December 31, 2018

For the fourth quarter the Montag & Caldwell Mid Cap Growth Composite gained 9.16%, outpacing the returns for both the Russell Midcap Growth Index, 6.81%, and the S&P MidCap 400 Index, 6.26%.  For the year the Composite returned 24.62%, which compared to a 25.27% return for the Russell Midcap Growth Index and a 16.26% increase for the S&P 400.

The market’s steady climb higher gathered additional momentum in the fourth quarter, especially as it became clear that Congress was poised to pass meaningful tax reform legislation, helping the year end with a bang.  The reduction in individual and corporate tax rates is likely to give the economy and corporate profits an added boost in 2018.  The U.S. economy has already seen a lift this past year from improving consumer and business confidence, ushered in by a more business-friendly, pro-growth administration intent on dismantling much of the regulatory regime that has contributed to subpar 2% trend line growth for the better part of the past decade.  After a weak start to the year with 1.2% growth in real gross domestic product in the first quarter, we have seen back-to-back quarters of 3.0%+ real GDP growth in Q2 and Q3 and we estimate similar growth of close to 3.0% in Q4.

For the year, all major equity indices showed robust gains; and for the first time on record, the S&P 500 rose every month of the year.  Underpinning the steady march higher was record low volatility.  The CBOE Volatility Index (VIX) (aka the “Fear Gauge”) averaged 11 for the year, the lowest in its history, and the index spent a record 52 days below 10 when it had only done so nine other times in the prior 26 years.  Meanwhile, the last time the S&P 500 experienced as much as a 3% pullback from its highs was before the 2016 elections, a record streak.  This lack of stock market volatility continues to deprive active managers the opportunity to add alpha by selling stocks when they get pricey and reinvesting once they have experienced a pullback and are selling at more reasonable valuations.

We were repeatedly stymied in our calls this past year for a pick-up in market volatility.  As a result, the cash reserves we accumulated from selling overpriced stocks was the single biggest factor preventing us from keeping up with our style benchmark this past year.  However, if history is any guide, we expect 2018 to be marked by higher volatility and lower returns.  A study of S&P 500 returns dating back to 1928 by Ned Davis Research[1] shows that there has only been one other year where the biggest drawdown was less than 3% (1995), and there was a notable uptick in volatility the following year.  In fact, there have never been back-to-back years with less than 6% market corrections; and in all nine previous cases of years with sub-6% market corrections, the following year’s returns were considerably lower than the year before.

Amidst this record year for records, the S&P 500 index gained 21.8%.  Within U.S. equities, large caps were the place to be (Russell 1000 +21.7%), while small caps were the laggards (Russell 2000 +14.7%), a reversal from 2016.  Midcaps again fell in the middle (Russell Midcap +18.5%).  Large caps similarly led the way in the fourth quarter (+6.6%), edging out mid caps (+6.1%) and besting small caps (+3.3%).  Also in a reversal from last year, growth handily beat value across all capitalization categories for both the year and the quarter.  Within mid caps, the Russell Midcap Growth index outperformed the Russell Midcap Value index for both the year (+25.3% vs. +13.3%) and the quarter (+6.8% vs. +5.5%).

The Composite’s positive relative performance versus the Russell Midcap Growth Index for the quarter can be attributed to strong stock selection, and in particular a preponderance of tax reform beneficiaries.  Jefferies [2] highlighted that stocks within the Russell Midcap Growth Index with heavy domestic sales exposure (70%+) (i.e., those most likely to see the biggest boost from a reduction in corporate tax rates) strongly outperformed those with heavy foreign exposure.

For the year, sector exposure, and in particular the aforementioned allocation to cash amidst a strong market advance, was the biggest drag on relative performance versus the benchmark.  An underweight position in Healthcare also weighed on relative performance.  Stock selection was a positive for the year, led by particularly strong performers within Staples, Discretionary, and Healthcare.

Looking ahead to the new year, it seems the only thing to fear is the lack of fear itself, a slight twist on FDR’s famous line.  Even though we are now in the ninth year of expansion, the economic and profit outlook remains positive, bolstered by tax reform and a synchronized global recovery.  Fiscal stimulus is being applied at a time when the U.S. economy is already operating at or near capacity, which raises the specter of rising inflationary pressures ahead.  But for now, inflation and interest rates remain under control and central banks outside the U.S. remain accommodative.  Provided inflation can remain low and the Federal Reserve can continue to increase interest rates very gradually, there is an opportunity for this economic cycle to set a record for duration and for stocks to climb higher.  We remain concerned, however, with elevated valuations, investor complacency, and suppressed market volatility.  And at least as it pertains to Bitcoin and the other cryptocurrencies, we are beginning to witness some of the hallmarks of a speculative bubble, similar to those we saw during the late nineties dotcom bubble.  However, these are merely pre-conditions to a market decline.

[1] “After Record for Records and Rare Lack of Pullbacks, Expect a More Normal ’18”; Tim Hayes, CMT, and Anoop Nath, CFA;  Ned Davis Research;  January 3, 2018

[2]“JEF’s SMID-Cap Performance Monitor: 17 was slow grind up amidst lowest vol ever”;  Steven G. DeSanctis, CFA; Jefferies US Equity Strategy; January 2, 2018