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We Respect the Message of the Markets

Not too many expected the worst December for the U.S. stock markets since 1930 to give way to the strongest overall first quarter performance in almost three decades! Corporate fundamentals such as earnings and revenue growth rates inform long-term investment outcomes, but over shorter periods of time, investor sentiment usually determines market direction. At no time has this been clearer than over the past six months, as by the end of the first quarter, the V-shaped move in U.S stocks had brought the S&P 500 back to within a few percent of the all-time highs set last September. Stock valuations, essentially measures of confidence in future earnings growth and surefire gauges of sentiment, collapsed late last year faster than at any time in the past four decades, only to rebound healthily despite falling estimates for future growth. The world has probably not changed as much as valuations and stock prices seem to indicate, but perceptions of the health of the global economy, the Federal Reserve’s positioning and what may transpire on the trade front have swung violently since last summer. We will leave attempts at predicting inflection points in these extremes to traders and market timers. It seems the “appropriate” sentiment should probably be somewhere between the pessimism of December and the much more optimistic outlook that rang in 2019. So, we will continue to maintain well-balanced portfolios that make sense for a wide variety of potential market outcomes. 

There is little value in trying too hard to determine in hindsight causes for such shifts in investor sentiment and market tone. Maybe there is simply a “Newtonian” explanation for the rally: that violent sell-offs lead to equally violent recoveries. Certainly, though, the Fed’s about-face in interest rate policy had something to do with the quarter’s strength. The S&P 500 dove 9% over just three trading days after the Fed announced a rate hike in December and held fast to their promise of more tightening to come. The Fed adopted a much more dovish posture in January. By March, not only had the Fed stated their intention to keep rates on hold until at least 2020, but the futures markets actually started pricing in odds of a rate cut this year. Expectation for lower rates can ballast stock valuations and provide stimulus for critical pockets of the U.S. economy, including housing. Hopes diminished late last year that China and the Trump administration would actually sit down to negotiate a thaw of the trade tension, which further compromised an already weakening global economy. Although there still appears much to be negotiated, investors welcomed the news that leaders were at least meeting and outlining potential areas of compromise in the first quarter.

Market commentators often lament how markets do not like uncertainty – as if there has ever been a period of “certainty”! The outlook has clouded though. The sharp 20% selloff from the September highs to the Christmas Eve lows represented a massive, collective recognition that the global economy was slowing faster than maybe most had previously understood, or at least cared to admit, while stocks were hitting all-time highs. Investors seemed slow to factor that the 20%+ corporate earnings growth rate of 2018, juiced a fair amount by tax cuts, was not sustainable this year and watched earnings forecasts come down sharply over the course of the first quarter. Talk grew of an “earnings recession”: at least two straight quarters of year-over-year negative earnings growth rates. However, remember, the oldest of investment truisms that stocks are discounting mechanisms – the economy is not the stock market and the stock market is not the economy. Just as 2017’s gains may have portended better growth in 2018, accompanied by the selloff last year that anticipated the cooling of that growth, the bounce-back in the first quarter likely reflected the combination of bad news already being discounted and investors looking forward to potentially firmer conditions later this year. Recent coincident economic indicators, such as retail and automobile sales, have been weak while leading data like consumer confidence and housing have been better. Fed commentary, too, has suggested that the recent weakness, at least here in the U.S., may be temporary. Any signs of improvement, both here and abroad, will be well-received given the pervasive negative sentiment. The current backdrop echoes the most recent growth stall in late 2015 through early 2016, which was followed by two years of double-digit gains for the S&P 500. Maybe this type of surge should not be our base case, but neither should an inevitable trudge to recession.

Still, it appears prudent to be a bit more cautious in the near term. Much was made, towards the end of the quarter, of the decline in interest rates and an inversion of the yield curve whereby shorter-term rates move higher than longer-term maturities. In a healthy economic environment, usually it is the reverse, as investors are compensated with higher rates for the longer holding time and potential for inflation. While the stock market reaction was relatively benign, this did rekindle the growth worries of December, and analysts were quick to note that each of the last seven U.S. recessions have been preceded by such an inversion with an average lag time of about a year. There is plenty to suggest things may indeed be different this time, and no one data point should be considered in isolation. Blindly following the headlines and consensus thinking has not been particularly helpful in portfolio decision making recently. It was just last fall that interest rates apparently had nowhere to go but up, yet the 10-year treasury yield has since fallen from yielding over 3% to just over 2.4%. Patient fixed-income holders have been rewarded by the corresponding higher prices. But the extent to which upcoming data supports a potentially negative signal like this needs to be monitored closely and, at the very least, could lead to enhanced market volatility. 

We will always prioritize risk management and not hesitate to reduce stock exposure if warranted, but market timing is typically less important over time than owning high-quality businesses that can navigate any type of environment. The recent trends, though, have certainly been very challenging for died-in-the-wool value investors as large U.S growth stocks have continued to be among the best performing asset classes in the world. The four worst performing sectors in the S&P 500 last year – Energy, Industrials, Materials and Financials - were also the cheapest on a valuation basis coming into the sell-off. Since roughly 40% of the S&P 500 Value index is made up of Financials while almost the same percentage of the Growth index consists of Information Technology, simply following the indices and betting too much on the former over the latter has been costly recently. 

While the lagging, mostly economic-sensitive sectors did rebound off their December lows in the first quarter, the prevailing preference for growth stocks informs our thinking in two significant ways: We should be careful not to extrapolate the recent past out indefinitely, and we need to maintain balance in our stock portfolios. Given how impressive the recent run in the S&P 500 growth stocks has been, it might be easy to forget that for the entirety of the previous decade (12/99 – 12/09) the index produced a negative cumulative total return. Meanwhile value stocks earned positive returns as did other recently underperforming asset classes such as Emerging Markets. Relative performance tends to run in cycles, and we need to be both humble enough not to think we are smarter than the markets and intuitive and wise enough to understand that conditions can and will change. Remember the Carly Simon line, “You're where you should be all the time”? While catchy, it is probably not the best investment strategy. Chasing just what is currently “working” will leave a portfolio precariously positioned when conditions inevitably shift. With this in mind, we have taken a balanced approach in our stock portfolios versus trying to guess what investment styles may be in favor. Given the still shaky outlook for the global economy, we own some companies with defensive characteristics that we would expect to be less sensitive to further slowing. Traditionally defensive sectors, such as utilities, have become very expensive relative to their paltry growth rates, so names like Verizon, AT&T, Merck and J&J provide relative stability at reasonable valuations. While we should not rightly expect immediate outsized gains from our cheapest, mostly economically sensitive holdings in this nervous environment, high-quality businesses such as J.P. Morgan, Celanese, Citigroup and Federal Express trade at significant discounts to their long-run intrinsic values. We respect the message of the markets and know that the cheap might get cheaper if conditions deteriorate, but we are willing to be patient and pounce when opportunities present. Borg-Warner is a strong player in the automobile supply chain and seemed too inexpensive to ignore at a significant discount to their own historical valuation range and the market in general. Automobile sales have been weak and are sensitive to volatile conditions overseas, however, they are well-positioned in key markets including the expanding demand for hybrids and electric vehicles. We believe we found a similarly attractive opportunity in Broadcom, which makes essential chips and other components for both wired and wireless communication customers. They have built a diversified business model and enjoy dominant market share in markets with attractive, sustainable growth outlooks. They also trade well-below their historical valuation levels and hope to grow their dividend from the current 3.5% level Our recent best-performing holdings in the portfolio are those that do not necessarily screen by some metrics as value stocks but still trade at sensible valuations relative to their expected, well-above average growth rates. Visa, Sherwin-Williams, Danaher, Alphabet and Starbucks stand out as great businesses that deservedly trade at premiums, yet not excessive, valuations. We added, in most portfolios, to two of what we might call “recovering growth stocks” that are each going through some transition. Booking Holding’s online travel bookings volume has compressed recently in the face of a slowing European economy, and Walt Disney is both digesting a massive acquisition of Fox Entertainment assets and rolling out a costly media streaming platform. It makes sense to look past the current depressed growth rates (and valuations) to a potentially better trajectory over the next few years.

Early March marked the tenth anniversary of this most impressive bull market in U.S. stocks that sprang from the abyss of the Financial Crisis. It is both ironic and appropriate that this anniversary came in the midst of the quarter’s double-digit percentage snapback move, as this has surely been the most consistently doubted bull market in U.S. history. Every minor pothole along the way has brought forth calls for its inevitable demise, and at no point have we seen the gushing euphoria that has marked the last gasps of prior bull markets. December 2018 recorded the largest dollar outflow from stock mutual funds in any month over the past 60 years, only to leave many on the sidelines for the rebound. It just may be this combination of generally subdued investor enthusiasm and relatively slow economic growth rates relative to previous recoveries that keeps this market going. Yes, “the market climbs a wall of worry”!

We often say that are our most important “value-add” is not necessarily stellar performance (although we are always trying!), but keeping folks in the game - grounded, disciplined and tethered to portfolio allocations (and financial plans) – when faced with so many distractions. These distractions will not dissipate anytime soon, nor will our resolve and commitment. As always we greatly appreciate your continued confidence and wish you all the best for a splendid spring!