January 11, 2019 by Martin L. Yokosawa

The recent volatility in the markets has left many investors struggling to make sense of it. During 2018 I wrote about many of the aspects which led to the depth of the December market drop.

1. Performance chasing.
2. Market gains, which are a result of outperformance by a very narrow group of stocks.
3. Rampant passive investing into ETFs which many times are constructed more on a composition basis with less regard to the investment analysis of its holdings.
4. Speculative buying due to media hype. The big loser here is Bitcoin.

There is a myriad of suggestions of how and why things happen. In addition to the contributing factors just listed, my view is that some of the shine has come off the stock market and the expected growth of the economy, but I believe there continues to be a foundation for both to continue growing. The silver lining in the recent market turmoil is that it serves as a much-needed reality check and hopefully a return to fundamental investing.

I expect that a significant portion of the recent market drop is a result of misallocation of funds by too many investors into ETF, FAANG (Facebook, Apple, Amazon, Netflix, and Google), as well as headline investing. In short, whatever is hot today has a good chance of not being hot tomorrow as investors emotionally keep bidding up stock prices until there is very little room for further appreciation. Then suddenly out of nowhere after years of complacency, the long-term uptrend of popular stocks has a sharp change in direction, creating disbelief. Many of the TV talking heads and analysts pound the table that the sudden market drop is a buying opportunity.

When these trendy stocks continue to drop there is a sudden realization that the long-term trend has changed, and a race to the exit creates a collapse in prices. Once again, investors chasing the performance are left with losses. Many of these companies and investment products are fine opportunities but were purchased with the misguided and unrealistic expectations that the long-term trend will continue.

On Friday, January 4th the U.S. stock market received a shot-in-the-arm and the major indexes gained more than 3% in one trading session. Federal Reserve (Fed) Chairman Jerome Powell said the central bank will be patient before hiking interest rates further. The latest jobs report showed that the U.S. economy added 312,000 jobs in December. And the U.S. and China were reportedly preparing for a new round of trade negotiations.

While our friends in the picture above were happy to crest the ominous wave, they, like us, are going to see more choppy seas ahead, but with a good boat and an observant captain they should be able to navigate the waves.

Thankfully, Fed Chair Powell calmed investors nerves, but one has to wonder about the Fed’s abrupt change in forward language about future interest rate increases and economic growth on the same morning that nonfarm payrolls jumped far more than economists expected in December. And more importantly, average hourly earnings notched their biggest full-year gain since 2008.

You may ask, what causes the Fed to suddenly change their language about future interest rate increases? Since September of 2018, I have been predicting that The Fed may quit raising the Fed Funds Rate due to the following reasons:

1.  The increases will indirectly raise the cost of funding the enormous and growing U.S. deficit.
2. On a global basis, higher rates cause a flood of foreign deposits to move to the United States, strengthening the U.S. dollar, which makes our products more expensive abroad and harder for U.S. companies to compete.
3. The flight of capital from places like the EU exacerbates an already weakening economic situation in their home countries.
4. The strengthening U.S. dollar and capital inflows further roils emerging markets since many rely on foreign capital and have U.S. dollar-denominated debt. Emerging markets are weak in nature and if they must convert more of their home currency into U.S. dollars to service their debt, it only worsens their competitiveness and financial position.

I continue to monitor these points for contagion.

US equities fell sharply in the fourth quarter of 2018 as investors negotiated concerns about a government shutdown, US trade relations with China, and the Fed raising rates too aggressively.

The sharp drops in stocks and commodities underpin the palpable unease in place right now.

During the fourth quarter of 2018, the NASDAQ Index lost 17.5%, the S&P 500 Index lost 14.0%, while the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) gained 3.0%.

In 2018, the much-needed market correction occurred later than I had expected, which caused it to be more severe than first thought. In 2019, from my vantage point, the economy appears to be on stable footing which should allow the stock market to grind higher. The stock market will likely trade in a volatile fashion as it digests many of the points I will mention in my positives and negatives section below. I also believe the chances of a full-blown recession remain low before the next presidential election.

Now that stock prices have adjusted to a level reflecting cautionary sentiment, prices of stocks in relation to their current and expected forward earnings look more attractive. In my opinion, it’s time to look forward and investigate which companies may do well and invest in new opportunities as they present themselves. My forecast from last year remains the same in that the economy continues to grow due to a healthy consumer, relatively low interest rates, and modest core inflation.

I also expect, as has happened in the past, that there will be a rotation to a new group of market leaders. This is a natural course of events as one area is overbought while others are passed over leaving them undervalued. Today I would say Apple Corp, with its slowing iPhone demand, will become less sought after than a company involved with the fifth generation of cellular mobile communications (5G). 5G products address mobile phone users seemingly never-ending thirst for faster speeds, higher bandwidth, greater availability and coverage, and crucially, ultra-low latency. The new 5G system is said to be 30 times better than the current 4G.

Along with the expected growth of mobile phone users to 4.78 billion in 2019 comes the problem of security as more and more daily activities are conducted wirelessly. These are two areas of particular interest in 2019. Last year we began to explore Blockchain technology-related companies, and after a time, we decided to put it on hold because so many obstacles surfaced. These obstacles included reliability, transaction fees, energy use, and cost of security. It continues to be an area of interest, but may fall away like the nanotechnology craze of the early 2000’s.

Taking away the math behind the economy and stock market, they are largely governed by the interaction of human perceptions, expectations, and sentiment which makes the future unpredictable. These reasons are why I don’t give much credence to what I hear in the financial media. Too many times the media personalities are chosen to tout the theme of the day or for taking an outlandish stance to capture the audience’s attention. The savviest professionals are usually successful due to diligent research which uncovers neglected areas of opportunity and then choose to eschew media attention.

This leads to my opinion about the positives and negatives facing us at this time. As I have stated before, stock market prices reflect the discounted value of future earnings by all investors. In this calculation, probability takes into consideration other external factors which are stated below:

Positives:

1. Consumer confidence hit an 18-year high in 2018 and consumer spending drives almost 70% of the economy.
2. Even though interest rates have risen, they remain at an attractive relative level.
3. Economic growth is slow but stable, with estimates in the 2% range.
4. Core inflation may continue to be modest.
5. The Atlanta Fed’s Wage Growth Tracker continues to point up.
6. Expectations may have been lowered to such a level that upside surprises may be seen.

Negatives:

1. Japan’s strengthening yen can causes widespread currency losses due to the forced unwinding of the Yen Carry Trade which could also cause a Japanese economic crisis.
2. Fear of an economic slowdown could change sentiment enough to impact consumer and corporate spending.
3. If the trade dispute with China continues to worsen it could cause slowdown in global growth.
4. Blindness to the state of the economic cycle can result in the Fed continuing to raise interest rates.
5. If Italy’s debt situation worsens and spreads to France causing an economic fallout.

I believe there will be many surprises in 2019, but innovation and a healthy consumer should prove to pull us through the current economic uncertainty. I look forward to reading, listening, and watching the barrage of earnings announcements and commentary for 2018 and to gain further insight into 2019. Hopefully some new market leaders can be identified and purchased at reasonable prices. Despite Apple’s woes, consumers have money in their wallet and a propensity to spend. We plan to find out where.

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