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After rising for nine years in a so-so economy in the belief that prosperity was just around the corner, stocks swooned, even as growth picked up.
That left many investors wondering whether the economy is turning another corner into a place where danger, maybe even a recession and a prolonged bear market, lurk.
The S&P 500 dropped 13.5 percent during the fourth quarter, including dividends, giving the index a 4.4 percent loss for the year by that measure. It was the worst performance since 2008, despite strong corporate earnings and the best readings in several decades in unemployment and consumer confidence.
As 2019 unfolds and the economic picture becomes clearer, it is possible that stocks will have a sustained, orderly recovery, investment advisers say. But achieving that clarity will take time, so they encourage investors to demand a lot of evidence that a recession will be avoided before they commit money to stocks or other risky assets.
“A lot of the derating that happened in the second half of 2018 started off being driven by political risk, but in the last few weeks, it has been driven by concerns about growth and stability,” said Kate Moore, chief equity strategist at BlackRock, referring to the decline in stocks. “I think that’s going to go on in the first few weeks of 2019. Everyone’s focused on economic data.”
Ms. Moore highlighted surveys showing weaker-than-expected business conditions and added: “It’s going to take time for that to work itself through the market. I would expect more volatility as we take in new data points.”
Just how weak those data points are likely to be is hard to predict.
“The underlying fundamentals of the economy certainly have deteriorated,” said Edward Yardeni, president of Yardeni Research. He noted that the five monthly regional business surveys conducted by Federal Reserve districts “were all extremely weak in December.”
But the latest employment report was not. It showed 312,000 net jobs created last month.
“We have a very mixed economic picture right now,” Mr. Yardeni said. “It all adds up to an economy that’s slowing but probably still growing.” If that’s true, then 2019 may not be so bad for the market.
“Stocks are very cheap, with one important qualification,” he said: “You have to believe the economy is not going to wind up in recession.”
He then offered another qualification, about forthcoming corporate earnings reports: “We still have to curb our enthusiasm because we can’t get too excited about the earnings outlook.”
The tax cuts that took effect in 2018 sent earnings up so much for the year — the latest estimate for the S&P 500 was 20.2 percent, according to FactSet Research — that a 5 percent rise in earnings in 2019, aided by corporate buybacks, is about as much as Wall Street can expect, Mr. Yardeni said. FactSet’s latest forecast is for a 7.3 percent increase.
Despite some good days for the market in January that may have been prompted by signs of flexibility from the Federal Reserve, the way stocks tumbled late in the year hardly inspires confidence. With anything like a repeat performance, investors will have to hope that other assets provide better protection than in 2018, when there were few places to hide.
“Cash was the only major asset class that posted positive returns in ’18,” according to a Bank of America report. Even the reed-thin 1.9 percent return on cash in money market funds was less than the 2.2 percent consumer inflation rate, the report said, but at least it was a positive number. Long-term government bonds, corporate bonds and gold all lost ground, although they beat the return of the S&P 500. Oil and foreign stocks were among the investments that did worse.
The average domestic stock fund lost 14.2 percent in the fourth quarter, with specialists in natural resources, technology and financial services leading the way down. These funds dropped 6.8 percent during the year, according to Morningstar. International stock funds outperformed during the quarter, losing 10.9 percent, but trailed badly for the full year, down 13.2 percent.
Bond funds lost 0.9 percent in the quarter and 1 percent for all of 2018. High-yield portfolios were particularly weak, off 4.6 percent for the quarter and 2.8 percent for the year.
Such across-the-board weakness is rare “because what tends to be bad for one asset tends to be good for some other asset somewhere,” said Ben Inker, head of asset allocation for the investment firm GMO. “The basic exception is when there is a combination of rising rates and slowing growth. Risky assets don’t like slowing growth, and fixed income doesn’t like rising rates.”
Mr. Inker, like many, is worried that the Fed could push a fragile economy into recession. That would be “fairly ugly for valuations” of American stocks, he said, and he would avoid them even if he were confident that a recession could be skirted. He prefers stocks and bonds in emerging markets, which are much cheaper than their counterparts in mature economies.
“We’re reasonably bullish on our ability to make money in 2019, just not in the assets most people have most of their money in,” he said.
One reason for the poor returns on stocks, especially in December, is that the Fed initially had not seemed to share the fear felt on Wall Street. When the Fed raised its target for short-term interest rates last month, the move was almost universally anticipated, but the statement about economic conditions and monetary policy made after the increase “was not as dovish as the market was hoping for,” said Steve Kane, a bond fund manager at TCW.
Recent data “signals an economic slowdown,” and not just in the United States, Mr. Kane said. Surveys “confirm a significant drop in manufacturing activity. There are also signals that growth in China is slowing dramatically and significantly,” he said.
The flattening yield curve, with short-term interest rates approaching long-term rates, is consistent with an economy that is running out of steam, and a source of concern in itself. But recent remarks by Jerome H. Powell, the Federal Reserve chairman, that the central bank will have “patience” in deciding whether to raise rates, appeared to cheer the markets.
If rates are priced for a slowdown, some corporate bonds are not, Mr. Kane said. At least not yet. Spreads in yields between corporate and government debt have widened, taking bond prices down. Medium-term investment-grade corporate issues yielded 1.76 percentage points more than equivalent Treasury paper, as of Tuesday, according to the Federal Reserve Bank of St. Louis, and an index of high-yield debt yielded 4.65 points more. A two-point cushion is roughly where investment-grade spreads tend to peak during a slowdown, but high-yield spreads typically soar to 10 points.
“One should look at the fixed-income market as being more attractive to invest in 2019 than 2018, but one must still invest with some degree of caution, especially in the high-yield market,” he said. “There will be better opportunities later in the year” in high yield, while “there is not too much downside to investment-grade credit at this point.” He called it “a fairly good asset class if we’re in the midst of a bear market in equities.”
Stocks that Ms. Moore at BlackRock thinks would do comparatively well against such a backdrop are of companies that are financially strong and able to grow, even when economic growth is modest at best. Health care is her top sector because it has those defensive qualities, as well as pockets of innovation, such as in medical technology, that support high profit margins.
She said she is “not throwing in the towel on tech” in general, despite plunging share prices in big names like Apple and Facebook, and she said she particularly likes Asian tech companies. Ms. Moore also is “modestly encouraged” about emerging markets in Latin America and Asia, most notably Brazil and India.
Brian Singer, head of dynamic allocation strategies at William Blair & Company, has been investing “with a greater emphasis on risk management,” he said. He finds American stocks “fundamentally less attractive” than others, such as emerging markets, including the two that Ms. Moore mentioned.
Among mature economies, Mr. Singer likes Britain, although he would rather wait until the question of its departure from the European Union, Brexit, is settled before stepping in, and Spain. Markets he is shunning, aside from the United States, are Japan, Canada, Mexico and South Africa. As for bonds, he is avoiding the high-yield market, and he talked up the virtues of another asset class that is often overlooked.
“In this environment, cash will be a relatively good alternative,” he said. “It won’t be a great return generator, but being cautious and holding cash is not a bad idea. It really is a time to remain defensive and have dry powder on hand.”
With so much up in the air, Mr. Yardeni recommends not getting carried away. Investors should be selective about stocks and avoid index-tracking exchange-traded funds.
“This is probably a year for stock pickers,” he said. “It’s not a year for E.T.F.s.”
He would emphasize domestic stocks and limit exposure to emerging markets, which may suffer from soft commodity prices, and to Europe, which is dealing with thorny issues like Brexit and Italy’s recalcitrance in reining in government spending. The aging population bodes ill for long-term growth in Europe, too, Mr. Yardeni said, something that also applies in China.
He favors industries like technology, communications and media, which he expects to benefit over the long haul from the impending introduction of 5G, the fifth generation of mobile communications technology. Big banks and health care companies should do well, too, he said.
With investors focused on what’s going wrong, Mr. Kane recommends that they also keep in mind what’s going right, in particular the strong job market, although he noted that employment is often the last indicator to deteriorate as the economic cycle turns.
“If that part of the economy holds up, then this may not be a recession,” he said. “You could get a very nice return for stocks if that turns out to be the environment.” But he acknowledged that it’s a big if.
A crucial question for him is whether the decline will be fairly mild by the time it’s over, or something more severe, as in the 2008 financial crisis. For all the talk of recession, the losses so far have appeared calm and orderly, suggesting to him that too few investors have been asking the same question.
“Whether it’s a garden-variety or end-of-days bear market,” he said, “there’s going to be panic, and we haven’t gotten quite there yet.”
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