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The Brave Report: Market Commentary for December 2018

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Yelling fire in a crowded theater… The markets decided to end the year on a bit of a sour note, registering one of their worst months since the financial crisis and logging the first negative year since 2008.  It seems that some people started yelling fire and investors and traders couldn’t get to the exits fast enough.  The selling was widespread, and few sectors were spared.  However, with all the carnage it is important to put everything into perspective.  While most in the media would have you believe the world is ending, the S&P Total Return (the S&P 500 including dividends) only lost just more than 4 percent for the year.  Not really that bad of a year following nine years of healthy positive returns.

Even with all these people yelling fire, I think the rush to the exits has been a bit overdone. While there are currently several risks to the markets and the underlying economy, the theater is not on fire yet.  If anything, there are a few candles burning on stage. Some may be getting bigger and tipping a little more than they were a few months ago but even if they do tip over (which very well might not happen), it doesn’t mean the theater will burn down. I think these risks warrant a reassessment of equity valuations and a normal, healthy correction or consolidation while the uncertainties become clearer but nothing like we saw over the past month. This view may change as we get 4th quarter data and start to get some earnings reports later in the month. I expect to see some softening in the data but not enough to warrant the type of moves we have been seeing.

Market Overview

The markets had their worst month in years, with all three major indices dropping around 10%.  More notable than the severity of the selloff was the lack of dispersion between the various indices and sectors.  It was an equal opportunity sell off meaning that fundamentals were being thrown out the window and the markets were being driven by technical factors, algorithmic trading and ETF selling.  Even more was the intraday movement of stocks.  We often see overnight gaps up or down during big selloffs or rallies but over the past month most of the movement took place throughout the trading day.  We saw a number of days where the markets sold off, recovered or rallied multiple percentage points throughout the trading day. This is not normal trading activity and not natural price discovery. By that, I mean there have been other factors other than the real valuation of companies and the economy driving stock prices.

Unsurprisingly, we saw a rush to safety as equity markets sold off. After starting the month with a yield above 3%, the 10-year treasury rallied to close the year with a yield of just under 2.7%.  We saw similar action across the fixed income complex. This rally in fixed income was not just due to a rush to safety but the fed announcement was also much more dovish than it has been over the past year. The indicated a slower and much more data dependent projection of future hikes.  While the equity markets didn’t fully see the statement this way, the interest rate complex rallied on the news.

Last month I discussed the various risks and uncertainties in the markets going into year end.  What we have seen is a continuation of some of these risks and a realization that unless news around these uncertainties is perfect the default stance in the current environment is to sell. This selling has not just happened because of real news or changes in actual economic data but on the prospect of future bad news and the breakdown of technical support levels. I continue to think these risks are a bit overdone and if there is any resolution around these uncertainties or the actual results are not as bad as the fear mongers would have you believe they could be then I think the companies with strong fundamentals could eventually divert from the rest of the market and rise.  At some point, valuations become to attractive for real money investors to pass up.

I am not saying we are necessarily at a bottom for equities yet and I still expect to see some downside pressure and increased volatility, but the disciplined long-term investor should be able to identify some real long-term opportunities in this environment. Once good news becomes good news again these investors should be rewarded.

To revisit my analogy from earlier, while the theater is not on fire yet there are some candles burning on stage that could tip over and cause some short-term damage. They won’t burn the theater down like we saw in 2008 but these risks should be factored into valuations.

Global Growth Fears: The candle that has moved to the forefront seems to be fear of global growth slowing.  The cheap money environment we have been in for the past decade is starting to be phased out. There is concern around the trade war with China and Brexit concerns in Europe.  Domestically we also saw a boost to the economy from the tax cuts that went into place earlier this year. With all these factors considered, a number of economists are projecting a slowdown in global growth. While I would agree we will probably see growth slow it is important to remember that it is slowing from a very high rate in historical terms. Since 2011 we have only seen four quarters with a higher growth rate than we saw the last two quarters so even if growth drops from the 3.5% we saw in Q3 of 2018 the expectation is still for it to be in well in line with long term average growth.

There have been some, especially in the media, that are calling for a recession in the next one to two years. So far, most economic data does not support this hypothesis. Some data does support a slowdown in growth but in the absence of a major policy mistake, a full recession is unlikely this year. The outcome of trade discussions along with Fed policy decisions could change this but I see that as a low probability tail risk. With that said, the things that could cause a recession is the fear of a recession itself.  Recessions can sometimes become self-fulfilling as fears of a recession cause companies to reduce spending and handicap growth. Again, I don’t see this happening any time soon, but I could be a concern is some of these uncertainties are not resolved in a responsible manner.

It is also important to point out that a recession doesn’t mean that the stock market drops.  It often drops leading into a recession but since World War 2 the market has been positive during 6 of the 11 recessions with a median return of 5.4%. So, while I am not expecting a recession to happen, especially if a trade agreement can be reached, I am also not overly concerned if one does occur.

Trade War:  I have touched on the trade war at length in previous reports, so I won’t linger on it. All signs seem to show that some progress is being made and that a trade deal will eventually get down. However, with the environment we are in right now, until an actual deal is announced any market reaction from progress will be muted.  As I said earlier, the only positive news investors are reacting to is perfect positive news.

Fed Policy: The other big candle that is burning on stage is interest rate policy.  The Fed again raised rates in December, much to the dismay of investors.  I think Powell is in a very difficult situation.  Most economic data are showing the economy is strong which would justify continued rate hikes. But the stock market is showing something different.  Powell’s job is not to react to stock market but to make decisions based on what the overall economy is doing, and the stock market does not always represent the underlying economy. Now, I am not saying Powell was right in raising rates in December, but I think the reaction to the hike and his statement has been overdone. Over the next few weeks we will start to get some real data about the 4th quarter and this will be very telling as to what the Fed’s next move is.

Many investors, and especially media pundits read Powell’s statement as he is going to do two hikes next year and this sent the markets into a tailspin.  I read his statement very differently. While he did project two hikes for next year he said that was based on the current economic data. He said if that data changes then he will adjust those projections. This is the most data dependent he has sounded in any of his statements since taking over leadership of the Fed. It is also important to note that since the Fed started to raise rates a few years ago they have never raised in line with their previous projections.  I think that in a different market environment this announcement would have caused a positive reaction in the markets but in the current environment it wasn’t good enough.

Strategy Commentary

I continued to maintain my equity allocation throughout the month. As I discussed last month.  Making widespread changes during these types of markets can be a dangerous game of timing that can often backfire.  The only adjustments I made were in the name of some tax loss harvesting and had nothing to do with a change in sentiment.  After years of gains there was finally an opportunity to realize some gains and losses in some equity positions and save some money on taxes

Domestically I maintained my allocation.  If we start to see a bottoming in the market I will selectively look to move into some high-quality names, especially in the technology space.

I am maintaining my underweight to most international markets. I will continue to add selectively to emerging markets names as news on trade negotiations materializes.  I think those markets have been showing more of a bottoming and could be huge winners if a trade deal is reached.

I have still maintained my underweight to most of the fixed income space. This was a major missed opportunity over the past month with the rush to safety but if equity markets stabilize I expect rates to bounce back a bit.  If the fed continues to sound more dovish I may start to add back some of my fixed income exposure, especially in my longer-term portfolios.