Life is full of choices. Every single day, we have to make countless decisions between various options.
Some of these decisions might be small ones, like whether or not we stay at work late today or tomorrow, or what we’ll choose to do for our weekend plans. Other choices require much bigger and more consequential decisions: should we take that job in a different city and uproot our entire life?
All of these decisions, both big and small, require us to deal with trade-offs. By the nature of choosing one thing over the other, we must lose or forego value in one option in exchange for gaining the value in the option we choose.
The Trade-offs You Face as an Investor
We make trade-offs when we invest, too.
You could opt to invest your savings in cash or cash-like instruments, for example, which offer very high levels of safety but come with the trade-off of relatively low returns. Or you might invest your savings in risky assets like stocks which historically have averaged higher rates of return — but come with the trade-off of less safety and a higher risk of loss.
The fact that the S&P 500 posted a positive return in 9 consecutive years since 2009, however, could have caused investors to forget about the trade-offs typically made when investing in the stock market.
Not only were stocks positive for 9 consecutive years prior to 2018, but during that timeframe there were only 4 corrections (defined as market declines of 10% or greater). Investors experienced the best of both worlds: superior returns to cash and very little market volatility.
This is why 2018 felt so painful. It was the first time in 10 years that the S&P 500 was negative, and we experienced 2 market corrections in short order after experiencing only 4 in the previous 9 years.
Let’s take a look at market topics that reminded investors of the trade-offs of owning stocks and what steps you can take to make sure your financial plan is still on track.
The Trade Tift Between U.S. & China
The 4th quarter finally brought hope for a solution to the trade dispute between the U.S. and China. Both countries agreed to a ceasefire on raising tariffs and to open a 90 day window to negotiate a resolution.
Investors from around the globe are watching closely as the dispute has pressured global growth due to its effect on many of the countries that trade with both the U.S. and China. While recent headlines have given investors hope of continued progress, there are still many issues that need to be resolved.
That will likely take some time. Investors should expect ongoing market volatility as the market responds to the natural ebb and flow of ongoing negotiations between the U.S. and China.
The Fed & Interest Rates
Prior to last year, the Fed raised their short-term interest rate 5 times since 2009 as the economy transitioned from being flat on its back to back on its feet. Even as the U.S. economy continues to grow, the Fed garnered plenty of attention as they raised rates four times in 2018 alone in hopes of keeping inflation in check and preventing the economy from overheating.
Much debate has surrounded the Fed rate hikes over the past year as investors express concern that the Fed runs the risk of raising rates too quickly and cutting off economic growth.
We believe some perspective is warranted. Despite 9 rate increases since this economic expansion began, the Fed funds rate is still only at 2.50%. Additionally, the Fed is likely to slow the pace of rate hikes in 2019 given current market conditions and moderating inflation.
When looking back at the start of the last 3 recessions in the U.S. dating back to 1990, the average fed funds rate was 6%.1 We expect the Fed funds rate to peak at a level lower than 6% given slower economic growth has been a staple of this market cycle. But we believe the Fed still has a fair amount of room to raise rates before economic growth is choked off, considering the current 2.50% rate.
The Rise of the Machines
There’s no doubt the trade dispute with China, ongoing Brexit negotiations, and questions surrounding the speed of Fed rate hikes left investors feeling a higher degree of uncertainty to finish the year. These uncertainties contributed to the S&P posting its worst December since the Great Depression. While these concerns drove some investors to sell and take profits, the selling pressure was likely compounded by a poor mix of increased computer-based trading and low liquidity around the holidays.
Computer-based, or algorithmic, trading has increased considerably over the past decade. While experts disagree on the exact percentage of the daily market traded by computers, most do agree it’s greater than 50%.
Computer-based trading isn’t inherently bad for markets, but it operates on a rules-based system. That means it can create greater momentum in the market when stocks are rising or falling, leading to increased volatility in the form of higher highs and lower lows.
When you combine increased computer-based trading with a market with less liquidity (in other words, fewer buyers) around the holidays and more selling activity, it’s a recipe for bigger market declines.
All Is Not Doom and Gloom
While the end of 2018 was painful for many of us, it’s important for long-term investors to take a step back and look at the big picture. Economic fundamentals softened a bit in the fourth quarter but remain solid as wage growth, the unemployment rate, and holiday retail sales all point to a healthy consumer. Consumer spending, which represents roughly two-thirds of U.S. GDP, will also continue to benefit from the recent tax cuts and a decline in gas prices.
While corporate earnings growth likely peaked in 2018 thanks to tax reform, we still expect to see positive earnings growth in 2019. Historically, when profits grow the stock market grows too. In addition, the combination of increased corporate earnings and declines in stock prices in 2018 left stock market valuations looking more attractive for long-term investors looking to put money to work.
What Can We Expect in 2019?
2018 reminded investors that owning stocks in hopes of earning a superior return to cash comes with a trade-off: you must be prepared to accept greater market fluctuation and risk of loss.
Given losses last year were relatively contained by historical standards, it offers long-term investors a great opportunity to review their financial plan with their financial advisor to make sure they remain on track to achieve their financial goals.
We would also advise investors to review their diversification of stocks and bonds in their portfolio as it relates to their comfort with risk to make sure they are appropriately invested.
We can’t predict future market uncertainty, but we can prepare for it by making sure we’re appropriately invested based on our risk tolerance and our financial goals. That’s a trade-off that can lead long-term investors to success.
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