The Markets	12/31/18 Close	09/30/18 Close	4th Qtr. Change	12/31/17 Close	12 Mo. Change	YTD Change
Dow	23,327	26,458	-11.83%	24,719	-5.69%	-5.69%
NASDAQ	6,635	8,046	-17.54%	6,903	-3.88%	-3.88%
S&P 500	2,507	2,914	-13.97%	2,674	-6.25%	-6.25%
MSCI EAFE	1,720	1,974	-12.87%	2,051	-16.14%	-16.14%
10-yr Treas. yield	2.69%	3.06%	-0.37%	2.40%	+0.29%	+0.29%
Fed funds rate	2.25-2.5%	2.0 -2.25%	+0.25%	1.0 – 1.25%	+1.00%	+1.00%

(stock indices are before dividends; yield and rate changes are absolute changes)

What a difference a quarter makes as the stock market went from a stellar third quarter into a slide that began on Oct. 3 and took most markets into bear market territory. The pressure eased a bit with a final week rebound and overall the decline felt worse than it actually was, even though 2018 ended up as the worst year for US stocks since 2008. (Note that the above returns are before dividends, which add around 2% or more to the S&P and Dow returns.) A Dec. 31 rally put the overall investment grade bond market just into positive territory to avoid the first year for negative returns on US stocks and bonds for 25 years.

Some areas of the bond market fared much better but other areas were also negative, some much more so – gold finished at -1.3% (after rallying 10% from its August low), crude oil was down 30% and bitcoin lost a full 78% of its value in 2018. Large tech companies, which had driven the market the entire year, also led its decline in the quarter. Volatility increased dramatically with a big drop on Christmas Eve followed by the largest one-day point gain ever for the Dow. Part of that volatility was fueled by Treasury Secretary Mnuchin contacting big banks to confirm their liquidity but what was meant to be a reassuring gesture backfired into greater fear.

The Fed raised rates as expected for the fourth time in 2018 and indicated they would continue reducing their holdings of bonds and would also continue rate increases into 2019. However, their language was less aggressive and although overall risks to the economy are still “roughly balanced” the consensus is now for two hikes in 2019 rather than three. The “neutral rate” at which the Fed is neither trying to boost nor slow the economy is also lower at 2.8%. Still, the benchmark 10-year Treasury slid from its early November peak of over 3.2% and the yield curve is now even flatter, which has often been seen as a precursor to a recession.

Social Security recipients will be seeing an increase of 2.8% in their benefits in 2019, the highest increase since 2011. The trade wars took a pause with a 90-day “cooling-off period” for the US and China to work things out. But the Brexit process fell into even greater disarray with Prime Minister May barely surviving and the big decisions being pushed down the road and the March 2019 deadline getting much closer. The year closed with a partial US government shutdown over funding for the border wall which shows little sign of resolution and which will spread to more of the government over time.

Home sales and price increases slowed as mortgage rates have gone up, even though supply is still tight. Existing home sales were down 7% from the prior year and prices moderated, increasing 5%. Non-defense spending excluding aircraft, typically considered as a measure of business investment, softened to a 0.6% decline on November. Hourly wages crept up 3.1% from the prior year and along with the personal savings rate of 6% (down from its February peak), consumer spending was the best in four years. Although third quarter GDP growth, at 3.5%, was down a bit from the second quarter, those are the best consecutive quarters since 2014. The last reading of consumer confidence showed the biggest decline in three years but the overall level was still quite strong and the analysis came in the middle of the stock market gyrations. Unemployment stayed low at 3.7% and all the core inflation readings were around a benign 2%.

General Motors announced a cut of 15% of jobs including plants in Ohio and Michigan and is cutting several car models as all the big auto makers try to position themselves for the future of transportation. The Treasury issued more debt in fiscal 2018 than in any year since 2010 and at more than twice the level of 2017. Corporate debt levels have skyrocketed 86% since 2007 and the ratio of corporate cash to debt is at its lowest ever. The windfall of the corporate tax cuts, to no one’s surprise, was used not only for investment but also to pay off $72 billion of debt and to make $81 billion of stock buybacks and dividend payouts.

Looking Forward

For several years we have enjoyed improving economic data, steadily falling unemployment and (this last quarter notwithstanding) a very positive stock market. What has been missing, and what has been a source of frustration for policy makers, is greater growth in wages.

An analysis by the Washington Post found that in the 10 years before the recession, 58% of wage increases could be explained by the unemployment rate. In the 10 years following the recession, that figure is only 2%, and even discounting the first seven recovery years only 30% of wage increases are explained by the unemployment rate in the three most recent years.

The Post’s analysis also recognized that a smaller share of 25 to 54-year-olds are employed now, and that group traditionally experienced wage increases. But there have been other factors that have kept a lid on wages.
• Both inflation and inflation expectations have been stubbornly low (of course, wage increases can drive demand and thus inflation, so this is sort of a chicken or egg situation).
• Productivity increases, or the output per worker, have been slower in the last decade.
• Workers have become less mobile, both in moving to better jobs in the same location or to relocate for better jobs. Family circumstances and local social services can discourage taking the risk of relocating for a new job. Still, by some measures job changers have wage growth of nearly 1% more than all workers.
• There has been a steady decrease in unionization and collective bargaining, reducing the risk to employers of an organized worker strike or coordinated push for more wages.
• The increase in automation, despite creating higher-paid and higher skilled jobs, has continued to put pressure on overall wages.
• A number of industries have become concentrated in several big firms at the same time that other industries are struggling to adapt, so these big firms are able to exert more unchecked power over workers.

Some of these factors, such as increasing automation, are unlikely to reverse and are indeed more likely to accelerate. Still, improvement in wage growth for whatever reason would go a long way in offsetting some of the other concerns about the economy.

Our Portfolios

Okay, let’s just skip all the hair-splitting debates about whether a particular slice of the stock market entered bear market territory (some areas went to bear territory and beyond) and accept that the market slide that began on Oct. 3 and picked up steam was enough to catch everyone’s attention. It certainly felt like a bear market, so what does that mean?

Here is our November 1 message to clients and it definitely continues to apply.

“We could provide plenty of data to illustrate that the recent upheaval is nothing unusual, that the declines have simply given back the increase since the beginning of the year, and so on. And all of that is true. Instead, we think these three points are most useful.
• Do not get sucked in by the inflammatory terms used by the media. Yes, they are reporting the facts, but words like “plummet”, “soar” and “rout” lack any connection to individual circumstances and long-term investing. In other words, the media is just trying to get your attention, not help you.
• Your portfolios are not invested solely in the stock market and to the extent they are holding bonds and cash, any stock decline will be softened.
• Most important, our analysis of your long-term financial well-being already incorporates the inevitable stock market declines. There will unquestionably be declines worse than we have seen this month, and probably more than one in our remaining lifetimes, but it is impossible to guess when, why or how much.”

The discipline of maintaining a long-term asset allocation can also soften the pain of a declining market. Rebalancing entails buying into the weaker market area, something that is hard to do without that steady process. Likewise, managing additions to and withdrawals from portfolios means that declining holdings are not sold to raise cash but are maintained for a recovery, however long it may take.

Just to be clear, we know market declines are stressful and we fully understand investor’s concerns for their hard-earned money. Market declines are difficult for us as well, both personally and professionally, and we know the market could continue to fall, maybe a lot. Our job, though, is to help our clients reach their long-term and manage portfolios that support those goals; it is not to conjure up some smoke screen that will magically make things better. Most things in life involve some setbacks and that certainly includes investing but just as we move forward in those other areas, perseverance in the face of adversity works also works in investing, and probably better.

Making Debt Easy

We don’t spend a lot of time talking abut consumer debt because thankfully most of our clients have any debt well under control. Since the recession nobody is thinking that if the lender is willing to lend me money, it must be okay.

Debt is still a critical part of financial planning and can be very helpful in reaching long-term goals – if used properly. Aside from the financial analysis of whether debt is manageable, here’s a simple framework to keep in mind.

Acceptable debt (appreciating assets) – “Good” debt takes advantage of debt’s primary advantage – purchasing something in today’s dollars and paying for it in cheaper dollars as inflation erodes purchasing power. An appreciating asset is typically a home, which despite local gyrations can be expected to increase in value by roughly the rate of inflation. Another reasonable use of debt is for education, as long as the education can reasonably be expected to increase earning power over the long term. But you should not “stretch” just to buy a larger, more expensive house and you should not take on excessive debt just to support a more expensive degree that can be obtained elsewhere. A riskier use of debt may be to start a business, but this debt should still stand on its own and not be guaranteed by the rest of the personal assets. Rolling all the dice on a new business venture is far too risky.

Managed debt (depreciating assets) – This debt involves something which has an initial value which lasts as long as the debt and which should have some residual value. A car is the typical purchase for this type of debt. As with a house, you should work to get ahead of the declining value and create some “equity” in your vehicle purchases. Avoid the temptation to get a new vehicle every couple of years, even if leasing, and be careful with adding seldom-used special purpose vehicles; those can be rented.

Bad debt (current value only) – I am tempted to call this “stupid debt” and frankly that would not be too harsh. Debt should never be used for entertainment, travel, clothes or other impulse purchases that have no lasting value. Quite simply, if it can’t be bought with current cash flow, don’t buy it. The pleasure from these things is diminished by the lingering pain of paying down the debt. As a simple exercise, replace any idea of “deserving” something with the idea of “earning” it and you will not only stay out of stupid debt but you will take greater satisfaction when you do spend on those things. Even better, adhering to a hard and fast rule in this area cold encourage you to get more creative in enjoying these things, opening opportunities you may have never considered before.

Any debt, of course, should always be within reason and taken with a clear analysis of whether it is compatible with current income. The tried-and-true ratios of debt to gross income (income before taxes and other deductions) are the best way not keep things under control. Your mortgage payment should not be more than 28% of your gross income and all debt payments (including mortgage, cars, student loans, even child support) should not exceed 36% of gross income.

Being disciplined about debt will probably mean that some purchases will be delayed or may be at lower amounts than you would like. But the financial control and freedom what comes with that discipline will make it all worth it in the end.