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The holiday season is supposed to be about good cheer. Given the economic news, you might think investors would have plenty to be cheerful about. For example:
- Economic growth is strong. The Federal Reserve Bank of Philadelphia’s Fourth Quarter 2018 Survey of Professional Forecasters projects real GDP growth of 2.7% for 2019, down just slightly from the forecast of 2.9% for 2018.
- Unemployment is at 3.7%, the lowest rate in 50 years.
- Inflation is moderate. The Philadelphia Fed’s latest 2019 forecast is for an increase of 2.3% in the Consumer Price Index (CPI), down slightly from its forecast of 2.4% for 2018.
- Consumer sentiment (a leading indicator) is strong. The final December University of Michigan Consumer Sentiment Surveycame in at 98.3, remaining near the highest levels we have seen over the past 18 years (despite the recent weakness in stocks). The last time the Consumer Sentiment Index was consistently above 90.0 for at least as long was 1997 through 2000, when it recorded a four-year average of 105.3.
- The November ISM (Institute of Supply Management) Non-Manufacturing Purchasing Managers’ Index came in at 60.7%, 0.4 percentage point higher than the October reading of 60.3%—representing continued growth in the nonmanufacturing sector and at a slightly faster rate. The six-month moving average of the index is at about its highest level in more than 20 years. The Non-Manufacturing Business Activity Indexincreased to 65.2% in November, 2.7 percentage points higher than the October reading of 62.5%, reflecting growth for the 112th-consecutive month, at a faster rate.
The bottom line is nothing in the economic data indicates we are headed > SEE MORE
To help prevent the next Great Depression, in 2008, the Federal Reserve increased the “price” of avoiding risk.
Fearful investors seek the safety of Treasury bonds (as well as government agency bonds and FDIC-insured CDs). When they do so, they forgo the risk premiums available from non-Treasury debt and equity investments. Driving the rates on Treasury bills to virtually zero led many investors who rely on a “cash flow approach” to investing to frantically search for higher yields.
Higher bond yields can be achieved in two ways. The first is to take incremental maturity risk, which would increase the volatility of the portfolio and subject you to increased risk of unexpected inflation. The second is to take incremental credit risk.
As the director of research for The BAM Alliance, whenever markets head south for an extended period, the number of calls I get from clients and other advisors jumps. This time is no different.
With that in mind, I thought it important to share how investors should be thinking about the recent drop. To begin, there is always a reason for investors to worry about the stock market, be it valuations at historically high levels, the economy, the risk of inflation or geopolitical risk. That is why there is an equity risk premium, and why historically it has been large enough to be called the “equity premium puzzle.” It’s also why it’s often said that “bull markets climb a wall of worry.”
While the news on the economic front has been just about as good as it gets, there are always things to worry about. To make sure you have a balanced view of things and are not just obsessing about potential risks, let’s first look at some of the economic news: