State of the Market
The fourth quarter of 2018 was tough for investors. After edging higher through most of the year, the U.S. stock market did an about-face. The decline started in October, but the biggest impact was in December. As of Christmas Eve we were on track to have the worst December in U.S. stock market history. The last week of the year saw a slight recovery but the U.S. stock market (Russell 3000) ended the year with negative returns of 14.3% for the quarter and 5.2% for the year.
The pressure on the U.S. market seemed to be driven, in part, by fears of a slowing global economy, so it is not surprising that stock markets outside of the U.S. suffered from bad performance as well. International developed markets (MSCI World ex USA) were down 12.8% for the quarter and 14.1% for the year. Emerging markets (MSCI Emerging Markets) were down 7.5% for the quarter and 14.6% for the year. Global real estate (S&P Global REIT) was down 5.8% for the quarter and 5.9% for the year.
In a market environment such as this, high-quality bonds can be considered a safe haven. This increased demand for the U.S. bond market (Bloomberg Barclays U.S. Aggregate Bond Index) resulted in positive performance of 1.6% for the quarter, which offset losses from earlier in the year and brought performance for the year to essentially zero.
The total returns for major asset classes are below.
Inside the Numbers
2018 stands out as a unique year in that every major asset class (except for cash and some fixed income) and every major country (except for Qatar) had negative performance. It also stands out as a unique year because almost everything that history tells us will add value to investments in the long-term – increased exposure to value stocks and smaller companies – worked against investors in 2018 and the disparity was significant in many areas. It is disappointing and frustrating when almost every part of your portfolio is facing a headwind. However, as stock markets around the world have rebounded in 2019, the exact opposite has occurred. As of 1/25/2019, small is beating large, value is beating growth, and the managers that underperformed last year are likely having a good January.
Significant Changes in Valuation
The valuation of any security, asset class or market is the relationship between the price and the economics, which can be defined as the value the asset delivers to its owner. For bonds, that value is the monthly coupon. For stocks, it is company earnings, paid out in dividends or reinvested in the company.
Your return on any investment is based on a combination of positive or negative changes in both the economics and the valuation. If you buy stock in a company and the valuation does not change, then the investment performance over time will be solely attributed to the internal growth of the company’s economics. However, if the valuation does change while you own the stock, it will either increase or decrease your overall return. The ideal situation is to buy something that’s cheap, with growing economics and rising valuation. The worst scenario is to buy something expensive with deteriorating economics and declining valuations (think General Electric in 2018). This is why companies that fall into the value category – boring companies in boring industries – are typically undervalued but deliver better long-term returns than companies that fall into the growth category – exciting companies in exciting industries that often have aspirational valuations based on expectations they often fail to meet.
Morningstar, a well-respected, independent research firm, has a unique perspective on valuation. They value thousands of companies individually and aggregate those valuations to determine if a given market is overvalued or undervalued. The chart above illustrates Morningstar’s estimate of valuations at the end of October in both 2017 and 2018. While it may be hard to discern all the individual country data, the overall trend is clear. From Morningstar’s perspective, last year’s decline took the global markets from significantly overvalued to significantly undervalued, and this does not even consider the fourth quarter decline.
Morningstar also breaks the markets down by size (large/mid/small) and style (value/blend/growth). The graphic below illustrates that the smaller and value-oriented segments of every market look increasingly undervalued compared to the larger and growth-oriented segments.
It is never easy to stay the course through a market decline but observing the fundamentals can put things in perspective and give investors’ some degree of confidence that there may be higher expected returns going forward for all markets but especially for value-oriented styles of investing.
As always, thank you for your trust and confidence.