Investment markets are fundamentally comprised of entities that are at odds with each other. It is that state of opposition which itself sets the equilibrium price for every single asset. The number of dollars committed to a price with a ‘buy’ order is equal to the number of dollars committed to the same price with ‘sell’ orders. Entities with fundamentally opposing views meet in the middle and set the market price. I say ‘entities’ because buyers and sellers are not people -- they are mostly computers now.
At the beginning of 2019, those selling stocks ended up being wrong, and those buying them were right. It is impossible to know in advance which view will ultimately prevail from one year to the next -- therefore the only thing to consider is the value received for your investment capital and the risks assumed.
Years such as 2019, of 30%+ increases in stock prices, are rare indeed. Last year was the first 30%+ year since 2013. And this in the 11th year of a bull market! Before that we have to go all the way back to 1997. 30%+ years make investing look easy…and hindsight bias leads us to believe that all one needs to do is put money in an index fund and forget about it. While that may have worked last year, investing is not that simple. Because sometimes, like today, the index itself is incredibly risky.
2019 began on the heels of a nasty selloff in the 4th quarter of 2018 that sent stocks prices briefly down over 20% during that quarter. Then on January 4, 2019 we saw a terrified panel of current and former Federal Reserve chairs capitulate to market turmoil by communicating a 180-degree policy reversal and stating flat-out that Fed policy would, from that point on, be driven by markets. It followed through with three interest rate cuts, and an injection of $400 billion of conjured money to provide liquidity as the short-term funding market (also called the repo market) seized up in mid-September. Effectively, the Fed put a huge amount of monetary stimulus into the financial system and stocks followed suit with a massive rally.
The rally of prices in 2019 did not represent a change in the long-term fundamentals of the underlying businesses of which those stocks own a claim -- it was simply algorithmic traders directing money into stocks due to the incentives created by the Fed. The value of future profits of US businesses did not increase by 30% in one year. As we have mentioned in prior letters, we are now at a point where the stock market itself (and asset prices in general) drives consumer behavior. The Fed knows this, which is why it admitted that markets now drive Fed policy.
So, the question is what now?
There are, of course, many factors that will determine the future direction of stock prices. Those factors cannot be predicted. But for long term investors, the risk of price declines is now higher than it was at the beginning of 2019 simply because prices are 30% higher. Therefore, a continued conservative approach makes sense.
On the economic front, the U.S. is doing fairly well. The three interest rate cuts have resulted in a favorable response by residential housing (a huge part of the economy and people’s net worth). Inventory levels and vacancy rates remain near record low levels underpinning prices. Strong labor and housing markets support consumer spending. Business capital spending should also benefit from lower rates, receding trade tensions, and rising wages, the last of which increasingly makes firms willing to automate.
On the global side, manufacturing has been at the heart of a global slowdown. Manufacturing cycles tend to last about three years – 18 months of weaker growth followed by 18 months of stronger growth. The current global slowdown began in the first half of 2018 and, right on cue, the recent global data has begun to improve. We believe that this will continue, that the global economy will outperform the U.S. in terms of the rate of change of economic growth and that the dollar will weaken.
A reacceleration of global growth argues for a continued healthy allocation to international investments and positioning for a weakening dollar (through holdings in gold, energy, foreign stocks, value stocks and non-U.S. bonds), as well as underweighting those investments that benefit from a strong dollar (tech, growth stocks, interest sensitive stocks, and high P/E (price-to-earnings ratio) stocks). There is far less risk in this strategy than in overweighting tech stocks.
Stocks overall tend to outperform bonds when global growth is accelerating because earnings tend to rise when growth picks up. U.S. stocks have outperformed overseas stocks by 137% since 2008. Today, the forward P/E ratio for U.S. stocks is 18.1 and for non-U.S. stocks it is 13.6. This means that market participants see U.S. stocks as much less risky (and have much better growth prospects) than overseas stocks. This is why overseas stocks are much cheaper. We see four reasons why foreign stocks could easily outperform U.S. stocks this year and in the longer run:
- Cyclical stocks are overrepresented outside the U.S. and cyclical stocks tend to outperform defensive when global growth is strengthening;
- Non-U.S. stocks are significantly cheaper;
- Profit margins have less scope to rise in the U.S. relative to outside the U.S. Operating margins are 10.3% in the U.S. compared to 7.9% abroad. Labor slack (unemployment) is generally greater abroad than in the U.S., which should limit cost pressure and allow for expanding margins outside the U.S.; and
- Uncertainty over the U.S. election could limit gains to U.S. equities. Democratic frontrunners have pledged to roll back the 2017 tax cut and Democrats have vocally championed increased regulations. Such a change would require Democrats to regain control the Senate and the White House, but it is still a risk.
A word on Iran and the killing of Soleimani: It is no secret that there is an ideological divide between the Arab world and the western world, hence significant tension. This has been going on for a very long time. How to get out of it without a war is the question and we don’t have the answer.
The killing on January 2nd (U.S. time) took the markets by surprise. Crude prices rose about 3.5% the next day and stocks were down about 0.7% -- a relatively small selloff given the huge rally in December from Fed stimulus. Trading on Jan. 3 was relatively subdued because there are many factors more important than geopolitics that drive market prices.
There is little doubt that this Iran development will bring more conflict, both direct and indirect, between the U.S. and Iran. However, it is important to know that the oil market, which, in the short run is driven by the communication strategy of both OPEC and non-OPEC suppliers, has speculators reluctant to drive crude prices higher in the absence of any actions that actually decrease global oil production volumes. Moreover, shale producers sell short their future production because they are heavily indebted and can’t risk price declines. As it is, foreign producers want crude prices to remain under pressure to keep a lid on U.S. shale growth and to prevent cash-strapped producers from jumping at the opportunity to ramp up production to make extra money if prices do rise. However, in the longer run, any Iranian retaliation that takes oil off the market is bound to cause a jump in prices. The irony is that Iran’s acting out will significantly benefit U.S. shale producers and their creditors!
One thing we do know with near certainty is that any adversity, geopolitical or otherwise, will likely bring intervention from global central banks. This will support equity markets in the short run but could also be counterproductive if it brings inflation. The bottom line is that the developments in Iran are not likely to have a major impact on financial markets unless something large and unexpected happens.
In terms of our own investment strategy, our continual goal is to earn high average annual returns for you with as little risk as possible (on an after-tax, after-inflation basis). The performance of any benchmark (such as the S&P 500) is irrelevant to your personal finances. The only thing that matters is the returns on the investments that we make for you and the risk that we take to earn them. This is why we do not care about benchmark returns other than as perhaps a source of occasional amusement. Most advisors and investment managers are out there trying to beat the S&P 500 because if they are successful it brings them business. But the act of trying to beat the S&P 500 leads to poor decision-making, non-awareness of actual and relevant risks, non-caring about valuation and a short-term orientation. All of which are bad for you.
Every client is super-important to our business and we treat them as such. Highgate’s reason for being is to help people sleep at night no matter whatthe market is doing—by doing the hard work of investing and avoiding bad risks. We work well with sophisticated investors who understand and appreciate our approach, who aren’t chasing returns, and who value their ability to always get ahold of us when they have questions. Our investment portfolio will often look very different from the S&P 500, but we feel that when so many others are invested that way, it is better for us to look elsewhere for opportunity.
We hope that you are enjoying your winter so far and we extend our sincerest gratitude to you for considering Highgate to help you with your investments. Please know that we work hard every day to make high quality decisions and that we strive to deliver a superior client experience.
We can be reached at
303-968-1230, or by email at email@example.com and are happy to perform a no-obligation portfolio evaluation for you.
 Source: BCA Research
 Source: BCA Research