Newsletter January 4, 2019

What Caused Stock Markets to Fall in 2018?

Basically, 2018 was the year that fear returned to the markets. While earnings mostly rose, investors grew fearful of a future recession caused by trade wars, higher interest rates, or simply the ebbs and flows and cycles of the economy.

This is illustrated dramatically by the performance of the S&P 500 index. Earnings for that index in 2018 rose a staggering  27% versus 2017. (Based on the actual reported results for the first nine months of 2018 plus the estimated earnings for the final three months.) This huge 27% earnings surge was driven primarily by the Trump income tax cuts but also by by continued growth in the total pre-tax profitability of the 500 companies in the index.

The index nevertheless fell 6% in 2018. Investors at the start of 2018 were valuing the index at 24.3 times the trailing year earnings. This high P/E ratio reflected optimism about future earnings growth including the impact of the Trump tax cuts.

In contrast, at the end of 2018, investors were valuing the S&P 500 index at a far lower 17.9 times trailing year earnings. The 26% decrease in the P/E ratio was enough to more than offset the big earnings increase. This 17.9 is the lowest end of year P/E ratio since 2012. Investors ended 2018 less optimistic and more fearful than they had been since 2012.

To some degree, the lower P/E multiple can be explained by higher interest rates which cause investors to “require” a higher expected return (that is, they “discount” expected future earnings using a higher interest rate). But the huge decline of 26% in the P/E ratio, to a level that is significantly lower than the average of 22 over the past 30 years,  is primarily explained by a fear of lower earnings (or at least low earnings growth) ahead due to fears of recession.

Even more fear however is apparent in the P/E ratios of certain individual stocks as the two examples in the following table illustrate.

Company P/E 2018 Price 2018 Earnings Comment
Canadian Western Bank 8.7 34% decline 15% growth Fear of loan losses and/or lower loan growth
Toll Brothers 6.9 31% decline 63% growth Significant fear of reduced U.S. home building starts and/or new home prices.

Here we have two companies with strong earnings growth in 2018 but which suffered big price declines. The very low P/E ratios here despite the recent earnings growth suggest real fear about the future earnings of these two companies.

Is There Any Silver Lining to The Storm Clouds of the Market Decline?

Well, for any retired investors faced with having to sell a portion of their stocks at the lower prices to fund living expenses, there is really no silver lining.

But for most investors there are two related silver linings.

Firstly, 2018 was also the year that value returned to the market. Most investors are not forced to sell stocks at the lower prices and instead are in a position to use their annual savings as well as cash distributions from their existing investments to buy stocks at these lower prices. Young investors may be distressed by the declines, but a temporarily lower market is in their long-term interest.

Secondly, 2018 was also the year that yield returned to the market. Interest rates on (so-called) high-interest savings accounts are sharply higher. Rates on GICs are up substantially. And dividends yields are up quite substantially due to the lower share prices as well as annual dividend increases. For the first time in years it is now possible to easily set up a simple balanced portfolio that will spit off a cash yield of about 4% using or even higher. It has often been estimated that, in retirement, 4% is the maximum safe withdrawal rate to prevent the portfolio from possibly hitting zero by about age 90. Well, now, one could withdraw cash dividends and interest of about 4%, without touching the principal invested in stocks and fixed income. And, the cash flow of dividends and interest would almost certainly grow over time.

Given the better valuations and higher yields, now, is a very opportune time to be setting up a balanced portfolio. That is not to say that stocks won’t continue to fall. They might. But it is a mathematical fact that buying stocks now is a more opportune time than at the start of last year. And, if history is any guide at all then stocks will continue to rise over the longer term as well as to provide dividends.

How to Set Up A Balanced Portfolio

See our updated article that describes how to set up a diversified portfolio using ETFs, or even just using one single ETF.  This article includes the specific ETF symbols that can be purchased. We also have an updated reference article that provides a list of selected Canadian ETFs covering equities, higher dividend equities , fixed income and commodities. Most of the ETFs appear to be significantly more attractive in terms of valuation than they were a year ago.

Are Investors Over-Fixated on The Market Value of Their Portfolios?

It is absolutely fair and right that investors focus heavily on the growth or decline in the market value of their portfolio. But the market value should not be the ONLY measure of performance.

It may be that investors need to be a bit less excited when the market index and their portfolios rise and a little less depressed by declines.

Stocks represent ownership shares in actual real businesses. The owner of the local Tim Hortons or Honda Dealership likely focuses a lot on earnings and cashflow and not much at all on what he could sell the business for.

If a stock portfolio has declined due to lower P/E multiples while the earnings and dividends have increased is it fair to judge the performance solely by the change in market value while ignoring the increase in actual earnings and dividends? A business owner perspective would not think so.

What Will Markets Do in 2019?

No one knows the answer. But it seems clear that economic growth will be at least somewhat slower. Interest rates will likely continue to rise but not soar. The situation of getting oil out of Alberta will likely see some progress by the end of 2019 which could boost optimism in that province. Given that the the near-term direction of stock markets is very difficult or impossible to predict, perhaps the best strategy is to invest gradually over time and especially at times when stocks appear to offer better bargains.


January 4, 2019

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