With 2018 in the Rear View

I used to think that a change of the year is just a calendar term. The thing we divide and measure time with based on the physical movement of our tiny planet in the indefinite space. It does help to provide some structure to base our thinking on, but I did not think it matters so much in the investment world. Change of the year has definitely brought changes in feelings about the markets. 2016 will be remembered by the three distinct market regimes it went through, 2017 will stay a permanent base of comparison for the low volatility and steadiness, while 2018 will be the one that brought the volatility back after 10 years of fairly stable recovery from the financial crash a decade ago. What makes the differences in the market performance of these years so definite is not the facts of the underlying economy, population growth, and geo-political changes which are all following its path on the cycle much longer than a year, but investors’ expectations and feelings about those paths tied to our built-in concept of the structure of space and time.

Don’t worry, I am not applying for a high school philosophy teaching job just yet. I am just going to discuss the past year in my opinion, reflecting on the super cycles and the smaller changes that happen within them. I will list the main issues and concerns we have in relation with the US economy getting closer to a possible recession. The larger themes are the same. We are moving through and following the path of the super cycle. A double-digit correction in 2018 did happen, as much as I was not rooting for being right on that one.

The World

As we follow the progression from one-superpower to a multi-power centered world order, globalization continues to be pushed against around the world. Populism has grown more and it is slowly becoming more connected and organized globally even though the themes of populism are not always the same. Disruption to the well-established world order and rules-based interaction is obvious more than last year.

As with any disruptions and changes that don’t happen naturally, the important question to ask is “Who benefits?” Not China as many believe. China needs the rules-based global society to continue its path to national strength and economic growth. The rules they would like to avoid are tied to protection of intellectual property, trade controls and currency controls. Iran benefited out of the last stages of the Iraq War and Syrian Civil War, but economically it continues to hurt with sanctions fully back on and internal unrest continuing against the regime that got rich on black market transactions. Russia benefited the most in the geo-political terms over the last two years. With the scheduled opening of the Siberian pipeline for natural gas to China this year, continuation of the southern pipeline with its closer relation to Turkey while providing favors in Syria, further weakening of the European and NATO ties in the west, larger involvement in Middle East militarily and with weakening of OPEC, and show of strength with its involvement in American politics and election process, Russian ruling class is hoping that the renewed show of strength internationally can continue to keep the rising domestic issues at bay and natural resources profits flowing to them. It is possible to see a more coordinated response to this from western powers in this year.

In the short-term, we have to keep our eyes on the kind and the effect of the Brexit scheduled for March 29, US-China trade talks, populist governments’ pressure on tech giants, the push and pull between the US Administration and the new Congress controlled by Democrats, and the usually uneventful but this time very important European elections coming in May.

The Investment World

Let’s review some interesting 2018 numbers:

  1. FOR THE YEAR – The S&P 500 lost 4.4% (total return) during2018, breaking a streak of 9 consecutive “up” years for the $22.1 trillion index that was created in 1957. The raw index fell 6.2% but after factoring in the impact of reinvested dividends, the overall decline was reduced by 1.8 percentage points. The S&P 500 consists of 500 stocks chosen for market size, liquidity and industry group representation. It is a market value weighted index with each stock's weight in the index proportionate to its market value (source: BTN Research).
  2. LONG-TERM - The S&P 500 has gained an average of +9.8% per year (total return) over the last 50 years (i.e., 1969-2018). The index was down in 2018 but has been positive in 14 of the last 16 years. Over the long-term, the S&P 500 has been up during 39 of the last 50 years, i.e., 78% of the time (source: BTN Research).
  3. MISSING THE BEST - The total return for the S&P 500 over the last 10 years (2009-2018) was a gain of +13.1% per year (total return). If you missed the 10 best percentage gain days over the last 10 years (i.e., 10 days in total, not 10 days per year), the +13.1% annual gain falls to a +7.9% annual gain (source: BTN Research).
  4. AVOID THE WORST - The total return for the S&P 500 over the last 10 years (2009-2018) was a gain of +13.1% per year (total return). If you avoided the 10 worst percentage days over the last 10 years (i.e., 10 days in total, not 10 days per year), the +13.1% annual gain rises to a +18.9% annual gain (source: BTN Research).
  5. SMALL-CAPS - The small-cap Russell 2000 stock index lost 11.0% (total return) in 2018. The small cap index has gained +9.0% per year over the last 35 years (1984-2018). The Russell 2000 index is an unmanaged index of small-cap securities which generally involve greater risks (source: Russell).
  6. FOREIGN STOCKS - The international stock index EAFE lost 13.8% (total return) in 2018. The foreign stock index has gained +8.2% per year over the last 35 years (1984-2018). The EAFE index is an unmanaged index that is generally considered representative of the international stock market. These international securities involve additional risks including currency fluctuations, differing financial accounting standards and possible political and economic volatility (source: BTN Research).
  7. BROAD-BASED BOND INDEX - The taxable bond market was up a miniscule +0.01% in 2018 (total return) but has gained +5.1% per year (total return) over the last 25 years (1994-2018). The Bloomberg Barclays US Aggregate Bond Index (created in 1986), calculated using publicly traded investment grade government bonds, corporate bonds and mortgage-related bonds with at least 1 year until final maturity, was used as the bond measurement. The index is a major benchmark for US bond investors (source: Bloomberg Barclays).
  8. TEN-YEAR NOTE - The yield on the 10-year Treasury note ended 2018 at 2.68%, up 0.27 percentage points from the 2.41% it finished at on 12/31/17. The 10-year note yield was 2.57% on 8/05/11, the day that the rating agency S&P downgraded the USA from a top-rating that our nation had held for 70 years (source: Treasury Department).
  9. HOUSING - The average interest rate nationwide on a 30-year fixed rate mortgage was 4.55% at the end of 2018. The record low national average was 3.31% as of 11/22/12 or just over 6 years ago (source: Freddie Mac).
  10. BAILOUT NOT NEEDED - No US bank failed in 2018, the first calendar year to achieve that result since 2006 (source: Federal Deposit Insurance Corporation).
  11. OIL PRICES - The price of oil ended 2018 at $45.41 a barrel, down 24% from its 2017 close of $60.12. As of 10/03/18, oil was trading at $76.41 a barrel before falling $31 a barrel (off 41%) by year-end (source: CME Group).
  12. OVERSPENDING - The national debt of the United States was $21.867 trillion as of Friday 12/28/18, an increase of $11.3 trillion over the last 10 years (source: Treasury Department).

Fundamental issues

Economic growth provides the basis for the asset markets. It is the catalyst for the corporate earnings, interest rates, inflation, employment and other economic factors. Therefore, we always start with the GDP forecasts as a foundation for our long-term market assumptions. The roots of the economic growth are population growth and productivity growth. Through the human history, both of these were positive over intermediate and longer periods of time, so that the global GDP was growing over the years increasing the value of all the capital assets. During much of the world’s history, improvements in productivity were slow. Up to the Industrial Revolution, the size of a nation’s economy depended solely on the size of its population. China was on top, India was next, and so on. Things changed about 200 years ago. Innovation changed everything and gave boost to productivity separating the developed world from the rest. For the first time in history, income per capita had a large increase and continued to grow in the US and some developed European economies. In early 1900s, when our city of Buffalo was probably the richest city per capita, the US overtook China as the largest economy despite having only one fifth of its population.

Population growth is of course easier to calculate of the two factors determining economic growth. According to the World Bank, labor force growth (the one that matters in our population number) has risen rapidly for several decades, but almost all countries will experience slower growth and will have less of the demographic benefit over the next 20 years. Japan and some parts of Europe will have significant issues with declining labor force. Without major changes in immigration policy (not likely in near term with conservative populists gaining strength) these economies might be stalling. In general, the trends should be much better in the developing world other than in matured developing nations like China, South Korea and Thailand, where labor force growth is flattening.

Productivity is harder to predict. According to Human Capital Index, which calculates educational and scientific achievement as drivers of future innovation, human capital accumulation should boost global growth for the next 20 years without a problem. Structurally, developed economies are ahead with institutions of development and stability that were nurtured over time. Some developing economies, like South Korea are almost caught up, while most of the others have a lot of catch-up potential allowing them to grow faster from their current base.

Multiple investment firms are calling for a much lower return numbers on capital assets over the next 10-20 years then were paid to investors historically. The fear of lower economic growth is setting into the minds of investors and it is due to the peaking of the globalization trend and more importantly to lower rates in inflation and interest rates globally. With most of the firms and economists predicting a recession in US after 2020, investors are getting driven by fear. At some point, the upswing in global growth will end. However, despite the global growth slowdown that market participants are afraid of now, we don’t believe this risk is right in front of us now. Long periods of positive markets and extreme highs don’t kill economic cycles. They do hurt them causing corrections. The death of them is brought by major macroeconomic events that cause the economy to shrink.

The debate is then tied to the level of economic impact that could be caused by further tightening from our Fed and their counterparts globally, along with further downward pressure on trade (Brexit and US-China relations) and globalization. It is important to point out that it is true that trade wars could hurt net-exporters more than net-importers (China, Germany, Japan, S. Korea and Italy would hurt more than the US), however, pundits are forgetting that tariffs do increase prices to the end-consumer bringing inflation and reducing US consumers ability to keep on buying luxuries and services. Our economy would also contract.

Liquidity Concerns

One of the issues here is fairly visible. Our government is spending more money than it is bringing in. We finance the deficit with new debt, and over time as the interest rates are rising, the cost of our interest service is becoming higher creating even higher pressure on our budget. For a long time now, this is not creating pressure on our currency because the US dollar is the ultimate reserve currency by the standards, we created from the Second World War on. However, over time, other economies might figure-out a way to trade and protect value without being solely dependent on our dollar. Any other currency pressed by our level of debt to GDP would be crumbling by now and inflation numbers would be sky high.

Our Fed has been on a mission to slow down the economy and prevent it from overheating. On top of the increases in the Fed Rate that we are all aviating like they are a professional sports draft, the Fed has been steadily reducing the size of their balance sheet by not reinvesting the interest payments and selling their treasury and agency bonds back to the market. This created an additional pressure on the bond markets and made large institutions the ultimate buyers of bonds. These institutions are acting as keen investors and are very price sensitive, therefore reducing the liquidity further.

Corporate side of the financing market is less visible to average investors. Since 2008, large firms were improving their stock prices by financial engineering besides the traditional growth operations. Some were even buying back their stocks with borrowed money. Low interest rates allowed for the liability side of the corporate balance sheet to grow back to the numbers close to the levels of 2007. Even more troubling is the fact that the fastest growing part of the corporate bond issuance was the BBB rated bond market. These are the bonds rated as only one notch above non-investment grade (step above junk bonds). One problem is that when these bonds rollover, the cost of the interest service will be higher for the issuer. The other one is that in a major slow down a large part of this debt could be downgraded. If that happens, the major bond investors (institutions) will be forced to get out of those investments due to their restrictions, effectively starting a bond sell-off without many large buyers. When the economy gets into trouble, corporate leverage is likely to make it worse. Just like in the now volatile stock market, active management of bonds makes more sense now.

Due to these issues, we expect that the strength of the US dollar will be somewhat falling from its recent highs, and that high-yield bonds and bank senior debt (floating rate funds – performing very good through 2017 and 2018) should be reduced a little in our portfolios.

Technical Component to the Volatility – Feelings

I am an investor, not a trader. Technical side of analysis has never been my strength. However, it is easy to see the panic in the market participants as all the shoulders they were highlighting on their charts were lost recently. Machines follow algorithms without feelings. The speed of trading has improved so much that the size of points movement in a market trading day are making us dizzy.

As the interest rates are slowly rising, large market volatility could cause investors to move to cash-like positions and leave the capital markets, coming back when they become greedy again. All-in and all-out positioning could increase volatility even more.

Our World

Franklin Pierce Adams once observed that: “Nothing is more responsible for the good old days than a bad memory. The world in earlier decades had more deaths from war, homicide, infectious disease and terrorism; more poverty, autocracies and nuclear weapons; more air and water pollution in rich countries and more cooking smoke and contaminated water in poor ones.”

At the high level, we invest for the long-term hoping to provide for all of your liabilities stated in your plans without running out of the funding portfolio and planning for the estate left after you. I hope that many of you still have 2000 and 2008 fresh in your memory like I do. Volatility is back and we are and will be prepared for it. Slower global growth should provide less of a tailwind to equity returns over the next period. Geographic opportunities tend to favor the emerging economies over the same time due to the population and productivity growth as well as the current valuations. Interest rates are rising over time, but we expect them to remain lower than their historical averages and not move much from these levels. Diversified and selective portfolios with a global opportunity piece may have the best potential to take advantage of the future growth. As long as there is some coordination of policies of the economic powers, 2018/2019 could be remembered as a dip that adjusted asset prices, preventing large bubbles in a longer economic growth cycle.

With 2018 ending, we ended our transition from Morgan Stanley to Culov Wealth Management joining Wells Fargo Advisors Financial Network. I cannot be prouder of our employees, their hard work and discipline they showed through the process. Some mistakes happened, but those were corrected fast and communicated to our transition team, so that they don’t have to be repeated. Please understand that our support team and us did everything possible to make this transition and transfer of your assets as clean and as fast as possible. Any delays were due to circumstances out of our control. I would like to thank all of you for your continued trust, support, and patience. It is our hope that we will grow from here in the quality of our service, our time availability, communication and planning and executions of your plans. Our practice is becoming a boutique private client services wealth management business we always planned for. Over time, I would like you to see the Stonehouse at 305 Elmwood Avenue as a true family office for your family among other families we serve.

We expect you to see us at least two times in this year as always. Vanessa Shady, Registered Account Administrator, will be updating you on your scheduled appointments and schedule new ones where needed. As we continue to build on to your planning, Matthew Richards, Senior Financial Advisor, will have additional appointments for some tied to the income gap and target calculations for retirement plans, and Amela Culov, Family Wealth Advisor, will be seeing some of you for additional appointments in finalizing the estate planning and goals for your inheritance. Allison Convissar, Senior Client Associate will be participating in these planning appointments in order to drive the process towards finalization as Mary Makin, Administrative Associate, takes over more of the daily activities and communications with you. Now that we are all here when you come for appointments, I will hopefully be able to see all of you more often.

As always, don’t hesitate to contact me or any one of us with your comments, questions, or concerns.


Emir Culov

Partner, Portfolio Management Director

Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.