By Mitchell Anthony


The equity markets retreated as selling beget more selling and fear beget more fear in the fourth quarter of 2018.  This dramatic change of course for the equity markets in 2018 was reminiscent of similar market action in 2014 and 2015 when weakness in global economic conditions emerged.  However this correction was sharper with most indices falling 20% or more, compared with 10% or more corrections in 2014 and 2015. Was this just a big bump in the road to much higher levels for US equity markets? Or has the path for equity markets already reached its summit because recession lies on the horizon.  Most investors have found themselves asking these questions over and over recently.  While none of us know what lies ahead, trends in economic data point to further growth for the US economy as the impact from the trade war becomes more of a distraction to economic conditions than a game changing event. Further this is all occurring while inflation and central-bank policy mostly remains benign.  This environment of continued steady growth will ultimately lead to higher equity prices particularly those equities that are insulated from the problems in manufacturing and highly cyclical industries.  As the equity market continues on its path of recovery the leadership in the equity market will likely to take on a different twist as investors avoid the US sectors and foreign markets that are directly impacted from the trade war that is likely to persist for the short to intermediate term. This is a difficult time to own deep cyclical industrial names but contrarily a great time to own companies experiencing organic growth occurring with innovation and development of great products.


We have had tremendous alpha for the last few years based upon our ability to identify where investors were going early.  We owned the fang long before most people knew what the fang was.  The acronym for the market leaders in 2019 will be a different version of fang, but will clearly be areas insulated from global trade and benefiting from organic or secular growth.

How did the US equity market and in particular the fang fall so far so fast if the environment is still benign and these companies are still experiencing great organic growth?  The first thing to understand before I attempt to answer this question is that the leadership in the equity market in the first three quarters of 2018 was the fang and or similar companies with strong organic growth that was insulated from the trade wars.  Almost all other types of stocks whether domestic or foreign including Industrial names, financials, and deeply cyclical areas began their selloff in April 2018 when Trump first announced his plans to impose tariffs on foreign countries unfairly dumping their products in America.  This was bad news for Europe and Asia as they are major manufacturing and industrial centers. As a result these areas of the market lost 20 to 30% in 2018 and were avoided by MACM clients. Most MACM portfolios were flat to down 3% in 2018.  The S&P 500 lost about 5% in 2018.  MACM finished the year with a modest 300 basis points of alpha over the S&P 500, after dominating the S&P 500 by over a thousand basis points at the end of Q3.


MACM sold all of its holdings in Europe and Asia quickly when the news of tariffs first unfolded in March and we reinvested the proceeds and increased our holdings in healthcare and the fang.  These areas did fantastic in the marketplace until the big short emerged.


So again the question how did the equity market and in particularly the fang fall so far so fast.   There are several answers. The first answer is that the environment became unfriendly for industrial names early in 2018 because of the trade war.  The environment in Q4 became somewhat unfriendly for the fang as they were attacked by the politicians who seemed unreasonably angry about minor privacy issues involved with social media and the digitization of data, and likewise forgot how great our world has become as a result of digitization and social media.   The third answer lies in the fact that this selloff appears to have had strong roots with program trading that was designed to short highly valued broadly owned names and create fear and then cover shorts once the cycle of fear had ran its course.  The equity market appears to have been ripe for this type of interference by traders.   America has become sharply divided and the political unrest is at all-time highs.  The average investor is not well-equipped to evaluate the impact of political unrest on the economy and consumer confidence.   This unrest combined with some real economic problems associated with Trumps attempts to change the global trading environment drove investors out of stocks and into cash as the initial shorts pushed market indices down 5 to 10%.  The fear driven investors then started to capitulate and became sellers and their selling pushed the market down another 10%.   Finally in December Washington and central banks clearly became alarmed and moved into action to ensure investors that all was still good in our economy. Chairman Jerome Powell backpedaled his previous hawkish position, and then we got somewhat different rhetoric from Trump about trade wars.   These traders likely knew that Corporate America is scheduled to report some terrific earnings for 2018 beginning in January and February that would likely be a catalyst to push equity prices higher.  All of this combined information I believe caused the program traders to decide it was time to cover their shorts and this selloff suddenly ended without any real change in economic data, political unrest, or real news on trade wars. Now clearly there is a bias to the upside. We are now seeing follow-through from investors who are wanting to get back into the markets and accepting the fact that they got whipsawed by the trader’s gamesmanship.  This will likely continue unless something new is added to the mix that spooks investors or brings the program traders to begin another position of shorts.


The American economy is clearly strong with consumer sentiment still near all-time highs and tax driven corporate spending still working.  The impact from the weakening economy in China is difficult to assess.  China is still growing at better than 6% but China is not happy with this and has announced plans to stimulate and seems motivated to settle the trade dispute with Trump as China is losing the trade war.  China exports about 550 billion of goods and services to America each year while America exports about 175 billion of goods and services to China.  Not hard to see who’s losing in that scenario.


How strong is the American economy and is this strength sustainable? There are lots of indicators to look at to measure the strength of an economy.  Unemployment is always a go to indicator.  Unemployment in America is close to all-time lows.  Seemingly anyone who wants to work can get a job.  Wages have been tilting upward for a few years now but still well under control.  This seems to be what chairman Powell talks a lot about when he worries about inflation and economic conditions overheating.  What seems missing in this economy that’s typical of a strong economy is a great underlying consumption theme.  What consumption theme is driving our economy? Every good cycle in the past has had a great theme.  Quite frankly there is nothing that stands tall and strong.   Housing has never become a great theme in this cycle and is on a plateau now.  It may have a second run but there is no indication of that on the horizon.  Autos have been quite strong and this has been a modest theme.  Clearly the demand for digital devices is a theme but is not a big consumption engine in a $17 trillion economy.  Healthcare spending is another modest theme.   Without the tax cuts I suspect our economy would have never accelerated in 2018.  It is unclear whether the above  trend pace is sustainable and it seems more likely the economy will fall back to modest growth of 2½% GDP.  This actually is Nirvana for equity markets and in particular growth stocks that have secular themes or innovative themes driving the growth.


We remain optimistic.