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Market Commentary: Fourth Quarter 2018

Market Commentary: Fourth Quarter 2018

December 31, 2018
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Executive Summary

When my kids were younger, we occasionally ventured to the amusement park for family fun. Rollercoasters were not my thing, but I would gather my courage to ride with my kids who loved the thrill. One day we came across a new ride called “the cliff”. The name says it all. We were strapped into a seat, lifted to the wall’s top, then pushed over the ledge and plummeted for what seemed to take forever. My stomach jumped into my throat. Thank goodness we survived.

Just like “the cliff” experience, the Dow dropped more than 1,000 points twice in February, and then again over a two-day period in November. Who would have thought the Dow would plummet 1,000 points?1 The stock market then staged a miraculous comeback the Wednesday following its worst-ever Christmas Eve. (2) Despite the rally, one good day is not a trend.

What do these dramatic swings mean for the economy?

For the economy, the U.S remains strong, but we are entering the later stages of the business cycle as the Fed tightens its reigns. China acknowledged slowing growth with a clear shift toward policy easing. Global activity has likely peaked. While corporate liquidity is ample, it may not be enough to offset central bank liquidity. Trade strains will persist as a headwind, with potential to adversely affect late-cycle pressures.

Bear to Recession?

The U.S. stock market flirted with bear-market territory (typically defined as a 20-percent drop from a prior peak) before a brief rally closed the month, reeling it back from the edge.

Globally, we were in bear market territory this past quarter. The question now is whether we are now entering a recession. Every recession was preceded by a bear market, but not every bear market was followed by a recession.3 So where do we stand?

Let’s take a look:

  • The S&P 500 finished December 2018 down 6.2% from the December 2017 level, the harshest month-over-month drop since early 2016.
  • The S&P 500 monthly data trend ended 2018 lower than it opened, posting the worst calendar-year decline for the US stock market since 2008.
  • The just-recorded month-to-month drop of 9.2% was the second-sharpest November-to- December decline on record. The sharpest? 1931 – not good historical company to keep. (4)

Unfortunately, it does not appear that the stock market has turned the corner with the new year. The actual economy is typically measured by U.S. Industrial Production or U.S. Gross Domestic Product, which are more reflective of the conditions that business leaders will be navigating in 2019 . That is not to say that the stock market is irrelevant, only that it does not always accurately depict what is happening on the ground.4

Some economists argue the economy will continue to be strong with no sign of recession and that equities remain cheap since valuations have declined. Data used to support this thesis includes:

  • Unemployment remains low.
  • Worker wages are accelerating.
  • Automakers reported that Americans bought cars and light trucks at a 17.55 million annual rate in December, the fastest pace since November 2017.
  • Monetary policy may be tightening but is not tight relative to historical standards.
  • Companies are still adapting to lower tax rates.
  • A trade deal was reached with Mexico and Canada and negotiations with Europe and Japan should result in lower tariffs.5

One could interpret this to suggest a recession will not start anytime soon. At some point the U.S. will have a recession, but these pundits believe “not now”.

So, What Is Our view?

We tend to view the S&P 500 as a leading indicator for what is to come. With the flurry of negative signals in recent weeks, the U.S. stock market has definitively joined the chorus of other leading indicators that are signaling a coming shift in the macroeconomy in 2019.4

Our outlook is deceleration in the macroeconomy in 2019. We believe the U.S. economy may experience a recession in 2019. Business executives should prepare for a more turbulent year ahead. Recession risks in China and other global regions may accelerate the timing.


What Does This Mean for the Stock Market?

The decline in stock prices in 2018, combined with higher corporate earnings, has reduced the multiple on 2019 consensus S&P estimates to less than 14 times. (Our definition of earnings is operating earnings with goodwill amortization added back.)6

That multiple is about 15% below its historical average. We see no reason to think bond yields have become high enough to warrant this lower P/E. The 10-year Treasury yield is less than 3% today, despite averaging 6% over the past 40 years when stocks averaged a higher P/E.6

Stocks have historically been the best performing asset category, and from this starting point, stocks may outperform bonds by more than they usually have.

Geopolitical events have been and will always be part of the investing climate. Elections, trade disputes, wars and other forms of conflict tend to have large impacts on short-term stock prices. The EU and China are both saddled with several meaningful economic issues. Despite this, what fundamentally impacts value is not macro events, but factors that impact a company’s ability to generate cash and create value for its owners over the long term. 

Ten-year Treasury yields rose to their highest levels since 2011. Inflation expectations have not changed much, but real yields are at the upper end of their range since mid-2011, signifying a modest but sustained rise in inflation-adjusted borrowing costs.7

What Does This Mean for Our Portfolios?

While our crystal ball is as cloudy as anyone else’s, we believe 2019 may experience a recession but asset prices may rise by year-end.

Bull and Bear Markets


It is important to understand that Bear markets are measured in months while Bulls are measured in years. On average, Bear Markets last from 9-14 months. Remember, a Bear Market means asset prices decline by 20% or more. If indices decrease by more than 10% but less than 20% the downturn is considered a correction.8 The longest Bear Market did not begin in 1929 or 2007. Rather, it started January 11, 1973, and lasted 437 days, or 14 ½ months.9

Also note that the market doesn’t lose an investor money. An investor loses money when he or she liquidates at the wrong time. If investors have enough cash to make it through a Bear market, then they should feel confident in their financial plans because they have time to let the markets rebound.

Given the average Bear Market length, we recommend investors hold 24 months of expenses in cash when they are in or approaching retirement. This insulates from raising cash from their portfolios to fund their expenses. 6-12 months may be appropriate for someone in the accumulation phase of life with plenty of years until retirement.


By contrast, the average length of a Bull Market is almost five years.10 Economists vary in their calculation of Bull and Bear market average lengths. What is important to note is that all estimate that Bulls last five times longer than bears.

While the bear’s duration is short as compared to a bull, it can seem long and sometimes scary. What is the risk of the stock market? Risk is the chance of a permanent loss of capital. In the 38 years in which I have been advising clients, it has never been clear to me how investors think this would happen.

One reason it is hard to imagine that a permanent or semi-permanent decline would not happen is that it has never happened. Equity values have certainly declined sharply on many occasions, as we saw in 2018, and should be expected to do so again and again. Prices have also risen sharply and on many more occasions. All declines have been temporary and have been completely overwhelmed by the subsequent advances to yield positive returns long term.

Long Term Investing Sounds Logical, But What About Those of Us Who Are Retired Already?

Since Millennials and Gen Z-ers have years to accumulate, Bear markets should not be a concern. For those approaching or in retirement, Bear markets and corrections DO matter. These investors do not have the luxury of waiting for the recovery since they need money today. They have already saved all they could and now need to make sure their money outlives them.

Does this mean that when we anticipate a market correction or a bear that we should move everything to cash? The answer is “NO”. Does this mean that we simply let portfolios ride in the market without making adjustments? The answer is also “NO”.

As we have preached over and over to clients in retirement, the first step from a financial planning perspective is to have enough cash in order to insulate the portfolios from being liquidated at the wrong time. In the past, this has proven successful for clients in retirement.

Our Portfolio Management & Financial Planning Advice

So, what do we do with the portfolios? There are ways our investment committee addresses both protection on the downside and opportunity on the upside. Our long-term approach is to adjust the portfolio’s risk through asset class tilts and security selection rather than try to time the market. Our investment committee seeks to increase returns more than the equity benchmarks during the bull phase and go down less during inevitable bear corrections. While certainly not a guarantee, we believe it is a viable strategy.

  • We track certain data points that signal whether the market is at risk of declining asset prices or has momentum pushing prices up.
  • One change we consider is tilting the allocation towards more fixed income and cash when asset prices are trending down. Alternatively, we tilt towards greater equity exposure when asset prices are moving up.

Time in the Market is More Important than Timing the Market

Research conducted by Charles Schwab showed that no 20-year holding period in the stock market produced negative returns. (11) Schwab also did a study that shows if an investor was out of the market the one best day each year for any holding period that the return would be almost one-half of that for those that remained invested all days.11

Bull market gains outweigh bear market pain.


Sound financial planning requires investors to hold strategic amounts of cash to mitigate the risk of liquidating investments at the wrong time. This is especially important when volatility is prevalent as it is today. While market declines may be emotionally difficult, the risk of permanent loss in a broadly diversified portfolio is not merely a misunderstanding, but a myth.

Stocks are shares of companies that represent direct ownership of the earnings, cash flow and assets of businesses, some of which investors patronize. The reality of stocks as companies and not casino chips is elementary to pacifying the emotional overreactions during the inevitable periods of market decline and perception of portfolio losses as permanent.

Another illusion is that the stock market is tied directly to the economy minute-to-minute and that during market downturns the economy is forever on the brink of implosion. The optimal long-term investment posture is not fear but faith in the market and in the companies that make up the market globally.

The press presents crisis after crisis, real or imagined, as the very thing that will take down the stock market and destroy everyone’s retirement.

As advisors, we exist to provide clients with transfusions of enduring faith when, under the onslaught of negative news and declining asset prices, clients’ own faith runs dangerously low. The economy will remain healthy this year, recession or not, and so will our clients’ financial plans.


(1) Jen Kirby, Vox, February 8,2018,

(1) Dow Jones Falls 1,000 Points In 2 Days; Will These 7 Growth Stocks Hit Bottom?, David Saito-Chung, Investors Business Daily, November 20, 2018.

(2) Dow Soars 1,086 points in a miraculous comeback, Sherisse Pham & David Goldman, CNN Business, December 27, 2018.

(3) The Relationship Between Bear Markets and Recession, Personal Finance, Written by PK,, DQYDJ, December 26, 2018,

(4) ITR Experts Say: Loaded for Bear, Institute for Trend Research, Connor Lokar, January 8, 2019.

(5) No Sign of Recession. Brian S. Westbury, Robert Stein, CFA®, Strider Elass, First Trust Monday Morning Look, January 7, 2019,

(6) (Bill Nygren Market Commentary Q4 2018, Harris Oakmark, “Seeking Alpha”, )

(7) (Fidelity Quarterly Market Update: Q4 2018, )

(8) How Long Do Bear Markets Last?, Investopedia, SearchBox&FORM=IESR4A

(9) The Worst Bear Market That Nobody Ever Talks About, Michael Batnick, CFA®, The Irrelevant Investor, May 4, 2016,

(10) Happy Birthday, Bull Market! It may be your last, Jen Wieczner, March 9, 2017, Fortune Magazine,

(11) Buy-And-Hold Investing Vs. Market Timing, Michael Schmidt, November 28, 2012, Investopedia,

(12) The following describes the asset classes that are referenced in these market commentaries and which make up the asset classes in our portfolios.

The U.S. Large Cap asset class is measured by the S&P 500 Index, which is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The U.S. Mid Cap asset class is measured by the S&P Mid Cap 400 Index, which is the most widely used index for mid-sized companies and covers approximately 7% of the U.S. equities market.

The U.S. Small Cap asset class is measured by the S&P Small Cap 600 Index, a market value weighted index that consists of 600 small-cap U.S. stocks chosen for market size, liquidity and industry group representation.

The International Developed Markets asset class is measured by the Morgan Stanley Capital International Europe, Australasia, and Far East (MSCI EAFE) Index, which is composed of all the publicly traded stocks in developed non-U.S. markets. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The International Emerging Markets asset class is measured by the MSCI Emerging Markets Index, which is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

The Real Estate asset class is measured by the Dow Jones US Select REIT Index. The index is a subset of the Dow Jones U.S. Select Real Estate Securities Index (RESI), which represents equity real estate investment trusts (REITs) and real estate operating companies (REOCs) traded in the U.S. The indices are designed to serve as proxies for direct real estate investment, in part by excluding companies whose performance may be driven by factors other than the value of real estate.

A Real Estate Investment Trust (REIT) is a tax designation for a corporation investing in real estate that reduces or eliminates corporate income taxes. In return, REITs are required to distribute 90% of their income, which may be taxable, into the hands of the investors. The REIT structure was designed to provide a similar structure for investment in real estate as mutual funds provide for investment in stocks.

The Commodities asset class is measured by the Bloomberg Commodity Index (BCOM), formerly the Dow Jones-UBS Commodity Index, which is a highly liquid, diversified and transparent benchmark for the global commodities market. It is calculated on an excess return basis and reflects commodity futures price movements.

The Global Equity Index as referenced in this report is the combination of the equity indexes listed above in proportion to Northwestern Mutual’s strategic asset allocation model for the equity aggressive model and as reported by Morningstar Direct as of 06.30.2018.

The Barclays U.S. Aggregate Bond Index, formerly the Lehman Brothers U.S. Aggregate Index, which is an index of the U.S. investment-grade fixed rate bond market, including both Government and corporate bonds, measures the Taxable Fixed Income asset class.

The Barclays Municipal Bond Index, which is a rules-based, market-value weighted index created for the tax-exempt bond market, measures the Tax-Free Fixed Income asset class, i.e. “muni bonds”.


The opinions expressed are those of John Gatewood as of the date stated on this material and are subject to change. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss. With fixed income securities and bonds, when interest rates rise, bond prices usually fall because an investor may earn a higher yield with another bond. Moreover, the longer the maturity of a bond the greater the risk. When interest rates are at low levels, there is a risk that a significant rise in interest rates can occur in a short period of time and cause losses to the market value of any bonds that you own. At maturity, the issuer of the bond is obligated to return the principal (original investment) to the investor. High-yield bonds present greater credit risk than bonds of higher quality. Bond investors should carefully consider risks such as interest rate risk, credit risk, liquidity risk, securities lending risk, repurchase and reverse repurchase transaction risk.

Investors should be aware of the risks of investments in foreign securities, particularly investments in securities of companies in developing nations. These include the risks of currency fluctuation of political and economic instability and of less well-developed government supervision and regulation of business and industry practices, as well as differences in accounting standards.