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Up a Staircase, Down an Elevator

Sometimes these commentaries are just plain difficult to write. The tremendous uptick in volatility during the fourth quarter made a fool of anyone trying to handicap market outcomes and reflected an increasingly uncertain future into which investors seemed to blindly sell at times. Attempting to concisely and coherently capture the most salient themes in such a challenging, kinetic environment, where 500- to 800-point market swings are the new normal, has been quite a task!

As the old saying goes, stock markets tend to “go up a staircase, down an elevator.” After almost six months of back and forth trading, U.S. stocks finally eclipsed their all-time highs, set back in January, only to be summarily pummeled during the fourth quarter to post their worst yearly performance since the Financial Crisis. Growing risks that were ignored over the summer – a slowing Eurozone and China economy, a more restrictive Fed policy, an ongoing trade war and the possibility that earnings have peaked – snowballed into an avalanche of angst. Even though there was little evidence of a material economic slowdown and almost none of the central elements present that led to the meltdown in 2008, investors quickly discounted a significant change for the worse on the horizon. It became a quarter of firsts, records and extremes: U.S. stocks suffered their greatest December losses since 1931, including the worst Christmas Eve trading session on record. The closely-followed S&P 500 closed the quarter down over 14% from peak levels and, at a few points in December, came very close to a 20% decline, the commonly accepted threshold of a bear market.  Most stocks did not bother with such technicalities and traded well into bear territory. The median stock in the S&P 500 closed 2018 over 25% below its 52-week high, and over 60% of stocks ended down 20% or more from previous highs. Investors responded by dumping mutual funds, which suffered their largest ever aggregate outflows (a herd mentality that successful long-term investors typically do not want to adopt). The diminishing confidence in the outlook for corporate earnings growth was reflected in a sharp contraction in valuation multiples to below five-year and even twenty-year averages. Apple shares, for example, fetched over 18-times their earnings as recently as September only to trade at 11-times by year-end. Valuations influence stock prices as much or more than the fundamentals themselves, and changes in the trajectory can lead to outcomes significantly different than fundamentals alone would suggest. 

The challenging environment that had persisted all year for diversified investors worsened during the fourth quarter. Modern Portfolio Theory, one of the most widely accepted and time-tested investment “belief systems,” submits that investors should spread their portfolios across multiple asset classes to achieve the optimal blend of reward potential and risk assumption. Like any successful long-term strategy, it does not always work over shorter periods. While this present environment bears little resemblance to the 2008 conditions, one thing that is similar is that traditional allocation models have not provided comfort. Back in January, it was almost consensus that international stocks should be over-weighted versus domestic stocks, which have finally posted positive returns in 2017 after years of poor relative performance. Any investor who rotated more in that direction likely suffered double-digit declines, as most broad international indices closed the year off 15% or more. A similar experience befell those who thought small capitalization U.S. stocks might benefit from a relatively stronger domestic economy, firm dollar and protectionist trade policies, yet the Russell 2000 doubled the decline of the S&P 500. 

However, just sticking to our core competency and being diversified within high quality S&P 500 names was challenge enough. All year the leadership in the S&P 500 was incredibly narrow, and most of the return came from a handful of market sectors (and a small number of names within those sectors). Even though all sectors declined in the fourth quarter, the relatively expensive Healthcare, Information Technology and Consumer Discretionary sectors still managed to head the pack. Meanwhile, the industries considered more economically sensitive – Financials, Materials, Industrials, Communications Services and Energy – sharply contracted, and all endured losses for the year in excess of 15%. Since these sectors were already trading at lower valuations than the overall market coming into the quarter, the mounting frustration for value investors turned up a notch as the cheapest stocks fared the worst during the late-year selloff. Such a landscape made it very difficult for any diversified investor to compete with the widely followed, growth-oriented benchmarks and to avoid being well-correlated with the markets on the big down days. Of course, the message should not be that spreading out risk and being disciplined with respect to valuation are bad ideas. In fact, we will likely look back on this quarter and wish we were more aggressively buying these names, which were, in many cases, selling at valuations not seen in a decade. Any smart, sensible strategy will encounter periods along the way where patience, research and analysis do not necessarily help reduce volatility. As the late Rick Malone, the founder of our group, was fond of saying, “These are the fleas that come with the dog.”

One might ask why we did not rotate our portfolios more into the so-called defensive stocks while the cyclicals were getting walloped. We do not believe that it makes sense to try to time short-term shifts in investor sentiment in long-term oriented portfolios (especially when the most intense declines unfolded over just a few trading sessions). Instead, we came into the quarter with an equity portfolio that is balanced between companies with a healthy amount of exposure to changes in the global economic outlook and those with “all-weather” qualities. It would not be surprising at all to see the fourth quarter’s worst performers outperform again if the markets prove to be overly pessimistic about the prospects for the global economy. Also consider that “defensive” and “value” are not synonymous characterizations. Utilities, for example, are typically considered some of the least economically sensitive stocks, but in a tough correction, eventually everything gets sold, and they too succumb to the pressure. On a few days, utilities may have temporarily served as a slightly less risky “way station,” but their long-term investment case is limited given their expensive valuations relative to, for the most part, paltry growth rates. Some of the other traditionally defensive sectors, like Consumer Staples and many of the big telecommunication names, did not offer much protection at all. The combination of China trade exposure, leveraged balance sheets and slow growth rates were too much for them to overcome. 

We of course remain value investors, but it is important to not be overly dogmatic with this classification or simplistic in our analysis. Many fall into the trap of just investing in companies with low price-to-earnings ratios. Some of the most cyclical companies may currently look extremely cheap, but the market may have already stopped paying up for what are perceived to be “peak” earnings. Conversely, economically sensitive stocks are often most attractive when valuations are higher and expectations for future earnings growth are low. Blindly investing in some of the sectors trading at sharp discounts to the overall S&P 500 may have led to 2018 returns well below any of the broad stock market benchmarks. This does not mean we will not be selectively looking for opportunities. Consider the Financials, for example, where some of the bellwethers finished the year trading at valuations below those seen at the trough of the Financial Crisis in early 2009. In anything short of a significant recession, the risk-reward tradeoff for the highest quality names looks very favorable. 

We spent a lot of time during the quarter making sure we were comfortable with the long-term “stories” behind volatile stock price movements and that the businesses we own have secular drivers that should endure beyond any short-term adjustments in the economy. With this in mind, we added to some of the highest quality growth companies in our portfolio when valuations seemed to discount an earnings slowdown greater than is likely over the coming years. With almost everything down to some degree, we are taking the opportunity to think about which “horses” to ride going forward. 

Legendary investor, Sir John Templeton, once quipped, “When it’s time to buy, you won’t want to.” This seemed to capture stock investor sentiment during much of the fourth quarter (we will not know for a while if it was the time to buy!), but it also applied to bond investors over much of 2018. Paltry yields from fixed-income investments of all kinds have been the norm for some time, but many balked this year when presented, in some cases, with double the yields available as recently as four or five years ago. Investors tend to overestimate short-term bond market risks and underestimate those experienced over the long haul. Even though bond prices dipped a bit more than the income received this year to produce slightly negative total returns, bonds did stabilize during the fourth quarter and provided at least some ballast when stocks collapsed. From an absolute return perspective, throughout history the worst bond bear markets have paled in comparison to the drawdowns stocks have experienced. Higher inflation that erodes purchasing power over a period of years is a much more significant threat to any fixed-income investment or portfolio. To mitigate this latter risk, we have to make sure we capture these higher yields when they become available. We have “laddered” out our bond portfolios for years and were very comfortable reinvesting the proceeds from maturing bonds at this year’s higher rates. If rates trend higher, we will continue to roll the average yield in our portfolios progressively higher as well. If they fall at some point, at least we will have “locked in” some higher yields through the longest maturities. 

Just as stock market strength in 2016 and 2017 portended double-digit corporate earnings growth and 3%+ GDP in 2018, the selling during the fourth quarter is probably sending the signal that we should expect some degree of slowdown going forward. However, there is a significant difference between deceleration and decline, and we have been surprised by the extent to which a potential slowdown has been conflated with the likelihood of a recession. If the now commonplace predictions are accurate, it will probably be the first time ever that everyone has called the recession in advance. Most corrections, in fact, do not lead to recessions or protracted bear markets for that matter. It seems like with every downturn in recent years, minds go right to 2008, the worst financial crisis since the Great Depression, as if it is the standard for risk. The 15.2% decline in the S&P from May of 2015 through February of 2016 and the 21.6% decline over the back half of 2011 were every bit as painful as what we experienced here in the fourth quarter, but they never morphed into full blown crises and ultimately were not that impactful for most investors.  Some pockets of economic weakness have recently started to emerge, but overall the economic data has been healthy, including some key forward-looking data like the Purchasing Managers Index and Institute of Supply Management readings that show the U.S. manufacturing and service sectors clearly expanding. Many of the severe problems that plagued the “real” economy in 2008, including massive amounts of consumer leverage, are not present at all in the current environment. Given how severe the selloff has been, particularly in the most economically sensitive market sectors, the risks might actually be skewed to the upside if our base case for tempered-but-still-positive economic and earnings growth comes to pass. Once we start hearing more of the 2019 earnings and revenue outlooks from the companies themselves, markets could easily firm. Valuations are certainly less demanding than they were a couple months ago.

Not only are corrections and periods of heightened volatility much more “normal” throughout market history than 2017’s relative tranquility, but rarely do markets recover quickly and tidily. Recoveries from such damage are a process, not an event, and stocks may trade back and forth for some time before forming a stable base from which they can sustainably move forward. With this back drop, it is very important to keep a financial plan up to date, so that you can properly account for periodic withdrawals and any extraordinary liquidity needs. Some naturally become more myopic as markets decline and may start to consider an investment portfolio more like a checking account. But even investors who are drawing down their portfolios in retirement often find that after the contribution of dividends and interest, they are only modestly tapping principal by a low single-digit percentage. The vast majority of the portfolio is still there, in these cases, as an investment to keep pace with inflation and grow over the long haul. We should keep this in mind when thinking about daily market swings, program trading and the whims of computer algorithms that will have virtually no impact on long-term, successful outcomes.

As always, we will do our best to distinguish the important themes that help us seek returns and manage risk from the daily noise that only distracts us from the task at hand. We greatly appreciate your continued loyalty and confidence through these turbulent times and look forward to successfully coming out the other side!