Market Stall
Plus 2018 Year-End Market Review

After hanging onto gains and fighting back losses for three quarters of the year, the markets lost steam in Q4 and ended 2018 in a volatile stew, producing a negative return of negative -10.08% for the year (MSCI All Country World Index). Volatility creates fear, often feeding on itself. But don’t lose sight of positive returns for the previous three, five- and ten-year periods, 6.49%, 4.17% and 9.74% respectively for the same index. Here we offer a historical perspective on the benefits of remaining diversified and disciplined in the face of uncertainty. First, a review of 2018 markets.

2018 Market Report

Courtesy of DFA

In 2018, the global economy continued to grow, with 44 of the 45 countries tracked by the Organization for Economic Cooperation and Development (OECD) on pace to expand.

Equity Market Highlights

Global equity markets, as measured by the MSCI All Country World Index, ended the year down negative −9.4%, with significant dispersion by country. US equities generally outperformed other developed markets for the year, although they lagged other developed and emerging markets in the fourth quarter. The S&P 500 Index recorded a negative −4.4% total return for the year and negative −13.5% return in the fourth quarter. Returns among other developed equity markets were negative. The MSCI World ex USA Index, which reflects non-US developed markets, was down negative −14.1% for the year and negative −12.8% for the fourth quarter, and the MSCI Emerging Markets Index fell negative −14.6% for the year and negative −7.5% for the fourth quarter. US small cap stocks, as measured by the Russell 2000 Index, returned negative −11.0% for the year.

Impact of Global Diversification

While markets around the world generally had negative returns in the fourth quarter, the dispersion in their returns highlights the importance of global diversification during market declines. The MSCI All Country World ex USA Index (IMI) outpaced the S&P 500 for the quarter (negative −11.9% vs. negative −13.5%). Given the strong returns of US markets through September, however, the US equity market was one of the stronger performing markets for the year, ranking seventh out of the 47 countries in the MSCI All Country World Index (IMI).

The S&P 500 Index’s negative −4.4% return marked the end of nine consecutive positive annual returns. Despite the negative return this year, the S&P 500 has still produced a 13.1% annualized return for the 10 years ending December 31, 2018.

When considering individual countries, 46 out of 47 countries were down for the year. Using the MSCI All Country World Index (IMI) as a proxy, no countries posted positive returns among developed markets, and only Qatar managed a positive return among emerging markets. As is typically the case, country‑level returns varied significantly. In developed markets, returns ranged from negative −24.1% in Belgium to 0.0% in New Zealand. In emerging markets, returns ranged from negative −41.3% in Turkey to positive 27.1% in Qatar—a spread of almost 70%. Large dispersion among country returns is common, with the average spread in emerging markets over the past 20 years of 90%. 

Without a reliable way to predict which country will deliver the highest returns, this large dispersion in returns between the best and worst performing countries again emphasizes the importance of maintaining a diversified approach when investing globally. To emphasize this point, Israel went from being the worst performer in developed markets in 2017 (positive 10.4%) to the second-best performer in 2018, returning negative −3.6%. Likewise, Qatar went from being the second worst performing emerging market country (negative −12.5%) in 2017 to being the best performer in 2018.

When investing outside the US, investors should remember that non-US stocks help provide valuable diversification benefits, and that recent performance is not a reliable indicator of future returns. It is worth noting that if we look at the past 20 years going back to 1999, US equity markets have only outperformed in 10 of those years—the same expected by chance. We can examine the potential opportunity cost associated with failing to diversify globally by reflecting on the period in global markets from 2000 to 2009, commonly known as the “lost decade” among US investors. While the S&P 500 recorded its worst ever 10-year cumulative total return of −9.1%, the MSCI World ex USA Index returned 17.5%, and the MSCI Emerging Markets Index returned 154.3%. In periods such as this, investors were rewarded for holding a globally diversified portfolio.

Broad Market Index Performance

In 2018, the MSCI Emerging Markets Value Index (IMI) outperformed its growth counterpart (negative −11.5% vs. negative −18.4%). In developed markets, however, this was not the case. The Russell 3000 Value Index underperformed the Russell 3000 Growth Index (negative −8.6% vs. negative−2.1%) and the MSCI World ex USA Value Index (IMI) underperformed its growth index counterpart (negative −15.6% vs. negative −13.8%). Small cap stocks generally underperformed large cap stocks globally. For example, the Russell 2000 Index returned negative −11.0% relative to negative −4.8% for the Russell 1000 Index. Similarly, the MSCI World ex USA Index outperformed its small cap counterpart (negative −14.1% vs. negative−18.1%), and the MSCI Emerging Markets Index outperformed its small cap counterpart (negative −14.6% vs. negative −18.6%). The mix of relative performance of value vs. growth stocks within and across regions this year serves as a reminder of the importance of integrating premiums when designing and managing portfolios.

US Market 

For the trailing 12 months US small cap stocks underperformed large cap stocks, and value stocks underperformed growth stocks using Russell indices. The Russell 2000 Index declined negative −11.0% for the year vs. negative −4.8% for the Russell 1000. The Russell 3000 Value Index returned negative −8.6% in 2018 vs. negative −2.1% for the Russell 3000 Growth Index. The variation in returns between these indices is within historical norms. Since 1979, there has been an annual return difference of 6% or greater 60% of the time.

Developed ex US Markets 

In developed ex US markets, small cap stocks underperformed large cap stocks and value stocks underperformed growth stocks. Despite underperformance in 2018, over both five- and 10-year periods, small cap stocks, as measured by the MSCI World ex USA Small Cap Index, have outperformed large caps, as measured by the MSCI World ex USA Index. Growth stocks, as measured by MSCI World ex USA Growth Index (IMI), returned negative −13.8%, outperforming value stocks, which returned negative −15.6% in 2018, as measured using the MSCI World ex USA Value Index (IMI).

Emerging Markets 

In emerging markets, small cap stocks, as measured by the MSCI Emerging Markets Small Cap Index, underperformed large cap stocks, as measured by the MSCI Emerging Markets Index. However, over the past 10 years, small caps returned an annualized 9.9%, outperforming large caps, which returned 8.0%.

Value stocks returned negative −11.5% as measured by the MSCI Emerging Markets Value Index (IMI), outperforming growth stocks, which returned negative −18.4% using the MSCI Emerging Markets Growth Index (IMI). This was the sixth largest outperformance of value over growth in emerging markets since 1999.

The complementary behavior of size (small vs. large) and relative price (value vs. growth) in emerging markets in 2018 is a good example of the benefits of diversification. While small cap stocks underperformed, diversified portfolios were buoyed by outperformance among value stocks. This integration can increase the reliability of outperformance and mitigate the impact of an individual asset group’s underperformance.

Despite recent years’ headwinds, the size, value, and profitability premiums remain persistent over the long term and around the globe. It is well documented that stocks with higher expected return potential, such as small cap and value stocks, do not realize outperformance every year. Maintaining discipline to these parts of the market is the key to effectively pursuing the long-term returns associated with size, value, and profitability.

Fixed Income

Over the full year, the return on the US fixed income market was relatively flat; the Bloomberg Barclays US Aggregate Bond Index returned 0.0%. Non-US fixed income markets posted positive returns in 2018, contributing to the return of the Bloomberg Barclays Global Aggregate Bond Index (hedged to USD) at 1.8%.

Yield curves were upwardly sloped in many developed markets for the year, indicating positive expected term premiums. Realized term premiums were negative in the US as long-term maturities underperformed their shorter‑term counterparts.

Credit spreads, which are the difference between yields on lower quality and higher quality fixed income securities, widened during the year, as measured by the Bloomberg Barclays Global Aggregate Corporate Option Adjusted Spread. Realized credit premiums were negative both globally and in the US, as lower-quality investment-grade corporates underperformed their higher-quality investment-grade counterparts. Treasuries were the best performing sector globally, returning 2.8%, while corporate bonds returned −1.0%, as reflected in the Bloomberg Barclays Global Aggregate Bond Index (hedged to USD).

In the US, the yield curve flattened as interest rates increased more on the short end of the yield curve relative to the long end. The yield on the 3-month US Treasury bill increased 1.06% to end the year at 2.45%. The yield on the 2-year US Treasury note increased 0.59% to 2.48%. The yield on the 10-year US Treasury note increased 0.29% during the year to end at 2.69%. The yield on the 30-year US Treasury bond increased 0.28% to end the year at 3.02%.

In other major markets, interest rates decreased in Germany and Japan, while they increased in the United Kingdom. Yields on Japanese and German government bonds with maturities as long as 10 years finished the year in negative territory.

Fourth Quarter 2018 Market Review

World Asset Classes

Equity markets around the world posted negative returns for the quarter. Looking at broad market indices, emerging markets outperformed developed markets, including the US.  Value stocks were positive vs. growth stocks in all markets, including the US. Small caps underperformed large caps in the US and non-US developed markets but outperformed in emerging markets. REIT indices outperformed equity market indices in both the US and non-US developed markets. ¹

 
US Stocks

US equities underperformed both non-US developed and emerging markets. Value outperformed growth in the US across large and small cap stocks. Small caps underperformed large caps in the US.  

International Developed Stocks

In US dollar terms, developed markets outside the US outperformed the US equity market but underperformed emerging markets during the quarter.  Value outperformed growth across large and small cap stocks. Small caps underperformed large caps in non-US developed markets. 

Emerging Markets Stocks

In US dollar terms, emerging markets outperformed developed markets, including the US. Value outperformed growth across large and small cap stocks. Small caps outperformed large caps. 

 
Real Estate Investment Trusts (REITs)

Non-US real estate investment trusts outperformed US REITs in US dollar terms.

Commodities

The Bloomberg Commodity Index Total Return declined 9.41% during the fourth quarter of 2018, bringing the total annual return to –11.25%. Sugar led quarterly performance with a gain of 7.41%. Energy was the worst-performing complex, with WTI crude oil and unleaded gas declining by 37.87% and 37.78%, respectively.

Fixed Income

Interest rate changes across the US fixed income market were mixed during the fourth quarter of 2018. The yield on the 5-year Treasury note declined 43 basis points (bps), ending the quarter at 2.51%. The yield on the 10-year Treasury note decreased 36 bps to 2.69%. The 30-year Treasury bond yield decreased 17 bps to finish at 3.02%.

For 2018, yields on the 10-year Treasury and 30-year Treasury increased 29 bps and 28 bps, respectively. In terms of total returns, short-term corporate bonds increased 0.78% during the quarter. Intermediate-term corporate bonds had a total return of 0.58%. Total returns for short-term municipal bonds were 1.10% for the quarter. Intermediate-term municipal bonds returned 2.00%. 

Impact of Diversification

These portfolios illustrate the performance of different global stock/bond mixes and highlight the benefits of diversification. Mixes with larger allocations to stocks are considered riskier but have higher expected returns over time. ²

Feature Article

The Upside of a Downslide

In the history of markets, steep declines are surprisingly frequent. Between 1900 and 2015, a 10% decline in the DJIA has occurred on average about once a year, while a 20% decline has occurred on average every 3.5 years. Of course it’s not like clockwork. If it were, investors could play the markets and win every time. 

Fast forward to Q4 2018. Over this three-month period, the S&P 500 returned negative `-13.5% and the MSCI All Country World Index returned negative -12.8%. What’s happening now? Stocks have staged a remarkable turnaround in January 2019. Three straight weeks of gains in the new year have erased nearly all of 2018 losses. It’s the best start to a year since 1987. After the S&P 500 rose 2.9% in the week through Friday (Jan 18), its up 13.60% from its December 24th low. According to DFA, “After declines of 10% or more, equity markets have been on average positive 71% of the time in US markets and 72% of the time in other developed markets.” ³

This doesn’t mean you should count on a rebound in a specified period of time. That’s another good reason to stay in the game long-term, following a diversified plan based on your personal goals and timeline. This requires considerable discipline. Uncomfortable as it may be at times, is there really any alternative? A crystal ball perhaps. To predict market movements with success, investors would need to be able to forecast future events and the markets’ reaction to those events better than everyone else. Many sophisticated investors have tried that and failed (for a reminder, read last month’s blog). 

Investors have much to be concerned about with the current government shutdown and no end in sight. Add to that the heavy debt loads of individuals, corporations and the government, a slowing China economy, and the lagging effects of quantitative tightening (the Fed raised interest rates four times last year and is likely to raise them again this year). The benefits of the fiscal stimulus (tax cuts) may be starting to wear off, while the economic effects of ongoing trade fights and an unfinished Brexit deal are yet to be fully realized. 

Taken together, these factors point to a slowdown in growth in 2019 and 2020 and more volatility for stock markets around the world. And yet it’s impossible to know how each of these variables will ultimately resolve, or to what extent they have already been factored into prices. That’s why, as we enter 2019, our advice is to continue to follow a proven investment strategy, stay diversified, control what you can and ignore the rest. The markets have demonstrated that this is the right approach, time and again.

Do you have questions or concerns? Call us. We are here to help. 

Regards,

1. Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio. The S&P data is provided by Standard & Poor's Index Services Group. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. MSCI data © MSCI 2018, all rights reserved. Dow Jones data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. S&P data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Bloomberg Barclays data provided by Bloomberg. Treasury bills © Stocks, Bonds, Bills, and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield).

2. Diversification does not eliminate the risk of market loss. Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect expenses associated with the management of an actual portfolio. Asset allocations and the hypothetical index portfolio returns are for illustrative purposes only and do not represent actual performance. Global Stocks represented by MSCI All Country World Index (gross div.) and Treasury Bills represented by US One-Month Treasury Bills. Globally diversified allocations rebalanced monthly, no withdrawals. Data © MSCI 2019, all rights reserved. Treasury bills © Stocks, Bonds, Bills, and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield).

3. Past performance is not a guarantee of future results. Declines are defined as points in time, measured monthly, when the market’s return since the prior maximum has declined by at least 10%, 20% or 30%, depending on the cutoff. Declines after December 2017 are not included, but subsequent 12-month returns can include 2018 returns. Compound returns are computed for the 12 months after each decline observed and averaged across all declines of the cut-off. US large Cap is the S&P 500 Index, from January 1926 through December 2018, provided by Standard and Poor’s Index Services Group. Non-US Developed Markets Large Cap is the MSCI World Ex USA Index (gross div.) from January 1970 through December 2018. Emerging Markets Large Cap is the MSCI Emerging Markets Index (gross div.), from January 1988 through December 2018. MSCI data 2019, all rights reserved.