Ask the investor: What happened in stocks and what should we do about it?

Yikes! Market volatility returned with a vengeance as stocks suffered the worst December decline since 1931!

So much for the Santa rally, the informal name given to the historical tendency for stocks to perform well in the period between Thanksgiving and the year-end. In 2018, the Grinch stole our rally! In the fourth quarter of 2018, the Dow Jones had a -12.5 percent change. The year-to-date return was -5.6 percent

So, what happened in stocks and what should we do about it?

First, let’s put the decline into perspective. The drop was significant enough, with U.S. markets selling off about 19 percent from their all-time high set in September. This was the worst decline in stocks since August 2011, and it brought back awful memories of the 2008 crash. However, a 19 percent decline in stocks is within the boundaries of what we should expect as a normal stock market correction. Since 1980, the average intra-year decline in stocks is 13.9 percent, according to Standard & Poor’s. The 2018 decline is more than the average, but not so dramatic.

What caused the sell-off?

I believe it was a confluence of three main concerns:

1. An escalating trade war. When the trade tariffs were first threatened this past summer, most observers saw it as a temporary squabble. But as the tit-for-tat dispute with China escalated, many corporate executives began to question how and when they should be reinvesting their profits. This uncertainty absolutely began to influence stock traders.

2. Rising interest rates. The Federal Reserve, as was widely expected, raised interest rates in December. Although the move was expected, it seemed out of step with what many saw as a softening global economy. More disturbing was that longer-term interest rates actually declined at the same time short-term rates were going up. This created what is referred to as a “flat yield curve,” meaning that short-term rates are not terribly different from longer-term rates. This is often a precursor for a recession.

3. Political uncertainty. Our old market nemesis, political drama and uncertainty, reverberated during the third quarter of 2018 from the results of the midterm elections and the likelihood of yet another government shutdown. The last time the market declined by 20 percent in a quarter was in 2011, when political impasse over the debt ceiling caused an S&P rating downgrade of U.S. Treasuries.

Is this just a stock market correction, or the beginning of a bear market?

Most market corrections are short-lived affairs correcting themselves within months and leading to new market highs. Bear markets are defined by declines greater than 20 percent and are generally associated with economic recessions. It is extremely rare for the stock market to enter bear territory when the economy is not in or near a recession. It has happened twice – in 1962 during the Cuban Missile Crisis and then again in 1987. Armed with that knowledge, it is useful to take a closer look at the economy.

The Conference Board’s U.S. Economic Leading Indicator index has plateaued in the past several months. Although this does not indicate the likelihood of a recession, it is suggesting that economic growth in the first part of 2019 will be moderate. Risk remains that the index will start to deteriorate, indicating recession probability in late 2019 to early 2020.

Employment remains very healthy, with more than 150 million Americans employed – an all-time high! And the unemployment rate remains at a low of 3.9 percent, the lowest since 1969. In addition, the housing markets nationally look very healthy, with numbers stabilized at around 1.2 million new housing units per year. Demand for housing appears to be well aligned with supply on a national level.

Bottom line? Stock market declines are a normal event that investors should expect. They are uncomfortable and may lead many investors to question their strategies; however, the wisest strategy is often to let the correction take its course. I see no signs of an imminent recession, which I conclude means a very small probability of further significant stock market declines (although it is entirely possible that we will have a retest of the Dec. 24 lows).

Jonathan Lokken, CIMA, is managing principal of Lokken Investment Group LLC in Lewes. He has been professionally managing client investments since 1997. For more information, go to www.lokkeninvest.com for details or call 302-645-6650.
Disclaimer: The foregoing content reflects the opinions of Lokken Investment Group LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Past performance is not a guarantee of future results. All investing involves risk. Asset allocation and diversification does not ensure a profit or protect against a loss.