The Return of Volatility
Below is a quick recap of the key themes we expected to dominate the news in our 2018 Outlook:
- Return of higher / “normal” volatility
- Investor Complacency
- Global growth (especially Europe ex-UK)
- The Fed (Interest Rates & Balance Sheet)
To a significant extent, each of the above dominated 2018 discussions, along with the trade disputes and political banter. Historical charts will likely reflect 2018 as a modestly negative year amidst a sea of much larger annual moves. Conversely, for many, 2018 has been a gut-wrenching game of tug of war. What began (and after a “wobble” returned to) a nicely positive year, ended with a giant thud.
The year began with a 7% surge in January, followed by a massive spike in volatility and an ensuing 12% decline over the following 3 weeks. Volatility eventually subsided and markets generally behaved through the end of Q3, finishing at +11%. The fourth quarter, however, was less kind to risk assets.
As tensions with China, a 40% selloff in crude oil, concerns about Fed policy moving too fast, a US Government shutdown, and global growth concerns mounted, a risk-off trade swept through the stock market. What began as a normal rotation and rebalancing act turned into indiscriminate selling of risk assets.
It seems that a decade’s worth of historic headlines was crammed into the space of a single year. Consider the partial list of 2018 headlines below:
- Apple is first $1 Trillion public company & GE is removed from Dow after 122 years as a member
- US Bull Market officially longest ever
- Trade war with China escalates while tensions with North Korea calm
- Cannabis Stocks go on a monumental tear while Bitcoin crumbles (-70% in 2018)
- Fed “normalizes” with 4 rate increases
US equity markets were not the only ones to finish in negative territory in 2018. Four rate increases led to a flat return for the Barclay’s Aggregate Bond Index. Concerns in Italy, coupled with the looming challenges of Brexit, cast doubts on the timing and scale of Europe’s recovery. Turmoil in Turkey and Venezuela, coupled with a strong US dollar, along with the continuing trade rhetoric and commodity sell-off, plagued Emerging markets.
With such a negative ending tone for 2018, where are investors to turn now…read on.
Buying Opportunities Rarely Feel Good
2018 left investors few places to hide, particularly in risk assets. It began as a market priced to near perfection (as if nothing could derail its momentum) and moved favorably as earnings continued to deliver during the first half of the year. In stark contrast, the year ended as one priced as though very little could go right and where disappointment was a near certainty in 2019.
The S&P 500 that was arguably overpriced for much of 2018 ended pricing in expectations for a 2019 earnings decline (assuming a 15 PE). It’s not been this cheap in several years. Consensus is for earnings to grow at a mid/high single digit clip in 2019.
Clearly, both market optimism and skepticism are rooted in truth and exaggeration. The truth is that selloffs often create buying opportunities.
Historically, the best time to buy/add is when it feels the least comfortable. Discretion and prudence are still essential, but one of the greatest lessons from the 2008 crash is “what if?” I wish I had…why didn’t I see how cheap XYZ had become?
As Baron Rothschild quipped over 200 years ago following the Battle of Waterloo, “the time to buy is when there’s blood in the streets.”
Selloffs are never fun in the moment. A vortex of selling can put the most seasoned of investors on edge. Such events often arrive suddenly, last longer than expected, and sometimes have inexplicable origins. But in nearly every instance, they leave many investors on the back end wishing they had taken advantage of the chance to buy the dip.
What Lies Ahead in 2019?
An investor entering 2019 will enter a year whose expectations vary greatly. The US Federal Reserve expects moderate to around 2% growth, with unemployment remaining low and inflation below 2%. Despite downward revisions in Q4, consensus earnings expectations for the S&P 500 remain near double-digits.
We believe the following themes are likely to dominate discussions in 2019:
- Does Europe remain stable (Brexit/Italy)?
- Does the Fed prove its data dependence?
- Do earnings deliver?
- Is there trade resolution?
Headline risks will likely remain elevated for the foreseeable future, with Brexit, Trade, the Fed, and D.C. discontent at the top of the list of expected topics. Among the greatest truths of investing is that equity markets don’t like uncertainty…Q4 ’18 reflects that!
Historically, short-term gyrations can often be directly linked to headlines, but long-term earnings have driven prices. As Benjamin Graham famously summarized, “In the short run the market is a voting machine but in the long run it is a weighing machine.”
The year ahead will likely require patience, discipline, and a strong will. A backdrop of expected global growth, low rates, tame inflation, and attractive valuations could lead to a bounce-back year filled with volatility. On the other hand, an overzealous Fed, geopolitical uncertainties and political posturing hold the potential for unraveling any positive momentum the markets can muster.
Consumer Sentiment is high. Unemployment is low. Inflation is at the Fed’s target. Corporate balance sheets remain rather solid and many corporations are flush with cash that they can use (among other ways) to buy back shares. Repatriation for buybacks is expected to show up significantly in 2019.
We expect 2019 to be a grind!
The late stage of a market cycle most often is a grind, followed by one final exuberant run before reversing course.
While we are not looking to introduce additional risk into portfolios, we are also not dramatically shifting away from equity exposures in most strategies. While owning equities may not always feel comfortable in 2019, we believe that such ownership is still a critical component of one’s portfolio and is more likely to perform than an overweight to fixed income.
Strategically Diversified portfolios are key as we move forward. As JP Morgan states in their 2019 Outlook, “in any one year a diversified portfolio is never the best performer.” Conversely, it’s also never the worst performer! This environment is not one we deem conducive to big bets nor overly concentrated exposures.
As we emphasize in nearly every communication, discipline and risk management are invaluable. After years of passive strategies outperforming, we expect active management to be among 2019’s biggest value adds. Security selection and security avoidance figure to once again provide value as the Bull Market heads into its final stages.
What is Strategy Diversification?
Many market professionals define diversification as a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio over time.
During periods of high volatility and market stress, correlations among asset classes commonly increase. In other words, the potential benefit of market cap, geography, manager, etc. becomes less visible as assets start moving together with one another.
Perhaps the most lasting lesson of 2008 is that traditional ideas of diversification do not go far enough!
Rather than simply allocating across asset classes, market caps, and managers, we feel investors are wise to consider a diversification of strategies.
History has shown that, at any point in time, a given manager or strategy may be in or out of favor. A style box may be in or out of favor. A part of the world may be in or out of favor. With an approach that owns assets for a variety of reasons, based on a variety of signals, with varying buy/sell disciplines, one distances a portfolio from dependence on outlook, timing, and biases in the manager selection process.
Rather than purely relying upon skill – whether that of a manager, an economist, or an actuary – it’s our belief that Strategy Diversification can provide investors a far more robust solution to today’s challenging investment landscape.
Head Investment Partners
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