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4th Quarter Strategy Implementation & 2019 Forecast


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Stock prices were pummeled in December – the worst December ever recorded for stock price performance.

Stock markets dropped last month based upon the ongoing tariffs, weak Chinese economic data caused at least in part by the tariffs, the Federal Reserve rate hike and announcement of three additional rate increase projected for 2019.

Despite these market moving items, other economic reports for the month were positive.  The manufacturing and services sectors of the economy both continued to growth. Retail sales were higher. Housing starts and existing home sales were both positive in November. Inflation was steady with the rate remaining at 2.2%.

With the broad market decline, the standard playbook for a distressed market kicked in:  large cap and higher quality stocks had relatively lesser declines on average than other types of stocks. Besides company quality and capitalization, price gain (i.e., momentum) and higher dividends yields were also favored by investors and performed better on average.

The worst performing companies had high betas (i.e., more historic volatility than the market) or were value stocks with factors such as price/sales, price/earnings and price/cash flow (i.e., value and momentum are typically opposite investing strategies).

No industry group had positive average price gains for December.  Driven by declining oil prices, most of the worst performing groups were in the oil and gas sector. Drug manufacturers and drug stores – typically a defensive area for investors to be when the market is in turmoil – also acted badly in December.

To recap our investment strategy implementation during the quarter, we began to raise cash in client accounts in August as the market was flirting with all-time highs.  We sold all companies whose current prices were above their intrinsic values as determined by a discounted cash flow analysis.  We also sold companies that had higher debt burdens or lower cash levels than industry standards.  This raised cash in client accounts that we could use for buying power if/when prices headed lower.

October 3rd was a seminal day in the markets as the Federal Reserve stated firmly that it planned on raising interest rates at least four more times.   This shook investors and they began to take profits and the stock market decline began in earnest.

As stocks that we liked fell in price, we would add shares, as is standard practice in order to lower our cost basis.

As the market decline continued, we used this opportunity to buy higher quality and larger capitalization stocks since, from a historical perspective, they perform better during turbulent markets.

We also added to health care companies – particularly those in cancer research that have products in the FDA approval process showing successful trials – given the historically defensive position healthcare companies have been treated by investors.

As the market continued down, we opportunistically started positions in certain high growth tech companies that have secular tailwinds but whose prices were down significantly from their highs several weeks prior.

For our Dividend Income clients, we followed a similar path, weeding out higher beta and lower quality companies with prices above intrinsic value and added to large cap companies with strong balance sheets and safe dividends.

As we got closer to year-end, and the negative impact of December was realized, we made tax loss sales in order to offset the gains we posted raising cash in August and September.  Many of the stocks we sold are on our re-purchase list because they are companies we want to own.   However, based upon tax law, we cannot repurchase them until after a month has passed.

As we enter 2019, we anticipate a rally in the first few weeks, but a potential lower low (i.e., a low in the market below that we saw in December) in March.  However, the news last week from the Federal Reserve that the 2019 rate increases are not a certainty may have made the December low the bottom for this correction.  We will just have to see what happens with the economy and corporate earnings announcements in coming weeks before we will know for sure.  If we do experience a lower low in March, then I’d expect a rally into the Summer.

There are a number of people forecasting a recession in the second half of this year.  I think it is too early to have a strong opinion one way or the other based upon the change in the Fed’s interest rate increase stance.   We do know that they have drained a significant amount of liquidity from the economy (see the chart of the Monetary Base – courtesy of Dennis Gartman and Doug Kass – at the top of this blog post ) but we do not know if it is enough to cause the economy to go into recession.

We also do not know the extent of the negative impact of higher interest rates on corporate earnings.  When 4th quarter 2018 earnings are announced beginning next week, we will have a better idea on this, but if significant, could drop GDP growth from the 3%+ level to 2% or below.  This could then be the beginning of a trend toward negative GDP growth that would define a recession.

One thing we do know is that the large GDP growth percentage in the prior quarter came from companies building inventories and not from increasing sales.  Typically, if inventories are building from sales that did not grow at an anticipated rate, this will also lead to a decline in GDP in subsequent quarters.

Longer term, the large debt levels for the State and Federal Governments, corporations, and individuals will be a big problem, negatively impacting the economy for a generation.  When you add in the off-balance sheet future liabilities for governments and corporations you are flirting with disaster – particularly with the next big issue likely to negatively impact the economy and markets, severely underfunded pensions at both the government and, to a lesser extent, corporate levels.  The demographics of our country, with the ratio of people receiving benefits to those providing funding to pay the benefits in a continual decline, will be very difficult for state governments to address without negative implications for their citizens.

It is easy to freeze up when stocks are going down in price – we don’t stop managing portfolios just because the market is turbulent.  We continue to watch the data and implement an investment strategy that will be defensive when needed and opportunistic when available.