U.S. stocks had their worst quarter since 2008 as concerns about the pace of global economic growth increased. U.S. companies reported strong earnings growth for the third quarter, but many companies reduced earnings guidance due to softening demand and rising input costs resulting from trade tariffs and higher labor costs. Investors also became concerned that the Federal Reserve (Fed) may continue raising interest rates despite a slowing economy. As a result, the S&P 500 Index of large company U.S. stocks declined 13.5% for the quarter and ended the year down 4.4%, the first negative year for the index since the 2008 financial crisis.
U.S. small company stocks fell by wider margins during the fourth quarter as investors disproportionately sold off riskier assets. The Russell 2000 Index was down 20.2% for the quarter and down 11.0% for the year. Value stocks performed better than growth stocks during the fourth quarter mostly due to weakness in the technology sector. For the year, however, growth stocks led value stocks.
Foreign stocks outperformed U.S. stocks during the quarter but were also down sharply. The MSCI ACWI ex USA Index dropped 11.5% over the period and ended the year down 14.2%. Concerns about economic growth outside of the U.S. increased during the quarter, fueled by reports out of Germany and Japan that their economies had contracted during the third quarter. Additionally, the pace of economic growth in China also ticked lower in the third quarter. Concerns about the continuing negotiations over the terms of Brexit and Italy’s budget deficit also pressured foreign stock prices.
U.S. bonds rallied during the fourth quarter as investors sought the safety of U.S. Treasuries. The yield on the U.S. 10-year Treasury ended the quarter at 2.68%, down 40 basis points from the beginning of the quarter. The Fed increased the federal funds rate in December as expected but lowered the number of expected interest rate increases in 2019. The Bloomberg Barclays US Aggregate Bond Index rose 1.6% during the quarter, erasing losses from earlier in the year to end 2018 virtually flat. In terms of commodities, the Bloomberg Commodity Index declined 9.4% during the quarter and 11.3% for the full year. The price of oil dropped approximately 40% over the last three months of the year as production rose at the same time investors were reducing expectations of future demand. Prices of industrial metals such as copper and aluminum also declined due to expectations of lower global growth.
The best-performing portfolio asset class in 2018 was cash — the last time this was the case was 1994.
It seems like a long time ago but it was only this past September when the S&P 500 was up over 10% for the year and making new all-time highs. Disappointing economic data, escalating trade wars, and concerns about Fed policy changed that situation quickly in the fourth quarter as stock markets across the globe declined. When all was said and done, diversified portfolios managed by B|O|S that had been showing gains through the first nine months of the year registered losses for the year as a whole.
One challenge for investors in 2018 was that virtually all of the individual country stock indices were down for the year. Considering the MSCI ACWI, which includes U.S. stocks as well as the stock markets of the other major countries around the world, only two of the forty-seven countries in the index, Qatar and Peru, generated positive returns in 2018. As such, the MSCI ACWI ended the year down 9.4%. Consequently, there was little benefit from diversifying stock exposures across countries.
Investment returns in 2018 highlighted one important limitation of diversification: when major stock indices decline sharply over short time frames, diversification among stocks often provides little benefit as correlations between the different categories of stocks (U.S. vs. foreign, value vs. growth, small vs. large) tend to increase. During these periods, the key diversification consideration is not what kind of stocks you own but instead how much stock you own relative to more conservative assets such as high-quality bonds. While global stocks fell nearly 10% in 2018, returns on high-quality, shorter-term bonds were modestly positive.
It can be helpful to keep last year’s stock market decline in perspective. Considering the 15 years prior to 2018, the S&P 500 had registered a loss in just one of those years (although that one year, 2008, was especially severe, with a loss of 37%). This recent period of annual gains is quite unusual. Going back to 1927, the S&P 500 had losses in roughly one year out of every four, on average. In other words, down years are a part of typical market cycles, and thus should be expected to occur with some regularity.
The dramatic turn in the markets in the last three months of 2018 is a good reminder of why it is important to prepare for tough markets before they happen and to position portfolios to withstand the inevitable storms that will occur over a long-term investment horizon.
|Index||Market||Last 3 Months||2018|
|Standard & Poor’s 500||Large Co. U.S. Stocks||-13.52%||-4.38%|
|Russell 1000 Value||Large Co. Value U.S. Stocks||-11.72%||-8.27%|
|Russell 2000||Small Co. U.S. Stocks||-20.20%||-11.01%|
|MSCI All-Country World ex U.S.||Foreign Stocks||-11.46%||-14.20%|
|Barclays 1-5 Year Gov’t/Credit||U.S. Shorter-Term Taxable Bonds||1.46%||1.38%|
|Barclays Aggregate Bond||U.S. Taxable Bonds (Broad-based)||1.64%||0.01%|
|Barclays 1-5 Year Muni Bond||U.S. Shorter-Term Tax Exempt Bonds||1.10%||1.77%|
|JPMorgan Global Ex-U.S. Bonds||Hedged Foreign Bonds||2.42%||3.58%|
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