The stock market sell-off, which began in early October, accelerated in December, and the S&P 500 and the small-cap Russell 2000 declined by 9.0% and 11.9%, respectively. Investors were fearful that the Federal Reserve was too hawkish and intent on raising interest rates despite a global economic slowdown and the uncertainty over the trade war with China. The S&P 500 fell by 13.5%, and the Russell 2000 dropped by 20.2% in the fourth quarter, which was the largest three-month decline since Q3 of 2011. Additionally, the S&P 500 and the Russell finished the year down 4.4% and 11.0%, respectively, which was their worst annual performance since the 2008 recession.

As the Trump administration increased tariffs on China and the Fed drained global liquidity by “selling” bonds and raising rates, investors anticipated a global slowdown, sold their international equities and invested in the U.S. stock market. This “flight to quality”, coupled with a record level of corporate buybacks, drove the S&P 500 higher despite the hawkish Fed and the intensifying trade war with China. In fact, the market’s strength probably emboldened President Trump and the Fed to pursue more aggressive policies.

The Fed made several more missteps. Despite the S&P 500’s 11.5% correction and the global economic slowdown, the Fed indicated that they would raise rates three more times in 2019 and stated that their Quantitative Tightening policy (i.e., selling $50 billion of bonds each month to reduce their balance sheet) was on autopilot. The Fed ignored the market’s message and investors panicked, which led to the stock market’s worst month of December since the Great Depression.

For many investors, 2018 was confusing because stocks had their worst year since the recession, yet the economy was strong (i.e., nominal GDP grew at its highest rate since the last recession, and the unemployment rate fell to its lowest level in nearly fifty years) and corporate profits increased by more than 20%. In our view, 2018 can best be explained by what is good for Main Street, may not be good for Wall Street.

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