The past couple of quarters have been the epitome of ‘volatile markets.’ We are glad to report things have bounced back quickly. During the fourth quarter, fear and uncertainty prevailed; we witnessed a volatile decline in asset values causing 2018 to go down as the worst performing year for stock investing since 2008. All of the woes that weighed on the markets during December suddenly vanished, and the markets snapped right back. As bad as the fourth quarter was, the first quarter of 2019 was the polar opposite.
U.S. stock returns had their best quarter since 2009. Small cap U.S. stocks led the rally, posting returns in excess of 14% for the quarter. Their larger counterparts were not far behind, posting returns of more than 13% for the quarter. Foreign stocks were up almost 10% during the quarter. Bonds also performed well during the quarter, with aggregate bonds and municipal bonds both posting returns of almost 3%. 
This recent market whipsaw reiterates that investors cannot simply extrapolate market movements from day-to-day or even month-to-month. These are extraordinary returns for a short three-month investment horizon, and one should not expect these returns to continue at this pace. The volatility we experienced the last couple quarters offers an important lesson: we should be buyers of assets as they are declining in price. As we mentioned in the previous quarterly letter, we took advantage of the drop in equity markets and rebalanced portfolios. Investors who took the December decline as an opportunity to buy stocks have been rewarded.
We wish investing could be like watching paint dry – boring and predictable; however, it rarely is. Instead, markets tend to act much more like irrational, emotional teenagers – happy and confident one moment; sad and unsure the next – an unexplainable roller coaster. Economically, not much has changed in the last six months. Even though there are a number of issues causing us concern, we are cautiously optimistic. Markets, especially in the short term, can be an unexplainable rollercoaster and cause people to make poor decisions based on how they are feeling instead of based on a strategy.
In December, investor sentiment shifted negative, but we did not believe there was anything structurally wrong with the economy. We referenced a number of issues we are facing in our year-end letter, and the first item listed was the Federal Reserve Bank’s (Fed’s) policy We have long written about the Fed’s ability to impact markets, and we have been fairly pleased with how the Fed has managed monetary policy the last decade. In December, the Fed raised interest rates for a fourth time during 2018, and they outlined they expected to see two interest rate increases in 2019. Six weeks later, in a somewhat surprising move, Fed chairman Jerome Powell stated that the case for continuing to raise interest rates has weakened. Then, during their meeting that concluded on March 20, the Fed voted unanimously to leave interest rates unchanged, which was expected; however, their stance softened, as they stressed needing to be patient and flexible. They also updated their projections to indicate no interest rate increases in 2019.
Higher rates are considered impediments to higher market valuations for two reasons: they create more competition in the form of bond yields, and they raise borrowing costs for companies looking to expand. Many market participants cheered this pivot by the Fed, as their actions match their words. They are making decisions based on economic data. Part of the year-end sell-off was attributed to market participants and the Fed inferring different outcomes from the same economic data. Now, it appears they see things in the same light.
We continue to be concerned with two other risks: US trade policy and Brexit. We are optimistic that a deal is going to be worked out with China that will be favorable for the U.S. China’s trade policies have long been unfair. We expect to see a resolution to the trade conflict with China soon. The unwinding of the United Kingdom (UK) from the European Union (EU) is proving to be more challenging than hoped. British lawmakers are misguided in their understanding of the possible outcomes. Our expectations are that there will be a “hard” Brexit, which is what will transpire if lawmakers cannot reach a deal that is acceptable to the EU. The outcome of Brexit matters, because the UK is the fifth largest economy in the world and is the seventh biggest trading partner with the U.S., not to mention a historical and vital ally to the U.S. Problems in the UK will impact the U.S.; the only question is how badly?
We remain comfortable in the near-term outlook for investing. Economic fundamentals continue to be stable. The reasons for optimism outweigh the rationale for being worried. The job market is robust, inflation is low, and companies are producing profits. With that, we anticipate a slowing of economic growth throughout this year. Slow growth is still growth nonetheless, which suggests a recession is not imminent.
It is worth remembering that some of the steepest market gains come right before a bear market when investors become over-enthusiastic despite declining fundamentals and high valuations. We are not there, as fundamentals are not deteriorating, although we are at high valuations. We do not believe in being able to time markets. When we experience such sudden and sharp shifts, which are actions that cannot be controlled, it causes us to focus on things we can control: do we need to generate cash from the investment portfolio, is the asset allocation correct, does the investment objective still apply, have there been any significant changes in your situation, etc? Being able to discuss and answer these questions with you will better enable us to ensure your investment portfolio and financial plan are synchronized. As we have seen over the past two quarters, markets go up and down. We cannot control this; however, we can control how we react to them. If your investment portfolio and financial plan are in harmony, we will not be forced into deviating from our strategy.