In a Nutshell
- Recession fears prompted the worst quarterly and annual performance for stocks since 2011
- Gold and bonds offered less than their usual support
- 2018 will be remembered as a year of poor performance across all major asset classes
U.S. Stocks – China, the Fed and Recessions, oh my!
Going into October, U.S. stocks were on pace for another solid year. They had continued to advance in spite of trade war worries, a flattening yield curve, and continued Fed rate increases. The market turbulence experienced earlier in the year seemed like a distant memory.
All that changed as summer turned to fall. First, in mid-September, U.S./China trade war tensions flared up with the announcement of increased tariffs. Less than 2 weeks later, the Federal Reserve announced its 3rd interest rate increase of the year, to 2.25%. Along with the increase, the Fed stated that it was going to continue on its planned objective to continue raising rates through the end of 2019.
As a result, the market became increasingly worried that the economy might enter into a recession in 2019 and began to sell off. October worries turned to outright fear in December and ultimately the S&P 500 fell 20%, reaching its low for the quarter on December 24th. This officially put stocks in a bear market.
From a historical perspective, this quarter was the worst for U.S. stocks since 2011. And because of the 4th quarter, 2018 as a whole was the poorest performing year since 2008.
Bear Markets and Recessions
So the question now is how bad will this bear market get and how long will it last. While there are no shortage of opinions on Wall Street, no one really knows for sure. However, if history is any guide, the answer depends on whether there is a recession in 2019. According to a study of bear markets over the past 73 years, the severity and duration of bear markets depends on whether or not the economy subsequently falls into recession. (Source: LPL Financial)
There have been 7 recessions since World War 2 and every one of them has been preceded by a bear market. However, there have also been 7 other bear markets that did not accompany a recession.
The bear markets followed by a recession were much more severe and longer lasting than those without a recession. For the recessionary bear markets, stocks typically dropped more than 30%. In the last 2 instances, 2000 and 2008, they dropped 49% and 56%, respectively. And it took on average 34 months to recover their old highs.
Non-recessionary bear markets, however, typically were much shallower, not dropping much more than 20%. And they recovered their old highs within 11 months, on average. The last 2 bear markets without a recession, in 1998 and 2011, recovered in 3 and 5 months respectively.
Severe or Mild?
So will this latest bear be more severe like those in 2000 and 2007 which preceded the last 2 recessions? Or will this be another non-recessionary bear similar to 1998 and 2011, where markets barely dropped 20% before rebounding strongly?
Barring a black swan event, the weight of the current economic evidence would indicate that this bear market won’t be accompanied by a recession.
There are a number of financial and economic indicators that historically have been very good at predicting recessions. One that gets a lot of attention from the financial press is the yield curve. I spent some time discussing it in my 2018 2nd quarter review.
Another is the Conference Board’s index of leading economic indicators. The latest reading shows the economy moderating in 2019 but not enough to go into a recession.
If these metrics are accurate this time, this bear may already be in the rear view mirror.
International Stocks – Watch Emerging Markets
Investors diversified in global stock markets saw no benefit in 2018 as both developed and emerging markets fared worse than U.S. markets for the year. However, emerging markets fell substantially less during the quarter. This could be a sign that they may be ready to take a leadership position after years of under-performance.
Bonds – Not Much of a Safe Haven
With the miserable quarter experienced by stocks, you would think that high quality bonds, as represented by the Investment Grade U.S. Aggregate index, would have performed well. After all, they have a reputation as a safe haven during turbulent markets. And they performed admirably during 2008, rising 5.2% that year (Source: Blackrock)
While they did provide a little bit of cushion for investors during the quarter, they finished essentially flat for the year. The reason, as has been discussed multiple times during past quarterly reviews, is that we are still in a rising rate environment.
The Fed raised rates 2 more times during the 4th quarter for a total of 4 increases in 2018. Just as important, in December Fed Chair Jerome Powell stated they were on track to continue raising rates an additional 2 times next year. Rising interest rates and the expectation of further increases tend to mute bond performance. The result was a year where short-term bonds and even some bank savings accounts performed better than long term bonds.
As they are closely tied to the Fed Funds Rate, money market funds and other interest bearing accounts saw their rates rise over the quarter and year. While still nothing to write home about, investors can now find 2+% interest rates for their savings, the best level in several years. And after enduring 2018, investments with a guaranteed return are looking more attractive to yield seeking investors.
Alternative Assets – Gold Glitters
Gold is known as another safe haven asset and it lived up to that title by performing the best of all major assets during the quarter. It’s quarterly performance, however, was not quite enough to generate a positive annual return. Real estate and a basket of other commodities also finished in the red for the year.
2018 – A Historical Year for (Poor) Performance
Looking back over the year, every major asset class had a similar story: solid performance during some portion of the year, but not enough to overcome its poor performance the rest of the time. And, when you look at the number of asset classes that had a positive year, 2018 will go down as one of the worst years in several decades.
Out of 10 major asset classes encompassing stocks, bonds and alternative assets, only 2, or 20%, generated a positive return for the year. By this measure, according to Dorsey Wright & Associates, 2018 was the worst year going back to 1971.
For comparison, in most years at least 70% of major asset classes generated a positive return. And even severe bear market years such as those in 2000 (40%) and 2008 (30%) were better by this measure.
All in all, the 4th quarter caused 2018 to be one for the record books.