The final quarter of 2018 had the feel of the highly volatile first quarter.  The year began with enthusiasm as lower taxes sent stocks to all-time highs.  This euphoria quickly subsided and morphed into a rapid 10% price correction.  Entering the fourth quarter, major U.S. stock market indices had reached new all-time record highs, only to finish the year with another round of gut-wrenching declines.  This time the correction reduced S&P 500 values by 13.5% for the quarter and ended down 4.38% for the year.

The fourth quarter left a mark on both client assets and their psyche. Wild price swings are uncomfortable even for the most seasoned investors.  Heightened volatility came from many sources.  This time the list included higher short-term interest rates, the Federal Reserve’s tightening monetary policies and hawkish comments, potential for an inverted yield curve, trade tensions between the U.S. and China, a government shutdown, slower global economic growth, falling oil prices, politics and simple old-fashioned fear.  Through time, the market cycles from rising prices to price corrections that eventually pave the way for future upside potential.  The pathway to a better 2019 will be built on a foundation of strong economic fundamentals.  Consumer confidence remains high, unemployment is low at 3.7%, corporate earnings are expected to grow 8-10% next year, and GDP growth is expected to be in the 2.0-2.5% range with low inflation.

Solid economic fundamentals did not deter this quarter’s painful price correction.  Stocks largely went into freefall from highs set in September.  The major indices experienced fear-inducing declines.  The NASDAQ Composite, S&P 500 and the Dow Jones Industrial Average lost 17.3%, 13.5%, and 11.3% respectively in the fourth quarter.  International stocks also struggled as the MSCI EAFE and emerging markets indices produced losses of 12.5% and 7.5% for the quarter.  The high flying “FAANG” stocks that carried the markets to new highs over the past nine years were hit hard.  Amazon, Apple, Alphabet (Google), Facebook, and Netflix experienced quarterly declines between 13.4% and 30.6%.

When stocks fall, bonds usually provide some portfolio relief.  Thankfully, investment grade and treasury bonds did that in the quarter.  Despite a fourth 25 basis point rate hike to the fed funds rate this year, the Bloomberg Barclays Aggregate bond index managed a positive 1.6% return for the quarter.  Unfortunately, high yield bonds suffered along with stocks, declining 4.5% in the fourth quarter.  The benchmark 10-Year U.S. Treasury fell below 3% yield in the fourth quarter, declining by 36 basis points to end the year yielding 2.69%. The yield curve flattened on the short end and steepened on the long end as the 2-Year Treasury fell by 33 basis points to end the quarter yielding 2.48%.  Meanwhile, the 30-Year Treasury fell 17 basis points to yield 3.02%.  The yield curve showed its first signs of inversion as the 2-5 year segment of the curve temporarily inverted, but for now the overall curve remains positively sloped.

We consistently preach the necessity to remain focused on your long-term financial goals.  A violent correction, like the one just experienced, creates fear.  If left unchecked, fear will cause well-intended long-term investors to sell low and buy back at higher prices.  It takes courage and commitment, but it is important to avoid this very-common investor pitfall.  Hopefully, your financial plan has been carefully constructed with your long-term goals and risk tolerance levels in mind.  Staying the course in the face of fear is challenging but necessary to achieve your long-term objectives.  The pain here is real, but time will eventually heal these wounds.  Starting 2019 after a fairly significant correction in 2018 energizes our outlook for the New Year, as we forecast generally stable interest rates and mid-to-high single digit stock returns.

MARKETS BY THE NUMBERS:

To expand on these Market Commentaries or to discuss any of our investment portfolios, please do not hesitate to reach out to us at 775-674-2222

In December, both US and international stocks have experienced a significant sell off.  The S&P 500 has now declined approximately 20% (peak to trough) from all-time highs set in September.

Many investors are left wondering what to do now. It’s perfectly normal to have questions and concerns when markets have severe downturns.  When making decisions after market sell-offs, it’s important to control emotions and avoid panic movements you may regret later.  In that regard, here are suggestions we have regarding the current situation and what investors can think about:

1. Understand that this happens in the stock markets. According to Sam Stovall, Chief Investment Strategist for CFRA, the S&P 500 has had 22 corrections (defined as 10% down from recent highs) and 12 bear markets (defined as 20% down from recent highs) since 1945.  While never enjoyable, these events are relatively common in the markets.  Over longer periods, however, stocks remain the best source of growth for portfolios. 
2. Understand the purpose of the different assets in your household portfolio. At Gradient, we strive to diversify client portfolios in accordance with their individual risk and return objectives.  What this means is that we utilize assets that are relatively safe (bonds, cash, annuities) in conjunction with more growth-oriented assets (stocks) to provide a diversified financial plan that meets your risk and return objectives.  When stocks are increasing rapidly, investors tend to wonder why they own assets that aren’t growing as fast.  When stocks are falling rapidly, investors tend to wonder why they have stocks in the market at all.  By understanding the purpose of the investments in your portfolio, it provides greater clarity on your financial plan on how those assets work together to meet your objectives.
3. Rebalance and make moves at the margin. If you feel the need to “do something” as a result of changes in the market, it is always better to make moves at the margin rather than making “all-in” or “all-out” transactions.  Timing the market is incredibly difficult to do and is typically a detractor of value over time.  However, an action that can add value is periodic rebalancing.  As markets rise and fall, current allocation weightings can change from their original long-term allocations.  Periodic rebalancing allows investors to sell stocks after a sharp rise or buy stocks after a significant decline. This realigns portfolios back to their appropriate percentage allocations in accordance with your financial plan.
4. At Gradient Investments we understand that during sell-offs investors often tend to throw out the baby (good companies) with the bath water. We use this situation opportunistically to realign our portfolios internally. During the decline we have been scouring each portfolio’s investable universe for opportunities as valuations get cheaper for companies that are high quality and have sustainable long-term growth profiles.  We transition stocks within portfolios to take advantage of those opportunities. We also aim to rebalance not only our allocation portfolios, but also the stock portfolios as prices bottom out.

In our opinion, investors fare better having a long-term financial plan that incorporates several asset classes to meet their objectives.  Diversification works over time, but doesn’t work all the time.  Understanding how assets work together in your overall financial plan can shield investors from making decisions based on emotion. This gives them a better chance of achieving their long-term objectives.

To reiterate our stance from early December, we believe:

• 2019 is a slowing growth, but not recessionary, economy.
• Consumers remain relatively healthy and are spending
• Corporate earnings growth will slow from 2018, but should still have mid-single digit growth in 2019
• Valuations are more attractive now than they were 3 months ago

In summary, market declines are normal but still difficult to deal with. A diversified financial plan (including both safe and growth assets) can provide less volatility over time while still helping achieve long-term goals. Before making portfolio decisions please talk to your advisor to get an objective opinion on the situation. Finally, keep in mind that our economic forecast is still constructive, and after the recent pullback we feel the prospects for positive market returns in 2019 are strong.

To expand on these Market Reflections or to discuss any of our investment portfolios, please do not hesitate to reach out to us at 775-674-2222.

Global markets have been under pressure so far in October. In fact, there really hasn’t been any safe-haven around the world except cash. Let’s look at the returns of the last 4 weeks and year-to-date (YTD) as of 10/26/2018 in various markets around the world*:

Those type of returns around the globe are alarming. Especially when things seem to be doing well in the US economy and corporate America. Isn’t US GDP growth quite strong, unemployment at record lows and corporate earnings growth strong? They are, so what is causing investors so much anxiety these days? I’ve explored several reasons why investors might be selling below:

The Federal Reserve has been raising interest rates. So far in 2018 there have been 3 rate hikes with the Fed telegraphing one more in December. Concerns abound that the Fed will raise rates too fast and spur on an economic recession. The benchmark 10-year treasury is now over 3%, a level it hasn’t seen since December of 2013. See chart below**:

In reaction to higher rates, homebuilding and auto industries are showing some slowdowns. These are important industries in the US. Will this continue? See charts below:

Inflation also has investors concerned. Full employment can lead to wages growing and a strong economy can lead to higher costs both for consumers and corporations. Inflation is now above the 2% level which is the Fed’s longer-term target. See chart below**:

The tariff wars the US is having with other countries is also causing investor angst. So far, the tariffs that have been imposed have not slowed down the economy. But if the trade war continues there is the potential for it to negatively impact the economy. The below chart reflects the possible negative impact a tariff war could produce on our economy’s GDP growth:

Finally, there seems to be some concern that the US economy and corporate earnings growth has peaked and will incrementally look less robust in 2019. There is some merit to this as earnings growth in 2019 is forecast around 10% yr/yr (versus roughly 20.5% in 2018)*** and it will be hard for the US economy to continuously produce 3-4% GDP growth every year.

In summary, investors are concerned about rising interest rates, inflation, tariffs and a peaking US economy. In addition, we are now in 3^rd quarter corporate earnings reporting season and many CEOs are mentioning that inflation and tariffs have the potential to hurt their profits going forward. All of this has led to the market pulling back despite what seems to be a constructive environment for stocks.

Is this just another correction in the stock market that happens all the time? Or is this the end of the long bull market and the start of a bear market? We don’t have a crystal ball, but we feel this is an overdue correction and not a crash. We don’t see the economy slipping into a recession anytime soon. Remember corrections (periods of 10-20% declines) are much more frequent than bear markets. In fact, since 1974 of the 22 corrections that have taken place only 4 have turned into bear markets. See the chart below****:

Stock markets look forward, and right now the concern is about future growth being negatively affected by interest rates, tariffs, inflation, etc. In times like these it helps to keep an eye on the longer-term and ask yourself if you are correctly allocated between stocks and bonds. Also, look back and see if your financial goals and objectives are on track. If they are, stay the course. Don’t let the emotional halo of a correction drive you into decisions you may regret.

*Morningstar, Inc Index Performance: Return (%)

**Economic Research, Federal Reserve Bank of St. Louis

***FactSet, Earnings Insight, October 26^th, 2018

****Schwab Center for Financial Research with data provided by Morningstar, Inc. The market is represented by the S&P 500 index.

To expand on these Market Reflections or to discuss any of our investment portfolios, please do not hesitate to reach out to us at 775-674-2222.