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Quarter in Review
|Asset Class†||4th Quarter 2018 Return||Past 12 Months|
|U.S. Large Cap Stocks||-13.5%||-4.4%|
|U.S. Small Cap Stocks||-20.2%||-11.0%|
If the recent quarters of steady returns and low volatility were starting to make investors yawn, the 4th quarter was certainly a wake up call. While stock markets were down starting in October, December was particularly bad with the S&P 500 posting its worst December return since 1931. The negative returns were especially prominent in the week leading up to Christmas, which runs counter to the usual “Santa Claus Rally”* and yuletide cheer quickly turned into the Nightmare Before Christmas for stock investors. Conversely, the gradual rise in interest rates took an abrupt reverse as well, with most interest rates dropping to their lowest levels in 2018 giving bond investors something to cheer about, since interest rates move in the opposite direction as bond prices.
The negative market movement of this past December also came as a surprise because most financial news remains positive with no obvious cracks to the foundation of the economy. Yes, the trade war with China, the Federal Reserve’s intention to gradually rise interest rates and the longest bull market on record are all issues in the headlines that raise concerns, but on the other hand U.S. employment continues to be robust and inflation is largely sanguine.
The first weeks of January seem to have investors focusing more on this positive news with stocks regaining much of the footing lost in December.
Reflections on Recent Market Declines
For starters, it is important to note that the rapid declines of the stock market in the 4th quarter do not portend a 2008-like financial crisis. Even a month into 2019, we’re seeing markets rebound as investors focus on the positive news. That is not to say that this 4th quarter decline was only temporary or that stocks are finished falling, but rather that our current economic landscape is much different now than it was in 2008. The declines in 2008 were due to the failure of the debt market fueled by wild speculation which created a contagion that rippled across all areas of finance, since the availability and cost of debt is relevant to all areas of the economy.
Just because there may not be a domino-effect atmosphere like there was in 2008 does not necessarily mean that trouble is not brewing. As noted above, the ongoing (as of this writing) trade war with China is starting to show its effects on company results with several companies, including Apple, indicating that profits will be lowered in some part due to the tariffs. What appears most likely is that the political scene (only exasperated by the government shutdown) coupled with an historically long period of prosperity could create a tinder box scenario where a piece of bad economic or political news creates a spark that inflames the markets, though likely in a more temporary manner than what we saw in 2008.
On top of the cloudy political atmosphere, the volatile trading in December highlighted that computerized trading plays a significant role in today’s market where market movements are increasingly disconnected from fundamentals, making predictions of future moves even more challenging.
In the Headlines: Computer trading
As noted in the Quarter In Review section above, the recent declines were odd not only for how quickly they came on, but also for the timing of the drop in mid-late December. Like many businesses, the second half of December is usually a quiet time for Wall Street. It was a shock then to see such incredible volatility and volume at a time when many people are not working or away for the holidays. The culprit appears to be computerized trading.
The fact that the market made such a big move at a time when there are typically few trades being made raised some eyebrows. An article in the Wall Street Journal on December 27th,* took a closer look at the issue. The article focused on a recent a JP Morgan report that 85% of the market trading is automated by computers, much of which is tied to the momentum of the market. This means that a change in the market direction, coupled with fewer human traders in the market could lead to swift and meaningful moves in the market.
The rise in computerized trading in the past decade has been widely publicized most notably with the Michael Lewis book, Flash Boys. In short, there are a number of investors who make money by creating computer algorithms with the intent to make money based solely on the computer code. The results of this behavior have shown up a few times in recent years, most notably the flash crash of 2010*, but largely hides in the shadows.
It may take some time for this sea of change to take hold in the markets, but if December is an example of how it can come into play, we may need to buckle our seat belts for near-term market volatility.
Glossary and Article Links
Santa Claus Rally – Stock market phenomenon, first noted in the Stock Trader’s Almanac in the 1970’s, where returns in the week following Christmas are significantly more positive than negative. Potential reasons this has occurred include new cash entering the market following Christmas and the larger proportion of retail trading.
Flash Crash – Was a sudden downturn in the stock market in during the afternoon of May 6th 2010 without any significant news reports. Various studies were commissioned after the crash with most pointing to an imbalance in trading orders where there were many more investors looking to sell than there were investors looking to buy.
† Indices used to represent asset classes:
U.S. Large Cap Stocks – S&P 500
U.S. Small Cap Stocks – Russell 2000
International Stocks – MSCI ACWI ex-U.S.
U.S. Bonds – Barclays Aggregate
Commodities – Bloomberg Commodity
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