A Good Start to 2019 for Value Investors

Value investors had a hard time in 2018 watching their holdings fall much more than the overall US market:  Value and small value have strongly outperformed the overall US market and the momentum factor ETF thus far in 2019.

2019 ytd (Momentum in black,value in gold, small value in blue, total US market in green) Performance top volatility bottom in bar chart.

 This is in sharp contrast to 2018 where value stocks had larger losses than the total market or momenetum.

Update on High Yield Bonds

Along with the stock market the high yield bond market has had a strong rally since the turn of the year. The secondary market and ETFs had strong performance as did the market for new issues

as the wsj reported:

A long freeze in the junk bond market thawed Thursday as midstream energy company Targa Resources Partners LP became the first business to sell below-investment-grade bonds since November.

Targa, which has credit ratings at the upper end of the speculative-grade spectrum, sold $1.5 billion of eight and 10-year bonds, twice the amount initially expected. In another sign of a strengthening corporate debt market, investment-grade Anheuser-Busch InBev SAalso sold $15.5 billion of bonds Thursday, the largest since October, as the beer giant moved to repay existing debt.

The high yield spread over Treasuries has dropped sharply from 5.35 on Jan 2 to 4.83 jan 8

And after experiencing a terrible 2018, underperforming the aggregate bond market (AGG) in 2018...

High Yiekd ETFa 2018 JNK

2018 returns
JNK (intermediate term high yield) -3.3%
SJNK (short term high yield in blue) -.3%
HYLD(short term high yield  in gold)+.2%
AGG (aggregate bond market in blue)+ .1%

...2019 has started out strongly for high yield bond ETFs

HIgh Yield Bonds YTD as of Jan 8
JNK +3.5%
SJNK+2.3%
HYLD+2.0%
AGG 0

Opportunity in Asian Emerging Markets ?

WSJ notes

Better Value Than U.S. Stocks: Asian Shares Hit Fire-Sale Valuations

Regional stock valuations are at their lowest levels in years

Compared with forecast earnings, regional share valuations are at their lowest levels in about five years, according to a FactSet index covering thousands of Asia-Pacific stocks. They trade at about 12 times expected earnings for the next 12 months, while FactSet shows U.S. stocks trade at about 15.5 times, roughly in line with their 10-year average.

Set against free cash flow, the stocks look even better value. On that basis, Asian equities are at their cheapest levels in more than a decade, below even lows hit at the depths of the financial crisis.

Despite a dismal 2018 (GMF emerging markets ETF -14.2 vs-4.6 for SP 500  ) emerging market Asian stocks outperformed the US in the fourth quarter (-6.4% vs -13.8% for  sp 500) and are up 2.0% ytd (3% sp 500).

GMF is very sensitive to short term news reports related to China's domestic economy and US Chinese trade relations. For long term investors these can be considered "noise" and declines in response to news may turn out to be excellent entry points for long term investors.

2018 Market Review

US stock markets ended the year with sharp declines and extreme intra and inter day volatility during the fourth quarter.  The US market ended the year with its worst performance since 2008. Perspective is in order, however, the decline in 2008 was 36%   for the total US stock market (total return) vs -5.2% for 2018.  Although the US underperformed  non US markets in the fourth quarter it far outperformed those markets for the entire year.

Below is total return for total US stock market ETF (VTI green) and world ex North America (VEA blue) for 2018:

The list of reasons for the decline includes the following:

• Fears of a “trade war” between the US and China with negative impact for US exporters and the overall US economy and for that of China the worlds second largest economy.  Economic data from China already show a significant slowing of economic activity.
• Slow growth from Europe due to the continued complications of Brexit and tensions related to Italy as well as fallout from protectionist US trade policy.
• Governance issues related to US domestic politics currently evidenced by the US government slowdown.
• Fears that the US is headed towards slower growth, if not a recession. while the Federal Reserve remains committed to continuing a tightening policy for the near term future.
• Regulatory and other issues related to the future earnings prospects of the stocks that dominated during the market rally (the “faang stocks of Facebook, Amazon, Apple, Netflix and Google)

US Stock Market

The US market fell 14.2% in the fourth quarter closing the year down (total return for the total US stock market index), Market movements were extremely volatile no doubt related to the large portion of each day’s trading which is based on computer generated trades such as algorithmic trades or index instruments of varying types. The technology leaders took the hardest fall in the fourth quarter but their strong performance during the earlier part of the year meant that the tech heavy Nasdaq index lost only .1% for 2018 and XLK the technology ETF was +.1%,

Similarly, despite the sharp retreat of momentum stocks in the fourth quarter they still outperformed value stocks for the year (see table below) among smart beta factor ETFS. The minimum volatility ETF showed itself to live up to expectations and outperformed other factors in the volatile down market.

US Stocks

	Total Return (%)
		4q	2018	3 yr
Vti	total us	-14.2	-5.2	27.4
Mtum	momentum	-15.4	-1.7	39.6
Usmv	minimum volatility	-7.6	1.4	31.3
Vlue	value	-16.8	-11.1	23.2
Qual	quality	-14.6	-5.7	23.8
Vbr	small value	-17.5	-12.3	20.6

Non US Stock Market

Emerging and Developed international markets had dismal performance throughout 2018 although they managed to outperform the US in the fourth quarter.

In the case of emerging markets there is evidence of an economic slowdown most notably in China due to the difficulties connected with implementing China’s domestic growth strategy, overextension of credit and difficulties related to trade tensions with the US Other emerging markets were affected by the trade tensions as well.

Europe continued to be plagued by slow growth and was also affected by trade tensions with the US. Germany (etf ewg ) was the worst performing market in Europe reflecting both the weakness in the local market and the weakness of the Euro. The lack of resolution of how Brexit will proceed weighed on the British pound and the UK stock market and its impact was felt in other European markets as well.

US Bond Market

The US market went through extreme volatility with the Federal Reserve continuing a policy of raising interest rates yet the bond market showing pessimism towards prospects for future economic growth. The Federal Reserve raised rates in December, the fourth increase for 2018 and indicated intention to continue rate hikes in 2019, The Fed policy is based on a positive outlook for the US economy and a desire to proactively move against any incipient inflation.

For bond market participants the “message of the market” is far more pessimistic with regards to the US economy. After starting the year with a 10 year bond yield of 2.48% taking the interest rate on the ten year treasury bond over 3.2% in October and November reflecting positive expectations for the US economy and therefore higher rates. The market reversed its outlook towards the end of the year. The ten year treasury bond ended the year at 2.69% , an extremely low rate in an environment of the Fed raising rates. .

 Other indicators of the message of the bond market which show an outlook for slower US growth, low inflation, and low interest rates can be seen in the market for inflation protected treasury bonds ,the narrow spread between short term and long term interest rates, and futures contracts on the federal funds (overnight) interest rate. The fall in longer term yields (increase in prices) meant a recovery in the aggregate US bond index (AGG) which ended the year +.1% and the long term Treasury ETF (TLT) +.5%.

Another reflection of a pessimistic view for the US economy was the widening of spreads between high yield bonds and investment grade bonds during the fourth quarter with high yield bond prices declining along with the US stock market. The most widely traded high yield ETF HYG fell  4.4 % in the fourth quarter

Looking Forward

Looking at the list of factors that generated the market decline at the end of 2018 they all continue to hang over the market. Resolution of trade issues with China would give some support to the stock markets in both the US and abroad. The negative profit outlook now built into the US market may be overdone which would mean the now lower valuations for US stocks may leave room for price increases from current depressed levels. The current P/E for the S+P 500 is a bit under 19 vs. close to 25 at the beginning of 2018 Sentiment seems almost uniformly pessimistic: usually a buying opportunity for disciplined long term investors. Non US markets are very low valuation levels from a valuation perspective emerging markets are likely the most attractive current p/e is 10.5 vs 13.2 in January of 2018.

Federal Reserve policy will be a focus of the stock market participants. Currently the stock market sees Fed policy as a negative with the central bank in a tightening mode based on their optimistic view of the economy. The long period of near zero interest rates was a major factor giving a boost to the US stock market the end of that policy as well as the unwinding of the bond purchases in quantitative easing presents a negative towards the US market.

The Federal Reserve indicates that its policy is “data dependent” so that any indications of an economic slowdown will likely mean an end to the tightening policy and perhaps even interest rate cuts later in 2019. Should the Fed’s optimism on the economy prove correct rate hikes are likely to continue but it would mean that the stock markets view for the economy was overly pessimistic.

One thing that seems near certain is that volatility will be high in both the stock and bond markets as can be expected at market inflection points.  Structural changes in the marketplace with activity dominated by algorithmic traders and index instruments exacerbate volatility. But the bottom line for investors is that market timing is impossible and the best strategy for long term equity investors is to stick with their long term plans, acknowledge that part of the price for higher long term returns for stocks vs.bonds and cash is higher volatility and periods with short term losses.

	Total Return (%) US Stocks
		4q	2018	3 yr
vti	total us	-14.2	-5.2	27.4
mtum	Momentum	-15.4	-1.7	39.6
usmv	minimum volatility	-7.6	1.4	31.3
vlue	Value	-16.8	-11.1	23.2
qual	Quality	-14.6	-5.7	23.8
vbr	small value	-17.5	-12.3	20.6
Non US  Stocks veu	world ex us	-11.5	-14.2	12.6
gmf	emerging asia	-7.8	-14.2	25.8
fez	euro zone	-12.7	-15.8	3.1
ewg	Germany	-14.8	-21.4	0.5
US Bonds vgsh	short term us govt	1.4	1.6	2.8
vcsh	short term inv grade	0.7	0.9	6
bsv	short term blend	1.4	1.3	4
flot	floating rate	-0.4	1.5	4.8
tlt	long term us treas	4.6	-1.5	9.1
agg	aggregate us bond	1.9	0.1	6.4
hyld	short term high yield	-6.4	0.2	29.9
sjnk	short term high yield	-3.9	-0.3	19.9
hyg	high yield	-4.4	-2	18