January 10, 2019 – Volatile equity markets have bounced off of their Christmas Eve lows, heading higher in almost as dramatic a fashion as on the way down. We are not surprised to see the rapid move upward, as we assessed equity markets to be oversold and pessimistic sentiment extreme by the end of 2018. Historically, a pullback of the magnitude and speed that we experienced in the fourth quarter tends to be followed by above-average returns on both a 3-month and 12-month basis (Figure 1).

Figure 1: A sharp pullback in equities has often been followed by strong performance

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Past performance is no guarantee of future results. Indexes are not available for direct investment.

As of December 31, 2018. The x-axis represents average S&P 500 returns over rolling 3-month periods. The data represents S&P 500 historical returns from 1929-2018.  Orange bars represent the S&P 500’s average return over the next 3 months. Gray bars represent the S&P 500’s average return over the next year.  Average annual returns from 1929-2018 ranged from (lowest -47.1%- highest 46.6%).

Sources: Bloomberg, Standard & Poor’s.

We have maintained our slight overweight to equities throughout this tumultuous time, advising our clients to ride through the volatility, rather than succumb to it. While we are optimistic on equities in 2019, we would caution against assuming the market’s straight upward trajectory of the past couple weeks will continue unabated. Reduced liquidity globally—as central banks around the world tighten monetary policy—suggests higher volatility could be here to stay. Importantly though, for long-term investors, volatility can be your friend and provide opportunities to grow wealth longer term, whether through deploying cash on the sidelines or estate planning strategies like making tax-free gifts or funding a trust at a discount.

The decline in equity market valuations at the end of the year (to around 14x next-12-month earnings estimates for the S&P 500 index), was consistent with what we tend to see one or two quarters before a recession. However, our research suggests we will see a slowing growth rate in the U.S. from 2018’s pace but not a recession. In fact, the 2%–2.5% GDP growth we expect in 2019 would mean “Goldilocks” is back. That is to say that we expect economic growth in the U.S. that is not so hot that it requires the Fed to hike rates more aggressively and kill inflation (and the economic cycle along with it), but not so cold that it risks a recession. Rather, a “just right” level of growth in the U.S.—and, critically, stabilization in growth abroad—is precisely what we need to extend the economic cycle. If productivity growth increases as well, as we expect and discuss in our 2019 Capital Markets Forecast, then we could see the economic cycle extend well beyond 2019.

Concerns about the Fed’s pace of tightening have been a major source of angst for investors. Recent weeks of commentary from Chair Powell and other members of the FOMC suggest the Fed will be more patient with rate hikes in 2019. The minutes from December’s policy meeting, released on Wednesday, are consistent with the more cautious tone we have heard from the Fed to start the year. We still think it’s reasonable to expect two rate hikes in 2019 if the economy progresses as outlined above, but the Fed is not on a preset course and will adjust policy based on the strength of the economy.

Looking ahead, earnings season is upon us. However, we find ourselves in an interesting predicament when it comes to interpreting corporate earnings results from the fourth quarter of 2018. For one thing, earnings estimates for the S&P 500 have been reduced by about 4% since the beginning of the fourth quarter. Though not out of line with the average decline in estimates we’ve seen historically over the course of a given quarter, the reduced estimates from analysts, along with CEO uncertainty regarding the outlook for 2019, mean we expect markets to move more on the macroeconomic data and news than earnings reports in the near term. The twin uncertainties related to U.S. government policy—trade and the budget—make it increasingly difficult for companies to provide insight into next year. 

Core narrative

Recent weeks of volatility have been uncomfortable, but looking out over the next year we expect equity markets to move higher and deliver respectable returns. Economic data are slowing, as expected, but to a more stable growth rate that should allow the cycle to continue. Stable economic growth does not necessarily mean stable markets, though, and higher volatility is likely here to stay. Above all else, it is imperative to remain focused on long-term goals and avoid rash portfolio decisions that could have long-term consequences. 

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