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Main | Q3 2018 Commentary »
Thursday
Jan172019

Q4 2018 Commentary

At the start of the year, popular market punditry focused on rapidly growing earnings backed by massive corporate tax cuts, business-friendly government and coordinated global growth.  The resulting popular narratives emphasized the lack of risks to markets, convincing investors to bid up stock prices to multiples not seen since the tech bubble.

At the time, the underlying picture looked rather strong, but there is a limit to just how much speculation markets will handle. 2018 was a stark reminder that valuations matter, sentiment is fickle, and the Federal Reserve is a dominant market force.

Markets dealt with heightened volatility throughout the year (particularly relative to the abnormally calm 2017), but still managed to enter the final quarter of 2018 with equity prices close to all-time highs.  Unfortunately, by the end of December, markets had wiped out over a year’s worth of gains, posting the worst quarter since the financial crisis and closing clearly in negative territory for the first time since 2008.

Most of our concerns from the start of the year resolved themselves largely in the manner that we expected based on market history. 

The Federal Reserve raised their benchmark interest rate four times (more than was anticipated at the start of 2018).  The final hike of the year sparked a massive selloff, with the S&P 500 falling more than 9% in under four trading sessions.  A tightening Fed was always going to be a headwind – to economic growth, valuations or both. 

The combination of significant earnings growth and falling stock prices in 2018 meant that price multiples have declined significantly.  Last quarter, even at record highs, price multiples had declined notably, but this commentary noted that the multiple contraction was not yet at a healthy phase and warranted more concern.  The abysmal price action of the fourth quarter finally brought the type of healthy multiple contraction we had expected.

The December market collapse also resolved what had been a wildly optimistic sentiment imbalance.  At the January highs, the Investors Intelligence survey showed a 5:1 ratio of bulls to bears – a record high reading.  In other words, only one out of six believed that stocks would lose value over the year.  Even through most of the year’s volatility, that ratio remained above 2:1.  The December weakness finally brought about the type of sentiment washout we look for at market lows, with the first survey of 2019 showing the bull:bear ratio below 1 for the first time since the 2016 lows.

We have seen the extreme sentiment shifts not only in survey data, but in actual money flows. In January, as investors chased markets to record highs, equity funds saw their largest inflows since 2002.  In December, as rattled investors sought safety, equity funds saw their largest weekly outflows on record.

The contrasts between the start and end of the year could not be any starker.

Meanwhile, as investors were panicking and selling stocks at a record pace, corporate insider activity was persistently positive (they had been sellers at the start of the year).  When the public is selling and insiders are buying, we generally know which side of the trade we want to be on.

All of our managed accounts were well prepared to deal with this market environment.  We began the year with our largest cash allocations since 2007.  All strategies did some buying throughout the year, but by the end of the third quarter, we were back at our most conservative positioning since 2018 began.

All strategies bought heavily throughout December, ending the year at or near full investment.

Our patience was well rewarded.

Our options-enhanced accounts finished the year outperforming traditional accounts by almost precisely the amount earned through options premiums, meaning that, though there were some divergences in underlying performance each quarter, options accounts are very closely mirroring the overall performance of traditional accounts, with the added benefit of collecting those premiums – just as designed.  Most importantly, this strategy performed as expected amidst significant market stress.

Global, ETF based accounts could not fully escape the weakness of international markets, but they avoided the double-digit losses of global indexes.

All strategies are now at their most aggressive positioning since 2015.  Given the dramatic reversal in most data sets, we feel very comfortable with high equity allocations at this point.  Sentiment and price data in the final week of the year closely resembled recent market bottoms in 2009, 2011 and 2016.  Depending on the data set, you can also draw close corollaries to the 1987 and 2002 lows.

That does not mean that markets are out of the woods yet.  The type of volatility we have seen recently tends to portend more volatility, and we would not be surprised to see stocks retest their lows (perhaps more than once) in the first quarter of the year.  We also remain quite concerned about valuations.  P/E multiples have come down more than 25% since the start of the 2018 and closed the year at their cheapest levels since 2013, yet multiples remain historically elevated.  Any sort of strong rally from here would place stocks firmly in “expensive” territory once again. 

Against that fundamental backdrop, long term equity return prospects remain below average and risks remain elevated.  Our long-held belief that stocks could revisit early 2016 prices (about another 15% lower from here) is still well within the realm of possibility. With that in mind, we will likely be quick to sell into any considerable market strength, locking in gains and re-allocating to cash when prudent. 

As always, we encourage our clients to reach out to discuss how we can best balance our investment approaches to suit your needs, and thank you for your continued trust

Wishing you a happy and prosperous New Year,

 

Robert B. Drach

Drach Advisors LLC

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