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2018 Year End Summary

January 4, 2019

The past year proved challenging for investors as the aging bull market for U.S. equities encountered several headwinds following a great 2017 that had been characterized by strong returns and record-low volatility.  After a strong first three quarters in 2018, the S&P 500 declined 14% in the fourth quarter (at one point declining as much as 19.8% from its peak) to end the year down 4.38%.  Other areas of the market fared even worse.  The Russell 3000 Value declined 8.6% for the year, while international and emerging market stocks (as measured by the MSCI EAFE and MSCI EM) declined more than 13% and 14% respectively. 

 

There have been no shortage of headlines to rattle the markets; however, despite the noise and market volatility, the recent sell off appears somewhat overdone given the prevailing strength of the U.S. economy. 

 

The American consumer, whose spending accounts for 68% of GDP, is healthy as tax cuts boosted confidence and spending in 2018, evidenced by Mastercard (MA) reporting the strongest holiday shopping season in five years.  The consumer balance sheet is strong as debt payments are at the lowest level in decades and well below pre-recession highs.  The 37% decline in oil prices since September 30 is also effectively an additional tax cut for consumers as they have to pay less at the pump.

 

 

The labor market continues to be another area of strength.  Unemployment is at the lowest point since 1969 and showing no signs of slowing as job growth remains steady.  The tight labor market is putting upward pressure on wages which are up 3.2% year-over-year, but inflation generally remains stable.

 

 

The confidence of small business owners also bodes well for the economy. Small businesses generate nearly two-thirds of net new private-sector jobs and about half of the country’s economic output.  In November, the National Federation of Independent Businesses (NFIB) reported that its Small Business Optimism Index remained near levels not achieved since 1983. The NFIB’s survey of 5,000 small business owners also indicted solid capital expenditures and plans for future capital outlays.

 

 

However, even with these positive company and economic points, we would not be surprised to see a number of companies begin to reduce earnings or revenue estimates in the near future related to a number of other areas of weakness.  Growth in the housing market is slowing. Trade tensions are creating uncertainty. A stronger dollar is driving up the prices of U.S. goods internationally, hurting U.S. exports and creating a headwind for corporate profits earned overseas.  Additionally, economic growth in both developed and emerging international markets is showing greater signs of slowing than in the U.S.  In fact, as we were putting our finishing touches on this letter, Apple (AAPL) significantly cut their first quarter earnings guidance, citing weakness in the emerging markets and specifically China as a primary cause.

 

One of the biggest perceived risks for the economic expansion and the stock market is the Federal Reserve stalling growth by hiking interest rates and unwinding its balance sheet.  Unlike prior tightening cycles, however, the economy is not overheating and inflation is tame, so there seems to be a greater chance that the Fed can continue to be data dependent and raise rates at a pace that doesn’t strangle the economy and put it into a recession.  Currently, the U.S. economy is growing at a solid, yet unspectacular pace; and the Fed is expecting GDP growth of just 2.3% in 2019 and 1.9% thereafter.  Inflation has also been running consistently at or slightly below the Fed’s target level of 2%.  By raising rates now from a position of strength, the Fed hopes to not only pull off a soft landing for the economy but also to increase its ability to help lift the economy if it were to fall into a recession down the road.

 

More than the tightening monetary policy, the trade war seems to pose the biggest risk to the economic expansion.  As it stands now, the proposed tariffs are not large enough to drastically hinder the U.S. economy.  The real risk is the uncertainty created by a prolonged trade war.  Uncertainty can cause business leaders to take a “wait and see” approach by putting growth projects on hold or delay the hiring of workers.

 

While the waning boost from the tax cuts and tighter monetary policy will slow the growth of the economy and corporate earnings, the current strength of the U.S. economy and reasonable stock valuations form a solid backdrop for the stock market going into 2019. Corporate earnings growth is expected to slow from more than 25% in 2018 to less than 10% in 2019, but the expected earnings for 2019 imply a ~14.5x forward P/E multiple on the S&P 500 Index which is below the 25-year average of 16.1x.  Ultimately, a trade deal with China – which both sides have significant incentive to accomplish – and the Fed’s successful navigation of the tightening cycle would be constructive for stocks. 

 

 

 

 

 

 

 

Important Disclosures:

 

Sources: JP Morgan Asset Management, YCharts, NFIB Small Business Optimism Index

 

Past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk.  Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Alpha Omega Wealth Management, LLC (“Alpha Omega”), or any non-investment related services, will be profitable, equal any  historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. 

 

Alpha Omega is neither a law firm nor accounting firm, and no portion of its services should be construed as legal or accounting advice. Moreover, you should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from Alpha Omega. 

 

Please remember that it remains your responsibility to advise Alpha Omega, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or  if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.

 

A copy of our current written disclosure Brochure discussing our advisory services and fees is available upon request. The scope of the services to be provided depends upon the needs of the client and the terms of the engagement.

 

Index Definitions:

International Stocks: The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada.

 

Emerging Market Stocks: The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.

 

Large Cap Stocks: The S&P 500 Index is widely regarded as the best single gauge of the U.S. equities market. The index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. The S&P 500 Index focuses on the large-cap segment of the market; however, since it includes a significant portion of the total value of the market, it also represents the market. 

 

Value Stocks: The Russell 3000 Value Index® measures the performance of the value segment of the Russell 3000 Index by including stocks that have low price-to-book ratios and lower expected growth rates. The Russell 3000 Index measures performance of the 3,000 largest publicly held companies incorporated in the U.S.

 

Select Risks:

The price of equity securities may rise, or fall because of changes in the broad market or changes in a company’s financial condition, sometimes rapidly or unpredictably. These price movements may result from factors affecting individual companies, sectors or industries, or the securities market as a whole, such as changes in economic or political conditions. Equity securities are subject to “stock market risk” meaning that stock prices in general may decline over short or extended periods of time.

 

Mid-capitalization investing typically carries more risk than investing in well-established "blue-chip" companies. Historically, mid-cap companies' stock has experienced a greater degree of market volatility than the average stock.

 

Small-capitalization investing typically carries more risk than investing in well-established "blue-chip" companies since smaller companies generally have a higher risk of failure. Historically, smaller companies' stock has experienced a greater degree of market volatility than the average stock.

 

Investments in emerging markets can be more volatile. The normal risks of investing in foreign countries are heightened when investing in emerging markets. In addition, the small size of securities markets and the low trading volume may lead to a lack of liquidity, which leads to increased volatility. Also, emerging markets may not provide adequate legal protection for private or foreign investment or private property.

 

International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can raise or lower returns. Some overseas markets may not be as politically and economically stable as the United States and other nations.

 

Bonds are subject to interest rate risks. Bond prices generally fall when interest rates rise.

 

High-Yield Bonds are lower-rated debt securities (commonly referred to as junk bonds) that involve additional risks because of the lower credit quality of the securities. The investor should be aware of the possible higher level of volatility, and increased risk of default.

 

ETFs and closed-end funds are traded on the secondary market and are subject to the forces of supply and demand independent of the NAV. This can result in the market price trading at a premium or discount to the NAV, which will affect an investor’s value.

 

The market prices of ETFs can fluctuate as a result of several factors, such as security-specific factors or general investor sentiment. Therefore, investors should be aware of the prospect of market fluctuations and the impact it may have on the market price.

 

 

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