The fourth quarter is off to a weak start which should not be a surprise. As I mentioned in my previous review on July 6, 2018, we expected a general stock market correction could develop as early as the latter half of the third quarter. The continuing uncertainty surrounding the Chinese tariff situation and mid-term elections still remains an obstacle for market progress. In fact, some areas of the stock market experienced weakness in the previous quarter despite the gain the overall market posted. Our overall investment thesis remains. If the current market correction extends and the prospects of continuing economic and earnings growth have not been materially damaged, it may be a good time to add to stocks if your risk tolerance accepts it. Each investor needs to be genuine in their long-term financial goals and be realistic about the investments they hold.
Recently a well-respected retired businessman who remains active by sitting on the board of directors of a publicly listed corporation shared with me his battle-hardened knowledge as we delved into an interesting conversation. It revolved around what philosophy a board of directors should adopt and convey to upper management in running a company. Is it to maximize near-term corporate profits and current stock market price or to methodically grow the business over time providing dividends and, possibly, slower long-term appreciation as a more stable return to investors? We were not able to arrive at a single solution since there are no two exact circumstances for how a business competes.
A board developing a philosophy to keep up with rapidly changing technologies in such industries as bio-technology, communication services, Big Data, Blockchain, or internet and social media will be quite different from companies with less technology-oriented offerings such as utilities, energy, housing, or products such as foot wear.
Investors struggle with a similar dilemma in allocating their investment dollars and managing their expectations. The dilemma is between the fear of missing a current hot trend or staying the course and building a sound long-term portfolio.
All too often, investment decisions are made by backward looking analysis which would be like driving a car by looking in the rear-view mirror. This sort of activity can lead to disillusionment as an investor’s high hopes of success do not become reality. The faulty logic of giving too much emphasis in analyzing and believing what is hot today will remain hot in the future develops from how our brains are wired. Humans tend to perceive and project unjustly. When an occurrence like buying the dip or a stock continuously meeting and exceeding analyst price targets happens repeatedly over the course of time, our brain tends to give that occurrence too much significance. This phenomenon is called Projection Bias and it is difficult if not impossible for some to reign in. Often, succumbing to cocktail talk is the catalyst for investors to be led astray.
An example of faulty analysis can be seen in examining how the Mega Millions lottery jackpot grows. After a certain threshold the jackpot grows exponentially as lottery buyers increase the rate of their purchases. Also, if one hears a friend or relative wins, it seems like people also change their behavior and purchase more tickets. There are only so many number combinations which make the roughly 1 in 303 million odds static, but many incorrectly conclude that if someone has not won, their chances of winning are now better. Backward looking analysis may not be the best investment choice.
In the investment community there is an erratic behavior called “performance chasing” which many times leads to losses as investors jump from one investment to another by emphasizing too much weight on past performance without critically analyzing if a company or investment is in the same position to perform in the future.
In today’s more than ever complex investing environment with the 24-hour news cycle and instant access to information from the internet, this intuitive model is very hard for most to execute. It is due to a lack of the deep-rooted understanding and discipline needed to deal with the intertwined global financial markets and its movements. At times there are disconnects in how markets traditionally operate leading investors to unknowingly make poor choices. For many investors, the current disconnect in the U.S. dollar relationships is going unnoticed or has shaken their confidence in understanding why many investments are not following the general market.
There is normally an inverse relationship between the value of the dollar relative to oil prices and the growth of multi-national companies – many of which are contained in the Dow Industrials and S&P 500 indexes. When the dollar strengthens, it causes U.S. products and services and commodities to become more expensive in nondollar currencies. The higher costs in turn has a negative influence on demand, and prices typically fall. This influence is a contributor to the recent poor stock performance of emerging markets. Some of the currencies involved include the Turkish lira, the Iranian rial, the Russian ruble, the Indian rupee, the Argentine peso, the Chilean peso, the Chinese yuan and the South African rand. These countries are also sitting on a ticking time bomb of U.S. dollar-denominated debt. As the dollar strengthens it requires more of their local currency to be exchanged into dollars to service the debt at a time when their profits are lower due to falling demand and higher costs. The situation is exacerbated by local institutional money flowing to the United States to capture our more secure and attractive bond rates.
In the United States one would incrementally expect the weakening demand to soften the price of oil and values of multi-national companies. What we have experienced year-to-date through the quarter ending September 28th is a 21% increase in West Texas Intermediate crude prices, the Select Sector SPDR Energy Trust however is only up 5%, but it did close slightly down in the third quarter. But, the stock prices for multi-national companies remain strong despite the slowdown. In addition, corporate management, thus far, has been eerily quiet which is a concern due to their lofty levels. These are some of the factors which make the recent stock market weakness not a surprise to me, but a future opportunity.
During the third quarter of 2018, the NASDAQ Index gained 7.1%, the S&P 500 Index gained 7.2%, while the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) lost 1.3%.
The time-tested principals of managing portfolios I have used for more than thirty years is to find and invest, at a reasonable price, in companies which can demonstrate the ability to increase their sales by providing a product or service that consumers increasingly demand, coupled with increasing their financial bottom line. When dealing with the stock market I look at buying good businesses, not stocks solely as an appreciation vehicle. Good businesses remain good businesses despite market turbulences, and their stock prices typically reflect that fact over time. But, it is anyone’s guess where highly traded stocks based on a speculative future may find themselves. Concentrating on buying good businesses is how we avoid situations like the temporary gains in Bitcoin and its ancillary related businesses. This situation is something I previously warned about in my reviews.
A burgeoning area I am looking at is The Internet of Things (IoT) which connects the physical world to the internet. Depending on the hype and valuations of a new growth area, one may need to look at collateral businesses for the best opportunities. For example, the security of IoT should have significant demand.
IoT is a system of interrelated computing devices, mechanical and digital machines, objects, animals or people that are provided with unique identifiers and the ability to transfer data over a network without requiring human-to-human or human-to-computer interaction.
Examples of how IoT could be used:
- Healthcare – ability to monitor patients more closely to use the data that is generated and analyze it.
- Industrial – applications for tracking goods, real time information exchange about inventory among suppliers and retailers. Automated delivery will increase the supply chain efficiency. According to GE, the improvements in industrial productivity will generate $10 trillion to $15 trillion in GDP worldwide over next 15 years.
- Consumer – smart homes that are equipped with smart thermostats, smart appliances and connected heating, lighting and electronic devices can be controlled remotely via computers, smartphones or other mobile devices.
Expectations of IoT future growth:
- Bain & Company expects annual IoT revenue of hardware and software to exceed $450 billion by 2020.
- McKinsey & Company estimates IoT will have an $11.1 trillion impact by 2025.
- IHS Markit believes the number of connected IoT devices will increase 12% annually to reach 125 billion in 2030.
- Gartner assesses that 20.8 billion connected things will be in use by 2020, with total spend on IoT devices and services to reach $3.7 trillion in 2018.
As always, I am champing at the bit each morning to analyze the news for the day and what its impact may be on the markets, the health of the economy, and the investment portfolios I manage.
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