By many measures, we are enjoying the benefits of a relatively strong U.S. economy.

Gross Domestic Product is growing nicely (see chart below), industrial production is at an all-time high, the unemployment rate is the lowest it has been since 1969 and inflation is not yet a worry.

Yet with all of this supposedly good news, risk markets around the world swooned during 2018. The S&P 500 Index dropped 6.24% in price and the Russell 2000 Index (of the smallest 2000 stocks in the Russell 3000 Index) dropped 12.18% in price, putting it solidly in bear market territory (bear market here being defined as a loss of 20% or more from its high).¹

Global equities, as measured by the World Index, suffered too, shedding 10.44% in price. Commodities lost 5.36% with West Texas Intermediate (WTI) crude oil down almost 25% for the year. We have said it before and we will say it again: the economy is not the market. Measures like GDP, industrial production, the unemployment rate and the Consumer Price Index are coincident indicators. They are like a snapshot of current conditions. They tell you where you are, not where you are going.

Markets, on the other hand, are thought to be leading indicators. Leading indicators are anticipatory - that is, they suggest where you may be going, not where you are or have been. In addition to stock prices, they include measures of new orders, building permits and consumer expectations and several others.

Rising interest rates, sometimes the sign of a healthy economy, can also provide a disconnect between a growing economy and a stumbling market. Many valuation models use a measure of interest rates as a discounting factor. When rates rise – all else equal – values decline.

There also may be a connection between rising rates and falling price earnings multiples, also known as PEs. During 2018, the Fed raised its target rate on Fed funds four times for a total of 100 basis points. Expectations for 2019 range from no more hikes to as many as four.

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According to data available at Bloomberg, the PE multiple peaked at 23.34 on January 6, 2018, and hit a low of 16.48 on December 21, 2018, a decline of 29%.

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Did the Fed and the bond market cause the contraction in PE multiples? It very difficult to say, and we always warn that correlation is not causation.

Yardeni Research Inc. publishes forecasts and consensus estimates on their website. A December 3, 2018 report gave their 2019 estimate of the earnings for the S&P 500 of $170 per share. Conventional wisdom is that the long-term average for a trailing twelve-month PE is approximately 15 times.

15 X $170 = 2,550. At the close on January 2, 2019, the S&P 500 was at 2,510.03. That doesn’t provide much upside potential. On the other hand, if investor confidence and risk-taking interest were to push the PE multiple back up to last January’s high of 23.34, we would be looking at 23.34 X 170 = 3,967.80, an increase of 58%! What could possibly go wrong? Here are a few possibilities:

At the risk of sounding the slightest bit pessimistic, here is a partial list of challenges for the stock market in 2019:

• Tariffs and trade wars
• Dealing with Brexit – are they in or are they out?
• The Fed: raising rates and shrinking their balance sheet
• Fiscal policy
• A general slowdown in global growth

After the headlines from the first week of the new year, you can add a few additional issues:

• Apple released disappointing forward guidance, largely blaming a combination of slowing growth in China and their retaliatory trade measures
• Delta’s disappointing revenue forecast on top of FedEx’s dismal guidance
• The ISM Manufacturing Index hit its lowest level in two years
• The Washington standoff continues (as of January 3, 2019)

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So with all of that to deal with, where does our Five Factor Framework stand?

Five Factor Framework Update

• Economic Outlook – RED
• Market Trend – RED
• Monetary Conditions – YELLOW (leaning to RED)
• Market Sentiment – YELLOW (much improved)
• Valuations – RED (leaning to yellow)

When markets start showing investors losses over the short term and volatility spikes, some may start to question the viability of capitalism over the long haul. I think that would be a mistake.

Regardless of what happens in Washington, Wall Street will find a way to make things work. It’s their nature. Capital has been accumulated over hundreds of years and it needs to be constantly redeployed to find its optimal return. Those returns are the long-term investors’ reward for suffering volatility and temporary market declines.

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Here is wishing all of our readers a safe, prosperous and very happy new year!

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¹ Indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts. You cannot invest directly in an index. S&P 500 Index is regarded as a gauge of large cap U.S. equities. The index includes 500 leading companies and captures approximately 80% of the available market capitalization. The Russell 3000 Index measures performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.