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4th Quarter 2018 Market Update

30 October 2019

Geremy van Arkel, CFA® | Principal

Late September Dogs

It is near the beginning of the year 2008 and I’m almost done attending a week-long conference in Seattle. Powered by exhaustion and nervous energy, I find myself in tow of my fearless leader, business partner, and one of our all-time great advisors, on autopilot and drifting towards a bar. As we arrive at the iconic “locals only” location, I can almost feel the chaos that is approaching. Little did I know that entering this bar would become a moment forever etched in my mind.

The spot itself is exactly what you would expect of a nameless hole-in-the-wall establishment – grungy, authentic, and noisy. My brain gradually classifies the sound coming from the back of the bar as music – definitely not the poetic, rhythmical kind, but resembling more an organized chaos. The band, “Late September Dogs,” is slaying “Pour Some Sugar on Me” in full regalia. It is a mesmerizing moment, and all I remember is just observing.  No more talking, no more entertaining or presenting, no more problem-solving – just sitting back and watching as this beautiful moment unfolds. It is as if the universe ordained this moment on me: it is meant to be, and not a moment too late.

A decade later – as if on cue – the Late September Dogs were unleashed again. At the time I’m writing this, the S&P 500® is off about 16% from its high in late September. This is not quite the venerable bear market marker of approximately 20%, but painful still. Worse, small cap stocks, international stocks and emerging markets’ stocks are all down more than 20% from their respective peaks. And quite ominously, the bellwether of economic activity – oil – is off over 40% from its peak. The fourth quarter, as well as December, turned out to be the worst quarter and month for equity markets since 2008. An astonishing $4 trillion in asset value has been erased, a sum equivalent to 20% of the U.S. annual GDP. Like a pack of wolves on a sunny beach, who predicted this?

Rewind three months, and you were in an environment of steadily, relentlessly rising asset prices and a booming economy. A decade of coerced asset price inflation had finally led to what was characterized as global coordinated growth. We could all relax and release a deep breath: the economy was strong enough to be deemed good. Maybe even too good. The balloon was full, and the outlook was glorious.

As the Danish proverb implies, “predictions are difficult, especially about the future.” I know of no strategists, economists, or pontificators that were bold enough to state that government bonds would outperform stocks in 2018. Such a quack would have been locked up. Yet here we stand. The most hated of bonds, Long-term U.S. Treasuries, outperformed the S&P 500® Index in 2018. How could so many have been so wrong?

When dealing with capital markets, it is quite often difficult to assemble the song from the wall of noise. Experiencing an excellent economy coinciding with poor equity market returns, or vice versa can be frustrating. Linear logic would imply that if the economy is the best in a decade, then so, too, should stock prices be. But this simple logic fails when it comes to what could be dubbed the main verse of the capital markets’ theme song:

Capital markets’ prices lead the economy, not the other way around.

Capital market prices represent the collective opinion of millions of forecasters/investors, which means that the general direction of capital markets foretells what is likely to happen in what most people consider the “real economy”. Unfortunately, most capital markets’ predictions reverse this equation and look to the economy for cues to how capital markets are likely to perform. Capital markets’ news has traveled around the world long before the average economist has tied his shoes in the morning, or even gotten out of bed. In other words: capital markets are pricing the future, while most investors are looking to the past.

In the fourth quarter, the air can leak out of the equity price balloon because investor/forecasters are likely pricing a change. After a decade of easy monetary policy, fiscal expansion, employment gains, and corporate earnings growth, the economy couldn’t be any better, and asset prices couldn’t be much higher. And that is exactly the problem. The marginal forces beyond normal growth and progress that have blown hot air into the balloon are now reversing themselves. Federal Reserve Bank policy has changed from easy to tight; federal governments have exhausted fiscal policy; employment and earnings can’t seem to get any better; and the late-stage economy seems, well, simply tired.

So far, this decline has been textbook. While no one went as far as to outright predict this, we did think it was possible. How the events are now unfolding is strictly by the book. Stocks have declined long before there have been any other signs of an economic slowdown. Credit-based debt instruments, often turned to for conservative yield, have started to come under pressure.  Universally, riskier assets are being sold, and only those few assets that are not cyclically tied to the economy are holding up: U. S. treasuries, high-quality corporate bonds, and money markets. Luckily, we at Frontier own some of them.

Thankfully, resets often happen much quicker than the long steady market of rising asset prices points to overvaluation. Historically, the S&P 500® loses, on average, approximately 10% once every 18 months, and about 20% once every five years. While capital markets have not experienced losses like this in a decade, the current circumstances are still nothing like 2008. The collapse of asset prices ten years ago was brought about by a credit crisis. Banks and lending institutions were failing, and the system was broken. This time around – so far – the “real economy” seems unfazed: it’s business as usual on the ground. Statistically speaking, if this is what you would call a normal, random market decline, we are likely at least one step past halfway through.

Endurance is defined as the ability to survive a multitude of outcomes that will inevitably occur over an endeavor. It is a fool’s errand to try to serially predict every outcome, for we are all grown-ups and we know such precision doesn’t exist in the real world.  Endurance, then, is more the art of evaluating and balancing what is possible, not just predicting what we think is likely to happen.

Most of you are long-term investors, requiring asset management for life. In order to endure, investment strategies need to be able to both perform well through the good times and to survive the bad times, but also to provide added value through a multitude of possible outcomes. We have been here before. The management team of Frontier has managed money through every bear market dating back to 1987. Our time-tested process is forward-looking and adaptive, and we are constantly adjusting our strategies and watching closely.

Additional Information
Past performance is no guarantee of future returns.  Performance discussed represents total returns that include income, realized and unrealized gains and losses. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any types of securities and no investment decision should be made based solely on information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Diversification and asset allocation do not ensure a profit or protect against a loss. Before investing, consider investment objectives, risks, fees and expenses.
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S&P 500®
Represents US large company stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ

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