The Hudson River Group at Morgan Stanley

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1 The Hudson River Group at Morgan Stanley 80 State Street, 12 th Fl Albany, NY / The opposite of love is not hate, it s indifference -Elie Wiesel December 2018 will go down in the history books as one of the worst months in stock market history. While the excuses for the drop have been well publicized by the many talking heads, the bottom line in our opinion is that the cacophony of negative news created a crisis of confidence culminating in a vacuum of selling in a world of low liquidity where buyers were non-existent. The selling was indiscriminate. We are not going to sugar coat this decline: it was fast, brutal, fearful and damaging to portfolios. Asking questions of why the declined happened is of much less importance than the real question that should be asked: What should we do now? The exact answer is different for each client as your personalized portfolios have been constructed and managed based on your specific goals and risk tolerances. The comments below will be broad based in nature and may not be the exact recommendations we make in our respective conversations; however they will give you an insight into our current thinking. Though valuation is tossed out during apathetic short term selling; it is the most important variable of long term investing. As we often say; markets/stocks follow the path of earnings plus or minus what the street it willing to pay for them. The chart below highlights this with S&P 500 in blue and expected S&P earnings in orange. It is hard to refute the strong correlation over the past three decades. Note the big selloff in blue at the end of the chart while orange line is hanging in there (for now). Source: Bloomberg Entering the year everyone knew earnings would jump higher versus 2017 due to tax cuts. It was our opinion one year ago that 2019 earnings were far more important. We wrote the following: Page 1 of 5

2 Though everyone is focusing on 2018 numbers, we are fixated with the current consensus EPS for 2019 which would represent almost 10% growth vs We already stated that we are not one to guess what will happen in twelve months so why are we even talking about twenty-four? Simple it just doesn t pass the smell test We see this as a lower probability event and if accurate we would not be surprised if the discount mechanism that is the markets sniff this out in the middle of The possibility for negative growth could finally cause a bit of volatility to enter the marketplace. 1 While we were spot on in our guess that earnings appeared too high for 2019, a double digit drop in the broader market with many massive intraday swings certainly does not fit our definition of a bit of volatility. Fundamentally 2018 S&P 500 earnings should come in around $ putting the multiple ~15x a level that is not cheap but far from expensive. Put another way; the reciprocal of price/earnings (called the earnings yield) is now ~6.5%, the highest level since 2013 while the 10 year US Treasury closed the year below 2.7%. At these valuations if forward earnings can grow just low single digits we see value at current levels. If earnings were to actually slip year over year, we can argue the path of the market is likely lower. A 20% decline; the definition of a bear market; typically occurs in a recession and more specifically the fourth quarter of 2018 will go down as the fourth non-recession bear market since 1940 along with the flash crash in Q (Cuban Missile Crisis), the flash crash in Q and the European Crisis of 2011 that started in Q2 and ended the first few trading days of Q3. The past is always easier to discuss than the present since we know already what happened in the past but have no idea what s in store in the future. Along with the sell-offs mentioned, five other quarters since 1940 had at least a 17% drop in the S&P 500. The average forward performance post the end of that specific quarter in one year was +23%; three years +50% and five years 98% 3. Though the sample size is not large enough to pound the table statistically it does help fortify Baron Rothschild s famous quote the time to buy is when there s blood in the streets. As would be expected during any large sell-off sentiment plummets. After the worst Christmas Eve action in the history of the markets, the CNBC Fear Greed Index, an indicator that factors in seven variables, came in at 2 on a scale signaling extreme fear 4. The AAII US Investor Sentiment Bearish reading recently came in at 50.3% a level not seen in five years and one that has not held for any length of time since the Great Recession 5. For the week ending December 19th, investors pulled $56b out of mutual funds the biggest outflow since October15, All this fear caused the percentage of stocks in the S&P 500 that traded above their respective 200 day moving average to drop below 20% for the first time in a year. Since 1990 this is was the seventh such occurrence. The average return for the S&P 500 six months after was 12.9% with 5 up years and 1 down 7. Our crystal ball is as foggy as everyone else s however the data does give further credence to Rothschild s quote. Page 2 of 5

3 One reason why 2018 was such a brutal year was the fact that diversification was essentially useless as cash was the best performing asset class. Bonds historically have provided support for portfolio s with decent gains; however that was not the case. Owning assets outside of the US severely detracted from performance yet again which has been the case more often than not since the Great Recession. Hard assets like gold; again usually a safe haven during panic was negative for the year; though strong in Q4 8. After a year like the one we just had the first rule of thumb is to review your financial plan. Have any of your goals changed? Should your risk tolerance; which we are sure was been tested, be reduced? If you cannot sleep at night due to the wild swings and drop in your account balance a conversation about what you can and cannot afford; not just monetarily but psychologically needs to be discussed. Though we believe valuations are supportive for equities not just in the US but also abroad; assets can always move lower. In 2019 it not hard to envision a handful of events that could normalize sentiment and cause prior sellers of risk assets to turn into buyers: A Federal Reserve that becomes more dovish in their communications and eventually lowers their forecast for rate hikes from two to zero; A smoothing of our relationship with China on tariff; Corporate earnings that surpass current expectations. It is easy to list all the known risks out there that aside from the Fed or tariffs: Mueller s report, higher probability of a recession, the current global political climate, rise of populism, European/Italy woes etc. etc. etc. Future returns are always predicated on the price/value you originally paid for the assets and since it is impossible to price the unknown risk, post the multiple compressions that has taken place we are recommending that clients who have a multi-decade investment horizon add to risk. For those who are retired or nearing retirement the situation is very different and ensuring your asset allocation is in line with your goals and risk tolerance is paramount. In our collective years of experience during both bull and bear markets we are very strong believers that asset allocation is the key to financial success. Shifting from risk on to risk off is nothing more than market timing; an investment strategy that puts luck as a key variable and has proven to be extremely difficult. Sitting in cash for an extended period of time while earning a negative rate of return post taxes and inflation is also not an investment strategy we have or will often recommend. We have and will always prefer gradual shifts in allocation based on your personal variables (wealth, age, goals, risk tolerance etc.) and our opinion of future returns. We will discuss this topic in more depth in our one to one meetings. On a personal note after decades in the investment advisory business Shirley Bayly has decided spending time with her husband Ben, two children and five grandchildren would be more enjoyable than spending time with us. Hard for us to disagree!! Her last day was on December 31 st and she will be sorely missed. Page 3 of 5

4 We are excited to welcome Krista Harwell as the newest member of the team. With an enthusiastic personality, a strong desire to learn and a background in banking we believe she will fit in perfectly. Happy and a healthy New Year! The Hudson River Group at Morgan Stanley Bert Trombly NMLS # John Malicki NMLS# Timothy Meigher NMLS# Brian Schlaks, CMT First Vice President NMLS# January 2018 Letter. The Hudson River Group at Morgan Stanley. CRC# Bloomberg. Strategist S&P500 Index Estimates for Year-End Awealthofcommensesense.com. Buying When Stocks are Down Big December 23, December 24, Bloomberg Terminal 6 Bloomberg: Mutual Fund Outflow Surges to %56b in Biggest Exit Since December 26, Nautilus Capital Research. Crow s Nest: Recent Extremes. December 28, Morgan Stanley: 2018 Year End Asset Return Analysis / Bloomberg Terminal Page 4 of 5

5 This material is intended only for clients and prospective clients of the Portfolio Management program. It has been prepared solely for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument, or to participate in any trading strategy. The individuals mentioned as the Portfolio Management Team are s with Morgan Stanley participating in the Morgan Stanley Portfolio Management program. The Portfolio Management program is an investment advisory program in which the client s invests the client s assets on a discretionary basis in a range of securities. The Portfolio Management program is described in the applicable Morgan Stanley ADV Part 2, available at or from your. Past performance of any security is not a guarantee of future performance. There is no guarantee that this investment strategy will work under all market conditions. The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Wealth Management or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results. The investments listed may not be suitable for all investors. Morgan Stanley Smith Barney LLC recommends that investors independently evaluate particular investments, and encourages investors to seek the advice of a financial advisor. The appropriateness of a particular investment will depend upon an investor's individual circumstances and objectives. S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market. An investment cannot be made directly in a market index. Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate. Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention. Diversification does not guarantee a profit or protect against a loss. Morgan Stanley Smith Barney LLC and its affiliates do not provide tax or legal advice. Any such taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor. Morgan Stanley Smith Barney LLC. Member SIPC CRC January 2, 2019 Page 5 of 5