January 14, 2019
The 4th quarter of 2018 marked a big change in markets. After a relatively uneventful year through the 3rd quarter, price volatility picked up significantly, investors became nervous and the financial media went into overdrive. What this portends remains to be seen, but the era of simply putting money into the S&P 500 and earning high returns may be coming to an end.
The sell-off in stocks and commodities brought declines of 14% in the S&P 500 and 41% in the price of crude oil for the 4th quarter. Because investors became more risk averse, bond prices rallied, and the yield on the 10-year Treasury declined from 3.2% to 2.6% in less than two months. Gold, one of the most universally despised asset classes during a period of rising stock prices, rallied 8%, with gold mining stocks rallying 14% for the quarter. Interestingly, one of the most beloved asset classes, cryptocurrencies, tanked, with Bitcoin down 71% for the year and 41% for the 4th quarter.
This turbulence and risk aversion surprised many investors because the financial press had been consistent in its story that a strong economy, full employment, low inflation and low interest rates would continue to support stock prices. This is a reminder to all of us that the chattering pundits on CNBC are simply white noise to be ignored. What matters is the Fed and its determination to raise (normalize) interest rates during a period of record high and rising indebtedness in the US economy and uncertainty over whether such an indebted economy can withstand short-term rates higher than 2.5%.
While we have no forecast on the absolute level of future interest rates, we do know that there will be a large supply of new bonds coming onto the market, which will put upward pressure on rates. The Treasury will issue new bonds to fund the fiscal deficit, and the Fed plans on selling about $500 billion of bonds to reduce its balance sheet (bloated from past purchases during crisis times). This new bond supply will total about $1.8 trillion or 8.3% of forecasted GDP—the highest ratio to GDP since 1945.
What was both interesting and telling, however, was the roundtable discussion Jerome Powell, Ben Bernanke and Janet Yellen had on Friday, January 4. Powell said that the Fed “will be patient” in hiking short-term rates and that the Fed is “listening very carefully” to the markets. Stocks promptly rallied over 3% on the day. This, to us, confirms that it is the direction of asset prices (stocks and real estate mostly) that drives Fed policy. So now we have a situation where the Fed, effectively, cannot normalize rates without causing pain. The Fed blinked because it is worried that stock price declines will cause a negative feedback loop that leads to recession. We are skeptical, however, of how well the Fed will always be able to control the behavior of market participants, so we will continue to avoid bad risks and areas that have been overinflated by years and years of ultra-low rates which prompted huge amounts of borrowing (aka credit expansion). We will avoid companies with marginal business models, stocks with high valuations and balance sheets burdened with excessive amounts of debt.
During this particular credit expansion, US stocks, especially those of super-popular large tech companies with such captivating growth stories (the so called FAANG stocks: Facebook, Apple, Amazon, Netflix and Google), were the main beneficiaries of zero interest rate policy. During the last credit expansion (that led to the 2008 financial crisis) it was real estate prices and pools of loans funding real estate speculation that were temporarily the main beneficiaries of the expansion. A contributor to the FAANG stocks’ outperformance was the ever-increasing popularity of index investing and the gobs of money that poured into passive index funds and ETFs. Confirmation bias (formed by the S&P 500 outperforming everything else for a long time) led to a belief system that indexes are always the best way to invest, and the money flowed in.
Algorithmic traders and speculators fueled by cheap credit jumped on the bandwagon and pumped money into hundreds of investment vehicles that mirror the indexes in a giant high-stakes game of musical chairs. And because most indexes are weighted by the size of constituent companies (market capitalization), it drove the prices of the mega tech stocks into the stratosphere. It is the modern-day, computer-enhanced version of the Nifty Fifty of the 1960s and 1970s—where people and computers acted on the (mistaken) belief that large growth companies could be bought regardless of price because the companies would keep growing and their stocks would always do well. We will call this belief the Great Mistake because the reasons behind it are not widely discussed or acknowledged, and the confirmation bias that created it is well-entrenched. These large US growth companies are, therefore, the positions that have the most risk today. And that risk is still mostly unrecognized.
As the Great Mistake unwinds, it will give the financial media something to get whipped up about because so many people own these risks. It has already begun with major declines in the FAANG stocks that have become so popular with so many individual investors. All of those stocks have traded down significantly since the end of the 3rd quarter (Apple itself is down 37% in three months as of the writing of this letter), and it is these FAANG stocks that people and algorithmic traders still believe hold very little risk and will always be stellar long-term investments. The market will likely continue the process of proving that belief to be untrue. This is what investment markets do—purge false beliefs.
On the other side, investments such as emerging market stocks, energy, gold, homebuilders and other such areas that are widely shunned and where the marginal seller is long gone possess far less risk due to widespread skepticism, disdain and lack of sex appeal. As market liquidity decreases and monetary conditions tighten, investors will be more discerning about where values are and rational in their use of capital. It may finally be a time where doing the hard work of investing—reading the footnotes of the financials to better understand the risk of an investment—begins to pay off.
Corporate buybacks have been a major source of market liquidity and the likelihood of fewer buybacks may take some of the buoyancy out of the prices of the more speculative stocks. Fewer buybacks are likely because corporate debt has soared from $4.9 trillion to $9.1 trillion (a record) in the last ten years. Moreover, the financial engineering benefits (artificially boosting EPS) declines as the return on cash increases. On top of that, lending standards could easily tighten as asset prices become more volatile in an environment of record levels of outstanding student loans, subprime loans, credit card debt and Treasury debt. The US economy is propped up by both low interest rates and high asset prices during a time when the Fed needs to raise rates due to full employment. This is what makes today’s environment unique.
Many investment advisors spend a lot of time convincing clients that because the economy is “fine” the stock market should do great. Most investment advisors don’t understand, however, that the economy doesn’t necessarily correlate to benign future investment markets. The economy was “fine” in 2007. Since we live in a financialized economy (meaning the level and direction of the stock market and interest rates drive economic behavior), naturally it will be strong when the stock market is near all-time highs as it was early in the year. It will be during periods of stock price declines and increased volatility that economic activity will begin to slow.
For now, absent an absolute disaster in stock prices, the Fed is on track to continue tightening rates. Why? Because everything it proclaims about the factors that drive its policy—i.e., the level of employment and stable prices—says it will. The unemployment rate is near 50-year lows, and one of the Fed’s mandates is to cool an overheating economy and reduce excessive speculation. But when large numbers of the public are involved in speculations such as FAANG stocks, the Fed must tread lightly. It may be that the decline in stock prices and tightening lending standards have already done some of the Feds’ work, but valuations remain extended in large companies such as Amazon and Facebook and most investors are overweighted in them due to their being such large components of index funds.
We spend a lot of time delving into the financial statements where the real risks are disclosed. The real risk in any investment is disclosed in the footnotes of the financial statements, and the vast majority of investors, including professionals, don’t spend time looking at them because it is hard, it is time-consuming and it requires knowledge, an understanding of accounting and the right analytical tools. Simply doing an earnings projection, deriving a PE ratio based on that projection and calling it good is not sufficient, and that is how many advisors end up with risks they don’t understand and poor investment performance.
The point is that the future is entirely unpredictable. As a starting point, we will not get involved in the Great Mistake. But further, we will avoid speculating—instead investing in companies where we receive significant value in terms of assets and cash flow for our investment dollars and where the management team is skilled and acts in shareholders’ (our) interests. If we do this well, the economy and the direction of the stock market become less important. We won’t get everything right, but we will always work hard on your behalf.
Every client is super-important to our business and we treat them as such. Highgate’s raison d’être is to help people sleep at night no matter what the 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 can be reached at 303-968-1230, or by email at firstname.lastname@example.org and are happy to perform a no-obligation portfolio evaluation for you.
John Goltermann, CFA, CPA, CGMA