After posting consistent quarterly gains over the past three years (with the -0.8% return in 1Q18 as the sole exception), U.S. stocks (defined as the S&P 500 Index) incurred a sharp correction in the fourth quarter.  The hallmark resiliency that U.S. equities have shown over the course of the current cycle was nowhere to be found in 4Q, as the wall of worry simply became too high for stocks to overcome.  The drawdown in equities was broad-based in nature, with large-cap stocks managing to hold up marginally better than their small-cap counterparts.  The fourth quarter return of -13.5% for the S&P resulted in a 2018 return of -4.4%.  Although the ratherly disorderly end of the year was likely unsettling to many investors, it is important to keep in mind that 2018 is the first year for a negative return in the S&P since 2008…it’s been a heck of a run.  In a year where almost all asset classes were auto-correlated to the downside, diversification efforts did not provide much relief for investors in 2018.  Cash was the notable bright spot for the year, although even this asset class may have finished in the red after adjusting for inflation.

In reviewing market action in the quarter, stocks sustained a mild pullback in October, stabilized in November, and then accelerated to the downside in December.  A virtual laundry list of concerns weighed on investor sentiment: a steep drop in oil prices, global growth concerns, a flattening yield curve (including a modest inversion between the 3-year and 5-year), the ongoing trade skirmish with China, and continued tightening measures by the Federal Reserve.  Of all of the above factors, the withdrawal of liquidity from the markets (and resulting increase in cost of capital) is likely the biggest concern for the equity markets.  The absence of the ‘Fed Put’ is a big change in market dynamics, and with policy error as the primary catalyst for past recessions, all eyes are understandably on the Fed.  This is not to say that the current business cycle cannot continue; however, the rising tide environment of the past ten years is unlikely to continue.

Stocks were volatile throughout the quarter, but particularly during the holiday-shortened last week of the quarter.  Given that most firms were in skeleton staff mode for the holidays, we believe that program trades amplified the mercurial moves in stock prices.  These systematic approaches take a variety of forms – algorithmic trading, high-frequency trades (HFT), trend following, delta hedging, etc…, but a shared attribute amongst these strategies is that buy/sell decisions are non-fundamental in nature.  The takeaway is that the shift in equity ownership from traditional active management to more systematic vehicles and passive/ETF options results in a change in market structure.  Small fluctuations in market flows can now lead to outsized moves in stock prices.

For Cambiar, the day-to-day investment process has not changed.  With no shortage of cross-currents in the market that can influence decisionmaking, the Cambiar team remains focused on fundamentals to drive the buy/sell decision in our portfolios.  We continue to seek high-quality companies where we believe to be a disconnect between current valuation and anticipated future cashflow and earnings.  To the extent that indiscriminate market declines provide an attractive attachment point for some of these great compounders, we are willing participants in identifying such investments on behalf of our clients.