Fourth Quarter 2018 Key Takeaways
Let’s begin with a comment from our 3rd quarter newsletter:
As for US stocks, no one knows exactly when this record-longest U.S. bull market will end. Despite their unattractive fundamentals, it’s certainly possible U.S. stocks will continue to be favored by investors over the short term. However, S&P earnings growth expectations are now exceedingly high, and the U.S. economy is operating at or near full capacity and full employment. These are unsustainable conditions, and the direction in which they will move next is less attractive for U.S. stocks.
No matter how we slice it, our analysis suggests that the U.S. market is the most expensive major stock market in the world. As a result, it presents one of the biggest risks to our portfolios. Therefore, we have diversified our portfolios’ stock exposure by investing a significant amount in foreign markets that, in contrast, look significantly cheaper and offer a much stronger medium- to longer-term growth outlook. But these positions come with additional shorter-term risk, as we’ve seen so far this year.
Outside of traditional markets, we have added lower-risk alternative investments to our portfolios for their risk management and portfolio diversification benefits. As we have mentioned multiple times in the past, we believe in private real estate funds as a tool that is less volatile than stocks and that pays higher income than bonds.
4th Quarter U-turn – December was one of the worst Decembers on record for investing:
For most of 2018 through mid-November, portfolio returns were treading water. U.S. stocks were positive while international stocks had small losses. At Dickinson Investments we were concerned, but we had no hard evidence in the economic indicators to do anything but hold the course.
Then like a trap door the floor fell out, and U.S. stocks dropped 20% from high to low. It was gut wrenching to watch because it was both violent and sudden. International stocks did slightly better than U.S. stocks, primarily because they had already taken a hit earlier in the year.
Over the short term, if the current recession fears are overdone, we expect to generate strong overall and relative returns. Outperformance should come from our foreign equity positions, active managers, and flexible bond funds.
On the other hand, if U.S. stocks slide into a full-fledged bear market, returns could continue to fall. The confusing thing about recessions is that a good portion of the recession damage occurs prior to any real evidence that we are in a recession. Investors may get scared, but some of the decrease in value has already happened. In fact, stock prices typically start to improve midway through the recession, which is why out-guessing the timing and direction of the next market move is so difficult. Our portfolios have allocations to lower-risk fixed-income and real estate strategies that should hold up much better than stocks.
Successful investing is a process of consistently making sound, well-reasoned decisions over time, and across market and economic cycles. We believe our diversified, fundamental, valuation-based investment approach meets this definition. As long as we continue to execute our approach with discipline and remain patient during the inevitable periods when it is out of favor, we have no doubt we will continue to achieve successful and rewarding long-term results for our clients.
Fourth Quarter 2018 Investment Letter
We have always told our clients that portfolios will show losses every four or five years. Since 2001 these setbacks (2001-2003 and 2008-2009, for example) were deeper than most historical corrections, making total cumulative returns over the years smaller than anticipated. Also, the setback was so deep in 2008 and the recovery was so slow. Even still it has been ten years since a meaningful setback has occurred. Volatility has been lower than normal, and it’s easy to get lulled to sleep and forget what is normal. Last year in the first quarter we warned that volatility would pick up in 2018, and unfortunately, we are back to the “old normal.”
Despite a few half-hearted rallies leading into the closing days, global financial markets ended December with the worst annual returns since the great financial crisis. Larger-cap U.S. stocks fell nearly 14% in the 4th quarter, wiping out year-to-date gains and ending down 4.5%. Smaller-cap stocks fared worse, falling 20% in the quarter and 11% for the year. Foreign stocks suffered through most of the year, with mid-double-digit year-end losses for both European and emerging-market stocks (despite their relative outperformance versus U.S. stocks in the 4th quarter).
Even though the 4th quarter was difficult, the total of 2018 really wasn’t that bad in comparison to what other loss years have been. We feel stress as managers when there are both portfolio losses and clients taking withdrawals, which when combined weakens portfolios going forward. In hindsight, we are thankful that 2017 was a strong year. In combination, 2017 and 2018 averaged out to produce positive returns overall for the two-year period.
In addition to the equity market declines, what stands out about 2018 is the breadth of negative returns across almost every type of asset class and financial market, whether bonds, equities, or commodities. Even core investment-grade bonds were in the red until the final weeks. It was extremely difficult to make money in the financial markets last year. Our only positive results came from investing in real estate, which both lowered the risk of each portfolio and offset the losses in international stocks.
The lackluster performance of so many asset classes, culminating with the 4th quarter’s dramatic U.S. equity decline, is largely due to the uncertainty that prevailed throughout much of 2018. As the year wore on, early positive market indicators, such as still-solid U.S. economic growth and declining unemployment numbers, were swamped by investors’ fears surrounding ongoing U.S.-China trade tensions, political uncertainties in Europe, and continued Fed tightening, among others.
A Consistent Focus
Most of us understand that maintaining a long-term perspective is important when investing, but often this offers little consolation when we see lower portfolio values than the previous year. This is true even when the previous year was a great year.
Throughout our history, we’ve succeeded on behalf of our clients by emphasizing the importance of having a long-term perspective. With a long-term perspective comes the necessity of discipline and patience in sticking to your investment process and executing it consistently over time rather than being subject to swings in investor sentiment and market consensus, which more often than not detracts from returns versus enhancing them.
While today’s headlines may be filled with distress signals and warnings of market weakness, it’s worth remembering that just one year ago those headlines boasted 20%-plus global equity gains and historically low market volatility. In fact, most investment strategists expected 2018 would bring a continuation of the synchronized global economic recovery. The sharp market pullback witnessed this past year only reinforces our view that no one can consistently predict short-term market moves. We were uncertain that the good times would continue, but there was no apparent economic news or signals to justify pulling back the risk.
Over the course of 2019, the range of potential equity market outcomes is just as wide as it was going into 2018. Our approach and preparation remain the same. We construct and manage portfolios to meet our clients’ longer-term return goals, which means successfully investing through multiple market cycles, not just the next 12 months. Given our current investments, we are confident our portfolios are positioned to perform well over the medium to long term and to be resilient across a range of potential shorter-term scenarios.
If the current recession fears are overdone, we expect to generate strong overall returns with outperformance from our foreign equity positions, active managers, and flexible bond funds. On the other hand, if U.S. stocks slide into a full-fledged bear market, our portfolios have “defensive positions” in the form of lower-risk fixed-income and real estate that should hold up much better than stocks. However, in a bear market portfolio values will nevertheless decrease in value.
Speaking of U.S. stocks, in the period since the financial crisis, there has seemingly been little need to own anything other than U.S. stocks. It’s a tendency for investors to look at the poorest performing portions of their portfolio and want to dump the worst investments. In other words, it’s very difficult to keep buying international and emerging market stocks. However, the multiyear period of U.S. stock market outperformance versus the rest of world is reaching an extreme relative to history. The results of the past 10 years are not sustainable, and they won’t be repeated over the next 10 or 20 years. It could be a disastrous result to dump the recent poor performing international stocks and to buy more U.S. stocks just at the moment this trend reverses.
Even after their 4th quarter declines, U.S. stocks are still expensive. However, many markets elsewhere are oversold (i.e. possibly cheap), strengthening their appeal for long-term, value-seeking investors like ourselves. Europe is historically cheap, with a lot of the worries (e.g., Brexit, Italy’s political and debt concerns) likely already priced in. Also, the selloff in Asia has been particularly severe. Here again the market seems to be overreacting to potential risks (e.g., a slowdown in China) rather than reflecting the true value of emerging markets, which is a vast investment opportunity that continues to expand at a faster rate compared to developed markets. Despite the risks we see over the short term, we have high conviction that our investments in European and emerging-market stocks will earn significantly higher returns than U.S. stocks over the next 5-10 years.
Our allocations to foreign stocks also provide our portfolios with diversification away from the U.S. dollar. After the dollar’s strong performance, the past several years, a U.S. budget deficit not seen outside of recessions or war, and the overvaluation we see in U.S. stocks, we believe the U.S. dollar is a risk factor that investors would be prudent to diversify away from.
There is a natural tendency to feel the pressure when the chips are down. After a bad year it might feel like risk is increasing and it’s now time to head for cover. We fight this tendency as well, but as disciplined investors we know that the truth is (even if it is counterintuitive) that the cheaper stock prices go, the lower the risk. This is not to say that everything will return to normal on cue; difficult markets may continue longer than we feel is natural. Eventually value is recognized, and motivated buyers step into the gap and start placing their bets, which stabilizes and even increases market values.
The 4th quarter, or more specifically December, may have seemed like a disaster if you overwatch the news, but the year taken as a whole was not as bad as historical corrections. In addition, keep in mind that your individual portfolio is not fully invested in the stocks you see on TV. After a strong 2017, portfolio values had some buffer built in, and a normal year in 2019 can restore investment values to where they need to be to make long-term retirement distributions.
Unfortunately, there is still significant risk, and a second poor year would indeed add significant stress. We also recognize that the economy has not experienced a recession for a long time. Let’s be clear: a recession in the economy does not necessarily mean a market crash. In fact, the December turmoil may just have been the stock market anticipating a recession in advance, so part of the damage could well be in the past. Still, a recession starting in 2019 would not be helpful. Most of our trusted research sources do not indicate that the risk is high that we will have a recession this year. However, we know as with all cycles that one is coming sooner or later.
Given our outlook, we continue to advise clients to allow us to play some defense, and we also ask them to avoid any unnecessary large portfolio expenditures. We have a lot of clients taking income distributions that average around 4-5% of portfolio values. These are OK when we have built this into your financial plan, but we advise against any distributions in excess of these recommended amounts. There will be years again like 2017 that earn in excess of your withdrawals and add a cushion to your portfolio.
Successful investing is a process of consistently making sound, well-reasoned decisions over time and across market and economic cycles. Our goal is never to track or beat a particular benchmark from one year to the next, but rather to provide our clients with the optimal return for the environment we’re given and the risk profile of their particular strategy. Given this approach, it is normal, not unusual, for us to go through periods that are difficult. As we continue to execute our approach with discipline and patience during these inevitable periods, we will continue to achieve successful and rewarding long-term results for our clients, as we have over the life of our firm.
As always, we appreciate your trust in us and welcome your questions.
Ron Dickinson , CPA, CFP®, MPA-Tax
[Financial Planning and Investment Management Services offered through Dickinson Investment Advisors, Registered Investment Advisor. Statistics and market information provided by Litman Gregory Advisor Intelligence.]