From the President’s Desk: Thoughts on the Fourth Quarter

by Donald Gould

More than 11 years ago, in October 2007, the mother of all storms hit financial markets, cresting in the fall of 2008 with many large financial institutions teetering after the collapse of Lehman Brothers. After substantial government intervention, the crisis passed, stock markets bottomed in March 2009, and the economy’s recovery from deep recession began soon after. The economy has expanded every month since, while the stock market—after a hiccup in 2011—climbed almost without interruption into early 2018.

After a sharp but brief decline around the end of January, the US market reached new all-time highs in September. And although we will only know for sure in the future with the benefit of more hindsight than is now available, it appears that the past decade’s remarkable stretch of balmy market weather could be morphing into something more volatile and less predictable.

The past quarter saw sharp stock market drops in October and December. The S&P 500’s 9% decline in December was its worst since February 2009, and October’s near 7% wasn’t far behind. You have to go all the way back to the dark days of 2008’s fourth quarter to find a substantially worse calendar quarter than this past one. And as extreme as these numbers are, they still mask some remarkable day-to-day volatility within the period, for example, the 2.7% plunge on Christmas Eve, followed by a 5% leap on Boxing Day. The gyrations continued into the new year.

Nowhere to Hide
Largely as a result of the fourth quarter stock market decline, 2018 as a whole was a tough year for almost every category of liquid asset. Only cash landed squarely in the plus column, and not by a lot. A bear market is defined as a drop of at least 20% from the most recent peak. While admittedly an arbitrary definition, it does give us a quick way to consider the performance of an array of asset classes. By this measure, the fourth quarter saw numerous markets reach bear status, including global stocks (MSCI ACWI, which includes both US and foreign stocks), international developed and emerging markets, US mid and small cap stocks, and crude oil. To date, the S&P 500 at its recent low managed to avoid the bear moniker by a mere two-tenths of a percentage point.

The Usual Suspects
No one can say what triggers a bear market, but as always there are likely culprits. It starts with the economy itself. In particular, major foreign economies worldwide showed decelerating growth in recent months. While the US consumer continues to motor along, even at home we see signs of possible slowing down the road, for example, projected slower manufacturing growth and softness in residential housing markets. Given how interdependent global commerce has become, even massive economies like the US and China are vulnerable to slowing elsewhere. A recent Wall Street Journal survey of economists puts the average odds of a recession beginning in the next 12 months at 25%, its highest level in 7 years.

This could be something as simple as the business cycle finally asserting itself after lying dormant for years. As the US economy has approached its full productive capacity, we see the Fed raising interest rates to prevent overheating, that is, excessive inflation. Rising interest rates brake the economy in many ways, from higher corporate borrowing costs to higher consumer interest expense to worsened terms for financing real estate purchases.

Valuation issues may also be playing a role in the market’s recent swoon. Using our internal estimate of the US stock market’s price-to-earnings (P/E) ratio, at its top, the market’s P/E was about one standard deviation above its historical average. This means that investors were paying a price per dollar of corporate earnings that historically was exceeded less than 15% of the time. While much of the high valuations could be justified based on below-average interest rates, it’s still fair to say that stocks were not cheap by any measure. After the recent decline, however, P/E ratios are back close to historical norms.

Then there’s the impact of interest rates and monetary policy on stock prices. The benchmark 10-year US Treasury yield rose from 2.46% at the beginning of 2018 to a high of 3.24% in early November, before sliding all the way back to 2.69% to close the year. The decline in both stock prices and bond yields in December confirms that investors have been focused on slowing economic growth, the one factor that explains both declines. Meanwhile, the Fed continued to tighten monetary policy, pushing up short-term interest rates and further shrinking its balance sheet (reversing its previous “Quantitative Easing”). Fed Chair Powell recently indicated the central bank is prepared to pause rate hikes if the economy softens sufficiently. If nothing else, higher interest rates at the shortest end of the yield curve make cash more of a competitor for investor dollars than has been the case for many years.

Finally, as always, domestic and international politics weigh on investors’ minds. In Europe, the risk of a disorderly Brexit seems to rise daily. Meanwhile, Italy’s banking challenges refuse to go away. The US-China trade dispute gets better one day and worse the next. And the US government shutdown drags on amidst high levels of rancor in Washington.

What to Do
It may be that in most fields of endeavor, a sense of mastery and control grows over time. When it comes to markets, however, the best we should hope for is a growing sense of humility and an acknowledgement of how much we don’t and can’t know. Future events drive the market’s course going forward and, perhaps sadly, we can’t yet write history books about the future.

However, though history can’t tell us if the next market chapter is up or down, it does tell us something about how bad a typical bad period might be. According to Goldman Sachs research, the average post-WWII bear market entailed a 30% decline over 13 months, and from its low point it took another 22 months to reach its previous peak. But these are just averages. Some bear markets have been quick affairs, while others have dragged over many years.

The key, as always, is having a portfolio strategy that enables you to ride out these storms without abandoning ship. For an investor with a 50% allocation to stocks, the average bear market of 30% means that the investor’s peak-to-trough decline in the stock portfolio equates to about 15% of portfolio value. The actual portfolio decline might be less than 15%—stock dividends, bond interest, and the potential for higher bond prices all cushion the decline on the equity side of the portfolio.

That is not to minimize in any way the unpleasantness of such a decline in portfolio value. We recognize that sudden and large market downturns are frightening. A big part of our job is to help clients stay calm and keep long-term goals in mind in the midst of blaring headlines and, yes, shrinkage in month-end statement values.

A Small Silver Lining Amidst the Market Swoon
While we naturally prefer up markets to down, there is one financial benefit we try to capture for clients when prices take a tumble. We call it tax-loss harvesting and it’s something we did extensively in December in taxable accounts where we could.

Suppose that due to a market decline, a $100,000 investment made in May is worth $80,000 in December. By selling the asset in December and immediately replacing it with a similar (but not identical) asset, we can realize a $20,000 tax loss that can be used to shelter capital gains realized in the current year or any future year. After 30 days, we can swap back into the original asset. Our portfolio value is essentially the same as what it would have been had we not sold the asset, but now we have a tax loss that could save our client as much as $10,000 in taxes.

Yes, it’s just another one of the many absurdities in our tax law, but it’s also an opportunity for us to take advantage of a down market to meaningfully improve clients’ after-tax returns.

IRA and 401(k) Contribution Limits Rise in 2019
Effective in 2019, the annual contribution limits for IRAs and 401(k) plans have been increased to reflect inflation. For traditional and Roth IRAs, the limit rises from $5,500 to $6,000. For 401(k) plans, the limit rises from $18,500 to $19,000. Investors aged 50 and above can contribute an extra $1,000 to IRAs and $6,000 to 401(k) plans. SEP IRAs and Individual (or Solo) 401(k) plan contribution limits also increase from $55,000 to $56,000 in 2019. Lots of restrictions apply; we’re happy to help review your options.

Gould Asset Management Turns 20!
2019 marks the 20th anniversary of the founding of Gould Asset Management. With nearly 300 clients, more than $500 million in assets under management, and 11 full-time staff members, the company has grown to become a significant regional investment advisory business. Most of all, we wish to thank all our loyal clients for helping us reach this happy milestone.

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