In Portfolio Commentary

Happy New Year!

Given that 2018 ended on such a scary note, BSW would like to put some perspective on recent market movements and set the stage for what tune the market might be carrying going into 2019 and beyond.

After a melodious 2017, where the S&P 500 “behaved” and rode a liquidity-fueled escalator to a 21.83% gain, we now find ourselves trying to figure out a cacophonous, noisy market that seems to have no anchor to reason. Let’s dive in. I’ve got some ‘splainin’ to do. . .

Investors are going through, what we believe is, one of the biggest transitions the market has seen in recent history. The liquidity that has poured into markets over the past 9 years is going away. The Fed is tightening financial conditions by raising rates and letting its gigantic balance sheet shrink. This drain in liquidity is causing an uncomfortable rise in market volatility – made even more uncomfortable by the fact that the U.S. has just emerged from one of the calmest periods in over 13 years.

As we can see in the table below, moderate volatility (as measured by the VIX) is the norm, not the exception. It’s been more common to see years like 2018 than years like 2017. Since 2004, the annual average VIX measurement has been 18.421. Generally, anything over 20 indicates some form of market turmoil. Today the VIX is at 25.42.

 

https://ycharts.com/indicators/vix_volatility_index

But what is turmoil?  Merriam-Webster defines it as a state or condition of extreme confusion, or commotion. Is the current market confused? Damn right. Is BSW confused? Heck no. We are taking the lemons that the market is giving us and trying to make lemonade.

Over the past four weeks we have been tax-loss harvesting in client accounts – locking in losses to offset gains and thereby reducing client tax burdens; saving clients real cash that would otherwise go to (politics aside) the black hole of government.  Importantly, we have remained invested by taking proceeds to temporary proxy positions because things could change very quickly and our financial security plans for clients demand they always have exposure to stocks.

Why is the market confused? It’s currently a long list, including: U.S. partial government shut down, Chinese tariff war, Fed interest rate uncertainty, global growth slow-down, EU plans to tighten financial conditions, corporate debt at all-time high levels, political uncertainty, and downward earnings revisions.

Much of the confusion is brought about by the market’s inability to appropriately price-in and handicap things like the trade skirmish with China, a Fed that is not communicating effectively and a POTUS that Tweets just about anything, anytime.

Uncertainty is and always will be part of the market and investing. However, it seems that incalculable uncertainties may now be a focal point of the market equation and the current narrative – the above-the-fold headlines that grab attention.

When faced with so many factors that could swing the market one way or another, BSW has (as always) buckled down and looked to the facts for answers and guidance.

Fact 1: Stock prices follow corporate earnings – According to Wall Street analysts, S&P 500 operating earnings are currently expected to grow 7.5% in 2019. This is on top of the tax-break-juiced earnings of 2018! We think it is likely to highly probable that this projection is too high. If we adjust these projections down to a more reasonable 2% growth rate (given GDP projections for 2019) and assign a market-average forward multiple of 15x, we get a fair value price on the S&P 500 of around 2,485 – within a whisper of where the S&P 500 trades today. Is today’s market level crazy, or was September’s market level out of line?  We think the latter; and that’s why we were underweight U.S. stocks for most of the year.

Fact 2: Volatility can breed further volatility – Depending upon the market environment in which they happen, big market swings can be self-perpetuating. In other words, riskier markets can cause consumer confidence to drop and can shift risk appetites. This can then trickle through to actual corporate fundamentals. We don’t think we are quite to this point yet, but are watching the data closely for clues.

Fact 3: Global growth is set to slow – It is widely accepted that global growth is set to slow in the coming years. Along these lines, China PMI (purchasing managers’ index) data was just released today showing a drop from 50.0 to 49.7.  Any reading below 50 indicates a contraction in manufacturing activity – not hard to believe given the tariff dispute.

After reading Haskel and Westlake’s new book, “Capitalism Without Capital,” I’m not so sure that GDP anywhere is being measured appropriately.  The authors argue that much of today’s economic growth is in the form of intellectual property and intangible investment (think: research and development), which cause the gross investment number in the calculation of GDP to be underestimated.

Why did the market move down so violently in December and what is BSW doing going forward based upon the above?

We believe that the market sell-off in December was due 1/3 to the repricing of stocks (in accordance with Facts 1 and 3 above) and 2/3 to computer-driven trading.  U.S. stocks needed to adjust based upon a deterioration in economic data and because of the higher interest rate environment.  A higher current short-term interest rate environment calls for lower stock valuations.  This is based upon how the market fundamentally values future streams of stock earnings.

Most of the extreme volatility, we expect, was a result of computers trading on momentum. Momentum has become a very popular investing style since 2009. A recent search of the Morningstar database reveals over $50 billion under management within the category of Momentum, spread amongst 50 funds – and that’s just public funds.  The premise behind the strategy is that “what has gone up recently will continue to go up” – and vice versa. With the thin trading volume around the holidays, these computer programs had an outsized effect on market moves. Not to mention it has become very easy to sell entire swaths of the market, due to the proliferation of index funds. There are now more indexes in the market than underlying global stocks – by 70 times!

 

https://www.ft.com/content/9ad80998-fed5-11e7-9650-9c0ad2d7c5b5

 

As a preview of things to come, BSW will be rebalancing portfolios this month and we anticipate adding to stocks at now lower valuations and higher expected returns. In our opinion, the recent sharp drop in the U.S. stock market (and relatively shallower recent drop in foreign and emerging market stocks) has created opportunities in select areas.  The fodder for additional stock purchases will come from bonds, which held up relatively well in 2018.

Due to the indiscriminate selling across all stocks, sectors, market caps and countries, there have been some real bargains that have surfaced.  U.S. equity fund outflows the week of Dec 14th was $46+ billion. The biggest weekly outflow on record.

Looking across the current tattered equity landscape, we are getting excited about Japanese stocks, which are now trading at valuations approaching their 2008 and 2012 lows. We feel this may be unjustified due to the country’s benign fiscal and monetary policies coupled with a slow, steady climb in the Japanese Consumption Activity Index.

Bank of Japan – https://www.cnbc.com/2018/12/14/record-46-bln-pulled-from-us-based-stock-funds-in-a-week-lipper.html

We also see opportunities within certain sub-sectors of U.S. financial and tech stocks. In some cases, they are 30%+ off their September highs! Critically, we look to distinguish between what stocks deserve to be 30% lower and stocks that have high earnings visibility, great growth prospects and little in the way of sensitivity to the business cycle.

We also continue to like emerging market (EM) stocks.  Emerging stocks had their stumble earlier in the year, so did not fall as much in Q4 2018.

Big Charts

EM stocks appear to be cheap by any measure and if any progress is made on the China tariff front, investors could see a rapid revaluation higher. In speaking with an Asia specific manager, they see multiple Asian stocks that sell only to Asian consumers priced as if their revenues were entirely dependent upon trade and exports to the U.S. We also think that the U.S. dollar has seen its strongest period and going forward, may stabilize or go lower. This would be a boon to EM countries, where much of the corporate debt is denominated in USD.

Along with targeting opportunities, we are looking to avoid areas where we feel there may be increased risks brought on by the current environment. Specifically, we are looking to minimize exposure to highly levered, lower quality companies who rely on borrowing to maintain their growth prospects. The U.S. has seen a rapid change in the corporate bond market over the past month. Interest rates have gone up and new high-yield issuance was non-existent in December. Companies issued only $8 billion of investment grade debt in December – the lowest amount since 1995. We are watching this closely, since much of the corporate borrowing over the past 2 years was used to buyback company stock.  This created a bit of a floor under stock prices. It looks like these financial engineering days may be behind us.

JP Morgan Guide to the Markets

What are the six key takeaways?

1. The U.S. is going through a major market adjustment which seems to be coming to a head as interest rates rise and financial conditions tighten. While it feels uncomfortable now, we hope this will result in a more “normal” market that will trade on fundamentals and real price discovery going forward and not on artificially low interest rates and liquidity induced financial engineering.

2. Current volatility is high, but for good reason AND it’s not unusual.

3. The increase in momentum and computerized trading has created opportunities in select areas where the baby has been thrown out with the bath water. We feel the market has overshot in some areas and that fundamentals will rule in the end.

4. Downside risks from here include a worsening of volatility, which in a negative feedback loop, starts to effect market fundamentals.

5. Given current valuations, BSW feels that risks from here may be asymmetrical and to the upside – but that stocks will continue to be a bit on the wild side, especially compared to 2017.

6. In our opinion, BSW has done the hard work up front – calibrating appropriate asset allocations for each unique client situation that is intended to consider periods like the one we just came through. Successful outcomes depend upon these asset allocations being adhered to over time and re-evaluated upon either financial or life changes.

Bouts of market volatility come and go and create opportunity – or as we like to say, periods of “volatunity” (trademark pending).  We love these periods because valuations disconnect, and opportunities abound for those that can keep a cool head and can see through the noise. By keeping grounded in fundamentals, we can buy what others are selling at prices that we feel confident should reward clients over time.

In closing, a dose of perspective. Yes, Q4 was violent, but in the end, U.S. large cap stocks finished the year down less than 5% – that on the heels of an up 21.8% year in 2017.  Diversification clearly matters – as can be seen by what JP Morgan calls an Asset Allocation portfolio.

J.P. Morgan

Have a healthy, joyful, generous, peaceful and rewarding New Year.

 

 

Craig Seidler – Director Public Investments

 

 

 

 

 

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