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Maybe it was that day in early October when Fed Chair Jerome Powell said interest rates remained “a long way” from neutral even after three rate hikes in the three quarters leading up to his speech.
Or it could have been mounting trade and tariff tensions between China and the U.S. as the year drew toward a close.
Perhaps it was the 10-year U.S. Treasury yield rising significantly above 3% for the first time in more than a decade. Or was it when the crude market crashed?
Whatever lit the spark (maybe a combination), it’s pretty clear that the U.S. stock market hit a wall early this fall. The resulting slide—which began in October, sputtered in November, and resumed with authority in December as worries about trade with China continued—completely changed the tenor of a year that, at one point, had looked like it might be another banner one for stocks.
By the end of 2018, it seemed likely that there’d been a complete shift in the market, and a repricing of assets both in stocks and fixed income. Suddenly, risk-taking wasn’t being rewarded, and neither were investors trying to pick a bottom in the market.
“Buying the dip doesn’t seem to be working,” said JJ Kinahan, chief market strategist, TD Ameritrade.
The sell-off accelerated in late December when the Fed raised rates another 25 basis points and said it expects two more hikes in 2019. The S&P 500 (SPX) quickly got sliced to a new low for the year, down about 7% since the start of 2018. As the new year approached, it appeared more and more likely stocks would suffer their first annual loss in three years and post their worst yearly performance in a decade.
Info Tech and FAANGS Hit a Wall
There’s arguably no better example of how things changed than the so-called “FAANG” stocks, or Apple Inc. (NASDAQ: AAPL), Amazon.com, Inc. (NASDAQ: AMZN), Facebook, Inc. (NASDAQ: FB), Netflix (NASDAQ: NFLX) and Alphabet (NASDAQ: GOOGL). These five contributed in an outsized way to the overall market’s climb to record highs throughout 2017 and then again in the summer of 2018.
As early as July, however, the magic started to fade as NFLX and FB failed to impress investors with their earnings. AMZN had a similar earnings disappointment in October, followed by AAPL falling short in its earnings outlook in early November. By early December, all five of these closely followed names had descended more than 20% from their all-time highs, helping to put what had been one of the biggest sources of upward momentum into a bear market and helping spike negative sentiment that flowed beyond just the info tech, consumer discretionary, and communication services sectors where they reside. The total hit to the market cap of just these five stocks hit $1 trillion by late November.
“There’s been a change of sentiment,” Kinahan said. “It’s not just ‘Go out and buy the FAANGS.’ People are getting more selective about buying stocks that might be better over the long-term, whereas before you could just buy momentum stocks and things would likely go well.”
As the market continued to slide late in the year, Kinahan observed that FAANGs have lost their place as a shield from negative news elsewhere in the market.
“FAANG stocks appeared to have been the hide-out in bad moments, but that play is clearly over,” Kinahan said. “The new hide-out seems to be steady, blue chip stocks with dividends.”
He noted that a trio of staples stocks, consisting of Procter & Gamble Co. (NYSE: PG), PepsiCo, Inc. (NASDAQ: PEP) and The CocaCola Co. (NYSE: KO) seemed to have weathered the autumn storm better than many other parts of the market, particularly FAANGs and info tech.
The dive in AAPL shares might have been particularly problematic for market bulls.
“Apple is a stock that psychologically drives a lot of people,” Kinahan said. “People have had a beautiful ride on it, but the ground is shifting. Apple is changing the way they report earnings, and that makes people nervous. What happens when they get nervous? They sell.” He was referring to AAPL’s decision to no longer report iPhone sales on a unit basis.
Geopolitics: Trade and Tariff Debate Dominates
When historians look back at 2018, they’ll arguably say the trade battle between China and the U.S. was the biggest story of the year. The impact of rising tariffs between the world’s two biggest economies boomeranged around almost every sector, and possibly helped lead to some of the slower overseas growth seen much of the year. By December, China was reporting slower export and import growth, perhaps a sign that the tariffs were really beginning to bite.
While President Trump and Chinese President Xi drew headlines in early December when they met to talk trade in Argentina, the year ends with a lot of question marks still haunting this continuing story.
Can the two countries actually make much progress in the 90 days (starting roughly Dec. 1) that Trump has said he’s willing to wait before raising tariffs to 25% from 10% now on hundreds of billions of dollars worth of Chinese goods? Will China be willing to cut tariffs on U.S. automobiles and buy more U.S. grain? Is there going to be some progress on long-term tangles between the countries, especially in the technology and intellectual property areas? Those questions didn’t get answered in 2018, but there’s always hope for more clarity in 2019.
Treasury Yields Steadily Rise, Then Pull Back
In one sense, 2018 was less a story about the U.S. stock market, and more one of the U.S. Treasury market.
Just over two years ago, the benchmark 10-year Treasury note yield dipped to a historic low below 1.39%. After that, it got on a chair lift ride that took it up to 2.4% at the start of 2018 before a peak at just above 3.25% in the fall.
Why were investors suddenly so eager to sell Treasury bonds (which move opposite of yields) through much of 2018? In part, it likely reflected Fed rate hikes (see more below), but also—at least for much of the year—it seemed to hint at investor confidence in U.S. economic growth. With gross domestic product (GDP) up 4.2% in Q2 and 3.5% in Q3, it appeared the U.S. economy might have finally started to escape the doldrums of 2% or lower growth that had haunted it for years after the 2008 recession.
However, the yield rally didn’t last, as 10-year yields fell back well under 3% by mid-December. By late in the month, the 10-year fell below 2.8% to its lowest level since late May as investors worried about possible slowing in the economy.
On Dec. 19—when the Fed dialed back U.S. GDP growth estimates for 2018 and 2019—yields dived even lower. Though the Fed raised rates, the rally that followed in Treasuries might indicate there’s potentially less economic optimism among market participants than there seems to be at the Fed. It looked like investors were embracing so-called “defensive” assets instead of taking more risk, perhaps out of fear that earnings and GDP growth could slow.
Economic worries started to resurface amid the U.S./China trade war and weakening overseas economies. By December, there was a yield “inversion” in which yields on the five-year note fell below yields on the three-year note. Sometimes this kind of inversion has been associated with recessions.
In addition, longer-term yields like the 10-year and 30-year never really were able to climb as much in 2018 as short-term ones, which are more sensitive to Fed rate hikes. By late in the year, when it appeared the Fed might take a more dovish stance in 2019, investors started coming back to the bond market. The Fed now sees two hikes in 2019, down from three, and that could be a factor in Treasury buying. Another factor might be the premium of U.S. Treasury yields to yields in foreign bond markets, which can make U.S. Treasuries appear more attractive.
“Fixed income is in vogue again, for the first time in a decade,” said Craig Laffman, director of fixed income and syndicate at TD Ameritrade. “The inversion shows that there’s been a shift in expectations as to what the Fed might do.”
Laffman added that late-year volatility in stocks (see more below) might also have drawn some investors toward fixed income as they looked for potentially calmer waters.
Figure 1: Tracking S&P 500 Vs. 10-Year Yield in 2018: As this chart shows, it was a volatile year for both the S&P 500 Index (candlestick) and the benchmark 10-year Treasury yield (purple line). Both rose in sync for a while this summer, but eventually concerns about everything from China tariffs to slower economic growth combined to pull both down sharply from their highs by December. Data Sources: S&P Dow Jones Indices, Cboe Global Markets. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
Fed Policy Watch: Steady Hikes Mark 2018
Rising yields through much of the year coincided with the Fed’s hawkish interest rate policy (see below), which saw four rate hikes in 2018 take the Fed funds range to a decade high. The Fed found itself under pressure to keep rates moving up based in part on steady U.S. job and wages growth that raised fears of possible inflation. By October and November, hourly wage growth reached 3.1%, and Fed Chair Jerome Powell, who took his position in February from former Chair Janet Yellen, appeared to spook the stock market when he said that the Fed funds rate is “a long way” from a neutral level that neither encourages nor discourages economic growth.
Powell arguably had to walk those words back in late November after the market endured two months of struggles, especially in a “red October” that saw some of the major indices enter correction territory (down 10% from highs) for the second time in 2018. In a closely watched speech, Powell said rates were “just below” neutral, even though there’d been no change in rates during the two months between his speeches.
Powell’s words, along with dovish remarks from some other top Fed officials, helped reduce expectations of continued rate hikes in 2019, and might have helped bring buyers back to fixed income. While at one point earlier in the year the futures market had given strong chances of three rate hikes in 2019, the year ended with futures prices pointing to odds of just one hike for the entire year.
“If you go all the way out to January 2020, the futures market only shows one more hike,” Laffman said. “Clearly there’s been a shift in expectations about what the Fed will do.”
Still, the Fed said in December it anticipates two hikes, not one, next year, meaning the Fed seems to be more positive about the economic outlook than the market. The Fed funds rate finished 2018 in a range of 2.25% to 2.5%, but if the Fed outlook proves correct, it could be 2.75% to 3% by the end of 2019. A lot of that could depend on data between now and then, with the Fed saying it intends to be more data dependent.
Volatility: It’s Not 2017 Any More
All of the China trade jitters, Fed worries, and FAANG pullback showed up pretty clearly for investors who follow the market’s most closely-watched “fear index,” the VIX. This metric, which fell to historic lows below 10 during parts of 2017, shot up to 50 in early February after the market got spooked by January’s payrolls report, which showed higher than expected wage growth and brought fears of possible inflation and Fed tightening.
Though VIX came back to nearer its long-term normal in the high-teens and low-20s as the winter and spring continued, and even fell below 12 during the traditional calm of summer, it quickly spiked again as markets crumbled in October, remaining above 20 much of the rest of the year and climbing above 25 by late December. Concerns about the China trade situation, lack of progress on Brexit negotiations in Europe, and worries about what the Fed might do next all contributed.
Higher volatility can, in and of itself, help weigh on the markets. By raising investor fears of impending whip-saws in prices, it may send some scurrying toward the sidelines or looking for less volatile places to put their money. That might explain in part the rally in fixed income seen at the end of the year.
Still, it’s important to keep things in perspective. “Volatility is only elevated compared to the last couple of years,” Kinahan said. “It’s actually normal on a historical level.”
Correction Capers: S&P 500 Suffers Two 10% Drops
As noted above, volatility started to spike early in 2018, when the S&P 500 (SPX) suffered a 10% correction between February and April. It may seem like it was just one sharp drop and then back to normal, looking back all these months later, but the malaise arguably lasted much of the spring. The first plunge came in early February after inflation fears surfaced on stronger than expected U.S. wage growth.
The beginning of a prolonged spat over trade between the U.S. and China might also have helped keep pressure going as the months continued, and the SPX ultimately matched its February closing low of 2581 in early April after falling all the way from January’s 2873 intraday high.
After that, the market began a long recovery that lasted most of the summer and took the SPX to a new all-time intraday high near 2941 in late September. A lot of the strength seemed to reflect booming U.S. corporate earnings (more below) sparked in part by the late 2017 tax cut. A stronger crude market that helped the energy sector was another factor in the rally.
However, the triumvirate of weak overseas growth, rising rates, and weakening oil—along with disappointing FAANG news—helped lead to the market’s second correction of the year in late October when the SPX dropped to an intraday low of 2603. The Dow Jones Industrial Average ($DJI) and Nasdaq (COMP) also fell sharply, with COMP hitting a correction of its own. Also, small-cap stocks in the Russell 2000 Index (RUT), which had forged new all-time highs earlier in the year likely in part on ideas that small-caps might be less vulnerable to international trade tensions, fell to new lows for the year and entered a bear market (down 20% from highs) by mid-December as some investors started worrying about the highly-leveraged nature of some small-cap stocks in a rising rate environment.
Earnings Shoot Up After Tax Reform Takes Effect
During all the ups and downs of the markets, corporate earnings put in a bravura performance. Even as the stock market cratered in late 2018, companies continued to post impressive profits and sales. In Q3, for instance, 77% of reporting companies beat Wall Street analysts’ earnings per share estimates while 62% beat sales estimates, according to FactSet.
While the 28% earnings per share growth for S&P 500 companies in Q3 is almost certainly a level that won’t be maintained, analysts continued to look for double-digit Q4 earnings growth as the year wound to a close. FactSet predicted 13.4% EPS growth in Q4. Though that’s down from the 20% or better growth of Q2 and Q3, it would look pretty strong compared with what investors were seeing a few years ago when quarterly earnings actually were falling.
Still, there’s a sense that companies need to do more than beat estimates to impress investors these days. Often in late 2018, firms reporting solid numbers saw their shares fall as investors focused instead on what they saw as cautious outlooks from the companies.
“This seems to be a continuing theme for earnings in 2018,” Kinahan said. “Investors keep punishing companies for what they say they’re going to do instead of rewarding them for what they did.”
Sector Shuffle: Which Ones Did Best and Worst?
By December, a majority of S&P 500 sectors were in the red for the year as the SPX remained in correction, or down more than 10% from its annual highs. With the SPX down more than 14% from its fall highs by mid-December, the leading sectors for 2018 were health care, utilities, and info tech.
Those sectors near the top of the leaderboard (health care and utilities) are typically thought of as “defensive” areas, meaning they tend to attract investors when times are rough and people are looking for dividends and solid blue chip companies. Meanwhile, some of the so-called “cyclical” sectors that tend to do better when the overall market is strong, including industrials, financials, materials and energy were all down double-digits for 2018 as of mid-December.
“Financials have been a frustrating trade most of the year,” Kinahan said. “Though big bank stocks often hog the attention, it’s regional banks that seem to have really taken it on the chin from declining yields and the narrowing curve. Earlier this year, the regionals had seen some investor interest as some of the major banks got hit by trade fears. The thinking then appeared to be that regional banks might not be exposed so much to international trade issues. That was then. Now the yield curve seems to be taking a toll on everyone.”
Commodities: Oil Takes a Roller-Coaster Ride
If the year had ended in October, the story in commodities would be about crude strong-arming its way back to highs last seen in 2014, before the epic collapse of the market later that year and in early 2016. Strength in the U.S. economy, along with what some analysts saw as synchronized growth between the U.S. and overseas economies, helped propel U.S. crude prices from the high $50s per barrel early in the year all the way to a four-year high of around $76 a barrel by October. Then the bottom fell out.
Weaker demand from foreign economies, record production in the U.S., and a surprise U.S. decision not to immediately implement sanctions on Iranian oil meant to punish that country, combined to help send crude down more than 30% in late fall. The month of November turned into the worst for crude since the plunge of late 2008, and by the end of the year, despite an agreement between OPEC and Russia to cut production by 1.2 million barrels a day, crude was barely hanging on above $50 a barrel. By late December, crude had tumbled all the way to 17-month lows under $46 a barrel as economic fears intensified.
Other commodities also couldn’t find much in the way of buying interest in late 2018, either. Copper, gold, ags, and other metals seemed to reflect fears of a slowing economy. Somewhat surprisingly, gold didn’t find much in the way of buyers despite economic concerns. A strong U.S. dollar might explain some of the weakness in gold, which seemed stuck between $1,200 and $1,300 an ounce for most of the year.
Greenback Plows Ahead
Speaking of the dollar, that was one area showing strength late in 2018. The dollar index, which measures the greenback vs. a basket of other major currencies, topped 97 several times late in the year, well above lows of around 88 back in early 2018. The dollar seemed to gain strength amid a so-called “flight to quality” trade that saw investors start to abandon what they saw as riskier assets amid the market weakness. The dollar tends to do well in this sort of environment.
However, a stronger dollar can help put a brake on stocks, considering about 40% of S&P 500 profits com from overseas and strength in the dollar raises the cost of U.S. goods for consumers abroad. That’s one reason analysts cited for weakness in emerging market economies in 2018, with the Chinese stock market in bear territory as the year drew to a close.
Economic Drivers: U.S. Data Stays Strong, But Overseas Stagnates
One possible reason the Fed might be re-thinking its hawkish strategy heading into 2019 is continued stagnation of many economies overseas. Much of the world economy saw relatively flat economic growth in 2018, while China’s growth pulled back from recent strength. In part, this might have reflected some of the geopolitical winds, especially the long tariff battle between China and the U.S. With fears mounting that a prolonged trade war could potentially slow economies around the world, more investor money began pouring into the U.S. dollar and into U.S. fixed income products. The dollar index, which had fallen below 90 in early 2018 from highs above 100 a year earlier, inched slowly but steadily up in late 2018. By December, it was back at 97.
The strong dollar might reflect faith in the U.S. economy, but it can also hurt foreign economies by making the cost of U.S. goods higher. That’s also potentially a tough slog for U.S. multinational companies, especially considering that about 40% of S&P 500 revenue comes from abroad. Stocks like Boeing Co. (NYSE: BA), AAPL and Caterpillar Inc. (NYSE: CAT), which have major exposure to China and other markets, pulled back in November and December.
Through the overseas struggles, the U.S. economy continued to shine, leading some analysts to wonder how long the U.S. can continue growing fast amid what looks like a slowdown abroad. The U.S. unemployment rate fell to 3.7% by late 2018, the lowest in nearly 50 years.
“The jobs market keeps humming along,” said JJ Kinahan, chief market strategist, TD Ameritrade.
Looking Ahead: Will U.S. Midterms Affect 2019?
Another major development lacking clarity as 2019 begins is the potential impact of U.S. midterm elections. In November, Democrats won back the House of Representatives and will hold the speaker’s chair for the first time since 2010. Republicans added seats in the Senate and the White House is still held by the GOP, but Democrats will be wielding some of the power in Washington, D.C. when the new year begins.
The Trump administration and the Republican Congress have spent two years cutting taxes and rolling back regulation, but there’s some question whether that can continue with Democrats holding a solid House majority. It’s arguable that some of the stock market’s exuberance in 2017 reflected hopes for less federal pressure on corporations after some executives had chafed about Washington during the Obama administration.
With Nancy Pelosi returning as speaker, it might be more difficult for Republicans to continue rolling back taxes and regulations—especially financial industry rules that a Democratic congress championed after the 2008 recession. However, there seems to be bipartisan agreement about getting something done to lower health costs, and President Trump made some verbal overtures about being ready to work with Democrats on policy.
“Both sides seem committed to infrastructure spending,” Kinahan said. If that happens, the materials and energy sectors might benefit.
On the other hand, a government shutdown battle in the final weeks of the year wasn’t exactly a tonic for anyone optimistic about chances for bipartisan cooperation.
Free and Accessible Financial Education
The past year has brought significant changes to educational initiatives at TD Ameritrade, namely with a drive to provide more accessible investing information that once cost “several thousand dollars” for free, says Lee McAdoo, Managing Director for Education for TD Ameritrade. “We realized how important education was for our clients’ success and helping them pursue their goals, so we decided to make it free for everybody,” she says.
Educational components are now available on every platform where TD Ameritrade does business, whether that’s the thinkorswim® platform, the TD Ameritrade website, and mobile platforms, among others, McAdoo says. In addition, artificial intelligence is now improving user experience by recommending educational content based on the client’s profile, including articles, events, webcasts, coursework, and videos.
Next, TD Ameritrade is launching more educational components geared toward long-term investors, such as courses for managing your retirement income. “We’re also going to be spending a lot of time this year engaging our clients with more events in the branch itself,” McAdoo says.
For now, investors who are getting nervous about when this long-time bull market will end and how to best position for more volatility, can turn to a number of online resources. Numerous daily webcasts, live events and hundreds of videos like Handling Market Downturns, can provide valuable education, she says. Turn to the TD Ameritrade Network or The Ticker Tape for more educational opportunities.
The TD Ameritrade Network is brought to you by TD Ameritrade Media Productions Company. TD Ameritrade Media Productions Company and TD Ameritrade, Inc. are separate but affiliated subsidiaries of TD Ameritrade Holding Corporation.
End-of-Year Retirement Review
The end of the year can be an ideal time to reassess your long-term investment and retirement strategy and examine your portfolio’s status, says Christine Russell, Senior Manager, Retirement & Annuities, TD Ameritrade. But, Russell also cautions against knee-jerk reactions to market movements and instead suggests those planning for retirement and retirees might want to think farther out. “With retirement investing, you don’t want to try to time the market. You want to think longer term. Remember that even once in retirement you should plan to invest for 30 years – or even more!”
Russell has several suggestions for your strategy. First, if available, contribute to a 401(k) account through your employer and aim to at least put in enough to get any matching funds. Each year, consider increasing the percentage of your salary that you contribute by at least 1 percent. It may take a while to build up to putting away 10 – 15% of your pay each year into a workplace retirement plan. If you are self-employed, consider a SEP IRA. Contributions grow tax-deferred just like in 401(k) plans.
Next, aim to contribute to a Roth retirement account, which can provide income that will not be taxed during your retirement years. Among other potential benefits, this strategy can lower your Medicare Part B Premium by reducing your taxable income. In addition to Roth IRA, some workplace 401(k) plans allow Roth contributions regardless of income level. Self-employers (without eligible employees) can consider the Solo 401(k) plan which can be set up to allow Roth elective deferrals in addition to tax deductible plan contributions. Finally, consider contributing to a Health Savings Account (HSA), which might also provide tax advantages for health care expenses.
In the year ahead, Russell encourages investors to keep an eye on Social Security, a major source of income for many retirees, and to watch for possible changes in the Medicare system. These are significant benefits for retirees that workers pay for with each paycheck, so make sure the health of those systems stays on your radar. “Finally, make sure you do not waste the tax breaks that Uncle Sam has available for you via workplace retirement plans by contributing toward retirement, if you’re not already. Your contribution today may not seem like a lot, but it can really add up,” Russell said.
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