Quarterly Commentary 4th Quarter 2018

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2018 proved to be a difficult year for investors throughout the world. Nothing performed well, and there were very few places to hide. In the United States, the majority of stock indexes reached all-time highs in January, only to suffer sharp declines over the next two months. A negative first quarter accompanied by worrisome foreign economic slowing led many to fear that the nine year bull market was coming to a close. However, the miracle of copious, nearly free money from the world’s central banks as well as a substantial domestic tax reduction revived the U.S. market, which climbed persistently to a new all-time high in early October. From there, equity markets assumed an entirely different complexion, with most indexes falling aggressively by almost 20% to the late-December lows. A rally in the last few days of the year left the S&P 500 down by 13.5% for the fourth quarter and 4.4% for the full year. Foreign markets fared even worse with the composite of world indexes excluding the U.S. down for the year by 14.1%.

Unfortunately, fixed income markets offered no productive counterbalance to the equity storms. Domestically, the Barclay’s Aggregate Bond Index provided a zero total return, and most foreign bond markets finished well into negative territory.

In a pre-Christmas email to clients, I indicated that those for whom we have full asset allocation responsibility had nothing to worry about over the holidays. Their portfolios were up both for the sharply negative fourth quarter and for the full year.

An old Wall Street aphorism suggests that stock prices go up on an escalator and down on an elevator. The fourth quarter was testimony to that venerable adage. At its trough in late-December, the price decline had erased 26% of the nearly 10 year S&P 500 rise since March 2009 and 28% of the rise in the Nasdaq Composite. It is remarkable to note that a single quarter’s decline wiped out the price progress of the past 18 quarters for the New York Stock Exchange Composite Index, which includes all common stocks traded on that exchange.

There is no way to know at this point whether the fourth quarter marks the first leg down in a far more serious bear market or merely a brief but painful interruption of the bull market that began in early 2009. Clearly, the consequences of the former could have monumental import. The past two bear markets in this country have cut stock prices by half or more. The bull market that began at the March 2009 trough required historical governmental efforts to pull the domestic economy out of what former Federal Reserve Chair Ben Bernanke indicated was about to become a depression, absent extraordinary rescue efforts. In retrospect, that entire ten year rally resulted from the creation of yet another credit bubble. While the banking system and most corporations have boosted their capital levels significantly since then, the increased amounts of debt assumed by governments and corporations could present an extreme danger when the next recession inevitably hits.

Notwithstanding an appreciable decline in price-to-earnings ratios in the fourth quarter, a composite of all the major valuation measures still rests not far below all-time highs. The combination of still very high valuations and historic indebtedness domestically and internationally poses a potentially toxic mix in the next bear market.

While very few analysts are forecasting a recession in 2019, almost all analysts anticipate a slowing economy and sharply reduced corporate earnings growth. The World Bank recently indicated that global growth is expected to slow to a very sluggish 2.9% – perilously close to recession level for world growth. Domestic growth, which normally underperforms global growth because of the effect of faster growing emerging economies, is expected by the Federal Reserve to decline to 2.3% in 2019, 2% in 2020, and 1.8% in 2021. Over the long run, corporate profits cannot be expected to outperform economic growth by any appreciable amount. Historically, while earnings growth has been decelerating, as it is now, the stock market has tended to struggle.

Economies worldwide have begun to slow as central bank loose money policies have been tightened. It is eminently logical that halting the monetary generosity that has provided an unparalleled tailwind to economies and equity markets for the better part of a decade will challenge a number of the world’s economies that have yet to demonstrate the ability to grow without central bank support.

The powerful fourth quarter stock market declines in both the U.S. and China prompted their respective central bankers to offer soothing assurances that looser policies may once more be forthcoming should stock prices fall far enough. Having allowed debt to rise to unprecedented heights, central bankers appear unwilling to let markets, economies and interest rates adjust to their natural levels. Elevated interest rates would lead to unsustainable debt service burdens for many highly leveraged governments and corporations. Additionally, a significant recession could lead to the demise of many companies whose credit ratings have declined to junk bond levels. At the risk of promoting even larger debt burdens, the Fed and other central bankers appear unwilling to allow their respective markets, economies and interest rates to function unaided.

Relative to the question of danger from excessive debt, Fed Chair Jay Powell spoke tellingly earlier this month before the Economic Club of New York. Asked about the ballooning amount of U.S. debt, Powell answered: “I’m very worried about it . . . The long-run FISCAL NONSUSTAINABILITY of the U.S. federal government isn’t really something that plays into the medium term that is relevant for our policy decisions.” [However], “. . . it’s a long-run issue that we definitely need to face, and ultimately, will have no choice but to face.” In other words, according to Powell, the very financial survival of the U.S. government is ultimately threatened by the ballooning U.S. debt. Yet current conditions are so fragile that Powell and his fellow Fed governors may be approaching the point at which they may reestablish the loose monetary policies that have already magnified the debt. Investors face the question: at what point does this debt burden becomes a front burner issue? Centuries of history, as recounted in copious detail by Carmen Reinhart and Ken Rogoff in “This Time Is Different”, demonstrate that excessive debt always ultimately calls countries to account, sometimes with destructive economic and securities market consequences. The United States and many other countries have already passed the level of debt relative to the size of the economy that has typically triggered dire negative consequences down through the centuries.

Supplementing the problems of excessive debt, overvaluation and slowing economies is a broad array of economic and political uncertainties: Brexit, riots in France, trade disputes with China and other countries, North Korean nuclear arms, the Mueller investigation, seemingly irreconcilable differences in U.S. political philosophies and the ongoing U.S. government shutdown.

Many of these concerns were cited as reasons for one of the worst Decembers and fourth quarters in U.S. stock market history. By December 24, the markets were severely oversold. From there, a dramatic bounce-back rally closed the year and continues into the new year as this is written. Rallies this powerful normally lead to even higher prices over the ensuing six months, not, however, on an uninterrupted path. Almost always, prices retreat to test the earlier low. Complicating this history is the previously mentioned fact that stocks typically struggle when corporate earnings growth is decelerating, as it is currently. Additionally, the prevalence of algorithmic and other computerized trading has made some historical patterns less predictive, especially in the short run.

Of utmost importance is correctly choosing the long-term investing path to follow. In recent years, we have characterized the choice that all investors (as contrasted with short-term traders) must make as a “bet”. One alternative is to remain relatively fully invested in equities, trusting that central bankers will continue to provide loose monetary support whenever stocks threaten a significant decline. Such central bank actions have promoted one of the longest stock market rallies in U.S. history, so far only briefly interrupted by 2018’s fourth quarter losses. The second alternative is to trust that stocks will ultimately revert to their long-term fundamental means, as they always have throughout every decade prior to the most recent ten years. Should such a price reversion occur quickly, stock prices would plummet, as they have twice since the turn of the century. With debt having risen to current levels, recovery from such a decline could likewise take longer than ever before.

In this uncertain environment, Mission continues to employ its value-based investment strategies designed to pursue absolute rather than relative returns. In high risk environments, we hold a limited number of risk-bearing securities, increasing risk exposure when valuations become historically more attractive.

2019 offers the prospect of tremendous volatility as markets react to unfolding economic and political surprises. Great volatility offers the potential for great opportunity as valuation and risk levels rise and fall over a broad range. We will work to provide protection when needed and exposure to profit when favorable opportunities present themselves.