2018 4th Quarter Outlook

Review of 3rd Quarter

During the third quarter, U.S. stocks provided good returns -- they earned 8% for the quarter and were up 11% for the year by the end of the quarter. International stocks rose by 1% for the quarter but were still down 3% for the year (emerging market stocks have fallen by 9% for the year). Bond returns were flat for the quarter, but bonds have lost 2% for the year.*

As we mentioned in our commentary in July, major daily stock market movements in 2018 had been mostly in reaction to a single factor – trade policy. Stocks declined when potential trade conflict became apparent and rose when those trade tensions eased. However, towards the end of September, the market reaction to trade policy announcements became very muted, suggesting that those announcements lacked credibility.

State of U.S. Economy

Below is a table showing key economic and market indicators (as of September 30)**:

The data continue to show the strength in the economy. During the third quarter market volatility lessened, and investors enjoyed solid returns, mostly because of these economic data.

Recent Events

While this is typically a forum for longer term analysis, we should spend some time reviewing the past few days. We’re publishing this on October 11 and we’re seeing a lot of volatility in the market over the past few days. First, some perspective - yesterday’s market decline of 4% means that the overall return earned by investors since June 30 is now only 3% --which is an above average three-month return. In that view, the market merely gave back some of the excess returns it generated during the 3rd Quarter. However, the recent volatility does demonstrate some concerns about stocks that should be discussed.

Stock Market Outlook

At Savant, we often focus on what predictable factors might negatively impact stock prices – one of our colleagues often refers to this as the Wall of Worry. Throughout this year the focus of stock movements has been on trade issues. Because markets have been reacting less to trade, we should discuss other elements of this “wall.”

Earnings

As we’ve been saying for two years, the growth in stock market values has been nearly entirely based on the growth of projected earnings. That forecasted growth, which we alluded to before the 2016 election, is still a key factor – earnings are always the most important component of stock market analysis. A decline in earnings, or even a lowering of the projected growth rate of future earnings, will cause additional volatility.

Interest rates

There is a concern that future increases in interest rates will cause economic disruption, which would obviously impact stock prices. We truly don’t see this as a long-term concern – interest rates are still at a level that would be considered abnormally low throughout most of our economic history. However, those concerns can trigger short-term volatility.

Trade

We’ve already discussed a lack of market reaction to recent trade news. That disinterest could be temporary. Many political analysts suggest that trade policy changes might be more severe after the upcoming mid-term elections – if that’s true, we’d expect more severe reactions from the stock market.

Volatility

This may seem circular, but historically, increases in volatility do beget future increases in volatility. Hence, even if none of the other factors we mentioned become a concern, we will likely see continued large movements in stock prices in the near future.

Bond Market

We’ve spent a lot of time discussing bonds in previous commentaries – we’ll resume normal coverage during our year-end review.

Summary

What does all this mean? Because of the strong past few years of stock market performance, we’ve had several clients recently inquire about increasing their allocation to stocks. We tend to be the wet blanket at the party and have cautioned clients about making such moves based solely on recent performance. Obviously, this is not the time to throttle up on your allocation to equities. However, if you’re a long-term investor, and most of your portfolio will not be needed for the next five years, these types of risks have been factored into your investment strategy. You’ve seen declines worse than this frequently over the past 20 years, and have benefitted from the stability of your strategy.

* Source of returns is Morningstar, Inc. Past performance is not indicative of future results. ** Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, JP Morgan, Federal Reserve Board

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