As the director of research for Buckingham Strategic Wealth and The BAM Alliance, whenever markets head south for an extended period, the number of calls I get from clients and other advisors jumps. This time is no different.
With that in mind, I thought it important to share how investors should be thinking about the recent drop. To begin, there is always a reason for investors to worry about the stock market, be it valuations at historically high levels, the economy, the risk of inflation or geopolitical risk. That is why there is an equity risk premium, and why historically it has been large enough to be called the “equity premium puzzle.” It’s also why it’s often said that “bull markets climb a wall of worry.”
While the news on the economic front has been just about as good as it gets, there are always things to worry about. To make sure you have a balanced view of things and are not just obsessing about potential risks, let’s first look at some of the economic news:
- Economic growth is strong. The Philadelphia Federal Reserve’s Fourth Quarter 2018 Survey of Professional Forecasters projects real GDP growth for 2019 of 2.7%, down just slightly from the forecast of 2.9% for 2018.
- Unemployment is at 3.7%, the lowest rate in 50 years.
- Inflation is moderate. The Philly Fed’s latest 2019 forecast is for an increase in the CPI of 2.3%, down slightly from their forecast for 2018 of 2.4%.
- Consumer sentiment (a leading indicator) is strong. The December University of Michigan Consumer Sentiment Survey came in at 97.5, remaining near the highest levels we have seen over the past 18 years (despite the recent weakness in stocks). The last time the Consumer Sentiment Index was consistently above 90.0 for at least as long was 1997 through 2000, when it recorded a four-year average of 105.3.
- The November ISM (Institute of Supply Management) Non-Manufacturing Purchasing Managers’ Index came in at 60.7%, a 0.4 percentage point higher than the October reading of 60.3%—representing continued growth in the nonmanufacturing sector and at a slightly faster rate. The six-month moving average of the index is at about the highest level in more than 20 years. And the Non-Manufacturing Business Activity Index increased to 65.2% in November, 2.7 percentage points higher than the October reading of 62.5%, reflecting growth for the 112th-consecutive month, at a faster rate.
The bottom line is there is nothing in the economic data to indicate we’re headed into a recession that could lead to a bear market (with the stock market being a leading indicator). While the economic expansion is now 10 years old, expansions don’t die of old age. They die either because geopolitical risks show up or because the Fed tightens monetary policy, driving real rates to high levels to fight inflation.
Today the real rate on one-month Treasury bills is about zero. Even if the Fed were to raise rates three more times over the 12 months (the market currently expects a hike in December and one more next year), the real rate would still only be around 1%, which is about the historical average, and certainly not indicative of a tight monetary policy. That said, there are always things to worry about.
Known Risks
While we will take a look at some of the concerns investors are dealing with, the list is not meant to scare you into action. Most importantly, you need to understand that all these risks are well known by the sophisticated institutional investors who do as much as 95% of the trading, and thus are setting prices (the risks are already embedded in prices). The only way you can exploit them is to outguess the collective wisdom of the market—something very few professional investors have been able to do.
Consider that, over the 10 calendar years from 2008 through 2017, the HFRX Hedge Fund Index lost 0.4%, a period in which all major equity and bond indexes produced positive returns. For example, the S&P 500 Index returned 8.5% and five-year Treasuries returned 3.2%. Here’s the list:
