January, 2019
By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC

Gift card

Did anyone else receive a gift card for Christmas? These items are great for online shopping, convenient to give people in different locations, and serve as a reliable backup plan when you aren’t sure what to get someone. I gratefully received cards for a golf swing analysis, as well as a local restaurant. Businesses love to sell gift cards, generating revenue now for goods or services that will be provided at some point in the future; with the added bonus that sometimes these cards go unredeemed altogether (a study by CEB TowerGroup indicated that about $970 million worth go unused.)

When we look back at the economic environment of 2018, we see record low unemployment, record high corporate earnings, rising wages, and lower gas prices. You would normally expect that given this positive economic news, the stock market would have increased handsomely. Instead, the S&P 500 dropped 4.4% for the year. It turns out that investors were like a business that sold gift cards, receiving the benefit in advance of delivering the goods. Perhaps in the midst of the recent volatility you may have forgotten, but the stock market gained 22% in 2017 which followed a 12% gain in 2016. While clarity to these events is only given in hindsight, we did mention this possibility in our April 2017 newsletter when we said that “you are currently receiving an advance on the long-term gains you are expecting."

During the period between September 20 and Christmas Eve, the S&P 500 fell 19.8%. Some of the main events experienced during this time were:

  • The Fed raising interest rates for the 4th time this year
  •  U.S. trade tensions with China ebbed and flowed
  • Slowing growth in Europe and China
  • Elections resulted in democrats taking control of the House of Representatives, but not the Senate
  • A partial government shutdown
  • White House personnel turnover

While these events are not insignificant, they do not seem sufficient to explain the magnitude of the stock market decline, especially in the context of reasonably solid earnings and economic data.

Meanwhile, the bond market managed a gain of the smallest magnitude: 0.01% (turning positive on the last day of the year after being in negative territory for the other 364). By doing so we avoided what would have been the first year since the creation of the bond index where both the stock and bond indexes were negative. The following chart shows how various market indexes performed. By looking at the Russell 2000 and MSCI EAFE, you can see that the recent returns for smaller companies and international stocks were down even more than the S&P 500:

Index      1st Qtr 2018      
Return
1 Year
      Return        
3 Year
     Annualized      
Return
5 Year
     Annualized      
Return
S&P 500 -13.5% -4.4% 9.3% 8.5%
Nasdaq Composite -17.3% -2.8% 11.1% 11%
Russell 2000 – Smaller Companies -20.2% -11% 7.4% 4.4%
MSCI EAFE – International -12.5% -13.8% 7.8% 7.9%
Barclays US Aggregate Bond 1.6% 0% 2.2% 2.1%

The most common question we hear when markets go in decline is “What should I do?” Of course, there is no blanket answer for everyone. If you are a young person regularly contributing to your 401(k), you should be hoping for a long down trend so that you can be buying in at lower and lower prices, fully expecting markets to be much higher decades from now when you need the money. For retirees, times like this can be a lot more stressful. Seeing your nest egg get smaller and smaller when you’ve passed your ability to add to it, naturally leads to emotions that range somewhere between nervous and panic.

For clients of Castle, you have an investment portfolio tailored to your situation that is designed to succeed through various market cycles. This does not mean that adjustments are not necessary. We are fully aware that a portfolio that mathematically meets your goals, but doesn’t let you sleep well when the market has a rough patch, requires some alteration to become ideal for you. It is prudent to keep in mind that market corrections are normal and happen with regularity. The chart below reminds us that despite frequent intra-year declines, over time the market has trended upward consistently. History has shown that selling during market declines has not been an effective strategy in meeting long-term goals.

Drawdowns chartSource: JP Morgan Asset Management 2019

Our general view is that the economic outlook is still solid and while there are a few areas that bear watching (such as the impact of tariffs on international trade), we do not see indications that a recession is imminent. As such, with the market offering prices that are 10-20% cheaper than they were a few months ago, it makes sense for many people as part of their overall plan to make some strategic equity purchases. A combination of lower prices and higher earnings (see chart below) makes current valuations quite compelling. The Price to Earnings ratio (PE) dropped from 16.8 (4% above average) to 14.3 (11% below average).

SP 500 EarningsSource: JP Morgan Asset Management 2019

Some other data points we’ve been watching: 

  • Consumer Finances - Consumer balance sheets seem to be in good shape as the percentage of income devoted to paying off debt is now below 10%.

Household DebtSource: JP Morgan Asset Management 2019

  • Jobs - Unemployment continues to fall and wages are rising.
    • Note: the reports that have most recently been released indicate that the unemployment rate has edged up to 3.8% as more people have entered the work force.

UnemploymentSource: JP Morgan Asset Management 2019

  • Energy - The drop in the price of oil from the mid $70s to the mid $40s has helped the consumer by lowering gas prices and should have the added effect of keeping inflation numbers lower. See chart to the right. No U.S. bank failed in 2018 – for the first time since 2006.

OilSource: JP Morgan Asset Management 2019

  • The average mortgage rate is now 4.6%, up from 3.3% in 2012.
  • The S&P 500 was positive on 53% of the trading days and negative 47% - exactly the same ratio as the 50-year average.

Looking back on 2018, while not a great one for investors, there was still much to be positive about as worldwide citizens:

  • Poverty around the world is plummeting.
  • Half the world is now middle class.
  • Illiteracy is declining.
  • Disease is receding.
  • As recent as 1980, almost half the world lived in “extreme poverty,” that number is now 8.6%.
  • “Over the last 25 years, more than a billion people have lifted themselves out of extreme poverty, and the global poverty rate is now lower than it has ever been in recorded history. This is one of the greatest human achievements of our time,” said World Bank Group President Jim Yong Kim. 

In closing, some of you may recall that I am on a personal project to read a biography on every U.S. president. This year I completed books regarding Grover Cleveland, Benjamin Harrison, another on Ulysses S. Grant, and am nearly through William McKinley. I appreciated this poignant photo taken by Alex Brandon that shows 4 of the 5 living presidents and First Ladies paying their respects at George Bush’s funeral.

Pres group photo

Thank you for allowing us to be a part of your journey. Here’s to a great 2019!

 DarrenSignature

Disclosures: 
Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation. This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.