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Welcome to Cardan Capital Partners’ third edition of “The Helm,” a quarterly market update providing a quick-hit look at general portfolio changes, our read of the markets and what we see ahead. Later this year, we will roll out a quarterly chart-book highlighting the data points we are analyzing. We hope it will help you gain perspective on your investments.

2018 in review

To keep last year in perspective, it is good to remember that 2017 was an atypical year for the stock market in terms of volatility. Stock market data stretching back to 1928 — a full 91 years — shows 2017 was the second lowest volatile year in terms of standard deviation (S&P 500 Index 1928-2018, source: Bloomberg LP). The market saw only eight days with price movements above 1% or below -1%, making it the fourth lowest total ever.

But then came 2018, which behaved much more like an average year. Historically, the market on average sees 60 days of price movements above 1% or below -1% in a year, and 2018 was right in line with 64 days of such movement. Still, that’s a sharp departure from the calm of 2017.

Even if 2018 moved back to a more normal environment in terms of volatility, it was atypical in other regards. As the year unfolded, fewer and fewer asset classes remained in positive territory. The final blow came in the fourth quarter with the selloff of the remaining survivors — Growth Stocks, which are concentrated in technology.

For much of the year, the old saying about March coming in like a lion and leaving like a lamb felt like an appropriate way to describe much of 2018. But as the year ended, it was apparent that 2018 had come in like a lion, felt only briefly like a lamb and left like a lion. An initial, 7% stock rally in January was wiped out in February with a drop of almost 12% in 10 days. That drop was precipitated by rising bond yields and an upbeat outlook from Federal Reserve Chairman Jerome Powell, which combined to spook investors into thinking interest rates were on a one-way trip higher. Then the market settled into a placid period during the summer only to be interrupted by the traditionally nasty month of October. The year’s finale was also its big surprise: The generally positive and mild-mannered month of December suffered its worst drop in decades and the 11th largest decline of any month since 1950. 

That December selloff was driven in part by the Fed’s unwavering stance to maintain a path of rate hikes, making the market fear a policy mistake was right at our doorstep. But as we noted in our last communication, we believed the Fed Governors would start communicating a more dovish take on the situation to calm market nerves — and that is exactly what happened. Concerns about trade wars with China, Brexit, thin holiday trading, tax-loss selling and the government shutdown also helped push the market lower. We believe the Christmas Eve panic low will prove to be a durable bottom and will at most be potentially retested — but, for now, Dec. 24 will mark the point from which the market can build gains.

These charts underscore some of the atypical themes 2018 provided:

Diversification was left wanting. The following chart highlights several asset classes (represented by an ETF) and their total returns going back to 2008. As you can see, 2018 had the lowest percentage (13%) of assets finishing positive over the last decade — lower than even 2008. The good news is this was highly unusual. That leads us to believe diversification once again will prove its merit sooner than later. Indeed, diversification, specifically Treasury bonds, finally did provide some relief during the market downturn (see second chart).

Data Source: Bloomberg L.P. prepared by Cardan Capital Partners

Data Source: Bloomberg L.P. prepared by Cardan Capital Partners

A brutal December. In December 2018 we experienced the month’s second worst stock market performance of all time (91 historical observations) after December 1931.

Data Source: Bloomberg L.P. prepared by Cardan Capital Partners

Valuation free-fall. The valuation metric Price-to-Earnings (P/E) ratio measures how much an investor is willing to pay for future earnings with a higher P/E ratio, indicating a more expensive stock market relative to a lower P/E ratio. In 2018, this metric dropped 4.6 points — the sixth largest drop in stock market history. The P/E ratio fell from 21.7 at the beginning of the year to 17.1 at the end, a 21% decline. This type of abnormal re-setting of valuations indicates that the market is re-adjusting its expectations, whether correctly or not. As the market moves between emotional states of pessimism and optimism, it may swing too far to one side or the other. In this case, it remains to be seen whether the market became overly bearish (our opinion is yes) or appropriately cautious.

Data Source: Bloomberg L.P. prepared by Cardan Capital Partners

2018 Conclusions. While 2017 was abnormal from a low-volatility perspective, a nice kind of abnormality (if such a thing exists), 2018 was marked by a bad anomaly: diversification did not provide the historical benefit we typically see in periods of market stress, such as that experienced in the fourth quarter. The good news is that it is rare for both bonds and equities to provide such poor returns in the same year, so we would not expect a repeat this year. Also, the painful selloff caused a re-adjustment of valuations across the markets, back to levels usually associated with positive market performance. The bad news is that many of the negative news headlines from 2018 carry onward into 2019, including the US-China trade war, tariffs, the U.S. Government shutdown and Brexit. This new year adds a few more wrinkles to the mix, including a divided Congress and associated gridlock; probable wrap-up of current federal investigations; potential new investigations; critical Fed decisions; and a general, slowing economy.

A word about bear markets. 2018 saw the first bear stock market — defined as a decline in price of the index of 20% or greater, using intra-day prices — since the Great Financial Crisis (GFC) of 2008-09, when the S&P 500 Index dropped 56% (although an investor could be forgiven for thinking it was the first since 2011, when the market fell 19%). On average, stock bear markets happen about once every 4.3 years. However, not all bear markets happen inside of a recession — as was the case with this most recent decline. In fact, of the last 21 bear markets, 11 happened outside of a recession. The average stock market decline outside of a recession is approximately 18.8% compared to 33.5% for bear markets that happen during a recession. While both are painful, one is significantly more so than the other. To recover from an 18.8% loss, a portfolio would need to gain 23.15%, but to recover from a 33.5% loss, the recovery required is 50.4%.

2019 items to watch

Recessionary headwinds. As we highlighted in our communication soon after the Fed raised rates in December, some economic indicators and market data now appear to have reached an inflection point and are trending toward recession. That said, these indicators may not reach levels associated with recession and could reverse course. These trends can provide a feel for where we are in the current economic cycle. If indicators begin to reach uncomfortable levels, we are prepared to move a significant portion of our allocations in response.

The following chart highlights an indicator we follow internally. The blue line is the Cardan Recession Watch Line, a combination of various data points (e.g. Leading Economic Indicators, Industrial Production, Employment, etc.) and is meant to detect whether the overall U.S. economy is weakening and approaching a recessionary period. We look at this line in combination with the gray line — which is the spread between the 1-year and 10-year Treasury yields. As both of these lines approach zero, the economy is moving closer to a recessionary period. The Cardan Recession Watch Line currently sits at 13.5, below its historical average of 19.2 when above zero. More importantly, it reached an inflection point in October and now is trending downward. The 1/10-year yield curve spread also has been trending to very low levels, although it has not inverted (meaning when the 1-year rate is higher than the 10-year rate). A broader look at a cross section of yield curves tells the same story. Bond investors believe the period of slower growth the economy is now mired in will continue and may tip to recession.

Data Source: Bloomberg L.P. prepared by Cardan Capital Partners

As noted above, we monitor the economy very closely not only to avoid the larger decline in stocks associated with recessions, but also to move into asset classes, such as bonds, that typically do well in recessionary periods.

Value, Growth and the Market. Growth has dominated Value since the GFC, outperforming Value for six out of the 10 years from 2009 through 2018. During this time, the annualized rate of return for Growth stocks was 15.8% versus 12.6% for Value stocks. This underperformance in Value has left many investors baffled given that Value over time has historically outperformed Growth. For some perspective, during the prior 10-year period 1997 through 2007, the annualized rate of return for Value was 9.5% versus 8.0% for Growth and 5.9% for the broad market.

Recent times have echoed the sentiment of the late 1990s tech boom when Growth also significantly outperformed Value. As was the case then, Growth this time has been led by the tech sector. Of course, we know the tech bubble eventually burst and Value once again regained dominance.

Value and Growth are both powerful investing styles, where one is usually leading the overall market. In 17 of the past 23 calendar years (1996 – 2018), either Value or Growth has outperformed the market. That is 74% of the time. Given their ability to outperform, we believe it makes sense to overweight one style versus the other with the intention of capturing stronger returns. Our work has led us to overweight Value for 2019.

Source: Bloomberg L.P. prepared by Cardan Capital Partners. 
Composites of Growth and Value are the equal-weighted returns of 
the S&P Dow Jones Indices for their Growth and Value indices, both style and pure.

Current allocation outlook

Due to the significant re-setting of valuations in the stock market during the sell-off in Q4 2018, equities remain attractive relative to bonds, leading us to maintain our equity overweight in the majority of our strategies. Within equities, our work indicates a shift in performance from Growth to Value.

One indicator leading us toward Value is the P/E ratio mentioned above. The P/E ratio for the S&P 500 Index fell 21% from 21.7 to 17.1. The P/E ratio for the S&P 500 Growth Index declined 20% from 30.2 to 23.6, a similar decline. However, the S&P Small Cap 600 Value Index fell by 44%, from 30 to 16.9, a level not seen since February 2009. From a valuation perspective, both to itself and relative to Growth stocks or the general market, Small Cap Value looks attractive.

Putting it all together

We believe the stock market has put in a low from which we will continue to rebound. While the strong move off the bottom does suggest a bit of a pullback may occur, we believe that any such pullback should be short-lived within the context of a positive market environment. Much of what is currently stressing the markets will have a binary outcome. The trade war with China, Fed Policy, Brexit and the Government shutdown all have a light at the end of the tunnel, and a positive resolution would be reflected in the market quickly.

Slowing — but positive — growth will serve to underpin stocks and corporate bonds as earnings will continue to flow from corporate America. Additionally, a more attractive valuation backdrop for stocks and corporate bonds should provide a more positive environment.

We believe a leadership change within the market is taking place. Large Growth, and specifically large technology, may take a breather and hand the baton to other participants. We believe the new leaders finally will be coming from the cheapest areas of the market — the Value stocks. That is why at the end of last year and the start of this one, we rotated portfolios to increase exposure to Value stocks where possible.

As always, we remain attentive to overall economic indicators and market conditions. It is possible that the strain of geopolitical and economic concerns already may have triggered a slowing of the economy and a glide path toward recession. Developments to the downside could trigger us to move a larger portion of our allocation into U.S. Treasury bonds, historically a strong hedge against stock market drawdowns.

This screenshot does a nice job of capturing the zeitgeist that was last year. We hope 2019 does not repeat history — or even rhyme with — 2018:

Disclosures: Any reproduction or distribution of this presentation, as a whole or in part, or the disclosure of the contents hereof, without the prior consent of Cardan Capital Partners, LLC, is prohibited. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy, completeness or timeliness of this document. Investments in securities entail risk and are not suitable for all investors. This is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the SEC. For further information please see Important Disclosure Information.

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