The Backdrop for Stocks is Good, But the Bear Case Is Strong

The Backdrop for Stocks is Good, But the Bear Case Is Strong

"Smart investing doesn’t consist of buying good assets, but of buying assets well. This is a very, very important distinction that very, very few people understand. Buying right, NEVER feels good.” 

– Howard Marks

July 2019

Dear Friend of Highgate,

The rally seen in most investment markets during the 1st quarter of 2019 extended into the 2nd quarter, but not without an uptick in volatility along the way as concerns about China trade increased. May’s drop in S&P 500 was the 2nd worst since the 1960s while June’s rebound was the best since the 1950s.  In the end, the S&P 500 rose 4.0% in the 2nd quarter. Interestingly, bonds also rallied with the yield on the 10-year treasury declining to 2.00% from 2.41% at the beginning of the 2nd quarter and the gold price rallied 9.2%. This indicates that despite a stock rally, assets also flowed to perceived “safety”, which may reflect a potentially weakening economy that will necessitate cuts in interest rates.

To be certain, a weakening global economy may also be in the cards as indicated by the price action of certain global stocks such as 3M and Fedex. Those two companies are excellent global economic indicators because they serve just about every consumer and industrial market around the world. 3M and Fedex are down 33% and 40% from their respective highs in January 2018.

The US economy strengthened in 2017 and 2018 due to fiscal stimulus, tax cuts and low interest rates. This led to the Fed to want to ‘normalize' rates in 2018. But the prospect of rates continuing to rise late in 2018 led to a strong selloff in stocks in the 4th quarter. We have a situation where the stock market is now dependent on low rates. The fact that inflation remained low in the 1st half of 2019 provided a workable backdrop for the Fed to “pause” on raising rates in January and for the stock market to rally anew in the first half of 2019. The Fed is now “listening” to markets when making policy decisions. The tail is wagging the dog. Stock market participants are now expecting the Fed to cut interest rates 3 times this year. If that does not happen, participants could throw another temper tantrum and a nasty sell-off could result. That is not a prediction, just a risk.

Higher interest rates in the US versus the rest of the world and during a period of a weakening global economy mostly explains a strong dollar, subdued commodity prices and asset flows to both US stocks and bonds. These asset flows provide the fodder for the economy to continue to grow, for credit (borrowing) to continue to increase (as rates dropped) and for the background for stock prices to continue to be generally benign. Again, this is not a prediction, but a base case scenario.

But wealth and income inequality is a serious problem and it is changing the political dynamics in the US. We would argue that the inequality is due to excessively low interest rates that absconds returns from savers, retirees and the risk-averse, and allows for cheap borrowing costs for stock and real estate speculation. While the economy has 50-year lows in unemployment, homelessness has increased 16% in the City of Los Angeles in the last year. Signs of decay like this, along with heavily indebted college graduates, detracts from the entrepreneurial enthusiasm we often see within American culture that has always enabled the US to pull through challenging times in the past.

We worry that increasing indebtedness is not a sign of a fundamentally strong economy, but is what is behind today's economic growth. If the economy was truly strong and self-sustaining, we would see debt being paid down across the board. Since we are long-term investors and not traders or speculators, this is the reason we have adopted a mostly cautious stance and look for value in unloved areas.

While the backdrop for stocks is generally good, the bear cases for stocks are:  1) even though conditions are benign for stocks, benign conditions do not predict further benign conditions or more gains (extreme levels of risk complacency);  2) Asset managers with long bets (that stocks will rise) on S&P 500 futures contracts are back to the level they were in September 2018 (right before the market declined 20%); and 3) The leadership in the stock market is narrowing. In 2013, so-called FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) made up 5.2% of the capitalization of the index. Today, those five stocks make up 13.3% of the index. 

In fact, the top 50 stocks now make up ½ of the S&P 500’s return, and those 50 stocks are highly correlated with each other. In other words, if the top 50 stocks advanced 1% and the other 450 fell by 1% the index would be flat.  Therefore, the S&P does not provide much, if any, diversification. At a moment of peak popularity of index investing, many people are blithely loaded up in S&P 500 index ETFs and mutual funds, or invested through firms whose portfolios closely mirror the S&P 500. This is a time to move away from blind exposure to the index and focus instead on individual investments where a business’ cash flow and valuation provide downside protection once the momentum investing game ends. Buying the right asset at the right price and not just what is most popular has never been more important. Investing with the crowd rarely proves successful for long-term investors.

One doesn’t have to look around very hard to see signs of speculative fervor and carelessness with money. I have a friend who was sitting next to person at a fundraiser who was regaling my friend with how he makes $30,000 a month trading “Bollinger Bands” to augment his income from his regular job of getting sponsor deals for YouTubers. He learned trading in a hotel conference room and was trying to get his wife to do it too. You can file that story under "things you do not hear or see when stocks should be bought aggressively."

We continue to see long-term value in our investments in gold, emerging markets, and oil and gas companies. These investments are unloved, underappreciated, and will benefit from lower interest rates and a declining US dollar. Value rarely exists in areas where there is significant enthusiasm such as the FAANG stocks today. As fundamental investors that rigorously analyze the cash flows and the sustainability of those flows, short-term our goal is to maintain safety of principal for times when market conditions change, or the unexpected happens. We also look to any future volatility opportunistically - if we can add new investments or add to existing positions at lower prices, we believe that will be a positive for long term returns. Oddly, stocks are one of the few things that people prefer to buy high rather than low to the detriment of their future returns. 

The advantage of an investment process like Highgate’s is that because our focus is on safety of principal and the value of what we own, we believe we get the double-benefit of having high return potential and carrying significantly less risk. When markets become adverse, we are not likely to suffer the painful declines that those who are trading in the most popular, and most expensive stocks will. And if we can limit declines during tough times, we will have much higher average returns.

Thank you for considering Highgate Securities Investments to help meet your investment goals. We can be reached at 303-968-1230, or by email at You can also visit our website at We are happy to perform a no-obligation, objective portfolio evaluation for you. 

Best regards,

John Goltermann signature

John Goltermann, CFA, CPA, CGMA
President, Highgate Securities Investments

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