Quarterly Commentary

Q4 2018

Wintery weather arrived before Thanksgiving in Vermont this past year. Frosty windshields and spinning ski lifts were out of synch with our usual routine. So it was for the stock market as December, on average the most rewarding of all the months(1), delivered a most unexpected and unwelcome result. The 9% decline pushed the quarter to a 15% fall. It was the weakest December result since 1931, and one of the worst year-end performances on record. 

Investors had embraced the start of 2018 with optimism and confidence.  After some early volatility, US markets gained strength over the summer even as stock markets elsewhere had turned negative.  A portion of October’s slide was recovered in November, fueled by talk of a trade deal with China. Then the bottom fell out. Just three months after setting new highs and marking the “longest-running bull market ever,” US stocks joined the global rout, falling more than 20% from their highs, which qualifies as a bear market.(2) The year closed with negative returns for every major asset class except short-term Treasuries, which rallied in the final six weeks.

The new year has brought some relief in the form of a 4% gain over the first six trading days. While this is a relief, there remain numerous reasons to be cautious. It is our view that prices have adjusted to levels that reflect the gloomy outlook and are more likely to move higher than lower over the course of the year.  However, there are many different paths that might lead to such a satisfactory conclusion and further bouts of weakness should be expected. 

What happened?

Several long-standing concerns became worrisome realities in the fourth quarter. Slowing global economic growth dampened expectations for large US companies, who earn half of their profits overseas. The slowdown first surfaced in China as government efforts to curb lending took hold. Consumer spending softened – car sales fell 6%, the first decline in over twenty years. The outlook darkened further midyear as tariff talk turned into tariff actions. Chinese stocks fell steadily throughout the year to a 25% loss. China’s economic health matters because it has been the world’s growth engine over the decade since the financial crisis. The slowdown’s direct impact is evident for US businesses such as the carmakers and Apple who have reported sharply lower sales in China. Just as significant but less visible, the indirect impact is transmitted to the US economy through our trading partners who are highly exposed to slowing Chinese demand.

The Fed held our attention in 2018 as it continued to raise short-term rates in the context of a healthy US economy. Behind the scenes has been the increasing scale of the Fed’s program to undo the stimulatory bond buying program of 2009 – 2013, which you may recall put $4 trillion of cash in the hands of bondholders that was then invested in other financial assets or lent to businesses. All else the same, reversing the process removes cash from circulation and increases the supply of bonds, thereby exerting downward pressure on the prices of financial assets and causing lenders to pull back. Of course, all else isn’t the same – we are in far better shape than we were ten years ago. Nonetheless, the unprecedented nature of the unwinding operation means the Fed and investors are feeling their way through and mistakes can be made.

By the fourth quarter it was clear that lenders were indeed pulling back, and that borrowing was getting more expensive. From January 1st through September 30th, the yield on 10-year treasury bonds rose from 2.4% to 3.0%, and the average rate for a 30-year mortgage jumped from 4.0% to 4.7%. When treasury rates began to fall in the fourth quarter, credit spreads rapidly expanded, with the gap between BBB-rated corporate bonds and treasuries blowing out from 1.4% to 2.0%.(3) Higher mortgage rates create a drag on the housing and consumer sectors. Elevated corporate borrowing costs impair profits for businesses and, perhaps more importantly, raise the required rate of return on new business investment. It’s reasonable to conclude that the era of ever-cheaper money has ended.

Increasing political uncertainty likely contributed to the December rout. Investors seemed less willing to assume benign outcomes regarding issues such as trade negotiations and the Fed’s independence. Also contributing yet difficult to measure were technical factors such as seasonal tax-loss selling and the fact that many stock traders were not at their desks over the last weeks of the year. Computers don’t break for the holidays – this was a first test for many recent market innovations such as algorithmic trading. Whether they stabilize or contribute to a collapsing market scenario will be better understood over time.

Where do we go from here?

It is not surprising that expectations for 2019 have been lowered. Earnings growth is now projected to be 7% (S&P 500), down from the 11% that was the consensus estimate two months ago. A recent poll indicated that 50% of corporate CEO’s expect a recession in 2019 and 80% foresee one by 2020.

The issues on investors’ minds are not new. We don’t need or expect solutions to these problems, just to feel that they won’t get worse.

The markets would embrace positive news from China, which has recently introduced policy changes intended to stimulate consumer spending. Underlying the sparring over who is winning or losing the trade war are significant differences between the US and China involving claims of state-sponsored theft of intellectual property and discriminatory trade practices. These are weighty issues that will shape the terms of global trade for many years to come. A rebound for the beleaguered Shanghai index (down 50% from its mid-2015 peak) would indicate an improving outlook.

To the delight of the markets, Fed Chairman Powell ushered in the New Year by signaling that the Fed intends to be more flexible with all of its monetary policy tools.  Nonetheless, with financial conditions still tight, it may be hard to sustain a rally until the Fed actually stops raising rates or suspends its balance sheet reduction.

On portfolio positioning

2018 turned out to be a year with few places for investors to hide. For US investors, it was also one when conventional portfolio diversification was particularly painful. A portfolio holding foreign stocks and/or US small caps significantly underperformed the US large cap sector as represented by the S&P 500 (and the Russell 3000).

One year’s results (even five years’ results) do not diminish the relevance of diversification designed to reduce risk and enhance returns over the long-term, but it’s worth asking why US large caps have outperformed the rest of the stock universe for so long. While there are a number of factors that can be cited depending on the chosen time frame, the primary difference is the growth of the US tech sector. Sales and earnings at Amazon, Google, Facebook, Netflix, Microsoft, and Apple have surged because they are the primary providers of software and disruptive new services to consumers and businesses around the globe. Will these companies continue to grow at exceptional rates? Will their share prices continue to shine? In the short term, it is hard to say. While US large caps are now among the most highly valued stocks in the world and US interest rates are higher than in most developed nations, the tech industry remains strong. It is impossible to know how or when the valuation gap will be resolved, but the increasing scrutiny of privacy and anti-trust issues surrounding these large tech companies means that regulatory limitations may be headed their way.

The significance of the fourth quarter shellacking is yet to be determined. Will it be viewed as a three-month bear market that is already over, or does it signal a transition to a new market dynamic? The end of cheap money and the magnitude of China’s challenges suggest that change lies ahead – the kind where diversification serves its intended role.

More opportunities look interesting in the wake of the recent upheaval. We believe there is no substitute for making risk and diversification decisions based on consistently-applied valuation methodologies and are confident that patience will be rewarded.

What we call normal winter weather has returned in Vermont. One day it’s 10 degrees and sunny, the next day 36 degrees and drizzling – frustrating for skiers, yet easier on those who shovel the snow. Similar volatility may reign in financial markets in 2019. Last year’s complacency has been washed away.



  1. (1)Since 1950, December has finished higher 74% of the time, with an average gain of 1.4%. November and April are close behind. September is the worst at 45% and -0.6%.
  2. (2)The S&P fell 20% intraday and 19.8% close-to-close, small caps (Russell 2000) fell 27% and tech (Nasdaq) fell 23%.
  3. (3)The spread between BBB-rated corporate bonds and treasuries reached 8% in 2008 and registered its post-crisis low of 1.15% early in 2018.