These are the charts and themes that tell the story of 2018…

I. All Good Things…

…must come to an end. After 9 straight years of gains, the S&P 500 finished down 4.4% in 2018, its first down year since 2008.

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The record run from 2009-2017 thus ends in a tie with 1991-1999 for the longest positive streak in history.

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Was a down year a foregone conclusion? Far from it. At the close on September 20, the S&P 500 was sitting at an all-time high, up 11% on the year.

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Over the next 3 months, it would give back all of those gains and more, with a peak-to-trough decline of over 20%.

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Why were stocks going down? Take your pick: rising rates, China slowdown, trade war, weakness in housing, etc. There’s always a “reason” after the fact.

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Regardless, this was now the largest stock market decline since 2011, leaving the S&P 500 at one of its most extreme oversold levels ever.

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Investors who were extremely greedy at the start of the year were suddenly extremely fearful.

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On Christmas Eve, the S&P was down 14.8% on the month, on pace for the worst December in history. A post-Christmas bounce averted this ignominious feat, but the damage was done.

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At -9%, December was the largest monthly decline in the S&P 500 since February 2009.

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II. Bear Markets and Recessions

Does this mean a recession is coming? That’s the question everyone seems to be asking today.

Looking back at history, the answer is far from clear. This is now the 21st Bear Market since 1929. Of the previous 20, only 11 were associated with a recession (55% of the time).

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Sometimes a Bear is just a Bear (the stock market is not the economy). Is this one of those times? We’ll find out soon enough.

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III. When Multiples Contract

If someone told you that earnings would increase 26% in 2018 and that profit margins would hit record highs, you would probably guess that stocks would be higher.

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That would’ve been a reasonable assumption in most years, but not in 2018. For the first time since 2011, we saw multiples contract (-25%), with the P/E ratio on the S&P 500 moving from 21.4 at the start of the year to 16 at the end.

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Investors learned once again that stock prices lead earnings, not the other way around. The strong equity markets of 2017 were anticipating the strong earnings of 2018.

What is the multiple contraction this year telling us about future earnings growth? That it’s likely to slow.

How will market participants respond to such a slowdown? Nobody knows because it requires predicting investor sentiment (what multiple will investors pay for next year’s earnings?). Needless to say, predicting investor sentiment is a difficult game, which in turn makes predicting future stock prices exceedingly difficult. Further complicating matters is the fact that predicting future earnings is not any easier.

IV. No Place to Hide

In a broadly diversified portfolio, there’s usually something working in any given year. When stocks are down, bonds are typically up. When bonds are down, stocks are typically up. When stocks and bonds go down together, something else is often up (TIPS, Commodities, REITs or Gold).

Well, not this year.

In 2018, more than any year in recent history, the overwhelming majority of asset classes were down. In the table below of 15 asset classes ranging from stocks to bonds to REITs to Gold and Commodities, only one finished higher: Cash.

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If you maintain a globally diversified portfolio, this was likely your worst year since 2008, with a 60/40 allocation (AOR ETF) down just under 6%. To be sure, this is but a scratch compared to the devastating losses investors faced in 2008. But for a whole generation of new investors who knew nothing but gains year in and year out, this is now their 2008.

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Every major global equity index finished lower in 2018, the polar opposite of 2017. U.S. equities actually fared much better than most…

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The 25 largest equity ETFs were all in the red.

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Only 3 country ETFs finished positive: Qatar, Saudi Arabia, and New Zealand. How many strategists had Qatar on their list of top picks for 2018?

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The major banks were hit particularly hard, both in the U.S. and in Europe.

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And asset managers had their worst year in a long time.

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With the exception of Tesla, auto stocks were slammed.

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In terms of sectors, the defensive health care and utilities names fared the best, while the more cyclical areas were crushed.

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V. Extreme Volatility or a Return to Normalcy?

In 2017, both stocks and bonds sported their lowest volatility in history (using monthly data going back to 1928 for S&P 500 and 1976 for Barclays Aggregate). The S&P 500 did not have more than a 3% drawdown the entire year and was positive every single month.

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Given this backdrop, any increase in volatility would have felt like a crash. And indeed it did, with many market participants describing the daily swings as “crazy” and “abnormal”.

The truth? What we saw in 2018 was standard behavior, the price of admission for long-term investors.

At 17%, the S&P 500’s annualized volatility in 2018 was just a hair above its calendar year average going back to 1928 (16.3%).

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While the number of days with large gains or losses was higher than any year since 2011 (ex: 20 swings >2%), one could hardly call this unprecedented (we saw a higher number of 2% swings in 1929-35, 1937-39, 1946, 1974, 1987, 1998-2002, and 2008-2011).

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The maximum intra-year drawdown of 19.8% (closing basis), while above the historical average (-16.4%), was also far from an outlier.

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If anything in markets can be described as “abnormal”, it was the minuscule 2.8% maximum drawdown we saw in 2017. Volatility and corrections are features in markets, not bugs. It can be hard to appreciate it when you’re in the midst of a decline, but investors should be thankful that this is true. For without risk there would be no reward.

VI. The End of Easy Money

While markets were hitting all-time highs in late September, an important shift in monetary policy had just taken place. With the 8th 25 bps interest rate hike, the real Fed Funds rate had turned positive for the first time in 124 months.

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The longest period of easy money in history had finally ended.

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The question I asked at the time: will market behavior begin to change now that it is over? We would soon find out.

But in spite of the deep correction that followed, the Fed would hike once more in December, bringing the Fed Funds rate up to a range of 2.25-2.50%, its highest level in over 10 years. Short-term Treasury rates moved higher in tandem, a positive for savers.

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Cash was king in 2018, having its best year since 2007.

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Should investors expect more of the same from the Fed in 2019? In a word: no. As I argued in a recent post, despite the Fed’s projection for 3 more rate hikes, a long pause awaits. The combination of plummeting inflation expectations, a global bear market, and tightening credit markets are enough to slow the Fed down for a while.

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The market (fed funds futures) is on board with that view, now pricing in no hikes in 2019 and an interest rate cut in 2020.

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As for the rest of the world, monetary policy remains extraordinarily easy, with the ECB and BOJ expected to remain in negative rate land throughout 2019.

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Long-term bond yields in Germany and Japan actually fell in 2018, making international bonds with the lowest yields (BNDX, 1% yield) the best performers in the global fixed income space.

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VII. Lions and Tigers and Yield Curve Inversions

The much-dreaded inversion of the U.S. Yield Curve finally occurred in December 2018. At year-end, the 6-month Treasury bill yield stood at 2.56%, 5 basis points higher than the 5-year yield.

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What made this possible? The combination of rapidly rising short-term rates (via 4 Fed hikes) and longer-term yields rising at a much slower pace.

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Why is a yield curve inversion feared? The last 9 recessions in the U.S. were all preceded by an inverted curve (1-yr higher than 10-yr), with an average lead time of 14 months.

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We also tend to see weaker stock market returns in periods following flat/inverted curves.

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While the entire yield curve is not yet inverted, it’s getting closer by the day, with the 10-year yield now just 24 basis points higher than the 3-month.

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Investors and the Fed will undoubtedly be watching this indicator closely in early 2019. What should they want to see? Long-term rates moving up again, signaling a resurgence in growth expectations. What do they not want to see? As I discussed on our last webinar, 10-Year Yields continuing to fall, which would mirror the action following the peak in yields in January 2000 and June 2007.

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VIII. The Other Side of a Mania

What a difference a year makes. In the 2017 year in charts, I outlined the mania that rivaled all other manias: the historic rise in cryptocurrencies.

Fast forward to today and investors found out what happens on the other side of a mania: an epic crash to rival all other crashes.

In 2018, every major cryptocurrency traded lower with an average decline of 85%.

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From its peak in December 2017 to its low a year later, Bitcoin declined over 84%.

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The 20 largest crypto coins at the end of 2017 had a total market value of $512 billion. During 2018, over $400 billion of this would disappear.

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IX. King Dollar Returns

While cryptocurrencies were moving lower, the U.S. Dollar was moving higher. With the exception of the Japanese Yen, the Dollar was up against every major global currency in 2018.

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As the dollar rose, most commodities fell.

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From its high of $77 in early October to its low of $42 in December, Crude Oil crashed 45%.

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As Crude Oil and inflation expectations moved higher over the past few years, the Fed hiked 9 times. The sharp decline in both over the past few months now gives the Fed room to pause.

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In a reversal from 2017, Lumber would fall 24% during the year. After hitting an all-time in May, it declined over 50%.

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Weakness in the housing market would follow, with new home sales hitting their lowest levels in over 2 years and homebuilder stocks sharply underperforming.

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The combination of rising mortgage rates (7-year high in November) and rising home prices (widely outpacing income gains in recent years) finally started to hit affordability.

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X. The Longest Expansion in History?

That’s a lot of negative charts. Let’s end this on a good note.

U.S. non-farm payrolls have now been positive for 98 consecutive months, by far the longest streak in history.

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At 3.7%, the Unemployment Rate is at its lowest level since December 1969. While that’s not necessarily good news for stocks (see here), it’s unequivocally good for the many that have found jobs at long last.

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And wages are finally starting to rise, with the 3.1% increase over the past year at the highest level of the expansion.

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The US economic expansion is now 114 months old. If it lasts for another 7 months it will set a new record, breaking the prior run from 1991 to 2001. If you told someone in early 2009 (after the worst recession since the Depression) that the next expansion would be in the running for the longest ever, they never would have believed you. But here we are.

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XI. Happy New Year

These were the charts and themes that told the story of 2018. As always, the narratives followed prices.

As prices change in 2019, the narratives will change as well.

Where will the S&P 500 end 2019? Where is Crude headed? Is Gold a good investment here? How many more times will the Fed hike rates? Is a recession coming soon?

I don’t know the answer to any of these questions. As Lao Tzu said, “those who have knowledge don’t predict. Those who do predict don’t have knowledge”.

What’s the alternative? Weigh the evidence as it comes, invest based on probabilities, be forever humble and thankful, and leave the predictions to those whose job it is to entertain. That’s the best you can do in this business.

In 2019, I predict one thing and one thing only: you will see many more surprises. That is the nature of markets.

Thank you for your readership this year. I hope in some small way you found this blog helpful in your journey as an investor.

I wish you all a happy, healthy, prosperous and fulfilling 2019.