Happy spring to everyone. I hope your weather is better than here in Chicagoland where we recently had a dusting of snow. Maybe the dusting is just a reflection of the cold-shoulder the markets have given investors in recent weeks.
The recent market choppiness is due to speculation surrounding inflation, interest rate increases, and possible trade tariffs. The conflict is mainly between the U.S. and China, but there could be a contagion if it manifests itself in a material way. As historians know well, a complete breakdown in trade and reliance between nations can lead to war as one nation finds itself backed into a corner and feels the need to fight its way out. As of today, it seems to me that the trade tariff proposals we hear about in the news are more about posturing from the leaders of the countries involved rather than an all-out trade war. I believe this is true since the much larger currency and bond markets have not been reacting in the same manner as the stock markets. Nevertheless, I will be closely monitoring the trade tariff situation in case defensive action needs to be implemented, but more importantly to take advantage of opportunities that may arise. The areas of potential opportunities are related to agriculture and heavy industry.
From the beginning of the year to the current, stock market volatility has risen considerably with some daily changes being over 3%. In addition, the correlation between market movements has diminished. In fact, we have seen several days when the S&P 500 index and NASDAQ Composite moved in different directions which was an odd occurrence in the past. A sense of normalcy is likely to return as investors digest the fast-changing current environment. During the first quarter of 2018, the S&P 500 Index lost 1.2%, the NASDAQ Index gained 2.3% while the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) lost 2.3%.
No one likes a setback such as a stock market correction, but it is a normal development that prompts investors to take a more realistic assessment of the fundamentals. One relationship I study is the current level of stock prices in relation to the probability of the projected future earnings and how it compares to the past.
Currently, the market correction appears to me to be a reality check rather than a market meltdown. We may be moving away from a period of investor complacency in which investment dollars seem to be blindly plowed into index and sector investments utilizing ETF’s (exchange traded funds) and mutual funds with little thought other than chasing returns. Until early February, investor behavior was reminiscent of the late 1990’s as the ramp-up of 401k retirement plans caused many investment dollars to be plowed into mutual funds. What many investors don’t realize is the high degree of similarity of the holdings across indexes, ETF’s and mutual funds. This means that investors may unknowingly be concentrating their investment dollars into a few large companies across their holdings of ETF’s and mutual funds instead of gaining the diversification they need to reduce risk.
In the late 1990’s Internet and related stocks were the rage, but it didn’t end well starting in early 2000. The decline was exacerbated by the fact that so many of these companies had negative earnings. More recently a great amount of money has moved into the FAANG stocks. The following is a list of these stocks and their recent stock market values as of early April 2018: Facebook – $456b, Apple Inc – $850b, Amazon – $680b, Netflix – $125b, Google – $700b.
These fine companies, which have served investors well, are now behemoths and will find it increasingly more difficult to perform as they have in the past. It is important to study market history. Back in the late 1960s to early 1970s, many investors thought a large company group called the “Nifty Fifty” was a sure bet. Think about what happened to some of the Nifty Fifty companies such as Xerox, Eastman Kodak, S.S. Kresge (Kmart), Sears or Polaroid: these companies stumbled because their rich valuations and large size created an inability to quickly adapt to economic and technological change. Before the Nifty Fifty there was the disappearance of the railroads, the steel industry, the tobacco industry, and further back the fur and tea companies.
The Nifty Fifty period was remembered by many as the “go-go years” for investing and the rapid development period of mutual funds. What happened next is interesting. No two experiences or time periods are exactly the same, but we all know history can provide insight. In the 1970’s the economy was heating up and so was inflation, causing the Federal Reserve (Fed) to adopt a policy to raise interest rates to slow economic growth.
This is similar to what is happening now as the Fed increases its Fed Funds target rate to thwart rampant inflation. One favorable Fed difference from then to now is their change to a goal of being as transparent as possible about their policies and operations without undermining their ability to effectively fulfill their monetary policy and other responsibilities.
In the table below found in the book titled Investments, by Bodie, Kane, & Marcus we can see the performance of small cap stocks, large cap stocks, long term bonds, and short-term bonds during the 10-year period of 1970 – 1979.
If $1,000 was invested on January 1, 1970 here is how the numbers would look:
Small Cap Stocks = $2,314
Large Cap Stocks = $1,774
Long Term Bonds = $1,900
Short Term Bonds = $1,840
What I see here is that smaller companies greatly outperformed the larger ones which means to me, there was a transfer from the Nifty Fifty stocks to smaller, more nimble companies which could more easily adapt and prosper from the changing economic environment. This small company performance was enjoyed during a time Treasury bonds paid up to 16% by early 1980.
In my mind, successful investing comes from actively applying a disciplined approach in making investment decisions without swinging for the fences. As a reminder, here at Torii Asset Management we focus on actively searching out companies which have proven sales and earnings growth from a product or service and can be purchased at a price which leaves room for further gains in the current environment. Currently some attractive areas include healthcare due to our aging demographic, energy to supply the needs of an expanding economy, and technology companies which address our thirst for secure computer processing.
During the current quarter I look forward to reviewing the financial performance of our current holdings and seeking out new opportunities as they present themselves. This is in addition to the impact of macro-economic developments I previously discussed.
To our existing clients, I extend my sincere thanks for your business. You have our continued commitment to your success. To prospective clients, I invite you to come and grow with us.
Very truly yours,
Martin L. Yokosawa