2018 Market Review

Markus Muhs - Jan 04, 2019
It's once again time for an annual market review. I do these reviews annually (find links to previous years at bottom) more for orientation purposes than to either dwell on the past or prognosticate the future.

In January our clients will be receiving their annual performance reports, and while one year of performance is completely irrelevant in a long-term investment strategy, unfortunately it is what's reported, and it's useful to gain some perspective on the cause of that performance and where we are today.

As such, below you'll find my usual annual market review table - an expanded version of my usual monthly table - with the principal returns (excluding dividends) of each of the major indices of the world, plus currencies, a few commodities, and some miscellaneous stuff at the bottom. The Russian and Brazilian indices were actually carry-overs from a few years ago when they really crashed hard; interesting to see how they've done since. Actually the only positive numbers to report.

If you're interested in seeing just how bad the month of December alone was, head on over to my monthly market update page. I also have plenty of links there to good articles I read throughout the month of December. 

In addition to the raw numbers in local currencies, I adjusted all performance to $CAD. As Canadian investors we actually didn't do too badly, thanks to a depleting $CAD (largely driven by the direction of oil prices). Once again, NOT HEDGING your investments to currency has yielded a better outcome in a "risk-off" environment, as the USD tends to rise when global investors flow their capital from stocks to safer U.S. Treasuries.  

Looking Back

In years past I used to comment at length and somewhat prognosticate (even though I always say I won't!) on the various major asset classes, but to dwell on it too much I think is a waste of time. Just some key points of observation, when looking at the calendar year:

After strong outperformance of international stocks (ex-North America) in 2017, in which the typical international fund did well over 20%, international stocks saw a horrendous year. This just goes to show how unpredictable the markets are, how last year's outperformer can quickly become next year's underperformer (and vice versa), and how we simply can't time these things; we need to be strategically invested in everything. Right now would be the time to dedicate more money to depleted international stocks as part of your regular rebalancing.

Does it surprise you to know that U.S. stocks overall are actually UP for the year 2018, when denoted in Canadian dollars? Even in USD, the drawdown really wasn't that bad, in fact the only thing that makes a 6% drawdown of the S&P 500 for the year unusual, is the fact that historical precedence is that usually bad years in U.S. stocks are double-digit negatives. This is the first negative calendar year closing number for the S&P500 since 2008, which is a good thing because now people can't proclaim that it has gone up 11 years in a row and keep trying to predict when it will stop.

Coincidentally, the drawdown of the S&P500, from highest point (in September) to lowest point (Dec 24th) was a little over 20% when looking at intraday figures, signifying a bear market. However, it was only 19.8% when looking at closing day market values, which is stupid because now "bear watchers" will continue proclaiming that there hasn't been a bear market since 2008 (also ignoring 2011 when the markets did almost the exact same numbers, intraday/closing).

Emerging Markets - an area of the world that always interest me because of the tremendous growth of the middle class, strong demographics, and general societal progress - are still a major contributor to global growth. What's hidden in the numbers, when you look at just the calendar year, is that they were having an awful year even leading up to the market highs in September. In the time since, they've actually relatively outperformed the rest of the world, yielding a year end number (I'm using a popular ETF above that relatively encapsulates EM stock growth, ex dividends, in Canadian dollars) that's not really that bad relatively speaking. In December, VEE was only down 1.4%. Either we saw the bottoming in EM stocks in September, and they're taking a leadership position (which is bullish in general, when a risky asset class starts outperforming), or they simply didn't have that much more to fall. Price/Earnings valuations in EM stocks have been quite a bit lower than developed markets, even before their stocks took a beating, which in my eyes either provides better growth opportunity or less downside (more on P/Es at the bottom).

Bonds in general were disappointing up to October, as they should be when markets are generally moving upward. I had plenty of conversations with clients as to WHY we have bonds in their portfolios when they're only diluting/offsetting positive returns in equities, especially given that we know rates are generally moving upward and this is not good for bonds. The final two months of the year taught us the lesson of why, with VAB (referenced above) rallying 2.33% in just those two months, to finish the year slightly positive.

Lastly, one other observation on currencies that reaffirms that overall the year was a risk-off year: what's clearly apparent in the numbers above is a strengthening in the two major risk-off currencies of the world. The USD went up (this is why most of the other currency numbers are red) and the Japanese Yen went up even more (a negative number above signifies that it strengthened versus the USD, essentially costing fewer yen to buy a USD). If we see a reversal of this trend (in particular, watch the Euro/JPY cross, for the number to go up, signifying weakening yen and increasing bullishness).


Looking at the Present

I thought about using the heading "looking forward", but like I said, I don't want to prognosticate. Markets are way too unpredictable to make any calls on what they'll do, as we so clearly found out in 2018. 2018 was a year in which U.S. GDP grew approximately 3% (in addition to the rate of inflation) and global growth was in the high 3s (for both these numbers I'm not quoting sources, as Q4 numbers are not yet available, so they're based on past actuals, plus Q4 estimates, thus the approximations). Net income of the S&P 500 constituent companies grew by around 20-25% for the year (again a conservative approximation, as Q4 figures aren't out yet) and despite all this, global markets were down across the board.

Looking at where we are in the global economy, we have an economy that's slowed a bit from a year ago. Where in 2017, we were in a "synchronized global recovery", with PMIs (Purchase Manager Index, a measure of the outlook of purchase managers at manufacturers; a good indicator of global optimism) positive for just about every country in the globe, we now have some areas of weakness around the world. I found this global heatmap of PMIs useful in visualizing this, showing there are obvious weaknesses in a few parts of the world, down from being almost 100% green or gray at the beginning of 2018. Nevertheless, we're still mostly neutral to positive worldwide and there are no foreseeable major headwinds that could plunge the global economy into recession.



When I look at economic headwinds, I don't overthink things too much like many economists. Obviously, I'm not an economist (an armchair economist at best!). My experience, largely based on what led to the 2007/2008 recession, tells me that economies generally do a 180 from growth to recession when the major input costs go up. Major input costs that can cause a global recession:

The cost of raw materials: as you can see in the table above, industrial metals costs (major inputs like copper, iron, steel, etc) are down almost 20% for the year. No worries here.

The cost of energy: Oil is a major proxy, as it's one of the major sources of energy we use worldwide, in particular for transportation. It's down almost 25%. Nat gas prices are down as well, after a surge in the middle of 2018, coal is cheap as always, and the trend in renewables is for them to get cheaper and cheaper, thanks to advances in technology.

The cost of labor: While labor is becoming tighter in the U.S. with sub-4% unemployment rates and finally some semblance of wage increases, in the rest of the developed world unemployment rates are still high. Further, this is a headwind that I think will become less of an issue with advances in robotics and AI; something I discuss further in this blog post from a few months back.

The cost of capital: The Fed is tightening the money supply in the U.S., however relatively speaking their balance sheet is still enormous coming down from 4.5 trillion to just over 4 trillion, relative to less than 1 trillion before the global financial crisis and around 2 trillion after QE1 (in 2009). This puts a perspective on just how irrational all the panicking over a bit of quantitative tightening of late has been: we still have a long way to go and the Fed will only make significant cuts to the money supply if the economy is truly doing well and all that cash sloshing around the system starts to pick up velocity and causes some scarier inflation figures (thus far it hasn't, U.S. inflation for 2018 was 2.2% (estimated). The rest of the developed world is far from worrying about tighter money supplies and for the most part is still easing or neutral. 

I will add one other thing, economically: the stronger USD has the effect of improving the upside of global companies who derive a lot of their income in USD, however will have the opposite effect on U.S. companies making money globally, as it did during the "earnings recession" of 2015. It should have the effect of keeping inflation in the U.S. manageable, as imported goods become cheaper, but can drive inflation higher in the rest of the world. 


Final Thoughts

This is the time of year when all the fund companies and other market pundits put out their forecasts for 2019. I've been doing this long enough to recognize that year after year those forecasts, on average, tend to be nothing more than a backwards look on the recent past in order to extrapolate what they expect in the future.

While most forecasts tend to be positive, many of them based on recent events tend to be "cautious optimism". I find this to be asinine, as recent events (a lower starting point for the year), based on history, should predicate a more bullish year. There's no way of knowing this for certain though, so all we can go by is by orientating ourselves to the present.



Especially useless are what the financial noise media tell us about the markets, always and forever focused on the emotions of the day, as we can see above. If they're not making emotion-driven predictions of the markets, they're feeding us absolute nonsensical sensationalism that is of absolutely no use to us, like in this article, which Nick Murray recently awarded winner of the "Award for Dumbest Financial Journalism of 2018" (subscribe to my eNewsletter to receive Murray's monthly "Client's Corner" newsletters, a good one-pager that'll help you keep a clear mind when investing).

If we equate our investing strategy to our golf strategy, for those of us who (try to) play golf, most of us double bogey golfers don't really know where our ball is going to end up after teeing off (distance and trajectory can vary greatly), but we can pay attention to the conditions, such as wind direction and speed, for what it's worth. Where the U.S. markets (the most important ones, that tend to lead the rest of the world) are concerned, this is my assessment of wind direction, paying no heed to future prognostications:

We entered 2018 with the S&P 500 at a total value of 2674. For that price, of $2674 per unit of S&P 500, we owned around 500 underlying stocks which had trailing twelve month as reported earnings (according to Standard & Poors) of $109.88 and paid out $50.03 per share in dividends over the trailing 12 months (multPL). We were effectively buying the S&P 500 at a price earnings multiple of 24.3 and a dividend yield of 1.87% Of course the P/E was high, as it predicted future earnings growth.

Throughout 2018, at least for the first 3 quarters of the year for which data is available at the link above, 80 to 85% of S&P 500 constituents met or beat their earnings estimates. While everyone was panicking about the markets in December, I heard no relevant news regarding a significant number of companies missing their earnings forecasts. Estimated trailing twelve month reported earnings for our unit of S&P 500 are now $140 for the year 2018, while the value of a unit of S&P 500 has fallen to 2507 to begin 2019, yielding a new price/earnings ratio of 17.9. The historical average, by the way, for trailing 12 month p/e going back to the late 19th century is just below 16 (multPL). The combined companies of the S&P 500 now projected (by S&P) to pay dividends of over $55 in 2019; a yield of 2.2%. 

Whereas the higher P/E going into 2018 predicted (and received) significant growth, bringing a high P/E back down to more historically average, the current P/E isn't predicting any growth in earnings for 2019. S&P's earnings estimates (again, in the link above) for $156 over the 12 months of 2019 may or may not come true, depending on a variety of economic conditions that are unpredictable, but if it holds, then this puts the forward price earnings at a paltry 16, based on today's value of the S&P 500. If there is no growth, then it is still pretty fairly valued. If we do enter a recession in 2019, then the S&P 500 has nowhere near as far to fall as it did last year or pre-financial crisis (when it was over 20) or at the peak of the tech bubble (when it was over 30).

That's as far as I'm willing to predict, which in short is to say that the risk/return relationship in U.S. stocks today is better than it was a year ago, as is the dividend yield, and - prognostications aside -  that's just about all we can go by.


Markus Muhs / CFP, CIM



If you're interested in reading my market reviews from past years (a warning that due to their age some of the links might not work and due to changes in my website, some of the formatting might be odd):