We don't play for the excess
One of the most difficult things I could possibly message right for my clients in the present and the future is the seemingly contradictory realities around valuations and timing. I insist on presenting the truth 24 hours a day, and doing so as part of a vow of trustworthiness I have taken to clients. Well, these three sentences are all emphatically true, yet require additional explanation by way of how they get applied to investor behavior:
(1) Valuation is an extremely important metric in evaluating risk and reward in investments and expected long-term returns
(2) Valuation is a nearly worthless timing tool, as markets spend significant amounts of time overshooting average valuations and significant amounts of time beneath average valuations
(3) We expect markets that get expensive to get more expensive and markets that get cheap to get cheaper still, and we believe this to be a worthless maxim in actual application.
So all of these things are true, but what does it all mean in the actual implementation of portfolio management, here and now? It means that stating "markets are richly valued," or "markets may get over-valued," is neither a mandate to sell or buy more. It does mean there is no mandate to sell (markets are likely to get over-valued, historically), but it surely does not mean we want to play for that excess!
Essentially, the disciplined approach - and the one we are confident will play best (outside of lucky timing) - is to maintain strategic allocation on to equities as is appropriate for one's timeline and risk tolerance, yet to maintain vigilant re-balancing and trimming along the way. All of those predicting the end of this bull market are right about one thing - it will end.
But they have no idea how wrong they are about timing such. No idea.
Looking for corroboration part I
If one was prone to believe that equities were in a state of bubblicious excess they would likely have corroborative evidence to go along with the high prices in the stock market. For example, we find the tightness of bond spreads in the high yield bond market to be a far worse indicator of present risk apathy than market valuations. But what else supports this narrative? IPO activity is very restrained. Flows of capital into equities are modest, if that. Margin buying has not skyrocketed. Bullishness in surveys has only recently even gotten back to median levels. Corroborative evidence may come for equity market excess, but it’s not readily visible yet.
Looking for corroboration part II
But is there corroborative evidence for the other side - that the bull market is set for a new stage of growth? Besides rising bond yields, increasing GDP growth, and accelerating profits, there also is rising business confidence, commitments of new capital expenditures, high cash levels on corporate balance sheets ready for deployment, deregulation in the financial industry, and the pending benefits from tax reform.
So it's easy - the bulls win, right? Not so fast!
The corroboration of the bullish thesis may be far more supported by empirical evidence than the bearish thesis, but that ignores a cruel reality of markets: Sentiment often flips in advance of the detectable evidence that would have forecasted it. We prefer to stand behind our major theme - the recognition that advancing stock prices should not be laughed at or thought impossible, but with a healthy respect for volatility and normalcy. Is there really any other choice?
Other than that, how was the play, Mrs. Lincoln?
So we see the 10-year bond yield moving higher - the Fed shrinking its balance sheet (ever so slowly), the Bank of Japan announcing it will back off from aggressive Federal treasury purchases, the European Central Bank slowly tapering its bond purchases, inflation expectations moving higher (ever so slowly), and then now China announcing a potential slowing of U.S. Treasury purchases. Is there anything out there calling for a decrease in bond yields? Not really. Perhaps rates will get ahead of themselves, but all things considered, fundamentals appear to be calling for this slow move higher in yields to continue. The caveat is just that there is a limit to how high they can really go as long as global accommodation remains this high.
Sector outlook 2018
Technology - bullish case is that new business capital spending has to find its way to technology; bearish case is already high valuations and limited benefit from tax reform given already low rates for many tech companies. Conclusion: Old Tech over Cool Tech
REIT’s - bullish case is that they are under-valued and have underperformed; bearish case is that rising interest rates may hurt their values as they are largely priced around their dividend payment to shareholders. Conclusion: When rates rise because of economic cyclical growth, the impact to REIT’s is highly transitory, and the economic growth pushing rates higher becomes a positive to REIT’s, not negative ones
Energy - bullish case is the broad sector’s lack of participation in broad bull move of last year or so; bearish case is, well, hard to find, quite frankly. The easiest risk to quantify is certainly commodity price risk. Conclusion: From upstream to midstream to downstream, we see certain companies with compelling value
Financials - bullish case is the deregulation movement taking place at executive branch level and federal reserve level across the sector, and the increased margins for banks with higher interest rates; bearish case is that much of this has already been priced in. Conclusion: Keep diversified exposure from big banks to regional banks to asset managers to insurance companies
Consumer - bullish case is that the consumer may spend more in a growing economy; bearish case is the e-comm effect on many retailers, and the financial leverage so many discretionary names have on their balance sheets. Conclusion: Limit exposure to areas of balance sheet strength and e-commerce strategy
Telecom - bullish case is that tax reform should be very beneficial to their high capex needs; bearish case is that there is market saturation throughout industry, and dividend payouts are already high, limiting growth possibilities. Conclusion: Neither overweight or underweight; stay the course; and look to the dividend sustainability of selective companies to drive decisions
A mere silver medal for technology?
One may not know it from media coverage or barroom chatter, but technology has actually NOT led the market since the election. While no one would complain with the 44% return seen the last 14 months in the technology sector, the first place performer has actually been - wait for it - our beloved bank sector. Banks are up 48% since President Trump was elected, a fact that is slightly less surprising when you consider the deregulation of Dodd-Frank's onerous requirements, corporate tax reform, the former President for Goldman Sachs being head of the National Economic Council, etc. Oh - and the huge underperformance of financials that preceded this period ... (1)
Why asset allocation matters
This is always a powerful chart, but a few things make it more powerful this year than normal.
The real message of the chart is to show the wild swings asset classes will have one year from the next, and how common it is for one year's loser to be the next year's winner, and vice versa. It reinforces the extraordinary need for asset allocation. But 2016 and 2017 both have a rather rare lack of any negative performing asset class in the top 10 of asset class performances. And as the great Ben Carlson pointed out (2), this will be the last year in the 10-year performance history that 2008 fits in. The 10-year record of risk asset classes starting 2009 is going to be something to behold. How many would have predicted that in early 2009?
Not all China fears are created equal
August 2015 - China announces they want to let their Yuan float against the dollar; markets go into convulsions as fears hit hard that China is seeing a massive depletion of its excess reserves and capital running to get out of the country.
January 2018 - China announces a quasi-similar initiative as the one they announced in August 2015, and global markets have one of their best weeks in years, as the stabilized credit conditions and particularly improved foreign exchange reserves paint a wildly different picture than that of 2015 (the chart below actually shows reserves actually higher at the end of 2017 than beginning of 2017).
Bottom line - the fundamentals that color a macroeconomic event matter, a lot. Our Chart of the Week below explains why all of this has mattered so much to global macro conditions, and from there, to investors of all shapes and sizes.
Inflation or not inflation, that is the question
So the final headline CPI number for 2017 came in at +2.1%, but it is an odd reading. Apparel inflation was down 1.7%. Airfare was down 4%. And wireless services were down over 10%. Consumer energy costs were up over 6% and rent costs up over 3% (3). So that 'tug of war' nets out at 2.1%, but who calls it inflation when auto prices, phone bill prices, clothing prices, and travel prices were all negative? Expect more metrics and measurements in the weeks ahead, all saying the same thing: They don't know how to measure inflation.
Most concerning economic metric for young adults?
No question about it; no hesitation at all in my answer: It is the exorbitant and absurdly high prices in housing, whether in the rental OR purchase market. There are now and will be worse in the future, ghastly economic consequences for the millennial demographic out of this policy-created mess. It is shameful.
Many point to the $1.1 trillion of student loan debt as the culprit, and the 5 million people already in default on said debt. You will forgive me for being unable to see the student debt fiasco as something other than a directly correlated by-product of the aforementioned housing price monstrosity.
2018 Prediction Check
Normally it is good to wait more than 10 days or so to check in on a prediction for a full calendar year, but in light of our belief that 2018 will be an interesting year for much of "big tech" as it pertains to their political and social reputations, I couldn't help but comment on this headline in this morning's Wall Street Journal. I guess it would be disingenuous to say that we saw this starting this quickly into the new year ... But we don't expect this rhetoric and vibe to die off anytime soon.
The lesson for bears, bulls, stock guys, bond guys, crypto guys, pundits, asset allocators, money managers, investors, dogs, cats, and humans
A thought occurred to me this morning about the conviction with which some very smart people told us the dollar would rally up last year. In fact a lot of things reinforced this thought: The insistence market skeptics have had for years and years that stocks were about to drop, seeing Bitcoin down over 40% in just a couple weeks, bond yields stubborn refusal to do what bond experts said they would do, and frankly any other number of forecasts that lacked necessary humility in making an economic or investment forecast ... And that is this: Investing capital is the job of the humble, and ought to be done by no one else. Arrogance and unbridled confidence in a certain prediction or forecast can do unthinkable harm to one's financial well-being. Humility is a good characteristic to have in all walks of life, but in the field of investing, it can be provided to you by Mr. Market if you do not enter the game already equipped.
The need for diversification and asset allocation is the necessary application of investment humility. Period.
Chart of the Week
I have to tell you - I think I am providing a real treat in this week's Chart of the Week. Call it 20/20 hindsight if you wish, but I don't believe I could provide you a better correlation with pretty darn strong causation to boot as to how equity markets have performed over the last seven years than this. Essentially, what you see here is the U.S. dollar relative to the Chinese Yuan currency. The red line showing a drop in the dollar relative to Yuan coincides with two periods of robust stock market strength. The period where the dollar violently rose against the Chinese Yuan (and yes, the much better way to say it is that the Yuan collapsed relative to the dollar) marked a two-year period of stocks not moving, and actually seeing heightened and sometimes violent volatility.
The temptation may be to assume that this chart says, "weak dollar, strong stocks; strong dollar, weak stocks" - but that actually misses the real message quite spectacularly. What it shows is that when the world is confident China is still plugging along, evidenced by a strong Yuan and healthy foreign exchange reserve management, markets have shined. But in the period where China's soft-landing was in question, evidenced by a collapse in foreign exchange reserves and freefalling Yuan, markets went into convulsions. In other words, and I mean this as much as I could mean anything, the dollar/Yuan movements have not been the cause of anything; they have merely been the evidence of the cause (namely, confidence in China's economic stability).
As earnings go, so goes the stock market (always and forever). This is a long-term mantra that has no exceptions in history. But in shorter periods of time, where the key question is gauging overall global macro sentiment (when risk is put on vs. risk being taken off), as China goes, so goes the world.
Quote of the Week
"Those who have knowledge don’t predict. Those who do predict don’t have knowledge."
- Lao Tzu
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Beware those who are sure what the market is about to do, for good or for bad. I believe in living one's life by a set of foundational principles, and I believe in investing money by principles as well. Sentiment shifts, market psychology, and other investors' behavior do not alter timeless and true principles. Stay focused in a tremendously positive bull market on a disciplined plan, just as you should stay focused (through adversity) in a bear market.