2018 was a great year for the U.S. economy as unemployment fell to a 50 year low of 3.7%, gross domestic product grew more than 3% and with an assist from a reduction in the tax rate, corporate earnings grew about 22%. Unfortunately, the economy is not the financial markets and the financial markets are not the economy as all major market indexes declined in value during the year. In particular, the S&P 500 experienced its worst year in a decade and while its total return was down “only” -4.4%, the decline felt worse as the market experienced a wipe out of $4+ trillion in value from its highs or roughly 20% of annual U.S. GDP. The much ballyhooed FAANG trade, Facebook, Amazon, Apple, Netflix and Google all declined into bear market territory, collectively shedding $1.1+ trillion from their highs. In addition, small cap stocks and emerging markets entered bear markets. From our perspective, the recent decline in the equity markets has largely been due to the following factors:
- For the first time since 1994, cash outperformed both stocks and bonds. Cash yields today are higher than the dividend yields of about 60% of the S&P 500. Income investors have gone from an environment of TINA (There Is No Alternative – to equities) to MEAN (Many Equity Alternatives Now).
- The markets have been signaling to the Fed that it needs to stop raising interest rates but until recently, the Fed has remained committed to “normalizing.” Unlike former Fed Chairs Greenspan, Bernanke or Yellen, Chairman Powell has seemed relatively unconcerned with financial market declines.
- Trade war rhetoric has evolved into a real world drag on growth globally and there is a increasing risk that the U.S. will be pulled down by slower growth overseas.
- Program trading – according to the Wall Street Journal, 85% of all trading is now on autopilot via machines, models or passive investing formulas. Behind these models are algorithms or investment recipes that automatically buy and sell based on pre-set inputs. One of the primary “ingredients” in these algorithms is momentum. When markets turn South, they are programmed to sell. If prices drop further, many are programmed to sell even more – regardless of fundamental valuations.
One positive of the market decline is that valuations have become more attractive but it also suggests a disconnect between what the financial markets are signaling about the economy and most economic data. From our perspective, the factors highlighted above trumped fundamentals resulting in a bull market for earnings and a bear market for valuations. The S&P 500 should earn about $175 in 2019, suggesting an earnings growth rate of 8% and a P/E multiple of 14x, its historical average. However, the recent volatility in the markets has caused several individual companies to become attractively priced within the S&P 500 and likens its average P/E of 14x to the proverbial statistician who drowned in a lake that – on average – is only two feet deep. This has created an environment where active managers focusing on valuations should outperform. In addition, we think Inlet Private Wealth’s active investment approach of focusing on the fundamental valuations of companies is well suited for more volatile environments. Given Brexit’s March 29 th deadline, ongoing trade negotiations, the government shutdown, a divided Congress and slowing global growth, 2019 seems likely to be a year of elevated volatility.