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As 2018 wound down, the fourth quarter certainly reminded us that markets don’t always go up in a straight line. Volatility returned to the markets as equities, fixed income, and commodities gyrated uncomfortably. 2018 was one of those rare years during which both equities and many bond funds finished the year with negative returns.

Much, if not most of the market’s negative sentiment and sell‐off was based on “what‐if” scenarios and not actual data. From the Fed raising rates, oil prices, a peaking economy, Brexit uncertainty, the split congress, China trade, China growth, Trump being Trump….the markets attempted to digest quite a bit of uncertainty without much success. Furthermore, the December correction was exacerbated by year‐end computerized, high frequency trading as momentum indicators kicked in and corporate fundamentals and valuations were pushed aside. Markets will sometimes do crazy things in the short‐term, and it can be frustrating for us investors.

Taking a step back from these various perceived risks, it’s important to remember that a “peaking” economy and earnings cycle does not mean a contracting one. The IMF still forecasts global growth of 3.7 percent for 2019 and for the US economy to expand by 2.5 percent next year. Earnings‐per‐share growth for S&P 500 companies is expected to be around 8 percent in 2019. Inflation measures are plateauing and interest rates remain at historically low levels; both should support higher valuations. Also, current valuations are attractive, with U.S. equities trading at 15x this years expected earnings and overseas markets closer to 12x earnings. Importantly, expectations regarding Fed rates hikes in 2019 have been reduced from as many as four to probably just one or two, which should calm the markets substantially. From the Fed’s perspective, the recent correction is not unusual. When the Fed tightens for 8 quarters in a row it does not expect to be totally ignored by the market. In particular, the Fed has been expecting a modest tightening in financial conditions, including a rise in the whole yield curve, and yes, the occasional equity market correction.

A few months ago I wrote that the likelihood of a market pullback is present and corrections are normal functions within the markets. Historically, these sell‐offs have been short‐lived especially when occurring during periods of strong corporate fundamentals, which presently is the case. The markets hit a low on Christmas Eve but, in showing signs of coming off a bottom, regained strength as the year closed. 2018 was a record year for corporate earnings (around 25% growth) and if 2019 has any growth at all (estimates range from 6‐12%), it will be another record year for corporate profits. Given the strength of earnings, continued GDP growth, and attractive valuations, once the markets return to trading on fundamentals, equity prices are poised to move higher. This upcoming earnings season should be important for the market’s near‐term direction. If earnings come in better than expected, we should see a higher move for stocks. If earnings don’t meet expectations, then this market will more likely continue to languish for a while longer before having its next run‐up. Importantly, corporate balance sheets are strong, valuations are attractive, and employment and wages are at record levels.

I hope you had an enjoyable Holiday Season and I wish you a blessed New Year.

Best Regards,
Clay

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