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Investment Letter

4th Quarter 2018

As we closed the books on 2018, investors were struggling with the sudden reversal of fortune in the financial markets.  That sense of frustration reminds me of how avid movie goers feel after seeing a disappointing sequel to their favorite movie.  Absolutely letdown!  The 2017 financial market was going to be a tough act to follow regardless, but the 2018 sequel was on track to deliver a solid performance until the final plot twist of the year.  Investors suddenly faced tough conditions early in the 4thquarter as “Shocktober” halted the market’s advance.  Prices stabilized in the following weeks until the “December Not to Remember” erased gains across the board.  The aftermath left most equity indices down for the quarter, the year, and in official correction territory (decline in value of 10% or more from most recent high).  Overall, a very disappointing financial end to 2018.   

 

The table below recaps the performance of major indices:

  

Asset Class

Index

4thQtr. 2018 Total Return

2018 Total Return

Cash

BofA/ML Three-Month U.S. Treasury

0.56%

1.87%

U.S. Bonds

Barclays Intermediate-Term U.S. Treasury

2.24%

1.41%

U.S. Large Co. Stocks

S&P 500

-13.52%

-4.38%

U.S. Small Co. Stocks

Russell 2000

-20.20%

-11.01%

International Stocks

MSCI EAFE (net div.)

-12.54%

-13.79%

Real Estate

DJ Select Real Estate Securities Total Return

-6.61%

-4.22%

 

Source: Morningstar

 

Investors have been spoiled over the past decade.  The S&P 500 Index enjoyed nine years of consecutive positive returns until the recent decline.  Seven of those nine years produced double digit positive returns and the index was up over 270% from March 9, 2009 through December 31, 2018.  The downturn in the market has raised recession fears, and some investors believe the run for this bull market is over.  Over the short-term, we believe the economy is still in good shape and recession fears are unwarranted.  Expansions do not end because of old age.  They end because of financial imbalances or aggressive monetary policy. 

 

The U.S. government shutdown has delayed some updated economic data from being released, but the available data revealed strong domestic economic activity during the quarter.  See the economic indicators below for additional information.  

 

GDP

3.4% Growth (annual rate) – 3nd Quarter 2018

 
 

Inflation

2.2% CPI (less food and energy) and 2.2% CPI (all items)

year-on-year November 2018

 
 

Interest rates

December 2018 increase 0.25%.

Federal Funds Rate range = 2.25 – 2.50%

 
 

Jobs

Unemployment at 3.9%; 312,000 non-farm payroll jobs added in December; Labor force participation rate 63.1%; Health care, food services, construction, manufacturing, and retail trade were contributors to job growth.

 
 

Manufacturing

Manufacturing activity continued to expand, and the overall economy grew for the 116thconsecutive month. The December ISM Manufacturing Index registered at 54.1%, a decrease of 5.2% from the November reading. Demand was softer, but business strength continued at lower levels. Tariff related issues remained a concern industry wide.

 
 

Business Spending

Private non-residential investment continued to trend upward; New durable goods orders increased 0.8% in November after an October fall of 4.3%.

 
 

Corporate Profits

3rd Quarter 2018 - U.S. corporate profits increased 3.5%.

(7 consecutive quarters of growth).

S&P 500 Earnings per share = $41.38

 
 

Housing

New home sales decreased 8.9% in October; November housing data showed starts were up 3.2%; Existing home sales rose 1.9%; Median sales price of existing homes rebounded 1.0% (ending a 4-month decline); Building permits rose 5.0%;

MBA fixed 30-yr mortgage rates = 4.84% ending 12/28/2018

 
 

Consumer Spending

Disposable income remained strong; Consumer confidence decreased in December following a November decline; Retail and food services sales increased; Total vehicle sales declined slightly but remained strong; Personal durable and nondurable spending increased; Savings rate = 6.0%.

 
 

Energy

Oil price (West Texas Intermediate) = $45.15/bbl – 12/28/2018; Gas price (U.S. average regular unleaded) = $2.27/gal – 12/31/2018

 

 

The big surprise for the economy was the decline in oil prices.  The price for West Texas Intermediate (benchmark for oil pricing) started the year just above $60 per barrel.  As expected, prices gradually rose to reach a high point in June of $77.41 per barrel.  Prices then stabilized for a few months until the fourth quarter collapse of over 41%.  While motorist cheer lower prices and savings at the gas pumps, investors are worried the deterioration in prices might be a precursor to some tough times for the economy.  Our analysis concluded the decline was more of a supply issue, and we expect prices to slowly revert to normal levels as world output is adjusted. 

The minutes from the recent Federal Open Market Committee (FOMC) meeting confirmed strong domestic GDP and labor market conditions.  The Fed stated that inflation remained low, industrial production expanded, household spending was higher, business fixed investment moderated, and housing activity was weak as rising mortgage interest rates reduced affordability.  Based on economic conditions, the FOMC decided to raise rates again in December (4thtime in 2018) and adjusted the target range for the federal funds rate by 25 basis points.  FOMC members agreed the timing and size of future adjustments would be dependent on incoming data relative to the Committee’s maximum employment and inflation objectives.[1]

 

International economies continued to feel the influence of Brexit, trade tensions, and slower growth dynamics in China.  The Brexit finality is scheduled for March 29, 2019.  British lawmakers are deeply divided over ratifying the withdrawal deal, and unanimous European Union approval is needed to grant a deadline reprieve.  A no-deal departure for the United Kingdom would be a chaotic and volatile end to the quarter.  Trade tensions between the U.S. and China were subdued with a 90-day truce on new tariffs.  Despite the armistice, major discrepancies on key trade issues still need to be resolved.  Prospects for slower growth in China continue to be a concern for global investors.  While recent data showed some signs of economic weakness, Chinese officials are working on stimulus measures to keep their economic engine from running out of steam.

 

Our 2019 outlook for the domestic economy is still optimistic, and we believe an abundance of evidence exists to support the continuation of the current market expansion.  The economic benefits from the 2017 tax cut have dwindled significantly and additional stimulus effects will diminish as time passes.  We expect positive economic growth this year, but lower than levels seen in 2018.  We anticipate continued strength from labor markets, healthy consumer balance sheets, solid corporate earnings, stable manufacturing data, low energy prices, and mild inflation during the next economic year.  We are also hopeful warm weather this spring leads to much needed improvement in the housing sector.  The Fed should continue to shrink their balance sheet, and we expect them to hit the pause button on rate hikes early in 2019.  Depending on market conditions, we foresee two additional rate hikes later this year.  Finally, we feel the political standoff in Washington will come to a resolution sooner rather than later so the government can return to normal operations.

 

Despite many of the uncertainties carrying over from 2018, our international outlook is promising for this year.  Foreign central banks should maintain lenient monetary conditions and government officials around the world are committed to supportive economic policies.  However, weaker economic growth in China, intensified trade tensions, and a failure to successfully negotiate a conclusion to the Brexit issue will continue to be major headwinds for global expansion.  We anticipate some financial divergences but expect overall global growth to remain positive.

 

Additional threats to the global economic picture include the following: fiscal and monetary policies, a prolonged U.S. government shutdown, political instability, growing workforce imbalance, geopolitical tensions, extreme weather events, natural disasters, cyberattacks, and terrorism.  We remain watchful for the potential impact of these issues.

 

Successful investing requires a plan, and one of the most important parts of a successful plan is to properly diversify your investment portfolio.  Diversification across multiple asset classes has the potential to improve returns when an investment strategy is selected based on goals, time horizon, and tolerance for volatility.   The key is investing in asset classes that do not historically move in the same direction each year (cash, bonds, and stocks).  Ideally when a portion of the investment portfolio is declining, the remaining parts should be moving in the opposite direction or at least not declining as much. The table below represents the annual returns of various asset classes and of a diversified portfolio.[2]  The diversified portfolio in the example uses offensive assets (stocks), as well as, defensive assets (cash and bonds) to smooth out the volatile swings of individual asset classes.  A performance comparison illustrates two points: a diversified portfolio is unlikely to ever lead the group in performance and a diversified portfolio is unlikely to ever be the worst performer in any given year. 

 

Asset Class Annual Returns

2000 through 2018

 

Date

Three-Month U.S. T-Bill Index

U.S. Intermediate Treasury Bond Index

S&P 500 Index

Russell 2000 Index

MSCI EAFE Index

(net div.)

Dow Jones US Select REIT Index

Diversified Portfolio

 
 
 

2018

1.87%

1.41%

-4.38%

-11.01%

-13.79%

-4.22%

-3.26%

 

2017

0.86%

1.14%

21.83%

14.65%

25.03%

3.76%

11.00%

 

2016

0.33%

1.06%

11.96%

21.31%

1.00%

6.68%

6.79%

 

2015

0.05%

1.18%

1.38%

-4.41%

-0.81%

4.48%

0.95%

 

2014

0.04%

2.57%

13.69%

4.89%

-4.90%

32.00%

7.89%

 

2013

0.07%

-1.34%

32.39%

38.82%

22.78%

1.22%

14.81%

 

2012

0.11%

1.71%

16.00%

16.35%

17.32%

17.12%

10.45%

 

2011

0.10%

6.57%

2.11%

-4.18%

-12.14%

9.37%

2.53%

 

2010

0.13%

5.29%

15.06%

26.86%

7.75%

28.07%

12.74%

 

2009

0.21%

-1.41%

26.46%

27.17%

31.78%

28.46%

17.42%

 

2008

2.06%

11.35%

-37.00%

-33.79%

-43.38%

-39.20%

-20.52%

 

2007

5.00%

8.83%

5.49%

-1.56%

11.17%

-17.56%

3.95%

 

2006

4.85%

3.51%

15.80%

18.37%

26.34%

35.97%

14.17%

 

2005

3.07%

1.56%

4.91%

4.55%

13.54%

13.82%

5.52%

 

2004

1.33%

2.02%

10.88%

18.32%

20.25%

33.16%

11.09%

 

2003

1.16%

2.10%

28.69%

47.25%

38.59%

36.18%

21.05%

 

2002

1.80%

9.29%

-22.10%

-20.48%

-15.94%

3.58%

-6.99%

 

2001

4.44%

8.16%

-11.89%

2.49%

-21.44%

12.35%

-0.93%

 

2000

6.19%

10.25%

-9.10%

-3.03%

-14.17%

31.04%

1.89%

 

 

Simply put, a diversified asset allocation strategy is a great method to manage portfolio risk while endeavoring to maximize portfolio returns. 

 

As I have often stated, our investment philosophy remains based on the fundamentals.  We believe it is time---not timing---that matters most.   Progressing toward long-term financial goals is more important than short-term performance, so stay focused and be calm when the markets are not.  

 

Your financial health is important to us, so consider making a New Year’s resolution to revisit and update your financial plan.  It is also a good time to review your estate planning documents for an update if you had any personal circumstance changes. 

 

Common events that could necessitate estate plan alterations:

·        Birth or adoption of a child or grandchild

·        Death of a spouse or family member

·        Marriage, divorce, or re-marriage

·        Illness or disability

·        Child or grandchild reaching the age of majority

·        Education funding

·        Death of a guardian, executor, trustee

·        Retirement

·        Sale of a home or business interest

·        Large gift or inheritance

·        Revisions in federal or state income tax or estate tax laws

 

As our firm enters its 36thyear of providing advisory services, we want to wish you and your family a happy, healthy, and prosperous New Year.  If you would like to schedule an appointment, wish to receive William Howard & Co.’s SEC Registration Form ADV Part 2A and Part 2B Narrative Brochure, or if you have any questions, please contact our office.  

 

In closing, I want to thank you for the opportunity of working with you and for your continued confidence and trust. 

 

With kindest personal regards, I am

 

Very truly yours,

 

WILLIAM HOWARD & CO. FINANCIAL ADVISORS, INC.

 



[1]Source: Federal Reserve System, Minutes of the FOMC Meeting, 18-19 December 2018, https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20181219.pdf

[2]Data provided by Dimensional Fund Advisors.  Diversified portfolio composition: Cash 10%, U.S. Bonds 30%, U.S. Large Co. Stocks 30%, U.S. Small Co. Stocks 10%, International Stocks 10%, and Real Estate Securities 10%.  Rebalanced quarterly.


 

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