The U.S. economy delivered great results last year — GDP growth, low unemployment and higher wages. Conversely, equity markets worldwide experienced one of the worst years since the Great Recession of 2008-09.
Equity markets offered no hiding place in 2018. The S&P 500, Dow Jones Industrials, Russell 200, MSCI EAFE, MSCI Emerging Markets and NASDAQ all ended the year in the red.
Negative years are difficult to explain or predict, and the explanation often comes down to an unsatisfying “because they do.” They occur with some regularity, it turns out — about one year in four. Stock prices often overshoot in both directions when changes occur in the economy, interest rates and corporate profits.
When central banks raise interest rates, bonds provide more competitive yields compared with stocks, and this draws capital away from equity investments. It happened in dramatic fashion in 1987 when inflation and rates increased starting January but did not penetrate investor consciousness until October of that year. The adjustment happened and markets resumed their winning ways.
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Financial markets hate uncertainty, and the November election delivered a dose with changes in the U.S. legislative branch. World trade negotiations, talk of impeachment, and the government shutdown created more anxiety and more volatility.
Changes in valuation measurements also contribute to market declines. According to J.P. Morgan Asset Management, the forward price-to-earnings ratio has declined from about 19 times earnings to 14 times. The 25-year average for this index is about 16 times. While corporate profits and dividends are fairly steady and predictable, what investors are willing to pay for them varies widely, and this affects stock prices when sentiment turns negative.
Finally, the leadership of the market changed after social communications companies succumbed to questions about valuations, privacy and regulation. Electronic trading now accounts for over 80 percent of daily volume, and volatility increases when ETFs rebalance portfolios (see 11/21/2018 Business Insider). Loss mitigation strategies may also contribute.
There is no credible evidence that market timing or going to cash is a proven wealth-building strategy. Deciding when to re-enter is next to impossible and can be complicated by trading costs, taxes and emotional stress. Rebalancing your portfolio, our preferred method, involves shedding some top-performing assets that have risen in value in favor of those that have performed poorly.
The fourth-quarter correction may have discounted the worst-case scenario, as these events often do. The year is starting out on the plus side, at least for now.
With the reset button pushed, fall’s volatility may set the stage for a continuing bull run in stocks, and a continuation of the longest economic expansion in U.S. history.