Clients of the Firm,

Many clients are asking whether or not now is the time to reduce or eliminate equity holdings as a result of the clear change over the last three months in market sentiment.  December is on pace to be the worst performing December since 1931 and in the top 50 worst performing months of all-time.  The declines are sharp and sudden and this can cause concern for many investors.  In addition, the markets have entered negative territory for the year with the S&P 500 down about 5% as of this note. 

This moment seems like a peak of negative hyperbole to us, but we agree it is concerning to hear the chorus of negative sentiment from noted investors and past Fed Chairs. Our view is that there is tremendous uncertainty in the news cycle compounded with the drama and policy confusion currently in Washington.  The issues range from the China trade war, government shutdown, Mueller probe, change of control of Congress and what the Fed will do tomorrow…the list goes on.   

Going to cash may appear to many to be the best short-term solution for capital preservation, but when there is a turn in markets from these massively oversold conditions one may miss that.   A bounce from these conditions might be quite large, as historically often happens, sometimes retracing 50% of recent losses. The market is down -7.61%  (as of this note) in December which places it in the top 50 worst months of all-time.  This list includes the recent history of the Lehman Brothers Collapse and 9/11.  To be clear, the economic conditions on the ground are nowhere near those dramatic moments. This selloff is sentiment driven and with interest rates as low as they are people are clearly wholly focused on a return of capital versus a return on capital.  If your goal is to preserve money, then liquidation might be a priority. If it is to invest long-term, holding or even adding to equities in these conditions would likely make sense.

We have attached a range of market outcomes based on a range of sentiments as measured by historical P/E ratios scored by variance from expected consensus earnings for the S&P 500 for 2019.  We then weighted the outcomes based on probabilities we assigned to the various outcomes and sentiment levels to come up with a target price for the S&P 500 for next year.  This should give some parameters around reasonable outcomes for the market going forward under many conditions. (see attached pdf)

This model gives an S&P 500 target of 2624 for next year embedding the probabilistic outcomes we determined.  

From a technical analysis perspective, the year lows are at 2531 and we were trading at 2530 as we wrote this, retesting those lows for the second consecutive day.  The robots and algorithmic trading programs are in charge these days of short-term market swings and volatility and every time we reach these technical levels they either hold or the market immediately moves to the next support (downside) or resistance (upside) levels.  These technical analyses inform our micro decision making, but do not form the basis of an investment thesis.  They do help inform the timing of when buying might be prudent.

From a valuation perspective, many high quality stocks are now trading at a forward P/E ratios in the low teens or single digits.  This implies the market believes earnings will shrink next year to fit these valuations or that sentiment is very low, or both.  We have not yet seen significant negative earnings revisions in most companies we invest in.  It remains to be seen whether estimates for earnings next year are accurate or whether market sentiment is more indicative of what earnings will be.  Remember, earnings are the ultimate arbitaeur of where the market goes and sentiment can be used as a tool to acquire good earnings streams at good prices when it is negative. 

We expect the Fed to hike interest rates by 25 bps or 0.25% tomorrow (12/19/2018) and to provide dovish guidance on future hikes, indicating they will be data dependent or even pause to see how conditions unfold.  If the Fed does not raise rates tomorrow, it may be read as a negative implying market participants may fear a sharper slowdown that forced the Fed to dramatically alter course.  Likewise, if the Fed does not give dovish guidance, the market will likely read that as being “tone deaf” to worries regarding higher interest rates and the drag on the economy.  The Fed therefore has to walk a tightrope to not shock the market and our belief is that is what will be accomplished by the scenario we have prognosticated above.

We hope this note helps put some perspective around recent market conditions and that going into the holidays you can focus on your families as we focus on managing your money through these turbulent times.  

Sincerely,

Peter C. Wernau CEO, Wernau Asset Management

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