In our last newsletter titled “The Christmas Bear”, we outlined the issues that we felt were driving the high levels of volatility in the stock market recently and shared our thoughts on how those may play out in 2019. That was only three weeks ago and now we’ve had another big swing in the market, this time to the upside, that has people wondering if the selloff is over.
2018 proved to be a volatile year, even from the beginning. As in most years, stocks started off with strong gains. The S&P 500 quickly advanced almost 7.5% in January alone but then gave all those back and then some. By the start of February, large cap stocks were actually down 2%. Then in mid-March stocks began a six-month rally that took all the major averages to record highs.
The small cap sector posted the best results gaining over 17%, while the S&P 500 rose 13%. From the end of September, however, it was mostly a straight line down with the S&P 500 finishing the year 6.2% lower. This was a drop of more than 19% from a September high and near bear market territory which is defined as a decline of at least 20% on a closing basis. It’s also important to note that it’s rare for stocks to enter a bear market outside of a recession.
There were a number of factors that contributed to these losses but as we outline in our last publication, this was really about higher interest rates. As proof of our thesis, the breadth of the selloff was enough to catch the attention of the Federal Reserve wherein officials took the opportunity at a January 4th, 2019 meeting in Atlanta to lay the groundwork for a break from raising short-term interest rates in the coming months. The Dow Jones Industrial Average closed up 747 points that same day.
The bond market also struggled with higher rates. This underperformance of the fixed income market in 2018 was not at all unexpected. As the Federal Reserve Bank continued their policy of raising interest rates, all bonds, especially longer maturities, came under intense pricing pressure. Knowing this is precisely why we have favored shorter term bonds for our clients over the last few years. The modestly lower yield by investing in shorter maturities has been well worth the protection against rising rates. Our preference toward shorter maturities has also allowed us to more quickly capture the higher rates since the Fed began its tightening.
In our opinion, the Federal Reserve has been holding interest rates down for far too long and we actually welcome higher, market-based rates. Since the financial crisis the Fed has been actively manipulating the entire yield curve through a number of policy measures. These policies have decoupled interest rates from the economic realities and have punished income investors. Investors seeking income have had to rely more and more on alternative investments to bolster their portfolio’s cash flow. These alternative investments come with much higher price volatility than one would typically want to see. In addition, this volatility is often tied to the stock market. We saw this with many of our strategic income investments during the fourth quarter.
As the Fed continues to remove itself from the bond market over the coming years, yields on traditional investment grade bonds will normalize allowing investors looking for income to reduce their alternative investment exposure. So, while this transition may create a headwind for some securities, such as stocks, it will actually reduce the overall volatility for well diversified portfolios.
Looking ahead into this year, we’re optimistic about 2019 because the underlying economic fundamentals in the U.S. remain strong. The market environment is likely to remain challenging, however, as growth slows from tighter monetary policies. We think the net result in 2019 will be modest gains in the stock market, improving yields on bonds and lower overall portfolio volatility.