In the face of numerous headwinds, which in aggregate fueled worries that the U.S. economy could enter a recession sooner than consensus had previously expected, stocks impressed with a modest third quarter gain to close less than 2% off the all-time highs. However, the gain did not come easily, as investors had to navigate a trade-tweet-induced draw-down in August, a spike in oil prices, concerning economic data, a collapse in bond yields, and of course, the launch of a divisive impeachment inquiry. Similar concerns about the economy and an unresponsive Federal Reserve fueled last year’s fourth quarter rout, but this time around, the Fed’s commitment to remain accommodative and a sharply lower global bond yield environment have been a steadying influence. In this environment, it is important to strike the right balance between continuing to participate in the upside of this still-very-viable bull market and recognizing that risks are clearly rising. When asked what made him unique, ice hockey legend Wayne Gretzky once said, “I skate to where the puck is going, not where it has been.” While perhaps his words are now overused in corporate board rooms, we will take a similar approach in a rapidly evolving investing climate.
The outlook for the global economy, and trade specifically, continued to be a primary driver of market angst during the quarter. Despite the strong year-to-date performance, U.S. stocks are flattish over the past 12 months (S&P 500 up slightly more than 2% from September 30, 2018 to September 30, 2019) and only up a few percent over the past 18 months, when tariffs were first introduced. Investors may have awoken to the reality that, regardless of any potential long-term benefits from a trade deal, for now the collective impact of the tariffs in place largely offset the fiscal stimulus from corporate tax cuts that lifted the markets so much over the first half of 2018. Even the impeachment process itself seemed to be less impactful on stocks (at least by quarter-end) than the idea that China might perceive a weakened president and hold out for a better deal. Starts and stops in negotiations with China continued to greatly influence daily (if not intra-daily!) price swings during the quarter and will likely continue to do so for the foreseeable future.
The manufacturing and industrial pockets of our economy that represent about 30% of national output and 15% of employment have borne the brunt of this trade tension (i.e. ISM-PMI). Meanwhile, the U.S. consumer and overall service side of the economy, which are by far the larger engines of growth, have been fairly stalwart. The lowest unemployment rates in 50 years, rising (but not too hot) wage growth, low inflation and interest rates and healthy individual household balance sheets have all lent support to the domestic economy. While there are emerging signs of a slowdown at the margins, particularly in hiring, we would need to see more “contagion” from the trade tensions to ratchet our expectations for a recession and associated bear market. We will also be watching for any deterioration in the various consumer sentiment surveys. The fear of recession can be a self-fulfilling prophecy if both businesses and individuals delay spending decisions.
This mixed macroeconomic backdrop was clearly reflected in investor preferences and sector performance during the quarter. Stocks perceived to be somewhat insulated from the deteriorating global trade environment and/or more correlated with the resilient U.S. consumer, for the most part, outperformed those stocks more exposed to global trade relationships and slowing economies overseas. This divergence correlated with the stretching of the valuation spread between growth and value stocks to its widest level ever recorded by early September. The most effective, but counterintuitive, strategy in recent years has been to buy the most expensive stocks and then keep buying them as they grow even more expensive. We question the merits of chasing currently popular trades like utilities, for example, which have become the most expensive sector in the S&P 500 with arguably the least attractive long-term growth profile. Given this internal market bifurcation, we continued to balance portfolios between companies with good visibility into current earnings and revenue growth, that are not necessarily cheap but still reasonably priced with respect to their future prospects.
Towards the end of the quarter, investors grew more optimistic about a potential trade deal or maybe the favoring of growth stocks had simply gone too far. Either way, the market underwent a violent rotation, and relatively underperforming sectors, like the Financials, Energy and Materials (the de facto value stocks trading at some of their lowest valuations in ten years), enjoyed their biggest rallies in quite some time. As part of this shift, the so-called “FAANG” stocks (Facebook, Amazon, Apple, Netflix and Google (now known as Alphabet)) collectively continued to abdicate some of their leadership position. At multiple points over the past few years these technology giants have been responsible for as much as one third to one half of the S&P 500 return, but their collective performance on a relative basis versus the broad market actually peaked last fall. There are some company specific issues, especially in the case of Netflix now finding the market for media content streaming significantly more competitive and expensive, and several face pending anti-trust reviews. These stocks had also become too “loved” and too widely held. When seemingly everyone owns the same five stocks and perceives them to be infallible, there is little room for further appreciation until the fundamentals dramatically improve. We also know it is likely premature to count on a sustained recovery in value stocks, as they typically start to outperform only when there is a rise in overall economic growth expectations. As conditions become more challenging, the right balance between finding attractive fundamentals and then determining a sensible price to pay for those fundamentals will increasingly matter. Look no further than next year, as consensus estimates calling for 10%+ earnings growth (Factset) are likely way too high, and thus U.S. stocks may be more expensive on a forward-looking basis than they appear on the surface.
The bond market always seems to remind us to be skeptical of consensus opinion. This time last year, the 10-year treasury yielded over 3%, and analysts far and away were calling more for the end of the secular trend of persistently low rates than a return to the sub-2% yields of a few years ago. Sure enough, yields fell during the third quarter to roughly half the levels seen last fall in response to the combination of global growth fears, a more dovish Fed and outright negative yields across much of the developed world. With this downdraft in yields (which move inversely to prices), U.S. bonds have significantly outperformed stocks over the past 12 months. And in doing so, they have reasserted themselves as an effective risk management tool, cash flow generator and, yes, positive contributor to portfolio performance. Rather than trying to forecast where rates might go in the future, a ”laddered” bond strategy, whereby we hedge the risk of rates moving in either direction, might be prudent.
As we head into the fourth quarter and start to look towards 2020, the central investor question for most investors undoubtedly remains: when is the recession and next bear market coming? Unfortunately, the market will likely not be the “tell,” nor will some of the other popular indicators in isolation. Recessions over the past 60 years have been preceded by both good stock markets and bad, low inflation and high inflation, low interest rates and high interest rates and stretched and cheap valuations. From our experience over the 12-18 months leading up to the trough of the financial crisis in early 2009, we know that reducing risk is more of a process than an event. As more signs went from “green to yellow and yellow to red” over that period, we reduced our exposure to the areas that seemed most vulnerable as well as risk exposure overall. We see it fit to maintain our “disciplined optimism” for now and remain on guard to adapt to a wide range of potential outcomes. As always, we greatly appreciate your continued trust and confidence along the way!
The Wise Investor Group