LBW Commentary Q4 2018
How LBW Sees It
2018 may be a year to remember. Each quarter we wrote about some new topic; be it the Federal Reserve (“the Fed”) and its policy agenda or the Trump administration and their attempt to renegotiate global trade pacts. Headlines driven by the uncertainty of such news allowed recession talk to rear its head, subsequently running the markets from all-time highs to bear market territory. The roller coaster analogy made in our Q1 commentary “How LBW Sees It” seemed to be 2018’s predominate theme. Even though we witnessed the S&P 500 TR (“S&P”) decline by -19.36%, the markets didn’t end 2018 on too bad of a note, just look at Chart 1.
Chart 2 represents the last 10 years of the S&P’s performance. As one can see, 2018 was the first year of negative returns in over 10 years. The last year the S&P experienced negative performance was in 2008 when it lost -37%.
Said differently, over the past decade we have witnessed one of the longest bull markets in U.S. history. Furthermore, the S&P has annualized 13.12% over the last 10 years! It may seem odd discussing the exceptional market returns over the last 10 years, but to understand 2018’s volatility, we must understand the markets past.
As many remember, almost 11 years ago the U.S. experienced the worst recession since the Great Depression. The markets tumbled and jobs were lost as the U.S. went through a large deleveraging process. To stabilize an imploding economy, the U.S. took extreme measures to drive liquidity back into the market. The Fed lowered the federal funds rate to near zero and began to buy massive amounts of bonds from the market, while the government put together a bailout package whereby the United States Treasury was authorized to purchase roughly $700 billion of distressed assets (i.e., Mortgage-back securities) within the U.S. market. This was the first time in U.S. history where such measures were taken to calm an unhinged economy.
Fast forward to today and the measures taken seem to have done the job. Over the past decade markets have produced exceptional returns and the economy has finally reached a point of stability not seen for some time. For example, the unemployment rate is at 3.9%, well below its 50-year historical average of 6.2%. The federal funds rate currently sits at 2.38%, up from essentially 0% back in 2015. And for the first three quarters of 2018, GDP came in at 2.2, 4.2, and 3.4 respectively. If the economy is doing so well, then why did we see such extreme swings in 2018?
As mentioned above 2018 did not disappoint in the news department. There was plenty to write about and even more to read – seems to be par for the course considering the information age we now live in. However, to understand what is truly going on one must recognize the incentives publications have – they want more readers and to get more readers they need something “newsworthy.” This leads to what many value investors call “noise.” When cutting through the political, geopolitical, and market noise one begins to see the light at the end of the tunnel and begins to understand why in 2018 the markets began to act as if the Great Recession 2.0 was on the horizon. Our economy is driven by consumption, allowing for money to circulate and provide income for others who then spend that income on other goods. A large part of our spending comes in the form of credit or debt. For example, most of the population cannot afford to purchase a home outright; in order to do so, they get a loan from a bank. That loan provides more purchasing power for the buyer and provides income to the seller. This transaction would not have occurred without the ability for the buyer to get credit. This credit cycle doesn’t only occur in the housing market – it occurs in any market where there is a good to be bought. In essence, the availability of credit and the ease at which it can be obtained is essential for economic activity. During the Great Recession the U.S. took measures to assist with credit. They lowered interest rates to entice business investment, and they flooded the market with cash by lowering the federal funds rate and buying back massive amounts of securities. This stimulus has lasted for almost a decade and now the run of “easy money” may be coming to an end. When economic data was released on February 2nd, 2018, the markets took a turn for the worst – not because it was bad, but because it was good. The market reaction was a reality check; the stimulus the U.S. economy had become accustomed to looked to be fading away. In 2018 the Fed continued to tighten their policy, selling the assets they purchased during the Great Recession and increasing the federal funds rate to ensure they kept up with inflation. Inflation could be driven by the economic growth we have seen for the past few quarters, but it could also be due to the trade wars manifesting globally. As mentioned in our Q3 2018 commentary “How LBW Sees It,” tariffs have the potential to create artificial inflation as prices will increase in order to compensate for the imposed tariffs. If inflation increases, then interest rates on loans will also increase. If interest rates on loans increase, then it will become difficult for individuals to borrow. If individuals can’t borrow at a sensible rate then their consumption goes down, and if their consumption goes down the U.S. may find itself in a recession. This domino effect became the leading story in the second half of the year. The markets feel the Fed is becoming too aggressive with their approach, and the uncertainty of what is to come next has created volatility we haven’t seen over the last few years. The measures taken in the Great Recession were considered a stimulant, and the definition of a stimulant is “an agent (such as a drug) that produces a temporary increase of the functional activity or efficiency of an organism or any of its parts.” The U.S. essentially provided a drug to the economy to keep it from faltering but, as we all know, if drugs are abused the results can be harsh. The problem is no one knows if the U.S. became addicted to the “easy money” concept because we don’t have any historical data to base it on – it’s never happened before. The stimulus we have experienced domestically and globally in order to generate the type of returns seen over the past decade is unprecedented, and may just be a part of the markets’ past and not its future. We roll into 2019 with more uncertainty and noise than we have seen for some time, and we expect that to continue. A recession is on the horizon, it always is, but to what degree is unknown. It will be difficult and turbulent for the U.S. to wean itself off “easy money”, but it is a necessary evil. We do not write this as a prediction of what is to come, but rather to portray the reality in which we currently sit. To quote our December blog: “The point is recessions will occur and their severity will change over the years. However, knowing this and accepting their uncontrollable nature frees us to focus on what we can control: saving money for a rainy day, leveraging ourselves appropriately, and making rational financial decisions.” 2019 will bring volatility, and we hope to take advantage of Mr. Market and buy quality holdings at reasonable prices.
Nathaniel's Beautiful Mind
I did a presentation at Manual of Ideas (MOI) “Best Ideas 2019” earlier this month on Liberty Sirius XM (US: (LSXMA/B/K)), a tracker stock of Liberty Media Corporation. So, for this quarter’s “Nathaniel’s Beautiful Mind” I present you with a link to an audio file that you can download to have some easy-listening material while commuting to work. We hope you enjoy and any comments are most welcome.
 LBW Wealth Management, sourced from: http://us.spindices.com/indices/equity/sp-500
 LBW Wealth Management as of 12/31/2018, sourced from: http://us.spindices.com/indices/equity/sp-500, https://www.ftse.com/Analytics/Factsheets/temp/aa06f668-255d-4537-96d7-c9ca1318f19c.pdf, https://www.msci.com/documents/10199/99459e68-5e21-4888-ace6-72a3ffe9b1ab
 LBW Wealth Management as of 12/31/2018, sourced from: http://us.spindices.com/indices/equity/sp-500
 JP Morgan Guide to the Markets U.S. 1Q 2019 As of December 31,2018 Slides pg. 25
 Ibid pg. 31
 LBW Wealth Management, sourced from: https://www.bea.gov/
 LBW Wealth December blog post “Recession Recon”: https://www.lbw-wealth.com/single-post/2019/01/06/Recession-Recon