Putting 2018 in Perspective

February 21, 2019

Despite a strong start to the year, capital markets finished 2018 with an intense bout of volatility and risk aversion.

Full-year 2018 returns were much less extreme than December’s performance, and by no means historically extraordinary.

Despite a strong start to the year, capital markets finished 2018 with an intense bout of volatility and risk aversion. Broad-based selloffs in the fourth quarter erased gains accumulated across most asset classes earlier in the year and pushed equity markets into negative territory for the year.

Exhibit 1 depicts the extent of this selloff — with risk assets trending steadily down during the fourth quarter, having few places to hide.

Exhibit 1: Fourth Quarter Returns

February commentary: Fourth Quarter Returns

Daily data from October 1, 2018 to December 31, 2018. Sources: MSCI, Bloomberg Indices, Bloomberg. MSCI World Index (net total return, CAD), MSCI Emerging Markets index (net total return, CAD), Bloomberg Commodity Index (total return, CAD), and Bloomberg Barclays US Corporate High Yield Index (total return, CAD)

Exhibit 2, which depicts the trailing 60 trading-day volatility of the S&P/TSX Composite index, illustrates the tumult. This measure climbed to finish 2018 at the highest level since early 2016, mirroring the Chicago Board of Options Exchange Volatility Index — the VIX, or so-called fear index, which measures expected volatility in U.S. equities — which jumped from 12 to 25 over the course of the fourth quarter.

Exhibit 2: Volatility Spikes to End the Year

Chart 2: Volatility Spikes to End the Year

As of December 31, 2018. Volatility based on price movement of previous 60 trading days from each respective month-end. Volatility expressed in standard deviations and annualized based on an assumed 260 trading-day year. Calculations are made by Bloomberg. Sources: S&P Dow Jones Indices LLC, Bloomberg

“The Worst December since the Great Depression”

The year concluded with attempts by the financial press to portray the market downturn as one for the ages. The most notable of these reports centred on the S&P 500 Index, which represents U.S. companies with large market capitalizations, registering the “worst December since the Great Depression.” Canadian equity markets were hit similarly, with the S&P/TSX Composite Index registering a dismal overall fourth quarter (as seen in Exhibit 3).
 

S&P/TSX Composite Index Fourth-Quarter Performance

Chart 3: S&P/TSX Composite Index Fourth-Quarter Performance

As of December 31, 2018. Data series extends from 1928 to 2018. Sources: Sources: Bloomberg, S&P Dow Jones Indices LLC. Past performance is no guarantee of future results. Information prior to 1/1/1977 is back-tested, based on the methodology that was in effect on the Launch Date. Back-tested performance, which is hypothetical and not actual performance, is subject to inherent limitations because it reflects application of an Index methodology and selection of index constituents in hindsight. No theoretical approach can take into account all of the factors in the markets in general and the impact of decisions that might have been made during the actual operation of an index. Actual returns may differ from, and be lower than, back-tested returns.

The headlines failed to convey necessary context for understanding the fourth-quarter plunge, thereby overselling the extent of the market decline. Canadian equities (as measured by the S&P/TSX Composite Index) had generated modest positive performance heading into the fourth quarter before volatility struck in October. As Exhibit 4 demonstrates, performance was much less extreme to begin the year than during fourth quarter, and by no means historically extraordinary.

S&P/TSX Composite Index January-to-September

Chart 4: S&P/TSX Composite Index January-to-September Performance

As of December 31, 2018. Data series extends from 1928 to 2018. Source: Bloomberg, S&P Dow Jones Indices LLC. Information prior to 1/1/1977 is back-tested, based on the methodology that was in effect on the Launch Date.

In fact, when limiting our focus to quarterly returns since the turn of the century, the most recent quarterly decline appears unlikely but not unprecedented (with a standard deviation of 1.1, assuming an annual volatility of 20.1% based on our latest Capital Market Assumptions). And since 2000, there have been seven quarters with softer total returns.

The dislocation at the end of 2018 may have felt particularly outsized because it occurred amid an unusually long period of volatility.

The Outlier That Was 2017

The dislocation at the end of 2018 may have felt particularly outsized because it occurred amid an unusually long period of volatility. Looking back to Exhibit 2, it’s plain to see that volatility measures escalated in the fourth quarter to the highest levels in several years. But in a longer-term context, this was not abnormal. Year-end volatility was nowhere near that of the financial crisis of 2008 or dotcom crash in 2000; it was more akin to the minor market correction we saw at the start of 2016.

This point is illustrated in Exhibit 5, which shows the number of daily one-percent price declines for the S&P/TSX Composite Index in each of the past thirty years. There was a large jump in single-day declines from 2017 to 2018, but the outlier was not the instability of 2018 — it was the notable calm of 2017. Last year’s turbulence was more of a return to normal equity-market behavior than a sign of looming crisis. And while many of its one percent-decline days occurred in the fourth quarter, such clustering is not unusual. Since 2000, there have been 19 other quarters with at least as many one-percent-decline days.
 

Ex. 5: One-Day Losses Greater Than One Percent

Chart 5: One-Day Losses Greater Than One Percent

As of December 31, 2018. Source: Bloomberg, S&P Dow Jones Indices LLC, SEI

“The Time to Buy Is When There’s Blood in the Streets”

Baron Rothschild, 18th century British nobleman and founder of the legendary Rothschild family banking dynasty, reportedly said, “The time to buy is when there’s blood in the streets.” No, we do not see last quarter’s weakness as a sign of equity prices hemorrhaging to the point of recession, drowning Wall Street with figurative blood. However, in light of the recent volatility, this quote is a good reminder that investors are best served by maintaining a thoughtful investment strategy — which might include capitalizing on opportunities during a downturn — rather than letting emotions drive decision-making. 

Market selloffs are often called corrections for a reason: When prices “correct,” they’re pulling back from overpriced or inflated levels to more moderate values. Even with the recent earnings boom over the past few years, equity multiples continued to climb as price increases far surpassed earnings growth. Meanwhile, investment-grade and high-yield credit spreads both remained historically tight, offering investors minimal compensation (by historical standards) for taking on risk. As we see in Exhibits 6 and 7, the fourth quarter of 2018 served as a release valve of sorts, allowing risk-asset valuations across capital markets to settle at more moderate levels — and, as equity valuations pulled back, credit spreads neared their 10-year averages.

Exhibit 6: S&P/TSX Composite Index Price Levels

Chart 6: S&P/TSX Composite Index Price Levels

As of December 31, 2018. Monthly data from December 1999 through December 2018. Implied prices are calculated using forward earnings times forward P/Es. Sources: S&P Dow Jones Indices LLC, Factset, SEI

Exhibit 7: Credit Spreads

Exhibit 7: Credit Spreads

As of December 31, 2018 Source: Bloomberg Indices, Bloomberg. Month-end values are used. High Yield represented by Bloomberg Barclays US Corporate High Yield Index. Investment Grade represented by Bloomberg Barclays US Corporate Index.

Looking forward, we are beginning to see mixed signals about where we are in the economic cycle; we still expect the global economy to continue expanding in 2019, albeit at a moderating pace. The challenging conditions seen in the final quarter of 2018 can prey on investors’ emotions. But the global economy is not exactly in dire straits, and we believe most markets have now corrected to more attractive valuation levels.

Our confidence is increasing that risk assets bottomed in late December. The sheer ferocity of the recent correction is reminiscent of other times in the past eight years when stocks sold down hard, only to turn around and hit new highs. Expected S&P 500 Index earnings growth for 2019 remain in the mid-single-digits as of late January, leading us to believe that — barring a collapse in multiples or a major black swan event — 2019 may be another solid year.

We believe investors are best served by maintaining a thoughtful investment strategy — which might include capitalizing on opportunities during a downturn — rather than letting emotions drive decision-making.

Putting 2018 in Perspective: Keeping a Strategic Mindset

While examining the volatile capital markets of 2018 can provide useful insight, it is important to maintain perspective and remember to keep in mind the broader historical context.  We believe that any reactionary, wholesale changes to a long-term game plan are not only ineffective, but potentially harmful, to an investor’s ability to achieve long-term goals. In our view, strategic allocations should be considered a permanent— or at least durable—core positioning designed to produce well-diversified, efficient portfolios. These allocations are tailored to an investor’s ability (including time horizon) and willingness to take risk (if applicable), with the ultimate goal of meeting long-term investment objectives. 

In our November 2018 paper, The global bull market: Is it time to get out?, we examined how timing the market successfully requires, at a minimum, two well-timed decisions (when to exit and when to reenter), both of which pose risks to meeting long-term investment objectives if poorly timed. That being said, there is a meaningful degree of activity occurring under the hood in many of our solutions as we believe that prudent active management can improve a strategy’s results. Sub-advisors in SEI’s actively managed strategies engage in active security selection and seek to exploit excess return sources, such as value, momentum and stability characteristics (factors); in some cases, our portfolio managers implement active tilts among these factors; and our Portfolio Strategies Group engages in active (or tactical) asset allocation. Tactical allocation positions can be thought of as temporary, as we expect them to be unwound at some point. These changes are marginal adjustments, implemented in a way designed to avoid overwhelming the strategic characteristics of a portfolio, but are still expected to enhance the return potential of a portfolio or lower its risk at the margins.

1 See CNBC.com on December 17, 2018; CNN.com on December 18, 2018; and Marketplace.org on December 25, 2018, for example.

2 Standard deviation is a statistical measure of historical volatility. A statistical measure of the distance a quantity is likely to lie from its average value. It is applied to the annual rate of return of an investment, to measure the investment’s volatility (risk). Standard deviation is synonymous with volatility, in that the greater the standard deviation the more volatile an investment’s return will be. A standard deviation of zero would mean an investment has a return rate that never varies.

Glossary of Financial Terms

The Bloomberg Barclays U.S. Corporate Index is a broad-based index that measures the investment-grade, fixedrate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers.

The Bloomberg Barclays US Corporate High Yield Index measures the USD-denominated, high yield, fixed-rate corporate bond market.

The Bloomberg Commodity Index reflects commodity futures price movements. The index rebalances annually weighted 2/3 by trading volume and 1/3 by world production and weight-caps are applied at the commodity, sector and group level for diversification.

The Chicago Board Options Exchange Volatility Index (VIX) tracks the expected volatility in the S&P 500 Index over the next 30 days. A higher number indicates greater volatility.

The MSCI Canada Index is designed to measure the performance of the large- and mid-cap segments of the Canada market. The index covers approximately 85% of the free float-adjusted market capitalization in Canada.

The MSCI Emerging Markets Index is a free float-adjusted market-capitalization-weighted index designed to measure the performance of global emerging-market equities.

The MSCI World Index is a free float-adjusted market-capitalization-weighted index designed to measure the equity market performance of developed markets.

The S&P 500 Index is a capitalization-weighted index made up of 500 widely held U.S. large-cap companies.

The S&P/TSX Composite Index, a capitalization-weighted index, is the principal reference for Canadian equities markets, based on data provided by the Toronto Stock Exchange (TSX). The index includes Canadian-based common stocks and income trust units.

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