A Steady Economy Beneath A Wobbly Stock Market

For many Americans, the last week of December is a quiet moment to catch a breath after much of the holidays have passed but before the beginning of the next year. But the stock market spent the end of the year anything but subdued.

After nine straight years of stock market appreciation, the S&P 500’s total return for the year was negative 4.38 percent, and on an intra-day basis the index fell more than 20 percent from its all-time high in September. This meant that the S&P 500 experienced its worst December since 1931. Other asset classes have also struggled. While interest rates fluctuated throughout the year, most bond indexes ended the year essentially flat.

Yet despite the sour note for investors at year-end, I see no reason to panic, because I see no serious problems when I look at the overall state of the economy. Instead, I think the downturn in December represented a simple return to reality.

Since 2008’s crash, the S&P 500 had appreciated for nine straight years, and the good times had to end eventually. Investors’ fears over the current downswing may also be stoked by the fact that, in the last 20 years, there have only been two bear markets, defined as a decline of 20 percent or more in the S&P 500: the 2000-02 technology bubble and the 2008-09 financial crisis. Both signaled major problems ahead well beyond the stock market.

At Palisades Hudson, however, we don’t expect the current market downturn to resemble the last two. Instead, this may end up looking much more like smaller downturns of the 1980s or ’90s, where stock prices fell but quickly recovered, as economic growth remained strong. In addition, while back-to-back annual declines in the S&P 500 can happen, they are very rare. We have only seen the phenomenon twice since World War II, in 1973-74 and 2000-02. Historically, back-to-back declines have been followed by sharp rebounds even when they do arrive. So taking the long view suggests that a down year, on its own, should not be a reason to worry.

In addition to this historical context, investors may rest easier when they remember that the fundamentals of our economy give every sign of strength.

The Bureau of Economic Analysis released its third estimate of third quarter gross domestic product in December, adjusting it to 3.4 percent. While this represents a decrease compared to the previous quarter’s growth of 4.2 percent, it still indicates strong growth overall. Meanwhile consumer spending, which represents more than two-thirds of American economic activity, is on track for its best quarter of growth in four years. Unemployment also remains historically low, at 3.7 percent nationally.

No discussion of the economy would be complete without mentioning the Federal Reserve, especially since the central bank has been a popular scapegoat for market volatility. The Fed raised interest rates for the fourth time this year in December, as planned. While this may have contributed to investor worries, it does not mean that raising rates was the wrong thing to do. The Fed’s job is to focus on the labor market, which is in great shape, and inflation, which remains around 2 percent but shows some signs of movement. I expect the Fed to be flexible in 2019, but it does not take its cues from the stock market – nor should it. The Fed bases its decisions on economic indicators. If those indicators stay on track, we can expect it to continue raising rates this year, though potentially at a slower pace. If the indicators change, the central bank will react accordingly.

Earnings projections feed more directly into stock market returns than some of the other fundamentals I’ve mentioned, so it is worth considering these too. Next year’s earnings growth will almost certainly be lower than this year’s, which means the volatility we are seeing now could simply be the arrival of lowered expectations that were bound to affect stock prices sooner or later. But while most analysts’ projections for corporate earnings growth are lower than they have been, sliding down to percentages in the single digits, they are still generally positive. Slower growth is, after all, still growth.

With economic fundamentals relatively strong, why was December’s stock market picture so rough? In essence, this appears to be a normal cyclical decline, driven by rising interest rates, a decade-old recovery, a tight labor market and concerns about trade. The first three are no surprise a decade out from a recession.

The last factor, trade, is one worth seriously considering. In early December, the U.S. and China agreed on a 90-day truce in order give both sides time to negotiate a way to end the escalating trade aggression between the two countries. A U.S. delegation will travel to Beijing next week to hold trade talks, and the outcome of that effort could have major effects on the U.S. stock market. If China and the U.S. cannot reach an agreement, ongoing and intensifying tariffs could trigger stronger inflation and deepen investor uncertainty, both of which may shape the market in 2019.

For now, however, I view December’s stock market decline mainly as a reaction to a previous overabundance of investor optimism. Some investors let themselves think stocks would appreciate unchecked forever. While stock selling picked up some momentum during December, lower prices created some attractive opportunities, and we saw stock prices rebound off their lows late in the month.

This raises the question of whether companies are, in general, overvalued at the moment. One way to consider this is to compare share price to earnings per share. Companies in the S&P 500 showed unusually high price-to-earnings ratios in the past few years, but now they have fallen back to just above the historical average. In other words, stock prices after December’s sell-off are about what we should reasonably expect.

All investments carry risk, and no investment can continue to appreciate month after month, year after year. Stocks are volatile by nature, though it seems that some investors have forgotten this fact after years of steady appreciation. If you participate in the market, you will see years with declines. These declines will always have presumed causes, and the factors that cause the decline will always pass.

Keeping a long-term focus and avoiding the temptation to panic does not necessarily mean doing nothing. Savvy investors may want to consider tax loss harvesting and rebalancing their portfolios to keep them in line with their long-term investment plan. This sort of disciplined reaction will allow investors to take advantage of investment opportunities caused by volatility; as always, your goal should be to buy low and sell high. For most investors, the market downturn alone is probably not a good reason to change an existing asset allocation target. However, if your situation has changed due to other factors, it may make sense to revisit your investment strategy

Investing for the long term means staying calm through the stock market’s ups and downs. Many investors are out of practice with the latter. But economic indicators simply don’t suggest that there is any reason to lose sleep over the return of a normal downward turn in the market cycle.