Stock investors are rejoicing that the markets have rebounded from the dismal end to 2018 while bond investors are moody due to the general decline in interest rates.
The hot debate among professional traders and investors revolves around what will happen during the balance of 2019 and the period leading up to the 2020 presidential election. Surely, any incumbent administration facing a reelection will likely do everything in its power to foster a positive economic and stock market environment. A relatively positive environment is my base case which I will expand on below.
Professional traders who make money by exploiting immediate changes in market influences and perceptions are campaigning for a continuation of 2019’s rally to recoup what was lost in late 2018. Professional investors, on the other hand, have a more tempered attitude by pointing out that the markets have basically been at a standstill for the past 7 months with stock and bondholders alike having been subjected to extreme volatility (risk).
During the first quarter of 2019, the S&P 500 Index gained 13.1%, the NASDAQ Index gained 16.5%, and the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) gained 2.4%. In the quarter your (diversified or balanced….) account gained….
Some seasoned investors are taking a more cautious approach due to current valuations and recent market volatility. Famed investor and Chairman of Berkshire Hathaway, Warren Buffet, has disclosed that their portfolio has recently held $110 billion or 20% of its holdings in cash. This cash position is no accident.
If one listens to a financial salesman or a less informed advisor, their war cry is that anyone who holds cash is doing themselves a disservice and the assets are non-producing. I prefer not to hold high cash positions, but the notion of being fully invested all of the time is ridiculous to me. In times of high or uncertain valuations, a cash war chest is more or less a riskless investment and entirely appropriate in order to take advantage of new attractive investment opportunities. When a correction occurs, fully invested investors many times miss opportunities since they loath to sell a position at a lower price to buy another.
To drive this point home, let’s examine globally what major institutions, along with their armies of analysts and portfolio managers, are doing with their asset allocations. As of March 13, 2019, Bloomberg News reported that the negative yielding debt index topped $9 Trillion. The magnitude in which institutions have actively decided to purchase investments which will return less than their original value tells me there is an imbalance in asset pricing.
When one looks at investment strategies, let me note that it’s very hard to effectively execute a trading and long-term investment strategy simultaneously. I advise carefully choosing one or the other. Traders are more interested in direction and magnitude of price changes to achieve a gain and are less concerned with valuation. For a long only trader, (one who buys versus one who may also sell stocks short), buying and holding highly visible names in what has turned out to be a long-standing bull market has worked well. As a result, many have lost perspective of the very real risks involved and their true objectives in return for seemingly safe and easy gains.
Current valuation levels in my opinion are high for many of the highly visible growth names. Problems begin to occur when high prices overtake potential reward and a correction occurs sending prices down. There is a widespread thought that prices may fall to a historic valuation level. The industry term for such a price movement is referred to as a Reversion to the Mean (μ). As a reality check, it is important to understand the tendency of long-term price movements and their relationship to valuation levels. An analogy would be packing away your coats in mid-winter due to an unseasonably warm spell. My guess is that the future temperatures will drop to its historical level and someone would be missing their coat.
Undiscerning investors with a trading mentality many times look at a price drop as a gift and keep buying (i.e. doubling-up syndrome) as prices slide without taking into consideration stock or market valuation. In a meaningful correction this action can easily amount to losses far in excess of gains since corrections can be swift and severe.
During market corrections, many opportunities may present themselves to seasoned investors who have the knowledge and make the effort to conduct thoughtful research into companies, the market, and risk. Taking a research approach is less attractive since it involves an enormous amount of time, effort, and discipline.
Going forward, my base case is similar to that of Fed Chairman Jerome Powell’s semi-annual testimony given in late February. He reiterated his themes of monetary “patience”, “muted” inflation, “solid” economic growth, and “stronger” wage growth. In my words, the potential for interest rate increases has diminished, inflation is not a pressing problem, the economy continues to expand, and there is more money available for buyers to make purchases.
On Tuesday, the global markets were down due to the IMF (Int’l Monetary Fund) lowering its 2019 global economic growth forecast to 3.3% from 3.5%, citing rising trade protectionism and instability in emerging markets. The forecast stated growth will stabilize in the first half of 2019, with a gradual recovery afterwards, and raised the 2020 US growth forecast to 1.9% from 1.8%. Despite 2019’s lower forecast, it is still a healthy growth rate. As we get into the latter half of the year, investors should watch for revisions in the 2020 forecast as a telltale of a recession.
It’s widely known that gains were recorded by investors during the latest long-lasting bull market by paying up for the largest tech names. Paying a premium for shares of Amazon Inc. and Alphabet Inc. (Google) over those viewed as a good value for the money has been a recipe for success for more than five years. Growth stocks have beaten their value rivals by a margin of more than two-for-one in that span until just recently, as explained by Reuters news agency on October 24, 2018. Given the change in the Fed’s subdued posture on interest rate increases and the IMF’s forecast, an intermediate market correction may be coming.
During my 35 years as a professional investor, I have never come across anyone who can consistently pinpoint the turns in the market. Someone is always right and many will profess they can determine the course of the market, but history proves otherwise. Burton Malkiel, an economics professor at Princeton University, went so far as to apply the Random Walk Theory to trading. This work states that the price of securities moves randomly, and therefore, any attempt to predict future price movement, either through fundamental or technical analysis, is futile.
However, for a fundamental investor there is opportunity if they have an eye for valuation. Some of the best performing big U.S. tech companies like Facebook, Apple, Amazon, and Google are facing increasing scrutiny recently over allegations of improper monopoly behavior. These companies remain highly sought-after investments, but the future looks less clear than the past and valuations seem to be too expensive for their potential growth prospects. I see some market participants reaching for returns, which also signals a change in investment views to me.
In late March there was an initial public offering (IPO) which came at a market value of almost 10 times their 2018 revenues. Yes, their revenues doubled over 2017, but their net loss was $911 million, wider by 32% from 2017. That doesn’t sound attractive to me and it is currently trading below its IPO price. Due to hype and investors reaching for returns, it may still go up, but at too much risk for me. The company is the ride-hailing company Lyft. Others expected to go public in 2019 include Uber, Pinterest, Zoom and Slack. (Uber, Lyft’s chief rival, is expected to release its S-1 and go public next month.) If you care about risk, other investments may be more appropriate. Traders may want to consider them, but initial open market buyers of Lyft are not faring so well.
Areas I perceive to show promise today are small and value stocks. In January the small-cap oriented Russell 2000 Index gained almost 10% compared to a gain of only 6% for the Dow Jones Industrial Average. From my vantage point, smaller companies have been ignored due to investors chasing and riding the wave of big tech growth names. The same has happened with value stocks. As reported by Northern Trust, in March, the valuations spread or price gap between growth and value stocks surpassed previous highs set in the dot-com era. In other words, on a relative basis, growth stocks have never been so expensive and value stocks never so attractive.
After experiencing the severe downward market reaction to the slowing earnings expectations in late 2018 there may be a renewed emphasis on fundamentals over sentiment. This should benefit the returns of active managers like Torii Asset Management. I look forward to the upcoming earnings reporting season to identify new opportunities and hear management’s discussion about the balance of 2019.
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