2018 started with a bang! Unfortunately for most investors, 2018 drew to an end with a barbaric yawp as the major indices suffered a stark reversal of fortune that was predicated on growth concerns and the price action itself, which was entirely out of character for a bull market.
Briefly, the S&P 500 was up 9.0% for the year at the end of September. As of this writing, the S&P 500 is down 9.7% for the year, with six out of 11 S&P 500 sectors registering double-digit percentage drops.
2018, then, is shaking out to be the first down year for the S&P 500 on a total return basis since 2008!
Will 2019 produce a negative return as well? No one knows for sure, because the future is unknown. That's why the price targets offered by market strategists today should be ignored. They are good for marketing purposes, but that's about it.
What we believe coming out of 2018 is that long-term investment prospects are looking better than they did entering 2018.
Roots of Optimism
We understand our last statement is not above reproach. Critics are apt to make a number of reasonable-sounding rebuttals:
- Interest rates are higher.
- Earnings growth is peaking and comparisons are getting more challenging.
- The trade dispute with China is unresolved and has potential to explode with increased tariffs and higher tariff rates.
- Global economic growth is slowing and the impact of fiscal stimulus in the U.S. is fading.
- Credit spreads are widening.
- The UK is on course for a messy divorce from the European Union.
- The U.S. Congress is a house divided, which is a likely roadblock to passing growth-oriented legislation, like an infrastructure bill, and perhaps a roadblock for a conciliatory agreement to raise the debt ceiling.
- The risk of a monetary policy mistake is rising as global central banks try to extricate themselves from crisis-era policy management.
Those aren't the only rebuttals, but that's a start on the many things to think about when making a case for the investment outlook.
The basis for our more optimistic-minded investment case is rooted in the following:
- Entering 2018, the forward twelve-month P/E multiple for the S&P 500 stood at 18.3x. Exiting 2018, it stands at 14.2x, which is a slight discount to its 10-yr average.
- Entering 2018, the S&P 500 earnings yield was 5.46%, 303 basis points higher than the 10-yr note yield. Exiting 2018, the S&P 500 earnings yield is 7.14%, 435 basis points higher than the 10-yr note yield.
- Entering 2018, the core PCE inflation rate stood at 1.6%. Exiting 2018, the core PCE inflation rate stands at 1.9%, which is still below the Federal Reserve's longer-run target.
- Entering 2018, the Federal Reserve projected three rate hikes in 2018 (and raised rates four times). Exiting 2018, the Federal Reserve is projecting two rate hikes in 2019 and acknowledging that it is closer to the neutral rate.
- Stock prices are lower on an absolute basis, which should be appealing for any long-term investor who still appreciates the fact that it is better to buy low and sell high. We're certain Warren Buffett is feeling that way exiting 2018.
A Shift in the Narrative
It's possible that 2019 ends up being another down year, particularly if trade negotiations with China go awry, interest rates spike, or earnings growth estimates get slashed in a material way because there is a major downshift in the economy, if not an actual recession.
A long-term investor, though, should have a time horizon that is longer than 12 months, which is why we are building the case here that a long-term investor is in a better position to earn a positive return than they were entering 2018.
Valuation is less stretched; the Federal Reserve is presumably closer to the end of its rate-hike cycle than it was at the start of 2018; and the price dislocation at the end of 2018 has started to discount the "known unknowns," which is to say the market has gotten a head start in accounting for negative outcomes for the unknowns, like the pace of economic growth and negotiations with China.
In other words, there will be less surprise if/when those unknowns become known.
That's not to say there isn't more downside to come. A bearish narrative has taken root, which is why there has been constant selling into strength since October versus constant buying-the-dip through September.
That narrative incorporates a flattening yield curve, expected cuts to earnings estimates, an increased risk of a monetary policy mistake, misgivings about the U.S. and China working out a trade agreement, talk of a recession, the underperformance of leadership stocks/sectors, and of course the inclination to sell into strength.
In many respects, it is the converse of the bullish narrative entering 2018.
That narrative featured talk of fiscal stimulus fueling above-trend economic growth and strong earnings growth, rising interest rates being a symptom of a strong economy, resolute leadership from the information technology, consumer discretionary, and financial sectors, invincible performances from the FAANG stocks, and of course the ongoing success of buy-the-dip efforts.
That narrative fueled a terrific start to 2018, so readers shouldn't be surprised if the prevailing narrative now fuels a negative start to 2019.
What It All Means
Crowd psychology can be a major driver of market action and the mood of the investment crowd just ahead of Christmas 2018 is definitely Scrooge-like. The persistent negativity could become its own positive catalyst, serving as a contrarian indicator.
These are short-term thoughts, though, which isn't where we want to go with this perspective on the long-term investment outlook.
The environment isn't ripe at the moment for an all-in investment approach for the equity component of an investment portfolio, but with the sell-off exiting 2018, an opportunity has availed itself to put some money to work at more attractive valuations.
That perspective might not be very popular entering 2019 anymore than a perspective to lighten up on stock holdings was entering 2018.
Still, buying the market at a lower valuation is a better setup for long-term return prospects and that should be the focus of a long-term investor at a time when the short-term outlook is cloudy with a chance of increased volatility.