2018 marked the first time since the global financial crisis that the U.S. equity market posted a negative return for a calendar year. After hitting an all-time high in late September, the market traded lower throughout the fourth quarter, punctuated by a record decline of 2.7% on Christmas Eve. Analysts were quick to blame the sell-off on a variety of reasons: fears that the Federal Reserve was raising interest rates too rapidly, concerns over escalating trade conflicts with China, anxiety about slowing economic activity, the looming government shutdown and so forth. Volatility spiked, and at year-end, pundits were quick to declare the end of the bull market, with a recession almost certain to follow.

As the calendar turned to 2019, equity investors welcomed a recovery in stock prices. Yet the bounce leaves many investors slightly uneasy and suspicious that the worst may not be past. We readily acknowledge that our crystal ball is no clearer than anyone else’s, and so we turn to history for insight into what is likely to follow. In the pages that follow, we put recent market developments into context, in acknowledgment of Antonio’s observation in Act 2 of William Shakespeare’s “The Tempest,” that “what’s past is prologue.” We can’t predict, but we can prepare, and history offers a guide.

The Link Between Main Street and Wall Street

The lifeblood of financial markets is the real economy. What happens on Main Street determines what happens on Wall Street, although this causality reverses from time to time, such as during the global financial crisis. In the long run, however, economic activity generates corporate revenues and corporate profits, which in turn enables investors to place values on financial assets such as stocks and bonds. As the nearby graph illustrates, over longer periods of time, the growth in these three variables – nominal gross domestic product (GDP), corporate earnings and stock prices – is remarkably similar, although the volatility of this growth is vastly different.

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Nominal GDP (real GDP plus inflation) has expanded at an annual rate of 6.4% over the past 60 years, with a standard deviation of 3.0%. This means that roughly two-thirds of the time, nominal GDP has grown between 3.4% and 9.4%. Corporate earnings have expanded at an annualized pace of 7.4% over the same period, a slightly better growth rate due to gains in productivity. Yet the volatility here is almost five times that of the underlying economy, reflecting cycles in corporate profit margins. When margins are rising, economic activity is magnified in corporate earnings, and when margins are falling, the translation is diminished.

A similar amplification takes place when corporate earnings translate into stock prices. The added dynamic here is the valuation cycle, which depends on interest rates and investor sentiment, among a host of other influences. At different points in the past, the stock market has valued a dollar of earnings (as measured by the price-to-earnings ratio, or PE) anywhere from $7 in the late 1970s to almost $30 at the peak of the 1990s dot-com bubble. The average return of the equity market over this same period is similar to economic and corporate earnings growth, at 8.6%, but with even more volatility.

The point of this brief analysis is that price volatility is a feature of our economic system, not a bug. Since the S&P 500’s creation in 1928, the market has experienced an average of 17 days per year in which the index moved by 2% or more in a single trading session. In 2018, the market experienced 20 days with this level of volatility – right in line with the historical average. In 2017, however, the market had zero 2% trading days, only the 10th year in the past century without a single day of exaggerated volatility. Volatility is normal. Stability is abnormal.

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The CBOE Volatility Index (VIX) offers a more sophisticated measure of volatility by aggregating the implied volatility of every stock option that trades on the Chicago Board Options Exchange. The price of an individual stock option requires multiple inputs, including the current price of the stock, the strike price of the option, time left to the expiration of the option and the expected volatility of the underlying stock. If we know all the variables but one (volatility, for example), we can solve for it. The VIX does precisely this for the overall equity market.

The nearby graph shows the VIX for the past 15 years and reveals that the Christmas Eve spike in volatility, while rare, is not unique. The index has risen above 35 on six separate occasions over this period, corresponding to pronounced market developments, from the onset of the financial crisis, to the downgrade of the U.S. debt rating, to the occasional elevation in fears about economic growth at home or abroad.

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It is, however, intellectually spurious to assign cause and effect to these volatility surges, although the labels on our graph do precisely that. In the same way that Sherlock Holmes found curious evidence in the dog that did not bark in “The Adventure of Silver Blaze,” there are plenty of dogs that are not barking in this graph of market volatility. There are, for example, no volatility spikes labeled “trade disputes” or “Brexit,” although both developments pose potential threats to the economy and financial markets. These “dogs that do not bark” should prompt us to exercise caution when assigning cause to market action.

It is, in fact, a product of hindsight bias that there are labels on this graph at all. It is human nature to want our effects to have causes, and in retrospect it is easy to assign blame for spikes in market volatility. The reality is that market moves often have more to say about the internal state of the market than about external influences.

Consider the following analogy. If we were to slowly build a pile of sand one grain at a time, a predictable shape would eventually emerge. At some point, one additional grain of sand, however, would cause the whole pile to shift. We would stop and wonder why the pile shifted, and as tempting as it would be to blame the last grain of sand that we dropped, the last grain was no different from all the grains that had come before. In reality, the pile shifted because it was in a critical state in which it was prone to overreact to external factors, even if that last factor was no different from what came before.

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Now consider the parallel to fourth quarter 2018. As easy as it is to blame the correction on trade disputes, higher interest rates, fears of an economic slowdown, a potential government shutdown and so forth, none of these developments was new. Investors knew all these things back in September when the market was establishing new highs. Even the government shutdown that began in December and lasted into January was the third shutdown in 2018. These developments are analogous to the grains of sand falling onto a sand pile that is in an increasingly critical state. As we saw previously, the pile of sand that is the equity market had gone so long without shifting (recall the absence of 2% trading days in 2017) that it was primed to overrespond to external developments.

This analogy offers both bad and good news. The bad news is that it is difficult to the point of impossibility to accurately gauge the critical state of a system as complex as a pile of sand or financial market. There is simply no way to determine that the pile of sand is a certain number of grains away from shifting, and this makes it impossible to predict the movement of stock prices over the next few days, weeks and months. The good news is that once the system shifts it is in a much more resilient state. Criticality may start rising again right away, but the reset makes the system healthier for a period of time.

Let us return once again to history as both a guide to and justification of this analogy. The VIX has risen above 35 only 12 times since the creation of the index in 1990, including last Christmas Eve. As the nearby table illustrates, equity prices often remain under pressure for a few weeks following the spike in volatility. One month out, the market remained in negative territory in half of our historical examples, for an average return of -0.7%. Further out, however, returns have historically improved, so that by a full year later eight out of 10 periods enjoyed positive and even double-digit rebounds.

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Two exceptions to that generalization warrant closer attention. In 2001, the VIX spiked to 42 on the day that equity markets reopened following the truly unprecedented attacks of 9/11. One year out, the market was down 17%, but for fundamental reasons. Although it was not clear at the time, by September 2001 the economy was slipping into recession for reasons unrelated to the attacks in New York, Washington and Shanksville, and the linkages with which we started this commentary held true. Weaker economic growth translated into weaker earnings, which in turn dragged down the equity market. The spike in volatility was correlative, but not causative.

2008 offers a similar lesson. On September 15, 2008, Lehman Brothers collapsed into bankruptcy, and the following day the government cobbled together a bailout of AIG. The VIX, which had been steadily rising as the financial crisis unfolded, spiked above 35 on September 17 and eventually reached a record peak of 80 a month later. This was the onset of the Great Recession, the worst period of economic contraction since the Great Depression. Once again, the fundamental linkages between Main Street and Wall Street held, and a year later the equity market remained lower.

Some market observers are quick to conclude that recent volatility is a harbinger of economic gloom to come. History tells us that a spike in volatility, such as we experienced in December, may indeed indicate the onset of something worse, but only if the fundamentals warrant it. We turn our attention now to the economic fundamentals to determine whether last fall was merely another in a long line of corrections in this bull market or the beginning of something worse.

The Economy in 2019

The primary driver of macroeconomic growth in the United States is personal consumption. The spending decisions that 325 million Americans make daily comprise 68% of GDP. This is not to deny the importance of business spending (17% of GDP), government spending (16%) and net exports (-3%), but simply to observe that every other part of the economy ex-consumption adds up to 32%, and this 32% cannot possibly be robust enough to overcome weakness in personal consumption. It is no exaggeration to conclude that as goes the consumer, so goes the economy.

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The nearby flowchart illustrates the role that various aspects of the economy play in translating personal consumption into GDP. The most important store of wealth for most American households is a home, not a financial asset. The rise and fall in the value of homes drives the wealth effect, which is both a real as well as a psychological dynamic. Even if a homeowner has no need or desire to sell her home, and no inclination to take money out by remortgaging or opening a home equity line of credit, rising home prices make her feel and act wealthier.

Similarly, the primary driver of the income effect is the labor market. Lower unemployment means more jobs – and more paychecks to spend. Psychology plays a crucial role here as well. A healthy labor market means more job security, which leads to a greater willingness to spend money. Furthermore, rising wages usually accompany an improving labor market, providing even more fuel for the personal spending fire. The state of these twin markets – housing and labor – tells us much about the current and likely future state of personal consumption, and therefore the economy.

Pressures in the housing market are well documented. Rising mortgage rates and new constraints on the deductibility of mortgage debt pose challenges to the housing market, but this has yet to appear in prices. The homebuilding sector is slowing down for these two reasons, but if anything, this decline in new construction supports the prices of existing homes in the longer run by not allowing supply to build too rapidly.

There is scant evidence that housing prices are under pressure. Nationwide, housing prices are up 4.2% year over year, and a study of major metropolitan areas shows that every geographic region of the country is participating in this rise, albeit at different paces. Whereas we readily acknowledge that higher interest rates and changing tax rules may slow down the rise in home prices, we have yet to see prices decline in any geographic market.

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The labor market is similarly in good shape. As of December 2018, the nation has added jobs for a record 99 consecutive months, bringing the unemployment rate down to 3.9%. The last time the unemployment rate was this low, Lyndon Johnson occupied the Oval Office, and the Beatles’ “Hey Jude” topped the Billboard charts. The unemployment rate for workers with a college degree has dropped to 2.1%, indicating that 97.9% of the people in this country who have a college degree and want a job have one.

Forward-looking measures indicate that this improvement will likely continue. As the nearby graph illustrates, the number of job openings has exceeded the available supply of labor for nine consecutive months, indicating that the labor market should continue to improve as this mismatch of jobs and workers is addressed. Furthermore, the fundamental laws of supply and demand argue that wages should also continue rising. Average hourly earnings were up 3.2% year over year in December, the fastest growth in a decade, and well ahead of consumer price inflation of 1.9%. The linkages are clear: More people with more money (even adjusted for inflation) should translate into more spending and economic activity.

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There is something different in this economic cycle. For the first time in decades, or even generations, American households are restoring the health of their balance sheets by deleveraging and boosting their savings. This may appear to be a counterintuitive claim, as reports show that household debt is at an all-time high. Whereas it is true that household debt has risen close to 1% per annum for the past decade, at the same time household income has risen by 3.5%, and household assets have grown by 4.3%. Therefore, debt relative to income or assets has declined, as the nearby graph indicates.

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From peak of 134% debt to disposable income in 2007, just prior to the onset of the financial crisis, household debt levels are now down to just below 100%. The difference between this peak and the current level amounts to $5.3 trillion of forgone spending, which explains why this economic cycle has been so modest. The ratio of debt relative to household assets is back to where it was in the early 1980s. In the long run, this is good news: The restoration of household balance sheets means that the next economic cycle is not likely to be as deep and protracted as the last one. In the short run, however, deleveraging represents competing demand for every marginal dollar of household wealth or income.

At present these dynamics are in good balance. There is enough improvement in the housing and labor markets to support personal consumption while at the same time allowing households to repair their balance sheets. Tax cuts boosted personal incomes in 2018, which fed through into better GDP growth. Our expectation is that growth will revert to more modest levels in 2019 as the tailwinds of tax cuts subside. The economic story of 2019 is moderation.

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Financial Markets in 2019

Recalling the linkage from Main Street to Wall Street with which we opened this commentary, moderate economic activity should support equity market fundamentals this year. Here, too, we expect 2019 to be a year of moderation, as the benefit of corporate tax cuts is fully included in year-over-year comparisons. We are just beginning to get a better picture on how corporate America ended the year, but it seems likely that earnings growth for the full 2018 calendar year will be around 25% when all companies have reported their fourth quarters. This is a remarkable pace of profit growth for a mature economic cycle, with tax cuts accounting for about half of the improvement.

A silver lining in the otherwise dark cloud of last year’s correction is that market valuations are back down to more reasonable levels. The combination of a 25% rise in earnings and a 7% drop in the level of the index brought trailing PE ratios down from 22x at the beginning of 2018 to a current level of 17x. This is by no means cheap in an historical context but much closer to the long-run average of 15.6x. If earnings growth moderates back down to a more sustainable level of 8% to 10% in 2019, as we anticipate, the implied forward PE ratio is right in line with the long-run average. This brings to mind once again the analogy of a pile of sand that is in much more robust shape once the shift takes place.

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The proverbial grains of sand will continue to fall in 2019, and we cannot rule out the possibility of more volatility ahead. As active investors, we welcome this, at least in measure. It is not pleasant when external developments whipsaw markets, but it is precisely the difference between price and value that we intend to exploit when allocating capital. Volatility creates this disconnect, and this disconnect creates opportunity.

Steady improvement in economic and corporate activity should allow the Federal Reserve to continue raising interest rates, and the absence of inflationary pressure should also allow it to do so at a measured pace. Nevertheless, at present the futures market seems skeptical that rates will rise at all in 2019, assigning the highest probability to a scenario in which the fed funds rate remains at the current level of 2.25% through the year. The January Fed meeting reinforced this expectation, as the statement following the decision to leave interest rates unchanged acknowledged “muted inflation pressures,” allowing the committee to “be patient as it determines what future adjustments to the target range” are appropriate. The path and pace of monetary policy is a development worth monitoring closely as the year unfolds.

The municipal bond market has offered several fleeting entry points over the past few years, although at present we find muni yields broadly unattractive. Over the course of last fall, the benchmark 10-year municipal bond yield fell from 2.80% to the current level of 2.25%, offering little real return at present. As and when rates rise to levels that offer better protection against inflation – even at modest levels – we will likely increase our clients’ exposure to traditional tax-exempt fixed income.

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What Could Go Wrong?

The preceding paragraphs lay out a decent fundamental expectation for 2019, albeit one that could still be plagued with volatility. As the year unfolds, we will closely watch several developments that could threaten to derail this otherwise benign outlook.

First, there is a disconnect between inflation expectations and economic reality. Perhaps because inflation has been so quiescent for so long, investors are placing a low probability on its return, despite a healthy labor market and solid economic fundamentals. Inflation expectations embedded in the 10-year government Treasury inflation-protected security (TIPS) have fallen below 1.8%, and the Federal Reserve’s own expectations for core inflation rise only to about 2.0% over the next few years.

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This seems incompatible with an environment in which wages are growing at 3.2% (as of December) and may accelerate as the labor market continues to tighten. In the nearer term, if tariffs on Chinese imports remain or even increase, import price pressure may feed through into consumer inflation as well. We are reminded of the old adage that, whereas the most anticipated risk is least dangerous, the least anticipated risk is the most dangerous. Inflation seems to be a more dangerous risk than the market is acknowledging at present.1

A second and related disconnect is that between economic reality and expectations for the path and pace of monetary policy. The market has interpreted Chairman Jerome Powell’s comments following recent meetings to indicate a pause in interest rate increases as the Fed determines the effect of last year’s four rate hikes. The futures market currently indicates close to a 90% probability that the Federal Reserve does not raise rates at all throughout 2019 and a growing (but small) probability that economic conditions actually warrant a rate cut in the fourth quarter.

We admittedly expect economic activity to moderate in 2019, but primarily as a result of annualizing the benefit of tax cuts last year. The current fed funds rate target of 2.25% to 2.50% implies that the real (that is, inflation-adjusted) rate is barely positive. We believe that the Fed could raise rates in 2019, particularly if wage growth continues to accelerate. Whether or not this surprises the market remains to be seen. We note that this year the Fed intends to hold a press conference following every meeting, and this enhanced frequency of communication may help to mitigate the risk of a surprise.

A third risk is based not in Main Street or Wall Street, but in our nation’s capital. Although we have historically concluded that developments in Washington are more noise than substance, we acknowledge that escalating political dysfunction could overwhelm sound economic fundamentals. This is a change. History shows that the market and economy historically ignore political squabbles, such as the one over funding border security that partially closed the government for 35 days in December and January. Indeed, the S&P 500 rose close to 8% over the course of the recent shutdown.

The current environment in Washington, however, demonstrates that both parties are willing to weaponize the normal functioning of government in pursuit of political ends, with unpredictable implications. There were two government shutdowns during the eight years of the Clinton administration and only one in Obama’s tenure in the White House. George H. W. Bush presided over just one government closure, and his son George W. Bush saw none. There have been three shutdowns in the Trump administration, and the current ceasefire is scheduled to expire in February.

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To add to the uncertainty, the ceiling on issuance of federal debt – suspended as part of the 2018 budget agreement – is scheduled to spring back into existence on March 2, 2019, likely at the prevailing level of outstanding debt on that day. The debt ceiling has become a political football before, and either party (or both) might resort to it again to further a political agenda. In previous episodes of debt ceiling crises, investors have worried that the U.S. might technically default on shorter-term Treasury bills that are legally prevented from being rolled over. Whereas we assign a low probability to the U.S. defaulting on its debt, even temporarily and technically, we must concede the possibility that an economic accident arises from the climate in Washington.

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Although this commentary focuses on developments here in the United States, we also acknowledge that circumstances abroad may affect economic and market conditions here at home. The real risk lies not in headlines related to Brexit or trade disputes with China: Total net trade with every U.S. trading partner amounts to only -3% of GDP (negative because of the aggregate trade deficit). The far more important translation mechanism is through corporate revenues and profits. For the full 2017 calendar year, companies in the S&P 500 generated 44% of their total revenues outside the United States. The geographic breakdown is not as precise as we would like, as many companies do not report granular exposures, but the nearby pie chart illustrates the reliance of U.S. companies on Asia and Europe in particular.

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Economic activity is slowing both in China and Europe. We believe that the Chinese slowdown is a story of secular transformation rather than cyclical weakness. Simply put, as the Chinese economy grows and matures, it will no longer be able to support the historical growth rates associated with an emerging economy. This is a mark of success, not failure. China is already the second largest economy on the planet, and large economies do not sustainably grow at high rates.

Europe is another story. Economic growth in the eurozone has decelerated for four consecutive quarters, to an anemic pace of 1.6% in the third quarter of last year. Uncertainty about the economic and trade implications of the United Kingdom’s intended exit from the European Union weigh on economic activity, and this uncertainty is likely to get worse before it gets better. We will listen carefully for how companies report their non-U.S. earnings for evidence that weaker growth abroad is translating into slower corporate profit growth.


The challenge confronting investors is to make a distinction between those developments that threaten to impair sentiment, and therefore price, and those developments that threaten to impair fundamentals, and therefore value. We have experienced plenty of damage to sentiment, leading to the price volatility of the previous quarter, exacerbated in turn by a market primed to overreact. Despite the litany of risks outlined in this commentary, we conclude that economic and market fundamentals remain sound while acknowledging that moderation is likely to be the storyline as 2019 unfolds.

Risks to sentiment abound, and volatility will likely return to markets throughout the year. Whereas patience and a disciplined focus on value are key ingredients of investment success throughout a cycle, they are particularly important in an environment of heightened uncertainty and volatility. We seek to allocate capital into assets whose value will remain healthy in periods of economic and market stress, even if the price of those assets does not reflect that health on any given day. Patience will become increasingly valuable when it is in short supply.

Past performance does not guarantee future results.

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1 For more on our views around inflation and the threat it poses for investors, read our third quarter 2017 InvestorView article, “Everything You Ever Wanted to Know About Inflation (But Were Afraid to Ask).”