As much as investors had hoped stocks in the U.S. could continue to buck the global trend, the fourth quarter proved otherwise. Major U.S. indexes finally joined the global equity decline as growing concerns about the future state of the economy overtook good feelings about the seemingly robust present state. The fourth quarter selloff took few prisoners and, after reversing good third quarter returns, left all the major averages underwater for the year. International markets fared no better. Please see the article on page 3 for more about what has investors worried. It is useful at times like this to take a step back and reconsider the basic proposition offered by investing in stocks. Over time, equity investing offers returns far superior to that of bonds or cash. The tradeoff is a certain amount of volatility. Stocks can get you where you want to go, but there will be some bumps along the way. Investing in bonds or cash offers a much smoother

ride but probably won’t get you where you need to go. Having a portfolio balanced among stocks, bonds, and cash has proved to be an effective way to get much of the longer-term benefit of equity investing while levelling out some of the shorter-term volatility. Looking at decades of stock market data, we know that the market spends more time going up than going down. Demand for stocks outstrips selling pressure roughly two-thirds of the time, giving us a generally rising market. The pain investors experience comes about because the downtrends tend to be more abrupt. That is the basis for the old saying that the market goes up on an escalator and down on an elevator. Since it is difficult to predict the short-term direction of the stock market but relatively easy to identify established longer-term trends, it is important to give a primary uptrend the benefit of the doubt and not be sitting on the sidelines when stocks start rallying after a correction. That is where we see ourselves now. We also know that the stock market will usually undergo a significant correction at least once every year or so. The smooth market ascent throughout 2017 was an anomaly. 2018 was actually more normal in terms of volatility. A few corrections will become bear markets, but most will not. In spite of these inevitable corrections the chance of seeing a positive return on an investment in the S&P 500 Index is close to 75% in any single year. Those odds increase to almost 95% for any consecutive 10-year holding period and are certain at 100% for any 20-year period. In the coming weeks and months we will monitor market rallies for signs that a sustainable bottom is in place, and for indications of which industry groups and individual stocks will be the next market leaders. Hopefully, current levels are close to low enough to attract the heavy institutional buying needed to kick off the next durable uptrend.

www.dh .com JANUARY 2019

Broad stock market selloff in Q4. 

Stocks beat bonds and cash over  me. 

Market declines are usually abrupt. 

Watch for market bo om and new stock leadership. 

 

Also in This Issue  

Pages 2: High Frequency Trading & Market Vola lity. Page 3: Tradi onal IRA Distribu ons.

Pages 3 & 4: Trying to Interpret Market Signals. Page 3: What is an Inverted Yield Curve?

Market Measures 4th QTR

2018

S & P 500 (price) ‐14.0%

Dow Jones Industrial Average ‐11.8%

NASDAQ Composite ‐17.5%

Russell 2000 ‐20.5%

MSCI EAFE ‐12.9%

Barclays Capital Inter Gov’t/Credit Bond Index

  12/31/18 12/29/17

10‐Year US Treasury Bond Yield 2.69% 2.41%

Three‐month US Treasury Bill Yield 2.37% 1.39%

1.7%

YTD 2018

-6.2%

-5.6%

-3.9%

-12.2%

-16.1%

0.9%

I  O   

Fourth Quarter 2018 Review & Outlook for 2019 by Whitney Brown

Page 2

The return of price volatility that has been largely suppressed during this record bull market has increased the clamoring for more oversight of firms employing high frequency trading (HFT) strategies. Just recently, Treasury Secretary Steve Mnuchin attempted to

place the blame for the rise in volatility at the feet of the many hedge-funds and other institutional firms which use HFT strategies. HFT strategies currently account for about 70% of trading volume on U.S. equity markets; however a substantial portion of this can be attributed to HFT firms in the business of “market-making.” These firms provide the market with liquidity, standing ready to buy or sell the securities of those wishing to transact. Firms of this nature are not part of the subset of high frequency traders being blamed by some for the recent rise in volatility. The HFT firms drawing the ire of some market participants use complex algorithms to detect when institutional firms are placing large orders and attempt to jump in front of them, thereby making a profit when the stock’s price increases (or decreases, if selling) due to the institutional buying. Other HFT strategies use algorithms with inputs such as momentum, interest rates, and mean reversion in order to predict the direction of a stock. These HFT firms have very short holding

periods, rarely carry positions overnight, and rely on volatility which causes large price swings that enable firms to leverage the small gains made in millions of transactions into large profits. Particularly in the case of algorithms using momentum as a main input, volatility can be exacerbated as many institutional investors pile into a rapidly advancing stock. However this volatility would be very short-lived, as HFT firms generally hold securities for only a matter of seconds. Are these strategies the cause of this increased volatility in the second half of 2018? The answer appears to be no. During the majority of this lengthy bull market, the lack of volatility severely inhibited HFT firms from generating profits. See the chart below. In fact, the past several years have seen large HFT firms consolidating in record numbers as they attempt to stay afloat. Studies performed show that the relatively small amount of volatility generally present during steadily advancing bull markets is closely correlated with the level of HFT. However, what about during periods of heightened market uncertainty such as we are experiencing today? Research shows that there is little to no correlation between HFT and volatility during these periods. Although HFT firms are generally more profitable during volatile periods, they are not the cause of the volatility. The likely culprit would appear to be a climate of rising interest rates, political turmoil, trade disputes with China and monetary tightening.

HFT firms are certainly deserving of oversight since there have been several past cases where an algorithm did not work as designed, causing erroneous trades. Mistakes like this cost the investor and therefore deserve close examining, however it does not appear HFT strategies pose any fundamental threat to securities markets.

High Frequency Trading and Market Volatility by John Hubard

High-Frequency Trading; revenue from US equities ($, billions)

2009 2010 2011 2012 2013 2014 2015 2016 2017

8 7 6 5 4 3 2 1 0

Courtesy IG.com

Page 3

Traditional IRA Distributions by Stebbins Hubard

Individual Retirement Accounts (IRAs) are intended for retirement savings. IRA investments are tax deferred until withdrawn when the distributions are taxed as earned income. If you take the money out

early, you miss out on the tax deferral and reduce what you have available at retirement; you may also incur penalties. Distributions from traditional IRAs prior to age 59½ are subject to a 10% penalty in addition to applicable federal and state taxes. Under certain circumstances, you can avoid the penalty on early withdrawals. Common exceptions include: first-time home purchase, qualified education expenses, death or disability, unreimbursed medical expenses, and health insurance (if you're unemployed). Starting at age 59½, you can begin taking

money out of your retirement accounts without penalty. Federal and state income taxes apply. Starting at age 70½, owners of traditional IRAs must begin making withdrawals, also known as required minimum distributions (RMDs), from their accounts. These withdrawals are mandatory and violations incur penalties equal to 50% of the amount that should have been withdrawn. RMD rules dictate how much, at a minimum, you are required to withdraw from your IRA. To calculate your RMD, you divide the previous year’s 12/31 value of your IRA by the distribution period factor from the chart below (Uniform Life). For example you turned 75 in 2018 and your IRA was worth $1 million on 12/31/17, your RMD for 2018 would be $43,668.12 ($1,000,000/22.9). See the table below. This is your minimum taxable distribution. You can always withdraw more.

Married IRA owners can use a different table (Joint & Survivor) which gives a higher distribution factor based on both life expectancies if the spouse is at least 10 years younger and the sole beneficiary. Also, IRA owners age 70½ or older can make qualified charitable distributions up to $100,000 per year from an IRA. Qualified charitable distributions are not recognized as taxable income but do count towards the RMD.

Trying to Interpret Market Signals by Jim Hall

We have all been aware of the extreme market volatility during the last quarter of 2018. Stocks that had been relatively stable during the first three quarters were suddenly under pressure and ratcheted lower in the last

few weeks of the year. A post-Christmas rally helped brighten the month and made prospects for 2019 look a little more positive. What precipitated the selling? As usual, rather than only one issue, there were several issues that combined to cause concern. As we have discussed before, the market is “forward-looking.” It is always trying to predict where stock prices might be next quarter or next year based on what can be determined or implied right now. When future conditions are less certain, the market (Continued on page 4)

What is an Inverted Yield Curve? An inverted yield curve is an interest rate environment in which longer-term bonds yield less than shorter-term bonds, assuming similar credit quality. Usually, bond investors expect to earn a higher return for holding longer dated bonds compared to shorter dated bonds because they expect to be compensated for risks associated with future interest rates, inflation, and potential default over longer holding periods. The curve can become inverted when there is a mismatch between where the Federal Reserve chooses to set the short-term U.S. federal funds rate and where the market determines longer-term rates should be based on expectations for economic growth and inflation. Yield curve inversions are sometimes but not always followed by recession. On December 31, 2018 the 2-year U.S. Treasury yield closed at 2.50% and the 10-year U.S. Treasury yield at 2.69% for a difference of only 0.19%.

Page 4

Cycle of Investor Emotions (Continued)

can weaken as investors attempt to unwind risk in their portfolios by selling some of their securities. A few of the major market concerns are: 1. Worries that the Federal Reserve will over-tighten

credit to fight expected inflation. This seems to be borne out by a yield curve that is inverting or nearing inversion where short-term rates are higher than long-term rates.

2. Worries that business sentiment surveys among company CFOs are reflecting more cautiousness and a reluctance to commit capital to long-term expansion plans.

3. Worries about trade disputes, particularly with China, that don’t appear to have any near-term resolution.

4. Worries about a global economic slowdown spreading to the U.S. as China, Japan, England, France, Germany, and Italy, to name a few, are all dealing with various economic stress factors.

5. Worries over a prolonged government shutdown as both sides appear to be entrenched and unwilling to compromise.

On the positive side, there are a few facts that appear to paint a rosier picture: 1. Holiday sales were at an all-time high. 2. Jobless claims are at historic lows. 3. Industrial production is at an all-time high. Even though the “worries” currently outnumber the “positives,” the government shutdown or the trade issues could soon be resolved and would most likely provide a strong tailwind for increasing stock prices throughout 2019.

(Continued from page 3)

Disclaimers: Dixon, Hubard, Feinour & Brown, Inc. (DHFB) does not render legal, accounting, or tax advice. Please consult with your legal and tax professionals before acting upon any information contained in this newsletter. This newsletter has been prepared solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. This DHFB newsletter may contain inaccuracies or typographical errors.