purchased by the Fed during the Great Recession. As a result, investors began reassessing the value proposition for stocks once the Fed began the transition from accommodation to tightening of monetary policy.
By the end of the 4th quarter, volatility spiked: The S&P 500 closed with more than a 1% move up or down 28 times. This led to more than half of the S&P 500 and U.S. small cap stocks (Russell 2000) to plummet by more than 20%, which constituted bear market levels.
This caused investors to demonstrate a host of emotions since many had been lulled by the quiet upward march of the markets up until this time. Behavioral scientists call this cognitive dissonance, that is, the stress and anxiety resulting from new information that conflicts with present understandings. These emotions have caused many investors to consider hasty actions in an attempt to relieve their pain.
From the beginning of every new client relationship, Wealth Dimensions educates clients about the intertwined relationship between risk and reward. In order to dependably capture the return premium stocks have to offer, one must tolerate times of significant volatility. When designing the appropriate portfolio for our clients, we consider volatility and seek to dampen it through diversifying among equity asset classes, as well as through allocations between stocks and bonds.
As the following chart demonstrates, volatility of return can vary greatly in the short run. However, over longer periods of time, the ratio of volatility to return decreases dramatically, which rewards the patient investor.
*As we were writing this letter, we were saddened to hear that John Bogle passed away at 89. John was a true investment pioneer who changed the investment landscape in a profound way. Investment professionals and investors will miss him.
While we are keenly aware of the discomfort downside market volatility can cause, our conviction in our investment methodology of prudent asset allocation and opportunistic rebalancing remains unchanged. Unfortunately, some investors, especially in times of duress, attempt to time the market. Market timing sounds wonderful. Who wouldn’t want to be in the market when it is going up and be safely on the sidelines before it heads down? There are even some professional money managers who sell this proposition to clients. But the probability over time of an investor making the right timing decisions through multiple market conditions and economic cycles is simply a fool’s errand.
There are a number of studies highlighting the folly of market timing, but arguably the most notable one is the 2015 version of the DALBAR study on ”Quantitative Analysis of Investor Behavior,” which demonstrates the significant gap between market timers and those who simply bought and held.
DALBAR compared the average return of all U.S. stock mutual fund investors to the S&P 500 Index. The study showed that mutual fund investors, over a 20-year period through 2014, left to their own devices and market timing maneuvers, earned less than a third of the money that they would hypothetically have earned by investing and holding for the long term.
As we have just witnessed, markets can move quickly, and in an unpredictable pattern. The chart below demonstrates how missing just a few days in the markets can result in dramatically different outcomes. It is also notable how the largest up days and down days occur in proximity of each other. Facts like these are a powerful reminder of the folly of trying to time markets.
We often talk about the equity tilts in our client portfolios. Over the long run, they have demonstrated to provide relatively high expected rates of return while lowering the volatility of the portfolio. The 4th quarter provided a glimpse of the volatility dampening effect of this asset class diversification. Our investments in domestic value, real estate, developed international, and emerging market equity, as well as fixed income all outperformed the S&P 500. We have also been at work during the last quarter reviewing our portfolios for tax-loss harvesting opportunities, and rebalancing accounts back to target allocations to take full advantage of this situation.
Looking forward into 2019, we see headwinds and opportunities that will play out in the coming months and years. However, no one can accurately predict the outcome of these events. You can rest assured that we will continue to seek to take advantage of opportunities when they present themselves.
In closing, we are excited to let you know that we have spent the last year implementing new technology in all areas of the firm to further enhance your client experience. We have new systems for information management, trading, reporting, and financial planning. We will be introducing these enhancements over the course of the year. This quarter we are rolling out the first reports from our new system and will offer electronic delivery of reports through secure e-mail or a client vault next quarter. As we conduct reviews throughout the year, we look forward to introducing all of our new capabilities and encourage your feedback.
Thank you for your continued confidence in our services.
For informational purposes only. Not intended as legal or investment advice or a recommendation of any particular security or strategy. Information prepared from third-party sources is believed to be reliable though its accuracy is not guaranteed. Opinions expressed in this commentary reflect subjective judgments of the author based on conditions at the time of writing and are subject to change without notice. For more information about Wealth Dimensions, including our Form ADV Part 2A Brochure, please visit https://adviserinfo.sec.gov or contact us at 513-554-6000.
Please be advised that this material is not intended as legal or tax advice. Accordingly, any tax information provided in this material is not intended and cannot be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer.