3 Market Developments to Watch in 2019

December 21, 2018

As 2019 beckons, we close the book on an unusual 2018. The market has demonstrated record corporate earnings and strong fundamentals this past year, 1 but has also been punctuated with volatility and major trade tensions2 that have kept returns at bay. 

 

In this article, we’ll identify the three most important economic considerations for markets to keep an eye on entering the New Year.

 

1. Trade war with China: The primary issue driving markets today is ongoing trade turmoil between the U.S. and China. This rift has already damaged both economies, particularly China’s as it contends with bear market conditions and indications of slowing economic growth.3 In the U.S., broad markets have declined 12 to 13 percent in value,4 while small companies have now tipped over into bear market territory.5

 

This mutual detriment caused by the standoff should hopefully motivate both sides to reach a resolution in the near future. China appears on the verge of making some concessions related to tariffs, purchasing goods from the U.S. and easing restrictive regulations on American companies. Overall, we are glad these important discussions are occurring rather than avoiding them altogether, and we will be paying close attention to how this situation develops in 2019.

2Market volatility: Following a period of very low volatility in 2017, 2018 featured two 10 percent corrections approximately eight months apart.6 In addition, the VIX Index, traditionally considered a market measure for volatility, reached all-time highs last year.7

 

This volatility has led to investor concerns that the economy is in a “late cycle” and could be reaching the end of the longest-running bull market.8 Recent declines and current valuations indicate the stock market has priced itself for recession.

 

The bond market is behaving similarly, with a declining 10-year9 and intermediate bond rates, 10 as well as an inverted yield curve.11 However, markets have been known to give false positive readings, and other leading indicators aren’t signaling a near-term recession. We’ll continue monitoring the stock and bond markets for any further weakening in 2019 to determine whether volatility is being driven by recession concerns or short-term news like trade tensions.

 

3. Fundamentals: At the start of 2018, U.S. broad markets were at the upper end of fairly priced with a price-to-earnings (P-E) ratio of about 20.12 You could say certain areas of the market were expensive. However, stocks are relatively cheap or near the bottom of their fair value today. That’s because the S&P 500 set an impressive new profit record last year, with corporate operating  earnings approaching $157 and surpassing last year’s record by about 25 percent.13 Combined with a stagnant market price, this has generated a P-E ratio of $16-17, which isn’t far off our long-term average.12

 

At the beginning of 2018, the market could grow only if it received positive news. Instead, good news on the economic front was accompanied by bad news related to trade, and the market didn’t have any margin to accept this less than ideal news. Heading into 2019, we have a significantly greater margin of safety. If earnings come in slightly higher for the first two quarters of 2019, the market should behave much better than it has this quarter. However, if we receive more negative news, markets have already priced in at least some of the negative data.

 

In conclusion, we use a saying at Exencial that “You earn your returns in some years and receive your returns in other years.” 2018 was a great example of earning our returns when risk and uncertainty came to the forefront. Investors who put all their money in bonds will probably receive returns of 2 to 3 percent in coming years, at best breaking even after taxes and inflation.14 Those with goals for higher returns must accept some risk along the way. We believe investors are earning their returns in years like 2018 and will be paid those returns in the future.

 

Sources:

  1. CNBC.com

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