Stock markets were significantly lower in the fourth quarter of 2018. All major indices were down double digits by December 31st, 2018. Small caps were particularly hard hit as the Russell 2000 Small Cap Index shed 20.21% in just three months. This left small cap stocks down 11.03% for the entire year. No areas of the stock market were safe as a technology selloff pushed the NASDAQ down 17.28% for the quarter while the S&P 500 and Dow Jones Industrial average (The Dow) were down 13.52% and 11.31% respectively. Although the selloff was “gut-wrenching” the entire year was much less remarkable. The S&P 500, The Dow, and, and NASDAQ each finished the year with a loss of less than 5%. The “pain” wasn’t that the year was negative for stocks (happens all the time) but the abruptness of the sell-off. Investors had become lulled into complacency during the first nine months of 2018 only to have a self-off return in full force. The velocity of the stock market decline in just 90 days made the event feel much more dramatic.

The upturn in volatility that began in early October continued throughout the entire fourth quarter.  The trend for stock market prices was distinctly lower. What began as a reaction to changes in Federal Reserve policy morphed into a technical selloff that pushed stock prices well below fair value.  The quarter began with program sell trading and indiscriminately followed by aggressive short selling.  This led to a year where stock prices generated returns well below average.  As a result, investors used the opportunity to “harvest” capital losses to reduce current and future taxable gains.  This practice produced its own downward momentum.  The more sells that were made to realize capital losses increased the pressure on stock prices that, in-turn, created additional opportunities to realize further losses.  (D’Arcy Capital was very active in tax reduction trades as well). The tax-loss selling was exacerbated by the unusually high capital gains being distributed by mutual fund companies.  This pressure reversed after the New Year.  Although it is unpleasant, it is very important that investors remain invested in their respective strategies.  Managed diversified strategies at D’Arcy Capital are designed to experience these periods of volatility.

In other financial markets interest rates declined, gold gained, and oil plunged. The yield on the U.S. Treasury Note (benchmark for interest rates) dropped from 3.06% to 2.69% during the fourth quarter. During the same time, the price of gold climbed 7.50% to end 2018 at $1,282 per troy ounce. The major mover in commodities was oil. The price for a barrel of oil dropped 35% during the fourth quarter (from $72 to $47).

The good news –

  • The fourth quarter market decline is well within expected volatility for long-term investing.  It is normal, relatively common, and essential.
  • Tax loss selling generally drops dramatically once a new tax year begins.
  • All the bad news is in the market (Good news will return in 2019).  The government is already partially shut down (it will reopen).  We already know the Federal Reserve’s projected interest rate increases (may turn out to be less than expected).  Holiday sales results will be released (will likely reveal strong consumerism). With the release of corporate earnings beginning January 15, 2019 investors will refocus on strong financial results, low unemployment, reasonable stock valuations, high consumer confidence, low energy prices, low inflation, and low interest rates.
  • When technical sell-offs end they typically reverse very quickly
  • The last three technical sell-offs have resulted in very strong 2-year returns, post-decline
    • 7/17/1998 to 10/8/1998 the S&P 500 declined 18.52%%.  From 10/8/1998 to 10/8/2000 the S&P 500 gained 49.20%
    • 7/21/2011 to 10/03/2011 the S&P 500 declined 17.84%.  From 10/03/2011 to 10/03/2013 the S&P 500 gained 59.15%
    • 11/13/2015 to 2/11/2016 the S&P 500 declined 12.81%.  From 02/11/2016 to 02/08/2018 the S&P 500 gained 48.91%
    • 09/20/2018 to 12/24/2018 the S&P 500 declined 19.33%.  From 12/24/2018 to 12/24/2020 the S&P 500 ???
  • 2018 was a negative return year for stocks.  Investors should be reminded that negative stock years only occur about 30% of the time.
  • 2019 will be the first year that the benefits of the 2018 tax cuts are realized.  Currently, investors are underestimating the effect of personal and corporate tax cuts.
  • The stock market finished 2018 with annual return of -4.39%.  This is within a single standard deviation of the average market return (very normal).

Looking Forward

  • Do not view account balances on a daily basis.  This is unhealthy and misleading.  Trying to analyze daily/weekly/monthly changes in stock values leads to unnecessary stress and an erroneous expectation of long-term returns.
  • View the fourth quarter stock market decline as an institutional investor.  It has created greater opportunity and lowered overall risk (not the opposite).
  • Understand that financial news programs on television, radio, and podcasts are designed to attract viewers and sell advertising.  They are not designed to improve listener/viewer outcomes.
  • Take advantage and make positive decisions based on economic facts and not fear.
    • Long-term investors with cash balances should buy stocks and increase their investment portfolios.  Do you want to look back on this period and be remembered as a buyer, holder, or seller? This may not be the bottom of the stock market cycle but it is significantly lower than previously supported equity price levels
    • Fix (i.e. lock in) any long-term liabilities.  If you currently have any existing long-term liabilities (mortgage, consumer debt, or student loans) that are variable, floating, or indexed, consider refinancing to a fixed rate loan
    • The current market will reward assets that float and liabilities that are fixed
    • Execute tax loss harvesting in taxable accounts
  • Remember that interest rate increases by the Federal Reserve is a good sign.  It means the brightest economic minds in the country view the economy as growing and strong.  Higher short-term rates provide interest income to savers and conservative investors.  It creates a better financial analysis dynamic when determining project development and investment outcomes.
  • Get used to bigger numbers.  With a Dow over 20,000, daily changes in multiples of 100 will be common.
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