Quarterly Update

  • “Goodbye Yellow Brick Road?”

    Fed Pivots, Trade War Ensues and Earnings Loom

    Over the past 18 months, global investors have experienced a number of crosscurrents which created quite a bit of drama, yet yielded little upside in global stock markets. For those less invested during this strange period, there has been little missed opportunity. During the past year and a half I have witnessed stock indexes attempt new highs not once, but three times, without success.

    I find this current fourth attempt of interest, since it is in the face of impending earnings results, well-documented slowing economic growth, trade wars and an inverted yield curve – all of which has caused the Federal Reserve to finally agree that we may have veered off “the yellow brick road” as they now consider lowering interest rates. If and when the Fed reduces rates, will it be too late given the well-publicized weakness in so many economic indicators? And what should investors anticipate for the second half of this year?

    Source: Bloomberg

    In many of my previous Strategy Updates, I have emphasized the importance of data: economic and corporate profit growth is essential for meaningful stock market returns. However, a third prong – policy – has played an increasingly important role in financial markets as evidenced by trade wars and the Federal Reserve. Has our path to generating great long-term returns changed? Should we say, “Goodbye yellow brick road?” I think not.

    Trade wars pose a significant risk to global financial markets as companies are forced to rethink supply chains, which impacts margins and ultimately profitability. With earnings season right around the corner, there are already a few companies like Broadcom and FedEx reporting poor quality earnings with explicit citation of geopolitical uncertainties – namely the trade war! It will be interesting to see if these reports are the “canary in the coal mine.” We continue to believe that this trade war must be resolved in order for this market to resume a longer-term uptrend.

    Jerome Powell and his colleagues at the Fed have pivoted their policy from just short six months ago, which has led investors to price-in rate cuts by year’s end. The purpose of lowering interest rates is to stimulate an anemic economy and inflation rate while attempting to counteract the inverted yield curve, which has historically preceded recessions. However, the idea of cutting interest rates so soon and so aggressively suggests that the US economy and moreover global economies are not on firm ground – a view we have had for some time now.

    We certainly do not want to “fight the Fed” if they do decide on a more accommodative policy path like European counterpart, Mario Draghi. However, simply flooding the stock market with additional capital is a bandage on a ten-year wound, which has never fully healed post-2008. The Fed’s lack of tools – specifically the inability to cut rates further from an already low level – leaves the global economy particularly vulnerable as we go forward. This is why I stand prepared to thoughtfully add stock exposure if the Fed acts as the markets want, yet keep on hand risk management tools, such as stop-loss orders and sector management if simply lowering rates does not get this economy back on track.

    While both global economic growth and earnings quality have decreased over the past few quarters, they are still positive (particularly in certain sectors), which bodes well for businesses with consistent revenue models – think goods and services you cannot live without! These are the types of companies we want in your portfolio. The better than expected index performance in defensive sectors such as utilities, consumer staples, and healthcare this year has validated my thesis.

    A lower interest rate environment would also offer more interesting opportunities in the public real estate market (REITs) and select business models. I am cautiously optimistic that the backdrop of low inflation, an accommodative Fed and resilient economic and earnings data will get this market back on track. I expect several corrections along the way as policymakers and companies alike navigate this new landscape and we should stand prepared to thoughtfully add exposure to sectors and companies performing well in this environment. Should trade talks continue to break down, the Fed acts too late, or corporate profits and economies deteriorate further, be well prepared to weather the storm.

    When there are periods of conflicting asset prices and data, I tend to err on the side of caution, as protecting capital in bear markets allows you to better reach your long-term goals of retirement, spending policy guidelines, or next-generation legacy. In that spirit, continue to look for further evidence of better earnings quality, economic growth, and trade resolution before becoming significantly more invested with your portfolio. I think such a period may come sooner than most investors think.

    I hope you find this update helpful.

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  • Patient and Value Conscious: Upcoming Data Should Align Stock Prices and the Economy

    Long-term investment success often requires short-term periods of patience, restraint and being value-conscious. In today’s fast-paced, short-term performance, the digitally-driven world this can be a challenging combination. However, the discipline to step away from short-term “noise” and carefully examine the “forest” as opposed to the “trees” can result in significantly better long-term returns. This can often mean going against the crowd in the face of a falling or rising market.

    Years ago I learned that short-term movements in equity markets are driven by psychology, but long-term trends are driven by economic and corporate profit growth. This comes to mind during the past few months as I witnessed the dichotomy of sharply rising stock prices in the face of declining economic growth and corporate profits. Investors need to ask at this point which of the two – the recent direction of stock prices (up) or corporate profits (down) – has greater longevity? And, how will this play out over the next few months and the balance of the year?

    In just a few weeks, stock prices appear to have lost their momentum. In fact, for most of March, global stock indexes were in the red. At the same time, economic statistics and corporate profit reports have continued to deteriorate. Perhaps the long-term fundamentals are beginning to trump short-term psychology? I believe that this may be the case. The bond market, which has historically been the best predictor of such things, appears to agree.

    This is evidenced by the bond market’s recent yield curve inversion – short-term yields higher than long-term yields. This unusual phenomenon often precedes weaker economic data and profits. A bit more time, along with earnings and economic data in April, should bring the disparity between stock prices and underlying fundamentals back in line.

    We faced the beginning of a bear market in the fourth quarter of 2018 with most indexes down 20% and many sectors down much more. Though we don’t predict Armageddon for the global economy or stock market, we also do not believe that a real bull market can begin again without at least a normal correction or perhaps something worse. We may be on the precipice of such a move given that the market has lost its momentum and we are heading into what is likely to be a dismal period of earnings reports and economic statistics from the first quarter when the US Government was shut down. For that reason, we continue to be a bit more defensive than your normal, fully invested portfolio.

    I suggest you continue to search for and take advantage of isolated opportunities in companies that represent great value regardless of the market’s direction. These are difficult to find and, given the overall market environment, the pace of adding significant exposure has been slow.

    It is always difficult to predict with accuracy the direction of stock prices, but one simple rule holds true: When the economy and corporate profits are rising, stocks do great! That has just not been the case over the past 4 months, which poses a risk to investors. As a reminder to anyone who has experienced a normal bear market, stocks typically fall before the bad news about profits as happened in October – and then have sporadic, often significant, advances as we’ve seen recently – only to decline again into poor earnings reports.

    Though global stocks historically decline approximately 40% during an average bear market, I am not predicting such an outcome. In fact, be ready to become more growth-oriented as soon as stock prices and earnings growth are more aligned – most likely when stock prices are lower and most of the bad news about profit growth has been digested. I wouldn’t be surprised to see this come to fruition in the next few months.

    After decades of managing money, I have experienced a number of these short-term periods of being less invested and they have proven to be a bit trying in the middle, but valuable in the end. None of those past periods lasted more than months and I don’t expect this period to be an exception.


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  • “Should I Stay or Should I Go Now”

    Is Recent Stock Market Strength a Sign of Safety…or Danger?

    Since early October there has been a “bear market” in stocks, both here and abroad. Though some indexes declined approximately 20% from their highest point, most stocks were down much more until just recently. In the past few weeks, stock indexes have rallied about 10% providing some relief for investors, but far from the peak reached in late September.

    This is a good time to explore if the recent strength in indexes is the beginning of a better stock market or just a short-term advance leading to further trouble ahead. As you know we have kept your portfolio defensive during this period, with less stock exposure and less volatile stocks. Though this is effective during market declines, it can be a bit trying in the face of the recent market strength.

    How can we determine if there is further downside ahead or if the recent rally is the beginning of a real recovery? Let’s review the data points that were the cause of the tough market. In my view, we need these data points to stop trending downward or to become more clarified, before we take a more “risk on” growth posture. 

    Economic Data
    The economy and stock market are co-dependent. The first sign of economic weakness at the end of the third quarter is what sent stock prices into the downward trajectory. Since that time most leading economic indicators continue to be in a downtrend. Investors need global economic growth to stabilize stock prices to stage a meaningful long-term recovery. If economic growth can stabilize – albeit at a lower rate – stocks could still do very well and better than most investment alternatives. However, we need to see clearer signs of stability on this front.

    Corporate Profit Growth
    Economic growth is directly tied to the profitability of companies both here and abroad. We are now at the beginning of earnings season and need to see companies meeting or exceeding the lowered expectations that analysts have adjusted downward since the fourth quarter. Some of the most recent warnings and reports have not been positive, including Apple, JP Morgan, Macy’s and Ford – all of which have been negative.

    However, the earnings season has just begun and we have some big bellwether companies reporting over the next few weeks including domestic heavyweights Boeing and Caterpillar. These upcoming reports should shed further light on the sustainability of the market’s recent advance.

    Lastly, when it comes to earnings reports, it is very important that investors realize that these reports are about what happened last quarter and are not a precursor to what may happen going forward. This is why we also want to consider the following three policy challenges. These policy issues need to be better clarified before markets can be on more sound footing. 

    Federal Reserve (Fed) Policy
    The Fed has raised rates nine times over the past two years in an effort to prevent the economy’s growth (inflation) from accelerating too quickly. As we have written before, this effort comes with the risk that the Fed can mistakenly “overshoot” their estimate of interest rate increases versus growth and turn an otherwise sound economy into a recession.

    This concern is real and is one of the reasons investors have been selling shares. Fortunately, the Fed has recently backed away from being so adamant about further rate hikes. In the short run, this has soothed investor’s fears. However, I would like to see further clarity in the Fed’s message and a willingness to reverse course if necessary. The next Fed meeting at the end of this month may provide this.

    Global Trade Policy
    Tariffs and other impediments to trade with China and other global trading partners are a negative for global and domestic growth. On this front “no news is bad news.” Economic data from China is slowing and they remain an important trading partner for the US and global economy. A trade deal that turns out to be better than earlier perceived would go a long way to alleviate investor fear and support both economic growth and global corporate profitability. We will be watching these negotiations carefully.

    Government Shut Down
    Though short-term government closures have been stock market nonevents in the past, we are now in uncharted waters. Previous government shutdowns have been measured in days while this one is now more than a month old. This has a negative effect on a number of sectors of the US economy and some of our country’s largest corporations. Investors would be wise to consider the shut down as a further risk to stock prices. As with the other policy challenges, any sign of improvement or positive outcome to this standoff would be supportive of a better stock market environment.

    Clearly, there is no shortage of bad news and challenges on the domestic and global front – for the sake of brevity, we left Brexit and US debt levels out of the discussion. At times the stock market “discounts” all of the bad news by lowering the price of shares. We are not sure that the stock market has fully priced in some of these current risks, particularly given the more recent elevated level of share prices. However, if it turns out that the recent strength is the beginning of the recovery – coupled with some clarity on the issues described above – a re-test or normal correction from these levels would be expected, allowing us an opportunity to invest at more attractive prices in the very near future.

    Keep in mind that bear markets often demonstrate periods of short term strength which are followed by declines back to the old lows or even lower. This was the case with the market rally in November that resulted in a further 10% decline in indexes. If this recent strength is just another temporary rally in the bear market – given that all major indexes still remain in long-term downtrends – I want to make sure your assets are safe. In that spirit, I continue with my recent, ongoing mantra of “better to be safe than sorry” when it comes to the bulk of your liquid net worth. Keep in mind that historically bear markets last just 6-8 months and this one is already entering its fourth month. Over the next few weeks and months I will be continuing to monitor the data points and view any pullback in stock prices as a possible re-entry point, but one that will need to be validated by better fundamentals. 

    I am excited about the prospect of re-investing in a significant global stock market recovery.


    I hope you find this update helpful.

  • Stranger Things: An Unprecedented Period of Low Volatility Will Run Its Course

    The rise of stock prices, coupled with the lack of market volatility, in the past 12 months has been wonderful. I hope you have enjoyed it as much as I have! However, it is unprecedented. Global equity indexes have not experienced a decline of more than 4% for more than 14 months in a row. Never in history has there been such a long period of low volatility. This is truly one of the “stranger things” that I have witnessed in my almost 25 years of managing financial assets and in my 35 years as a professional investor. Is this the new normal? Have we entered a new era? Sadly, I do not think it is possible.

    It’s not that months of low volatility and rising stock prices are uncommon, it’s just that this one is much longer than most. When I revisit similar periods of low volatility paired with advancing stock prices, there appears to be some common ingredients. Almost always low volatility and rising stocks come with an environment of better than expected economic and profit growth, underinvested institutional and individual investors (high cash balances) and some type of outside stimulus that make stocks the most sought after investment alternative. Historically, these phenomena have been most common during periods of economic and profit improvement – think 1985, 2003 and 2009. When I consider the financial circumstances of the past 14 months, this all fits neatly into place. We have certainly experienced a significant recovery in global economic and profit growth, which caught the over worried and underinvested public and private investor by surprise. Pile on the significant pro-growth fiscal policy, such as tax cuts, and you get the makings of a huge demand for stock exposure. The mere concept of trillions in currencies chasing a fixed number of publicly traded stocks makes for higher stock prices with low volatility – the Holy Grail!

    This cozy and profitable environment will eventually end – and we don’t dare predict when so as not to spoil its longevity. However, investors would be wise to prepare for a return to a more normal stock market. Still profitable – but not as cozy. There is enough economic and profit growth momentum for stocks to continue upward – and we believe for quite some time. Global stock prices based on earnings (Price/Earnings Ratios) are not excessive at 18.3 and the “E” continues to grow at a great clip, with the help of fiscal stimulus. This should keep the P/E reasonable as equity prices rise. What this market will be missing going forward are the over worried and underinvested public and private investors. They are no longer underinvested or as worried. Over the past 14 months every dip in stock prices was met with piles of cash itching to get more fully invested, preventing normal stock market corrections. Now that those cash levels have been depleted, we can expect business as usual. As global stock markets grind higher, we will likely see very normal 8-10% corrections along the way.

    Whenever we get our first real correction in stock prices we should be prepared. The numbers can be a bit unsettling when the Dow Jones Industrial Average is above 26,000 (it was 700 when I started in the business!). A simple and normal market correction of 8-10% would be the equivalent of 2000-2600 points! Don’t let the absolute numbers mess with your brain or emotions – try to keep your wits and look at your portfolio and the market in terms of percentages.

    For the fixed income investor, the higher interest rates that have come with the stronger economy and profit cycle are a blessing. I expect the Federal Reserve to continue raising rates this year which will make purchases of bonds even more attractive. This is not a time to own bond funds or bond exchange traded funds. These products perform very poorly as rates rise, which investors are just starting to experience. I only invest in individual bonds, which will benefit me well as rates continue higher.

    I am optimistic in regard to outlook, however circumstances could change or get “stranger”.

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