“Far more money has been lost by investors trying to anticipate corrections, than has been lost in the corrections themselves.” & Peter Lynch, 1944 – present, legendary manager of the Fidelity Magellan fund

CHANGE IS THE INVESTOR’S ONLY CONSTANT The pre-Socratic Greek philosopher Heraclitus of Ephesus (c. 535 BC) was known to his contemporaries as the philosopher of eternal change. While very little of his work has been preserved – only fragments of his writings exist – his philosophy can be summarized in just two Greek words: ‘Panta Rhei’, which translates to ‘everything flows’, and is often rendered as ‘change is the only constant’.

First uttered over 2,500 years ago, Heraclitus’ wisdom still rings true today, particularly in light of 2018’s choppy stock market, which signaled a sentiment change on Wall Street and reminded investors that markets can and do go down from time to time.

Following an unusually calm 2017 that saw steady gains with basically no pullbacks, volatility made a dramatic reappearance in February and gave investors who had been lulled into complacency their first correction in almost two years.

After that major bout of turbulence, stocks staged a powerful comeback during the summer months as investors were emboldened by the strong economy and a healthy earnings backdrop. The major U.S. benchmarks cleared their late January peaks and rallied to fresh all-time highs in the third quarter. It was one of the strongest quarters for major U.S. indexes in years, climbing more than 7% and giving investors an impressive 9% gain for the first nine months of the year.

October brought renewed pain however, as the floodgates in global equity markets reopened and the nearly decade-old bull market succumbed to a second correction - defined as a 10% drop or more from the prior peak - within eight months.

The markets’ slide intensified in December, which is typically a very positive month for markets. The rout erased all of the indexes’ 2018 gains amidst increasing volatility. After a series of often

dramatic swings that saw Wall Street’s worst-ever Christmas Eve selloff, followed by its biggest one-day points gain on record the next day, both the S&P 500 (-6.2%) and the Dow Jones Industrial Average (-5.6%) concluded a tumultuous year with their worst performances since the financial crisis.

Yet the challenges for investors didn’t stop with stocks as there was literally no place to hide, not even for investors with globally diversified portfolios. According to the Wall Street Journal, “90% of the 70 asset classes tracked by Deutsche Bank are posting negative total returns in dollar terms for the year through mid-November… [In

2017], just 1% of asset classes deliverednegative returns.” (see top chart next page). By that measure, 2018 was the worst year for investors in more than a century.

Major stock benchmarks in Europe (FTSE -13%, Stoxx 600 -13%), Japan (Nikkei 225 -12%), China (Shanghai Composite -25%) and Emerging

Markets (MSCI EM -16%) all slipped into correction or even bear market territory for the year.

Thanks to four successive interest rate hikes by the Fed, last year wasn’t great for bonds either. The yield on the benchmark 10-year Treasury note ended the year at 2.69%, just 28 basis points above where it started the year. That equates to an annual loss of 0.5%.

Rising interest rates also caused instability for pprecious metals and rreal estate. Crude oil lost more than a third of its value in the fourth quarter and ended the year down 25%.

Those rate increases did help the UU.S. dollar to strengthen against most major currencies, however. The Euro, which turned 20 on January 1st, slid 4.2%, the Chinese yuan shed 5% and the British pound dropped

6% against the greenback. Most Emerging Markets currencies got battered at some point

or another last year amidst a blend of country-specific issues, rising global bond yields, a strong U.S. dollar and slumping oil prices. All these losses pale in comparison to the collapse in ccryptocurrencies. Bitcoin, the pioneer, saw its value drop precipitously by more than 80% from nearly $20,000 in December 2017 to just $3,747 at year-end. Cash in the form of money market funds was one of the few assets that had a positive return in 2018. Our view that “returns will be lower across the globe, accompanied by a normalizing of volatility levels as the new year certainly will bring its shares of challenges” (TelosGram January 2018) proved prescient. 2018 proved to be a challenging year for most asset classes as investors had to adapt to a succession of Fed rate hikes, global growth concerns, an escalating US-China trade dispute, and a late-stage business cycle. It’s fair to say that change was the investor’s only constant in 2018. Heading into 2019, we believe that these issues will continue and that investors should be prepared for ongoing market volatility as there are a number of significant risks in the outlook that, to varying degrees, all threaten risk assets. We see a few key themes that are likely to shape market sentiment and drive portfolio returns in the year ahead: U.S economy – growth

moderating but no recession: It is somewhat ironic that the February correction was caused by investors’ fears that the recent tax cuts might overheat the economy and cause inflation to pick up, while the second correction – a mere eight months later – reflected fears that the flattening yield curve signals an impending recession. In other words, the market has gone from worrying about too much good news to fretting about the slightest bad news within just a few months. Now that’s what we’d call a Heraclitan change! As the domestic economy enters its tenth year of expansion, it will become the longest on record in July 2019. While there are worries that the solid expansion is starting to show its age, there are few signs so far that a recession is imminent. In fact, growth in gross domestic

product (GDP) for 2018 is expected to exceed 3% year-over-year, its strongest gain in more than a decade. That pace is projected to give way to more moderate growth of 2.6% this year, according to the average estimate of 51 economists. However, there is a difference between a slowdown and a recession, which is technically defined as two consecutive quarters of negative economic growth. Sure, the housing market has been slowing and new car sales were weak, but with unemployment near 50-year lows at 3.7% and inflation still low and steady, the U.S. economy looks remarkably healthy and does not show any signs of an imminent recession. Besides, day-to-day swings in the stock market don’t necessarily reflect developments in the economy as a whole. Since 1900, for example, there have been 36 bear

markets, according to Ned Davis Research, but only 22 recessions. Trade Protectionism

The single most important risk to the global outlook is the unresolved U.S.-China trade dispute. For now, the two nations are in a 90-day truce in a bid to work out their differences and reach an agreement. While trade represents a relatively small 20% of the U.S. economy, tariff increases would likely result in higher consumer prices and reduced trade activity, and ultimately have a negative impact on inflation and global growth. We view a trade war between the world’s two largest economies as the biggest threat to both

businesses and financial markets this year. A truce to resolve those tensions would remove a significant source of uncertainty und could provide a boost to risk assets. Fed rate hikes

Sustained economic growth, tight labor markets, and target-level inflation led the Fed to raise their benchmark interest rate four times last year to a range of 2¼ - 2½%. In a statement, policymakers signaled that they would likely slow the pace of upcoming hikes to no more than two this year, but investors were not appeased. In fact, there are good reasons to worry about higher interest rates: according to David Rosenberg at Gulskin Sheff, “there have been 13 Fed rate hike cycles in the post-WWII era, and 10 landed the economy in recession.” To wit, rising interest rates have an excellent record of

foretelling a stock market decline. Wall Street is worried that higher tariffs could drive up inflation and force the Fed to tighten too much. U.S. yield curve flattens or inverts

The yield curve is a graphical representation of the yields available for bonds of equal credit quality and different maturity dates. In general, short-term bonds carry lower yields to reflect the fact that an investor’s money is at less risk. An inverted yield curve refers to that rare occasion when the yield on short-term bonds is greater than long-term ones. According to research by two Federal Reserve research advisors in San Francisco, “every U.S. recession in the past 60 years was preceded by an inverted yield curve.” It is important to note that we do not have an inverted yield curve – at least not yet! Moreover, data from LPL Research shows that “looking at the past five recessions, the S&P 500 didn’t peak for more than 19 moths, on average, after the yield curve inverted.” (see bottom chart on previous page). Contrary to what many investors think, an inverted yield curve – if and when it happens – should not be viewed as an automatic and immediate sell signal. Geopolitical and

other wild card risks There are a number of other plausible uncertainties on the horizon that have the potential for either positive or negative outcomes and will add to the directional uncertainty of markets. Chief among them are the gradual withdrawal of central bank liquidity, Brexit, European political challenges, the outlook for lower growth in China, financial pressures in Emerging Market countries, plunging oil prices, and last but not least, domestic politics. OOur Concluding Thoughts: There was a pronounced change in the wind across global markets in 2018 and for most investors, the year couldn’t end fast enough. Following one of the least-volatile years in recent history, last year turned out to be a lot more challenging, with investors having to endure not one, but two corrections. There’s no denying: volatile markets can be unsettling. They are also an inevitable part of investing as risk and return tend to go hand in hand. One of the fundamental principles of investing is that higher risk investments, such as stocks, should lead to higher rewards. Indeed, according to Morningstar, the average annual return on stocks from 1926 through 2017

was 10.2%, while bonds, which are considered less risky, offered a lower return of 5.5% during that time. By allocating a portion of their investments to different asset classes (known as asset allocation), investors are typically better able to withstand market turbulence. The image on this page (sourced from J.P. Morgan) illustrates the annual rolling returns of stocks, bonds and a balanced portfolio (50% stocks/50% bonds) from 1950-2017. Over a one-year time interval, stocks oscillated wildly, ranging from a 47% gain to a 39% loss (left green bar), while the swings of the balanced portfolio were much more tolerable, ranging from a 33% gain to a 15% loss (left gray bar). Over longer time periods, the range of annualized returns becomes less volatile. In fact, a 50/50 balanced portfolio has never seen a five-year rolling period of negative returns in the past 67 years. Nobel Prize-winning psychologist Daniel Kahneman demonstrated with his ‘loss-aversion theory’ that it is

investors’ natural instinct to flee the market when it starts to plunge. We understand that it can be difficult to stick to your long-term investment plan in this volatile market environment. Rather than

jeopardizing their long-term investment strategy out of fear, investors should revisit their asset allocations and investment plans to ensure they remain aligned with their long-range goals, specific needs and tolerance for risk. That way, they are well positioned for whatever comes their way and gives them the ability to look past today’s headlines.

If you are concerned about market volatility, we encourage you to contact us. Our experienced financial advisors can talk you through your concerns and help you ensure that your long-term strategy is aligned with the level of risk you are willing to take. Our aim is to continue to assess the risks and rewards in the markets, and to construct investment portfolios that will be resilient in the face of the challenges investors will inevitably face in 2019. In closing, all of us here at Telos Capital Management, Inc. would like to thank you for your continued trust, loyalty and confidence. We are both humbled and honored by the great responsibility you have bestowed on us. Happy New Year! JJANUARY 2019