Market Outlook

4th Quarter 2018 Market Commentary

Monday, January 07, 2019

PREPARING FOR A ROCKY MARKET TERRAIN IN THE FIRST PART OF 2019

I believe that the market has entered into a rotational bear market, but it is cyclical in nature. That means I expect a 20-25% decline from its high and the S&P 500 has already dropped about 14% since its high (level of S&P 500 at 2507 at the time of this writing). Based on our analysis, the length of this cyclical bear market could be shorter than the average 12-18 months, but the magnitude may be worse than the 14% decline of the previous one in 2015-16. This time I believe it will qualify as a bear market rather than a cycle because it could exceed a 20% decline. However, the second half of 2019 looks promising.

There are four main reasons prompting the current market selloffs and my outlook for the next year.

#1 International Tensions and #2 Declining Global Growth

Britain is in a state of turmoil as they prepare for the Brexit. Italy is playing with the idea of leaving the European Union (EU) as well, sparking talks of "Italeave" while working to revise their budget to avoid EU sanctions against them. France is not immune to some conflict with anti-government protests going on, budget revisions, and tax struggles. These are some of the issues prompting the global selloff. I think some of these European political issues could resolve in a positive manner as we enter 2019. I expect the U.S. real GDP growth to be at 2.6% and globally to be at 3.5% in 2019, down from the OECD 's 2018 forecast of 2.9% for the U.S and 3.7% for the world.1

#3 Fed Tightening Policy

You may hear some economists focusing on The Federal Reserve 's (Fed) tightening policy as a market risk. We just had the ninth rate hike in this tightening cycle in December and next year there might be two more. I think the risk associated with interest rate increases in 2019 may be overblown because the Fed is going to be data dependent. They are not just going to keep blindly increasing rates.

#4 Tariff War Between U.S. and China

The fourth and most important risk factor is the brewing tariff war between the U.S. and China. Unlike some economists, I believe China 's slowing economy may give them an impetus to come to a trade deal. Both the U.S. and China have huge motivation to come to a successful trade deal. President Trump and General Secretary Xi could not only resolve the tariff turmoil, but also save face and claim a victory with their respective citizens. I feel they will come to a solid agreement before the end of 2019 resulting in a relief rally.

We may get a Santa Claus rally in the next couple of weeks but it is not likely to sustain. Therefore, over the short term, we will view any rallies as selling opportunities. While we may experience a market low in the first half of 2019, I haven&rsquot seen any indications of a recession. The second half of 2019 could be very rewarding to investors in equities, particularly emerging market equities. As a result of the technical damage and negative price action, we currently sit at the highest U.S. equity risk premium and the lowest forward P/E multiple since 2013 making valuations more attractive. But the weak technicals could cause this correction to continue. Fundamentally speaking, the market could be ready to turn around, but technically the markets have had too much damage. The market typically needs to go through a bottoming process to repair that damage and then it can start to rally. The U.S./China trade war should resolve favorably in the first half of 2019. I also believe that the supply cuts should create a floor for oil prices that should help alleviate the credit stresses. Furthermore, I expect the S&P 500 earnings to be around $170 for 2019 with a price to earnings ratio around 17 1/2, which is close to the long-term average. As a result, the S&P 500 index could surpass the 3,000 level for 2019 with a solid double-digit return from the current prices after we get through the market decline in the first part of the year.

I think the sectors to focus on in the first half of 2019 are going to be markedly different from the second half because of the varying market patterns. In the first half I think consumer staples, utilities and energy could do well and then technology, health care, consumer discretionary, and utilities in the second half.

One of the reasons I'm not as bullish as I was a year ago is because of the changes in Congress. It is not a sure shot that the tax cut will be permanent, we may not even get infrastructure spending, and there is chaos surrounding immigration and health care reform. I don 't think the deregulations will be reversed which could help keep equities in a range bound environment. That being said, once these four hurdles begin to clear up, particularly the trade between China and the U.S., we could see equities break through that range and go to new highs in the second half of 2019.

Source: 1https://data.oecd.org/chart/5qBn

Shashi Mehrotra, Chartered Financial Analyst, is the Chief Operating Officer and Chief Investment Officer of Legend Advisory. The opinions and predictions expressed herein are those of Shashi Mehrotra solely and not necessarily the opinions or expectations of Legend Advisory or any of its affiliates. Such opinions and predictions are as of December 20, 2018, and are subject to change at any time based on market and other conditions. This material includes forward-looking statements that are subject to certain risks and uncertainties. Actual results, performance or achievements may differ materially from those expressed or implied. No predictions or forecasts can be guaranteed.

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