January 15, 2019
Eighth Annual
Worried Faces
Television producers love shots of nervous and worried fans during big sporting events. They convey the drama of the moment and the importance of the event to everyone watching. But I wasn’t expecting to see my daughter’s face in that context. That’s a screenshot of her on the right, with her husband, from the national broadcast of an MLB play-off game in 2017.
Emily and her husband Josh are big baseball fans and have partial season tickets for the Washington Nationals. In 2017, the Nats were in the play-offs. My wife and I were watching them in a tense match-up when we saw, again and again, our daughter’s worried face on the screen. Our phones (and hers) lit up from people who recognized her. Everyone who knew Emily, especially in a sports context, was familiar with “Emily worried face.” She’s expressive and, well, she worries.
A big game is a big deal, even for fans without expressive faces. From first pitch to final out, a rush of adrenaline overtakes us. The bodies of nervous players and fans alike produce cortisol, the “stress hormone,” in large amounts. Fans may “only” be watching, but it feels like we’re playing. A New England Journal of Medicine study found that viewing a fraught athletic contest more than doubles the risk of a cardiovascular event. There is a 300 to 400 percent increase in blood flow pumped out of the heart during a big game.
Investing requires elements of being both a player, a coach, and a fan. When markets are turbulent, as they have been of late, there are many investors with worried faces and with cortisol coursing through them in abundance. Lots of people seem to think that “this is a perfect time to panic.”
I regularly write that investing successfully is hard. And it is. Really hard. It is intellectually challenging, yes, yet it isn’t Rubik’s Cube hard, where it’s difficult but you can solve it and move on to something else. It is much more like learning to play the piano well, losing weight, aggressively saving money, or living a healthy lifestyle. It requires constant patience, discipline, and vigilance. Every single day. Good investing is boring, even when the markets are roiling. Day after day. Good investing is consistent, even when your feelings are screaming for you to be aggressive and take precipitous action. Month after month. The exceptional, the truly worthwhile, takes time. Year upon year.
Good investing is powerfully rewarding, but it can take decades to arrive. It is a long, often tedious, slog in the same direction.
That’s why getting back to basics is so important in times of stress. The primary investment lesson over at least the past 100 years: Own stocks in the largest amounts you can and hold them for as long as possible. Your default setting should be to buy stocks rather than sell them. Volatility will make doing so hard some of the time. In 2017, there wasn’t a single trading day in which the S&P 500 moved by more than two percent in either direction and every single month was positive. In 2018, there were 20 daily moves of at least two percent. If 2017 lulled us into a false sense of security, 2018 brought us back to reality. Volatility is the necessary price to be paid for the outsized returns available from stocks as compared with all other investment opportunities.
If you are inclined to panic – and we all are; it’s human nature – current events will always provide more than ample justification. As the Nobel laureate Robert Shiller says, parroting Jimmy Buffet, “We’re always in a bubble somewhere.” It’s also a plain fact that humans overreact to perceived danger. For example, we kill approximately 100 million sharks a year, while unprovoked shark attacks kill roughly five people per year.
The past year was a reminder, after nearly a decade of one-way traffic, of how unpredictable markets are. The extended period of historic calm in equity markets that dominated 2017 ended in 2018 as volatility resurfaced in a major way. For example, after recording daily declines of one percent or more only four times in 2017, the S&P 500 in 2018 fell by more than one percent on 32 separate days and more than three percent five different times.
In January of 2017, with a vibrant global economy, a very strong domestic economy, and tax cuts in place for both corporations and individuals, the outlook for stocks in the United States and the world was great. To be sure, stocks did hit a record high in September, and Apple and Amazon become the first publicly traded American companies to be valued at more than $1 trillion (for a while).
But 2018 was also turbulent, with stocks falling sharply in February and again at the end of the year. The S&P 500 missed a bear market drop of 20 percent from a recent high by a whisker; a final week rally allowed it to close 2018 down “just” 14.5 percent from its high. A bear market could yet be in the offing. If the downturn deepens, the pessimism that hovered over the stock market in December could leak into the economy at large, as companies grow wary of taking risks, expanding, or adding more workers.
The year wrapped up with the unemployment rate still near a 50-year low, tame inflation, and annual (Q4 to Q4) growth possibly above 3 percent for the first time since 2005. But markets have been volatile, economies in Europe and China are slowing, and federal fiscal stimulus is fading.The U.S. economy is doing well, but not as well as it was. President Trump is lashing out at the Federal Reserve, suggesting that its longstanding independence may be in jeopardy. The central bank’s consistent and carefully telegraphed interest rate increases may pose a risk to corporate profits and the market’s appetite for stocks. The president’s trade wars with China and, to a lesser extent, Europe, continue, and the technology giants that have dominated the stock market for years face heightened and intense scrutiny about their business practices and whether their growth is sustainable.
Despite headlines like “Worst Year Since 1901,” it was hardly (despite CNBC’s claim) an Annus Horribilis. It also wasn’t the “greatest economy in the history of our country,” as the president repeatedly claims. Worried faces are totally okay and perfectly human. There was plenty of "stress hormone." But it was an entirely normal lousy year in the markets.
Market performance does not arrive on schedule or upon demand. However, as Warren Buffett explained about his buying stocks in 2008, during the depths of the Great Financial Crisis, “If you wait for the robins, spring will be over.” Legendary investor Shelby Davis noted that, “Bear markets make people a lot of money, they just don’t know it at the time.” Here’s to hoping that this eighth annual Investment Outlook will provide a basis for making 2019 satisfying and profitable to readers, irrespective of what happens in the markets.
Source: Callan
Bad Breadth
Source: Callan
In 2018, in the markets, it was as though Christmas never came and we were left with Festivus, focused on airing our grievances.
In terms of the breadth of market losses, 2018 was about as bad as it gets. More countries, more asset classes, and more market sectors were down than in any other year. If investors are looking for a reason to panic, it’s easy to find one. Or several.
Source: The Irrelevant Investor
In strong markets, investors of every sort and disposition pay frequent lip service to the notion of risk, but ignore its relevance, soothed by (accurate) bromides that stocks win over the long haul. It is therefore healthy, albeit painful, to be reminded that the risk in stocks is real, and that there is a reason why investors, overall, earn a lot more money by investing in equities, as opposed to other investment opportunities. Markets the world over delivered that message loud and clear in the last quarter of 2018.
A fantastic 2017 gave way to a strong opening to the new year in 2018, as technology and momentum ruled the day and the markets. In February, the first hints of trouble appeared via reports of higher inflation and self-inflicted wounds inflicted by and upon Facebook and Google. However, by the end of the first quarter, all seemed well again, and stocks continued to grind higher, peaking on September 20, as summer came to an end.
Downside volatility returned to the market with a vengeance when autumn came. In October, the S&P 500 fell by 6.94 percent. It felt even worse because of the day-to-day and intraday price swings that had been largely absent over the previous two years. In November, the S&P 500 was basically flat, but volatility continued unabated. In December, domestic equities finally succumbed to selling pressures, as a sharp sell-off pushed stocks close to the "bear market" threshold, down 19.7 percent from the high, before recovering some by year-end. Despite that late recovery, the S&P 500 was down 9.03 percent in December and 4.38 percent for the year.
2018 was disappointing not just because the S&P 500 declined for the first time since 2008, but also because so many other financial markets fell as well, often far more than the preeminent U.S. large-cap index. S&P Dow Jones cites escalating U.S. trade tensions with China, a flattening yield curve, and uncertainty about future interest rate hikes by the Federal Reserve for the disappointing year in U.S. equities.
A quick recap of the total returns of multiple markets in 2018 follows. Please note that these returns include dividend payments, which is why S&P Dow Jones reports that the S&P 500 lost 4.4 percent in 2018 rather than the 6.2 percent that has been widely reported but excludes dividends. S&P MidCap 400 and SmallCap 600 indexes suffered even larger losses, of 11.1 percent and 8.5 percent, respectively. Within domestic equities, only the defensive sectors of healthcare and utilities finished decidedly higher, ending 2018 with gains of 6.5 and 4.1 percent, respectively. Growth sectors such as consumer discretionary ended with a 0.8 percent gain while technology finished down 0.29 percent. Earlier in the year, the pattern was reversed with tech and consumer discretionary stocks leading and defensive sectors falling. “Leading” on the downside was energy, down 18 percent, followed by materials, off 14.7 percent, and industrials, off 13.3 percent.
Within the S&P 500, certain factors performed better than others largely due to rising volatility in the fourth quarter. The S&P 500 Growth Index fell 0.01 percent while the S&P 500 Low Volatility Index gained 0.27 percent. The S&P 500 Quality and Value Indexes lost 6.8 percent and 9 percent, respectively.
Fixed income sectors performed better than equity sectors in 2018 although, not surprisingly, their gains were limited. The S&P U.S. Treasury Bond 7-10 year Index gained 0.7 percent. The S&P U.S. Agency Bond Index rose 1.34 percent. S&P corporate bond indexes fell, led by losses in the S&P 500 High Yield corporate bond Index, down 2.2 percent.
Moving overseas, international stock indexes, including emerging market stocks, fared even worse than their domestic counterparts. The S&P Emerging Broad Market Index (BMI) finished 2018 down 13.5 percent and the S&P Developed BMI excluding the U.S. plummeted 14.4 percent. Several commodities markets posted even larger losses. The S&P GSCI Energy Index ended 2018 down 17.1 percent, while the S&P GSCI Industrial Metals fell 18 percent. Plunging oil prices and trade tensions underpinned these losses. The S&P GSCI Precious Metals Index fell 3.6 percent.
At the country level, only three finished the year in positive territory – Qatar, Peru, and Russia – and Qatar was the only one to stand out, with 30 percent gains. Every global developed market saw losses last year. Meanwhile, 29 emerging and developed countries were down 10 percent or more, nine were down 20 percent or more, three were down 30 percent or more, and one — Turkey — ended the year with a 41 percent loss.
Facebook dropped more than $120 billion of market value in a single day last year, the largest one-day dollar loss of any listed company in U.S. history, but there were big gains to be had, too. Advanced Micro Devices ended the year atop the S&P 500 with a gain of almost 80 per cent. Its year-end closing price was barely half its September high, but still enough to win the Wall Street
race in 2018. The drug makers Merck and Pfizer, which both boast strong pipelines of new drugs and stand to grow with an aging population, took the top spots on the Dow in 2018 with gains of 36 per cent and 21 per cent, respectively.
Goldman Sachs was the dog of the Dow, losing over a third of its value. Banks were the worst performers generally, as the yield curve — the difference between short and long-term rates, a key determinant of bank profit margins — flattened. General Electric, an iconic name almost synonymous with American capitalism, was down 57 percent in 2018 and slashed its dividend to a penny. It would have been the Dow’s dog for the year had the curators of the index not kicked GE out midyear.
About 47 percent of S&P 500 stocks outperformed the benchmark during 2018, slightly below the long-term average of 48 percent, according to Bank of America Merrill Lynch. Last year's total was still an improvement from 2017, when just 43 percent of stocks outperformed.
In short, volatility in 2018 was above the norm, but still lower than roughly one-third of years. Returns were below the norm, but better than roughly one-quarter of years. Drawdown was significant, but still less drastic than in roughly one-fifth of years. The FANG+ Index, so strong for so long, was down for the year. Bonds outperformed stocks for the first time since 2011, but that happens sometimes. The key here is that 2018 was a modestly disappointing year, clearly in line with ordinary expectations. It has not been an outlier. We had a lousy three months after almost ten excellent years.
Markets and economies change, often in the blink of an eye. Human nature doesn’t. Because we are so highly loss averse and fearful, we consistently overreact to difficult markets. Warren Buffett buys stocks and holds them. His “favorite holding period is forever.” The typical investor, on the other hand, does the opposite.
We often say we’re long-term investors, but find lots of reasons not to be. The typical investor chases performance instead, and almost always pays a very heavy price for doing so. As Morgan Housel says, “Every past decline looks like an opportunity, every future decline looks like a risk.”
In the long run, in the famous formulation of Benjamin Graham, markets are a weighing machine. They respond to the overwhelming weight of evidence coming to them about economic and corporate fundamentals. In general, those fundamentals are quite good today, valuations notwithstanding. There’s nothing wrong with the U.S. economy. Unemployment is near historic lows, inflation remains under control, and companies continue to generate remarkably fat profit margins.
In the short run, however, Graham said that markets are a voting machine — they register the swiftly made priorities of traders and would-be investors as they shift their opinions, their positions, and try to understand what is going on around them. The voting machine has been hard at work of late.
That suggests that the long-term investors among us ought to be thinking more about opportunity and less about risk, even though the market environment may well get worse before it gets better. You should recall Warren Buffett’s famous hamburger analogy.
“If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef?
“Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices?
“These questions, of course, answer themselves. But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period?
“Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the ‘hamburgers’ they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”
Valuations have dropped significantly. Valuation is a terrible timing tool in that it doesn’t tell us anything about what markets are going to do in the short-term. However, over the longer-term, when valuations are lower, future returns tend to be higher, and when valuations are higher, future returns tend to be lower. The all-important equity risk premium has grown from roughly five to roughly six percent in the past year. What that means is that stocks are significantly cheaper than they were a year ago. If you were looking for a new suit and the one you liked was marked down, would you see that as a good thing or a bad thing?
From September 12, 2008 to March 9, 2009, the S&P 500 lost 45.15 percent – almost half its value, in less than six months. However, from that same September 12, 2008 starting point to September 12, 2018, the S&P 500 gained back those losses and was up 185.9 percent more – 11.08 percent annualized overall – nearly tripling in ten years. Over shorter time horizons, stocks appear to be very risky. Over 10, 15, or 30 years, stocks look like a fantastic bet.
The stock market is a wonderful reallocation machine, moving money from those focused on today to those focused on their long-term goals, from the emotional to the dispassionate, from those who trade on gut feelings to those who use a systematic method, and from the greedy to the patient. So long as human beings price stocks, this will remain a fundamental function of the market.
Still Strong, but Not as Strong
As 2019 dawned, President Trump doubled down on his positivity, claiming that the recent downturn in U.S. stocks was caused by “a little glitch” and predicting a strong 2019, with close to 30 percent returns, for the market. Fed chair Jerome Powell said the U.S. economy "is solid," adding that he doesn't predict a recession in 2019.
CFOs, on the other hand, are pessimistic about global economic growth this year. Economists see a growing risk of recession in the U.S. The big worries: trade tensions with China, rising interest rates, and market volatility.
We don’t know yet if our economic glass is currently half-full or half-empty, but its weakening state is pretty obvious. The World Bank cut its forecasts for global growth in 2019 and 2020, citing factors from trade tensions to financial-market instability to currency challenges in a number of emerging markets. Maurice Obstfeld, then chief economist of the International Monetary Fund, warned that global growth is slowing and the U.S. will likely feel the drag. Fresh economic figures from Europe and China added to concerns that weakening growth at the end of 2018 will carry over into a sharper slowdown next year, weighing on the solid but cooling U.S. expansion.
As reported by The New York Times (among many others): “The global economy is ... palpably weakening.” Many countries “are mired in stagnation or sliding that way. Oil prices are falling and factory orders are diminishing, reflecting slackening demand for goods.” Major companies have been “warning of disappointing profits,” which sent stock markets into a tizzy that “reinforces the slowdown.” In recent months, the economies of “Germany and Japan have both contracted” and “China is slowing more than experts anticipated.” Perhaps worst of all, “Even the United States, the world’s largest economy, and oft-trumpeted standout performer, is expected to decelerate next year as the stimulative effects of President Trump’s $1.5 trillion tax cut wear off.” The causes include “rising interest rates delivered by the Federal Reserve and other central banks” and “the unfolding trade war unleashed by the Trump administration.”
We just began the 39th straight quarter without a recession in America (officially, according to the Fed). Thirty-nine ties the record longest streak without one since the Great Depression. At 114 months and counting, the U.S. economic expansion is long in the tooth, given that the record is 120 months (1991-2001) and the average expansion since 1950 has lasted 67 months. American incomes rose and poverty declined for the third consecutive year in 2017. Unemployment is near a 50-year low. Maybe we’re “due” for a bad economy.
However, the U.S. economy was strong in 2018 and is likely to remain strong in 2019, if not quite as strong, according to the key economic indicators. The most important indicators are the gross domestic product, which measures America’s production output, how many and how well Americans are employed, and how much inflation there is. GDP is expected to remain within the range of between two and three percent. Unemployment is forecast to continue to be low. There isn't too much inflation or deflation. By and large, that's a Goldilocks (“just right”) economy.
U.S. GDP growth was three percent in 2018 but, according to the Fed, is expected to slow to 2.3 percent in 2019, to two percent in 2020, and to 1.8 percent in 2021. The projected slowdown in 2019 is largely the result of the impact of President Trump’s tax cuts wearing off and a side effect of his trade war. The ongoing governmental shutdown increases the risk in this area.
The unemployment rate at the close of 2018 was 3.9 percent, near 50-year lows, although a bit higher than it had been due to more new workers joining the workforce. Those levels are much lower than the Fed's 6.7 percent target rate. However, former Federal Reserve Chair Janet Yellen has noted that many of those who are employed are part-time and would prefer full-time work. Moreover, most job growth has come in in lower-paying retail and food service industries. Structural unemployment has increased. These traits are unique to this recovery. Yellen admitted that the real unemployment rate is a more accurate measure of economic performance and it's double the widely-reported rate. Inflation remains mild at 1.9 percent, close to the Fed's two percent target inflation rate.
After a long drought, for the past two years, workers have been receiving modestly bigger paychecks. Those gains look bigger and steadier today. The most recent jobs report provides further support. Workers had an average gain in hourly wages of 3.2 percent in December, well above the average of 2.4 percent during the past five years. More gains seem to be on the way. A decade ago, there were 6.6 job seekers for each opening. Today, there is less than one person looking for work for each opening, thus more vacant positions than there are job seekers.
S&P 500 companies are expected to post earnings growth of 11.2 percent for the fourth quarter of 2018, according to FactSet. Based on the average change in earnings growth due to companies reporting positive surprises (nobody wants to “miss”), it's likely that the index will report growth above 15 percent for the quarter, but below the 25 percent growth reported in the prior three quarters; still excellent.
The strong but mostly backward-looking jobs data do not counter the more worrisome forward-looking indicators in the weak ISM manufacturing data released January 3. Nor do we know how projected economic weakness in Europe and China (the latter highlighted by Apple’s recent earnings warning), market volatility, the potential for political stupidity, and the possible resolution of trade tensions will impact the economy going forward.
The Federal Open Market Committee raised the current fed funds rate to 2.5 percent on December 19, 2018. It expects to increase this interest rate to three percent in 2019, and then leave it there. The fed funds rate controls short-term interest rates. These include banks' prime rate, Libor, most adjustable-rate loans, and credit card rates. Current conditions can, of course, change these expectations.
The Fed began reducing its $4 trillion in securities in October 2017. The Fed acquired these securities during quantitative easing, which ended in 2014. Since the Fed is no longer replacing the securities it owns, it will create more supply in the bond market. That should raise the yield on the benchmark 10-year U.S. Treasury note some (which opened 2018 at 2.46 percent, went as high as 3.24 percent in November, before rallying back to close the year at 2.69 percent). This will likely also drive up long-term interest rates, such as those on fixed-rate mortgages and corporate bonds.
The Philadelphia Eagles won the Super Bowl last January by defeating Bill Belichick, Tom Brady and the New England Patriots. They were coached by Doug Pederson, a remarkable young leader in just his second season as head coach, whose aggressive style and forward-thinking approach, driven by analytics, led the Eagles to their first Super Bowl championship. Pederson’s leadership style is epitomized by his daring fourth down goal line call just before halftime.
Quarterback Nick Foles set up in shotgun formation and moved down the line of scrimmage talking to his linemen in hopes the defense wouldn’t be set when the ball was snapped. Running back Corey Clement took a direct snap, moved left, then flipped the ball to Trey Burton on a reverse. Rather than running the ball, Burton flipped a pass to an uncovered Foles. Touchdown, Eagles. Foles became the first quarterback to throw and catch a touchdown in the Super Bowl, and Pederson’s reputation as an aggressive and successful play-caller became legendary.
Yet another fourth down conversion late in the game kept a drive alive and allowed the Eagles to score the game-winning touchdown. Doug Pederson. Innovator. Super Bowl winner. Great coach.
Two years earlier, Doug Pederson was a punch line.
Pederson was one of seven NFL head coaches hired before the 2016 season. NBC Sports began its coverage of the Pederson hiring with, “Well, that was a mess” and called it “high comedy.” Deadspin called him an “outlet store version” of one-time Eagles coach Andy Reid. NJ.com predicted that the Eagles would fade into obscurity, with no Super Bowl “in sight.” Long-time NFL executive Mike Lombardi was highly critical. "Everybody knows Pederson isn’t a head coach,” Lombardi said. “He might be less qualified to coach a team than anyone I’ve ever seen in my 30-plus years in the NFL.”
USA Today called Pederson a “blergh hire” (really) and sarcastically mocked the Eagles’ choice, ranking it last among the new hires. Bleacher Report had him dead last among the new hires too. Athlon had one hire as worse than Philadelphia’s, but gave the Eagles a grade of D for choosing Pederson. Chat Sports also had Pederson’s hiring as sixth best out of seven, praising the pick as “not a terrible hire.” CBS Sports had Pederson second-to-last as well, but at least offered a C+ grade. NFL.comwas more optimistic, ranking him fifth out of seven. Not to be outdone, Pederson was adjudged by ESPN to be the worst head coaching hire of 2016.
What about the six geniuses ranked ahead of the Super Bowl champion, all those great hires? All fired – each and every one, within just two years.
Prediction is obviously dangerous business because we humans are so bad at it. And the proof that we’re bad at it is astonishingly easy to find. Fox News pundit Laura Ingraham predicted that, “Our economic news is only going to get brighter in 2018.” President Trump predicted a “red wave” (more accurately, a “RED WAVE”) in the 2018 elections. Newt Gingerich did too. Multiple parties (including Bill Mitchell, Glenn Beck, Steve Bannon, and Rudy Giuliani) predicted a swift end to the Mueller investigation.
Not to be outdone, Democratic pundit Scott Dworkin predicted that Vice President Mike Pence and President Trump would leave office by the end of 2017, paving the way for Speaker Paul Ryan to become president. Then, in 2018, Republicans would lose the House (they did) and Senate (they didn’t), at which point, President Ryan would be impeached. And HuffPost congressional reporter Matt Fuller predicted that Joe Cowley would become Speaker of the House. Cowley ended up losing a primary fight with unknown newcomer Alexandria Ocasio-Cortez and couldn’t even hang on to his House seat. Michael Avenatti predicted that Donald Trump, Jr. would be indicted in 2018. President Trump’s former ghostwriter predicted that the president would resign in 2017…and 2018.
In late 2017, antivirus mogul John McAfee tweeted confidently that “BITCOIN is still the crypto giant. It is at a low price, and will never be cheaper. It will be ten times this price in 2018.” Instead of advancing ten times, over the year it dropped more than 80 percent. At the beginning of 2018, then New York Attorney General Eric Schneiderman solemnly vowed to continue to protect the safety and well-being of all New Yorkers. It remains unclear if he meant to include the four women who accused him of sexual and physical abuse shortly thereafter, leading to his resignation in May. President Trump tweeted in December 2017, just over a year ago, “I predict we will start working with the Democrats in a Bipartisan fashion.”
Of course, financial and market prognostications are always among the worst of the lot. As the legendary investor Benjamin Graham wrote, “Nearly everyone interested in common stocks wants to be told by someone else what he thinks the market is going to do. The demand being there, it must be supplied.”
Michael Batnick compiled year-end price targets from Wall Street’s alleged expert strategists going back to 2005 (2018;2017; 2016; 2015; 2014; 2013; 2012; 2011; 2010; 2009; 2008; 2007; 2006; 2005) and found that out of the 153 price targets, only six called for lower prices. The average forecast was a nine percent gain which, not surprisingly, is right around the average annual return, even though the actual return is almost never average. In December 2007, shortly before the financial crisis, Barron’s wrote “the dozen seers we’ve surveyed all have penciled in higher stock prices in 2008…On average, the group sees the Standard & Poor’s 500 at 1,640.” It closed at 903. Alleged Wall Street experts expected 8.6 percent returns in 2018. Instead, the S&P 500 lost 4.4 percent. Central banks and professional investors are no better.
In each of these unfortunate cases, “mistakes were made,” a phrase the political analyst William Schneider says should be called the “past exonerative” tense, because nobody accepts responsibility for the errors.
The entire charade has gotten so ridiculous that within the first week of the current new year, January 6, 2019, many Wall Street market forecasts for the new year had already been withdrawn and altered. They couldn’t even survive for a week. Of course, these new and revised predictions could be right. However, if they are, it will be more accidental than prescient. Facts don’t get in the way of our desiring stories. Facts don’t get in the way of our desired stories. Thus, numbers don’t drive markets. Narratives do. As the mathematician Alfred Cowles observed decades ago, people “want to believe that somebody really knows. A world in which nobody really knows can be frightening.”
If you think you (or “somebody”) can predict the future in the markets, think again. Your crystal ball does not work any better than anyone else's. Even when we recognize the fallacy of thinking in terms of single, linear causes (Fed policy, market valuations, etc.), the markets are still too complex and too adaptive to be readily predicted, as we have already seen. There are simply too many variables to predict market behavior with any degree of detail, consistency, or competence. Pretty much the only forecast that is almost certain to be correct is that market forecasts will be wrong. If they are right, it's probably because of luck rather than skill.
Portfolio reviews are a very good thing. They happen a lot this time of year. And they happen more often in difficult market environments.
However, a portfolio review isn’t a time to rush in and make changes, to try to time the market. A review better serves as a reminder that volatility is normal and to make sure you aren’t getting more of it than you can handle while checking if you have as much as you need to reach your financial goals. The risk of not meeting long-term goals is probably higher and more catastrophic than the risk of losing money in the markets over the near-term.
Remember, everybody talks their book. Every major investment firm still calls for decent returns in 2019, often after a difficult first half. They may be right, of course, but they also have an interest in their clients and prospects being positive about the markets. On the other hand, major bond shops, such as DoubleLine and Pimco, have a different interest and are, accordingly, much less sanguine. Again, they too may be right, but their forecasts also align with their business model.
As Warren Buffet reminds, “[f]orecasts usually tell us more of the forecaster than of the future.” That’s why I avoid predictions to the extent possible and, instead, consider instead what I’m concerned about and will be watching closely in the year to come (mostly with a desire to clarify our thinking).
We may be lousy at investment forecasts (and we are), but the idea that we can live our investing lives forecast-free is as erroneous as the market predictions that are so easy to mock. As Cullen Roche emphasizes, “any decision about the future involves an implicit forecast about future outcomes.” As Philip Tetlock wrote: “We are all forecasters. When we think about changing jobs, getting married, buying a home, making an investment, launching a product, or retiring, we decide based on how we expect the future to unfold.”
It's a grand conundrum for the world of finance. We desperately need to make forecasts to succeed but we are remarkably poor at doing so. What should we do with that knowledge? Why an Outlook at all?
There are three primary reasons. The first is that doing so is interesting and fun. It forces serious consideration of what has gone on and what's going on. That is a valuable exercise. The role of a financial advisor is less to predict the future and more to see the present clearly.
Secondly, longer-term outlooks (and especially those based upon appropriate valuation measures) do have a history of very rough accuracy. We can have almost no idea of what will happen in the near-term while still having a pretty good idea of what investment prospects and returns should look like over the next 5-10 years.
Finally, a good Outlook can remind us where we are and highlight the trends and possibilities we are most likely to face going forward. As Howard Marks puts it, “while we never know where we’re going, we ought to know where we are.” There are so many variables and “unknown unknowns,” to use Donald Rumsfeld's famous phrase, that we will necessarily be wrong a lot. Nobody can offer Truth with a capital “T.” But it is possible to be helpful. It's a modest but important goal.
What to Expect
Long-term financial planning requires some measure of expected investment returns. Unfortunately, as noted, we can have almost no idea of what will happen in the markets over the near-term. As Nobel laureate Robert Shiller, from the first edition of his classic, Irrational Exuberance, explained, “The U.S. stock market ups and downs over the past century have made virtually no sense ex post. It is curious how little known this simple fact is.”
If you think some manager, advisor, or strategy can hide from difficult markets, provide the upside, and manage the volatility of markets, you have been badly deceived.
However, we can ascertain a very rough idea of what investment prospects and returns should look like over the next 5-10 years – long-term capital markets assumptions – based upon a variety of factors. These calculations can be quite valuable and roughly accurate.
As Corey Hoffstein explains, capital market assumptions will rarely be exactly right, so relying on multiple sets is a way to reduce the risk of choosing the wrong one. Doing so doesn’t remove the risk that they are all wrong, or even wildly wrong, but using multiple sets of capital market assumptions and blending the results reduces the likelihood of this happening by increasing the coverage over the parameter space.
Impressive expert firms assembled by Morningstar's Christine Benz agree that U.S. equity returns will likely lag their long-term averages over the next several years. Expected returns for annualized large-company stock performance from those sources range from seven percent, after inflation (BlackRock), to negative two percent (GMO), with a median of three percent. Six of the seven sources expect similar or higher results from investment-grade bonds.
Current valuations suggest, but do not ensure, that the intermediate term (7-10 years) is unlikely to be as rewarding as the long-term numbers. However, that likelihood matters only within the context of the expected returns of other asset classes, most prominently bonds. Since these, in the aggregate, are also low relative to history, stocks look relatively more attractive. Moreover, stocks look much cheaper today than they were at the start of the fourth quarter and the equity risk premium is relatively high.
The relevant conclusion is, in my view, a simple one. Longer-term equity returns are likely to be below their longer-term averages. The stock market may well remain volatile. But there is no current reason to exit the markets for long-term investors. Those who will be net sellers of stocks in the relatively near-term ought to consider how to plan for that likelihood, whether that be via asset allocation, hedging, or otherwise. There is risk, as there always is. Drawdown risk is the price that must be paid for the much higher historical returns provided by stocks as opposed to any other investment alternative.
What's Next?
“You should see the size of the shark the Chinese are using.”
Source: The New Yorker
I subscribe to Balaji’s Srinivasan’s one-liner about the future: “More upside, more downside.” However, I’d supercharge it a bit: More variance, faster.
There are any number of potential hot spots or problems that could flare up at any moment, as always. I will highlight six to which I am paying particular attention.
China. President Trump’s trade war with China1 has caused damage that has spread farther and faster than generally expected. By compromising free markets and free trade, American industry and American consumers are being hurt. China is being hurt badly by the trade war too. Factories in China and the U.S. have seen orders slump. A space battle is brewing. Our economy has begun to slow and the world’s second-largest economy is slowing faster than expected, particularly in the export-oriented manufacturing sector. American farmers are hurting. A drop in Chinese demand for iPhones knocked nearly $75 billion off Apple’s market cap in a single day. Slower growth has prompted China’s central bank to ease monetary policy (again), and, despite (because of?) recent encouraging news on U.S. jobs, the Fed is having second thoughts about its plan to normalize interest rates.
Former White House economic adviser Gary Cohn resigned shortly after President Trump announced his tariffs and cautioned earlier that a trade war could wipe out the economic gains of the GOP tax law. And that is essentially what has happened. The stock market has given back all the gains it had gotten from the president’s tax cut. We're back to December 2017 levels (when the tax cut became law). Earnings got a significant boost from that plan, to be sure, and stocks raced straight up. But, since we’re basically right back where we started, it seems much less significant now.
Last June, Kevin Hassett, chairman of the President’s Council of Economic Advisers, assured Americans that Mr. Trump’s trade policies wouldn’t be an economic problem. However, after Apple opened 2019 by acknowledging weaker performance on account of lessening Chinese demand, Hassett conceded that a “heck of a lot of U.S. companies,” and not just Apple, could see earnings difficulties on account of a slowing Chinese economy.
Meanwhile, China is being buffeted by both domestic and external factors: the government is trying to arrest its growing debt, which is hitting fixed asset investment, while its exports face U.S. tariffs, and threats of more. The latest weakness has boosted expectations of stimulus from Beijing and lends urgency to settling the trade dispute with the U.S.
The president has a legitimate complaint about China’s theft of intellectual property and its glaring favoritism toward its own companies. China understands it can’t go on like this indefinitely, but will make changes only to the extent it must to make this issue disappear. Some sort of compromise remains likely, and both sides have excellent reasons to do so, but it may not come easily.
Under President Xi Jinping, state control over the economy has increased rather than decreased and China has been promising bold reforms since at least 2013 without following through. China’s recent offers to treat foreign and private Chinese companies the same as state-owned enterprises, and to ban the forced transfer of technology to Chinese partners, are welcome but deserve skepticism.
When President Trump took office, many feared that he would tear apart the global trading system. Instead, he is presiding over its realignment into two distinct systems. One such system, among the U.S. and its traditional, democratic trading partners, looks a lot like the system that has prevailed for roughly the past thirty years: generally free trade with a smattering of quotas and tariffs, despite ongoing tensions with Europe. The second system reflects an emerging rivalry between the U.S. and China that harkens back to the Cold War. The most likely World War III scenario sails right through the South China Sea.
On trade, investment and technology, the U.S. is moving to undo some of the integration that followed China’s accession to the World Trade Organization in 2001. Two big issues hang over this realignment: How far the U.S. is prepared to decouple from China, and whether Washington can persuade its allies to join a united front to contain Beijing. Since there has been precious little coordination of foreign policy with trading partners (indeed, there has been an undermining of traditional U.S. trade alliances through the national security tariffs), there is good reason to be skeptical that the administration can thread this needle. Meanwhile, some of Mr. Trump’s thinking, such as his sometimes insistence that bilateral trade be balanced, simply makes no economic sense.
While there are many major issues to solve between the U.S. and China, for my money, the major one is not who “wins” the ongoing game of trade Chicken. It’s not who wins the fight over intellectual property or over corporate espionage and theft. It’s not even American hegemony generally. It’s whether the U.S. and China are giving up on cooperative and multi-play international games to play only competitive and single-play games. More narrowly, it’s whether capital markets are becoming political utilities. The post-war era has shown that free trade provides huge benefitsto national security and to the global economy. Those benefits could be in jeopardy. How the dispute and debate surrounding it play out in 2019 will have much to say with how markets perform and what our lives are like going forward.
The Technology Sector. Despite what I wrote about forecasting above, 2018 was a banner year for forecasting. But it was a different sort of forecasting. Wall Street is no better at predicting market action than it has been in the past – and that’s plenty lousy indeed. However, as reported by Harvard’s Jill Lepore, truly “[p]redictive algorithms start out as historians: they study historical data to detect patterns. Then they become prophets: they devise mathematical formulas that explain the pattern, test the formulas against historical data withheld for the purpose, and use the formulas to make predictions about the future. That’s why Amazon, Google, Facebook, and everyone else are collecting your data to feed to their algorithms: they want to turn your past into your future.”
What we do and say in private (or where we think it’s private) is much more revealing than our public personae. Your social media posts may describe your spouse in glowing terms while your search history shows you to be investigating divorce. Of course, what the big tech firms see as a feature – a greater and greater understanding of everything you think and do – more and more people are seeing as a bug.
The internet is a remarkable social experiment, but it is a totally uncontrolled one. We have no idea what the consequences of this experiment might be. But that has not prevented, or even slowed, the big American technology and social media companies from dominating U.S. stock markets by growing to behemoths of enormous size and influence. Indeed, technology stocks compounded at an annual rate of 11.7 percent over the past 25 years (1993-2018) despite a 75 percent decline from 2000-2002 and a 53 percent decline from 2007-2009.
Source: The New York Times
Netflix (+39 percent) and Amazon (+28 percent) had good years in 2018, especially as compared with their fellow “FAANG” members Google parent Alphabet (-1 percent), Apple (-5 percent) and, especially, Facebook (-25 percent), but all got hammered by big losses in the fourth quarter before bouncing back somewhat in early 2019 trading. Less than half of Wall Street analysts tracked by FactSet have "buy" or equivalent ratings on Apple shares for the first time since the start of 2006, according to FactSet, for example.
These companies provide monolithic services on-line that allow you to search the web, pretend to have a better life than you do, and waste time both longer and more efficiently. They also track your every move, literally and figuratively, to provide that information to advertisers, law enforcement, and Russian intelligence. Apple, like Google before it, and despite self-righteously refusing to cooperate with American security officials, has even eagerly complied with the demands of the Chinese surveillance state, even as China builds concentration camps for dissidents and religious minorities.
“[T]he 2016 election was the Pearl Harbor of the social media age: a singular act of aggression that ushered in an era of extended conflict,” The New York Timesreports. In recent testimony before the Senate Intelligence Committee, Renee DiResta, a researcher involved in analyzing social media data for the committee, used the term “Information World War” to describe the battles being waged by nations and ideological factions on social media platforms. Russia is essentially an organized criminal enterprise with a standing military, but it “is just the beginning. Other countries, including Iran and China, have already demonstrated advanced capabilities for cyberwarfare, including influence operations waged over social media platforms.”
The big American tech firms have been enablers of this war.
Facebook, for example (and as reported by The Ringer), suffered a year of staggering revelations concerning everything from misuse of private data, to enabling Russian election interference (on both sides), to knowingly providing inflated metrics publishers used to remake the media landscape, to being caught giving other big companies access to its users’ information outside the framework of its normal privacy rules, all in order to harvest “human intimacy for ad dollars.” Facebook has created a long line of PR stunts to pretend it’s fixing things, but you are right to remain skeptical.
It’s hardly far-fetched to argue that Facebook will spy for anyone with the cash to buy your secrets (Apple CEO Tim Cook makes the same point about Google). Facebook is ostensibly free, but it’s hardly cheap. As computer security expert Bruce Schneier explained, “Don’t make the mistake of thinking you’re Facebook’s customer, you’re not – you’re the product.” We’re like armadillos on the information superhighway.
The growth and the misadventures of big tech have finally attracted the attention of regulators here in the U.S. As seen with the European Union's General Data Protection Regulation, which took effect in 2018, regulators increasingly are seeking greater purview over issues of intellectual property, data storage, and privacy. Therefore, serious regulation may be coming for the big tech firms. They may not even be all that opposed to it.
So as not to become collateral damage, some tech firms have broken with social media firms in ways not seen previously, as all of tech used to run essentially as one pack when it came to policy questions. For example, IBM, Oracle and Hewlett Packard Enterprise supported the anti-sex trafficking bills in Congress that Facebook and Google fought against.
Not to be outdone, services we pay for are doing the same sorts of things. “T-Mobile, Sprint, and AT&T are selling access to their customers’ location data, and that data is ending up in the hands of bounty hunters and others not authorized to possess it, letting them track most phones in the country. As should be obvious, we can’t have everything, and surely not for free. Big tech has become a constant in our lives. Some are rethinking that and big changes are afoot.
The Fed. Traders really dislike rising interest rates. The worst of the recent bad spell came on the heels of a December 19 statement from the Federal Open Market Committee that seemed disinterested in the market’s weakness while citing “strong” economic growth, and said “some further gradual increases” in rates would likely be necessary to keep the economy from overheating.
Rising interest rates, and expectations about where those rates are headed, weighed on stock prices in 2018. With the United States’s economy strong, the Fed “took its foot off the gas” and increased its target short-term interest rate four times in 2018, pushing up borrowing costs across the economy. The yield on the benchmark 10-year U.S. Treasury note, which is the basis for debt like home mortgages and corporate loans, climbed to its highest closing level since 2011 (3.24 percent on November 8) before falling back to 2.69 percent at year’s end. When borrowing costs rise too much, they can be restrictive. Companies and consumers pull back, and the economy suffers.
Fed Chair Powell observed last fall that the performance of the U.S. economy “is testament to the fact that we remain in extraordinary times.” If you think that means extraordinarily good, that might mean the current expansion, which is set to become the longest on record next year, continues for several more years.
Perhaps the most extraordinary feature of this expansion is continued impressive labor market performance coupled with modest inflation pressures – the twin issues within the Fed’s mandate. As growth slips, the unemployment rate should drift higher. Many expect core inflation to rise above the Fed's target next year, though the magnitude of this overshoot is likely modest. Recent softer inflation data should help to offset some of the tailwind from a tight labor market.
With the labor market beyond full employment, inflation slightly above the Fed's target, and recent promises to be flexible due to stock market conditions, it remains unclear how restrictive the Fed will be in 2019 and what its expected endpoint to rate hikes will be. Balance sheet unwind, which has been on autopilot to this point, could reach its endpoint in late-2019.
Fed action and even Fed officials talking about possible action has had a big impact upon markets recently. That is likely to continue and bears close scrutiny.
The Dollar. A key reason 2017 was both great and smooth, while 2018 was anything but, has been the performance of the dollar. A weaker dollar in 2017 made doing business easier for U.S. companies and relieved the pressure on emerging market economies. The rising dollar in 2018, which took many by surprise, reversed that trend. As John Authers has noted, the dollar today is almost exactly where it was on election day in 2016, even though U.S. bond yields are much higher, which should generally attract funds into dollar-denominated assets and put upward pressure on the dollar.
The greenback has moved roughly in line with the difference in yields between the U.S. and Germany since last summer, but it remains far weaker than the widening gap between U.S. yields and the rest of the world suggests. As noted, a weaker dollar makes life easier for U.S. equity investors and companies generally and relieves pressure on firms in emerging markets. President Trump should want it. But can the dollar go lower without a major narrowing in yield differentials? And how can such a drop in yields happen without further signs of trouble for the U.S. economy?
Debt and Deficits. The Congressional Budget Office is forecasting $895 billion in red ink for the first 11 months of fiscal year 2018, up $222 billion from the same period a year earlier. Revenues are expected to rise one percent, while outlays jump about seven percent.
The U.S. budget gap widened in the first two months of the fiscal year (October and November), as tax collections, reduced due to the president’s tax cuts, lagged federal outlays, which increased significantly due to new spending initiatives. Customs duties during October and November rose 86 percent to $11.8 billion due to an increase in tariffs (increased consumer prices due to tariffs don’t impact this calculation). But that was hardly enough to offset the month's $205 billion shortfall.
The deficit is headed toward $1 trillion this fiscal year. “Rarely have deficits risen when the economy is booming. And never in modern U.S. history have deficits been so high outside of a war or recession (or their aftermath)...Now would be the time to act: today's relatively strong economy offers policymakers the opportunity to reduce deficits without fear of worsening a recession or disrupting a fragile recovery,” the Committee for a Responsible Federal Budget writes. The bottom line: This is a deficit of choice, initiated by both political parties, and we should be watching it carefully.
President Trump. Calvin Coolidge demonstrated that presidents do have an impact on markets, but it’s usually far less and less direct than we generally assume. Presidents generally take and get too much credit for strong markets and get too much blame for weak ones. Because ours is a free market system, the president’s impact on it is more indirect than direct. Like coaches of sports teams, their influence is felt more by the mistakes they make than by the strategies they implement. And, most fundamentally, their control over the economy and the business cycle is surprisingly limited. However, there is good reason for thinking that Mr. Trump bears more responsibility for market performance than most presidents. It hardly seems coincidental that stocks jumped in the days after his surprise election and continued to advance for nearly two years.
That’s why it’s not altogether surprising that when RBC Capital Markets surveyed institutional investors in December about their biggest worries, Mr. Trump topped the list (interest rates and the trade war ranked second and third). But his core base of support remains strong. Ohio Representative Jim Jordan is one of the president's most loyal and enthusiastic supporters. Jordan, as lead Republican on the House Oversight Committee, which has an exceptionally broad investigative mandate, sees his primary job as “getting to the truth.” Yet, when challenged on the president’s seeming mere passing acquaintance with the truth, Jordan’s response is instructive: “the last two years have been amazing.” That sort of response is typical among the president’s supporters. His truthfulness (or character, or style, or management, or inability to keep staff, or breach of norms, or denigration of allies and support of authoritarians, or, or, or) is not directly defended.
For them, only outcomes matter. And his supporters have loved the outcomes they have seen from the president so far.
That’s not necessarily wrong. Good results cover a multitude of sins. Practicality isn’t crazy. The Girl Scouts said in 2014 that they did not allow scouts to sell their famous cookies in front of marijuana shops, liquor stores or bars. It has since abandoned that policy and one scout sold 300 boxes in front of a legal marijuana shop.
Since President Trump’s election, we have seen some excellent results, financial and otherwise, results his critics never expected. For example, according to the Bureau of Labor Statistics, roughly 2.5 million new American jobs were created in 2018. From the perspective of his supporters, it’s promises made, promises kept. Most seem to agree with his recent claim that he's had "the most successful first two years" of any American president.
However, given the strength of the economy, the Republicans should have performed much better in the 2018 mid-term elections than they did. To get those results, moreover, President Trump made several big, longer-term bets, the outcomes of which remain unknown.
- He sees himself as America’s leading businessman and has consistently tied his success with that of the market, now on less than sure footing;
- He continues to insist that he can get North Korea to surrender its arms, despite few signs of substantive cooperation to this point;
- He wagered he could bring peace to Middle East because of his unique deal-making skills and despite his controversial removal of troops from Syria and the killing of writer Jamal Khashoggi in Saudi Arabia, without much progress so far;
- He keeps escalating his trade war with China, certain Xi Jinping will buckle, as outlined elsewhere herein;
- He rolled big that tariffs would assert American strength and protect domestic industries despite alienating allies around the globe, causing hardship to American companies caught in the blowback, and increased prices to American consumers;
- He bet that the boost from his (needed) corporate and (not so needed) individual tax cuts would overshadow the longer-term impact of dramatically increased federal debt and deficits;
- He president continues to keep the government shut down in his desire for Congress to fund his border wall, despite public opinion seeming to be against him; and
- He bet on loyalty, believing that people, both patriot and criminal alike, such as James Mattis, Michael Cohen, Jeff Sessions, David Pecker, John Kelly, Paul Manafort, Brett McGurk, Michael Flynn, and Omarosa, wouldn’t turn on him or couldn’t damage him.
All of this bears watching. The concerns of institutional investors are not without basis. When Mr. Trump referred to himself on Twitter as “Tariff Man,” the message helped spur a drop of more than three percent in the S&P 500. The markets didn’t take kindly to his routine Fed bashing and his threats to fire Fed Chair Powell, who he appointed barely a year ago, either.
The president tweeted a lot more in 2018, but a lot less about the stock market, as its performance has deteriorated.
Before U.S. stocks peaked in late January 2018, Mr. Trump drew a direct connection between the increase in market value of American companies and his administration’s pro-growth policies at least ten occasions in that month alone. Since then…not so much. But that doesn’t mean nobody is making the connection. To this point, the president’s base of support, about one-quarter of voters, has been enough to sustain him. We’ll see if that continues.
Looking Ahead
We have seen significant danger signals lately. “The [global] expansion may now have peaked. Global growth is projected to settle at 3.7 percent in 2018 and 2019, marginally below pre-crisis norms, with downside risks intensifying,” according to the OECD Interim Economic Outlook. Significant economic slowdowns are underway in Japan, China and Europe, with suggestions the U.S. is moderating too.
In late September, the Fed pushed interest rates above the rate of inflation for the first time in a decade, signaling the end of “easy money” in the U.S. In December, the ECB confirmed it would end its $3 trillion bond-buying program, suggesting the same in Europe. Higher rates mean something we haven’t seen in a while: cash and bonds producing yield, which forces fewer people into stocks. In each of the first three quarters of 2018, profits of S&P 500 companies rose about 25 percent from the prior year, aided by the corporate-tax cut. According to FactSet projections, earnings growth for the S&P 500 in the fourth quarter will come in at less than half what it was earlier in the year and will fall into single digits in 2019.
Finally, politics the world over is a mess. The U.S. and China are embroiled in a bitter trade war. President Trump is openly denigrating the Federal Reserve. Britain is fumbling through Brexit and Italy through an economic drought. Authoritarian governments have been elected in Brazil, and remain in place in China, Russia, and elsewhere. We are in fractured and difficult relationships with China, Russia, Iran, North Korea, and more. The Middle East remains a powder keg. We are still at war in Afghanistan and Iraq.
Most U.S. economic data and surveys of consumers and businesses are still optimistic, if a bit less so. The Federal Reserve has moderately lowered its median projection of 2019 economic growth from 2.5 percent to a still-strong 2.3 percent, if still well short of the President’s promises. Markets are portending a darker message. Yields on 10-year U.S. Treasury notes fell nearly 70 basis points between early November and early January, a sign many think the economy won’t be strong enough to make steady interest-rate increases possible.
In that context, what follows are my best ideas for managing your money in 2019 and beyond. I begin, as always, with my “evergreen” ideas – ideas that are always good and are much more important than my 2019-specific ideas. If you only follow-through on my “perennials,” you will almost surely be in excellent shape.
Perennial Great Ideas
These ideas are always good. You will have seen them before. Ignore them at your peril.
Save more. Advisors who focus on retirement planning spend a lot of time and energy considering such things as asset allocation plans, decumulation strategies, and needs analysis. But advisors and their clients spend far too little time and energy on the most important factor of all – how much money is saved and how to save it. Saving is the most fundamental and most important component of successful investing.
As my friend Wade Pfau succinctly points out in his seminal paper on this subject, "[t]he focus of retirement planning should be on the savings rate rather than the withdrawal rate." Put another way, "someone saving at her 'safe savings rate' will likely be able to finance her intended [retirement] expenditures regardless of her actual wealth accumulation and withdrawal rate." Using Wade's analysis, these "safe savings rates" generally range from 9.3 percent to 16.6 percent over 30 years under various sets of market conditions. Simply put, we should all be maxing-out out our defined contribution plans, usually a 401(k), every year of our working lives and leaving the money untouched until retirement.
Aggressive saving allows one to take advantage of compound interest, the so-called "eighth wonder of the world." The best thing any of us can do for ourselves and for our families' futures is to save more and to keep saving more.
Plan. Similarly, we should all have a carefully constructed plan for dealing with our financial futures. Every financial planning client, like every financial planner, should have such a comprehensive financial plan in writing and in place.
Low fees. The leading factor in the success or failure of any investment is fees. In fact, the relationship between fees and performance is an inverse one. In 2018, according to Morningstar, 60 percent of mutual funds paid out a capital gain while only six percent of ETFs did. The tax efficiency of ETFs matters. And they are among the lowest cost investment options. So, choosing lower costs (when the product is the right one, of course) can have residual benefits too. Every investor needs to count costs.
Diversify. The theory behind diversification is simple: Don't put all your eggs in one basket. A single holding has huge potential for gains if the right instrument is selected, but even huger risks (because investing "home runs" are so hard to come by). In general, the greater a portfolio's diversification, the lower its riskiness. Lower risk is a good thing, but only if the portfolio's potential return is healthy enough to meet the client's needs. Fortunately, a well-diversified portfolio captures most of the potential upside available with much lower volatility.
A diverse portfolio – one that reaches across all market sectors, foreign and domestic – ensures that at least some of a portfolio's investments will be in the market's stronger sectors at any given time, regardless of what's hot and what's not and irrespective of the economic climate. At the same time, a diverse portfolio will never be fully invested in the year's losers. For example, according to Morningstar Direct, about 25 percent of U.S. listed stocks lost at least 75 percent of their value in 2008 but only four of over 6,600 open-ended mutual funds lost more than 75 percent of their value that year.
J.P. Morgan Asset Management published the distribution of returns for the Russell 3000 from 1980 to 2014. Forty percent of all Russell 3000 stock components lost at least 70 percent of their value and never recovered. Effectively all the index’s overall returns came from seven percent of components. Thus, a diversified approach provides smoother returns over time (even if not as smooth as desired!). On the other hand, a well-diversified portfolio will always include some poor performers, and that's hard for us to abide. As my friend Brian Portnoy quips, diversification means always having to say you're sorry.
So, as a starting point, make sure your time horizon is long enough. If you don't have at least a five-year time frame before using the money, stocks are almost surely a bad idea. That's because the chances of negative returns over shorter time periods are too high. But over the longer term, our investment prospects with equities are bright.
Diversification pays off over the longer haul. It's the one sure "free lunch" in investing. I recommend it yet again, as always.
The “political trade” is a threat. We know that basing your investment decisions on your politics is a recipe for disaster (as detractors of President Obama who avoided the market from 2009 going forward found out and as detractors of President Trump discovered after the 2016 election). That's especially true because a president has far less control of market performance than is generally assumed. Those who love or (especially) hate any given political person, party, or policy need to be very careful that their politics don't dictate their investment decisions.
"Personal Volatility" is dangerous. While a further correction or even a market crash remain real possibilities, the "personal volatility" of trying to time the market is almost always a bad idea. As the great investor Peter Lynch put it, "Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves." Furthermore, those who guess right and get the sell timing right almost never get the buy-back-in timing correct. Trying to guess and time the market almost never works once, much less twice or more.
Overall, markets are positive roughly three-out-of-four years. The market's path of least resistance is higher, making big cash positions a major risk. Moreover, investors and advisors should temper their tendency to fire money managers for recent underperformance. Multiple studies have shown that the wealth lost by investors from the practice of firing and hiring managers on the basis of recent performance – at both the personal and institutional levels – far exceeds the average net-of-cost underperformance of active management. This sort of "personal volatility" is highly dangerous.
"A sense of where you are." The Pulitzer Prize-winning writer John McPhee wrote a wonderful book - his first, in 1965 - about Bill Bradley at Princeton called, indelibly, A Sense of Where You Are. It was about Bradley as the best basketball player Princeton had ever seen as well as his self-discipline, his rationality, and his sense of responsibility. The title comes from Bradley always knowing his position on the court, in relation to the basket, his teammates, the opposition, the situation and the score.
Speaking to McPhee in the Princeton gym, Bradley looked him straight in the eye while tossing the ball cleanly through the hoop. McPhee was astonished. "When you have played basketball for a while, you don't need to look at the basket when you are in close like this," Bradley said. "You develop a sense of where you are." Bradley's constant awareness, as well as his athletic gifts, distinguished him as a player.
Good investors also need exceptional self-awareness. Dealing with risk doesn't just mean knowing how much tolerance one has for pain when markets are uncooperative. It means understanding how much risk capacity one can undertake without putting one's financial goals at risk and how much risk must be taken to assure that one's financial and investing goals are likely to be met. It recognizes that risk avoidance can be just as damaging as foolish risk-taking. It means understanding which risks are real and which are illusory. We all need a "sense of where we are" in our financial and investment journeys.
Don't bet against America. As Yale Endowment head David Swensen emphasizes, "we should never underestimate the resilience of this economy." Avoiding stocks is betting against the American economy. Doing so has never turned out well. Don't sleep on U.S. stocks.
Guaranteed income. Since at least 1965 and the seminal research of Menachem Yaari, economists have recognized that retirees should convert far more of their assets into guaranteed income vehicles during retirement than they do. Guaranteed income is the surest way available to deal with the three great threats to retirement income security: longevity risk, sequence risk and stupidity risk.
Longevity risk is increasing steadily in that life expectancies continue to expand throughout the developed world and is exacerbated because consumers are both retiring earlier and have less and less access to private pensions. Moreover, the distribution of longevity is wide. Guaranteed income vehicles hedge longevity risk simply and efficiently as risk pooling makes them 25-40 percent cheaper than do-it-yourself options. Thus, retirees who purchase an income annuity assure themselves a higher level of consumption and guarantee it as well.
Sequence risk relates to market volatility and the order in which returns on a retiree's investments occur. Essentially, when drawing income from a portfolio, low or negative returns during the early years of retirement will have a greater impact upon overall success rates than if those negative or low returns occurred at a later point of retirement, even if the overall average return was the same. Therefore, if poor returns and ongoing withdrawals deplete a portfolio before the "good" returns finally show up, financial disaster can occur.
Stupidity risk relates to the management of portfolios to provide retirement income. Allegedly "safe" withdrawal rate provisions assume that both consumers and advisors will make and continue to make good choices throughout retirement. What we know about cognitive and behavioral biases as well as the real-life actions of consumers and advisors during periods of market stress doesn't just suggest, they scream, that we should be skeptical about the ability of people to make good decisions and keep making good decisions when the going gets tough.
Most "safe withdrawal" analysis assumes safety as something like a 90-95 percent success rate over a set period, commonly 30 years, and emphasizes that, most of the time, this approach should not only work, but should provide significant portfolio growth. However, with the consequences of failure being so high – being destitute at a time in life when vulnerability is at a peak – a 5-10 percent failure rate (which may be too low given that "100-year floods" seem to happen in the markets about once a decade or so) hardly qualifies as anything like "safe." Moreover, limiting the analysis to a set period is similarly deceptive due to longevity trends.
Guaranteed income is almost always a good idea in retirement. For those who have saved less than they ought to have, it is crucial. Don't forget about other forms of insurance either. Volatile markets provide effective reminders that stocks, despite their unmatched long-term value, can and do lose money. Those same volatile markets also provide a good opportunity for investors to make sure their insurance needs are in good order. Diversification in retirement planning approaches always makes sense.
Don't go it alone. American virologist David Baltimore, who won the Nobel Prize for Medicine in 1975 for his work on the genetic mechanisms of viruses, once told me that over the years (and especially while he was president of CalTech) he had received many manuscripts claiming to have solved some great scientific problem or to have overthrown the existing scientific paradigm to provide some grand theory of everything. Most prominent scientists have drawers full of similar things, almost always from people who work alone and outside of the scientific community.
Unfortunately, these papers didn't do anything remotely close to what was claimed, and Dr. Baltimore offered some fascinating insight into why he thinks that's so. At its best, he noted, good science is a collaborative, community effort. On the other hand, crackpots work alone. We all work better with help, advice, support, correction, criticism and accountability. A good financial advisor not only can provide a good financial plan with excellent investment choices. He or she can also provide needed guidance for perhaps the hardest work to be done in finance: managing expectations, behavior, and our inevitable mistakes. Make sure you aren't trying to go it alone in the investment world.
Current Considerations
We all want "high leverage" ideas - the ideas that will make the biggest impact on our portfolios and our lives. But the best ideas available are not still more investment recommendations about hot sectors, hot funds, hot strategies, and hot managers. They are the Perennials outlined above. The data makes that abundantly clear.
We should focus on the Perennials above, like a broadly diversified global portfolio. We should worry far less about overweightings, tilts, and ideas are that unique to the current situation. They are far less important. Josh Brown explained why perfectly: "People can't be accurately modeled. And it's people who work and vote and invest and trade and make deals and stick things into themselves that require a trip to the emergency room."
However, an important issue remains. A good portfolio that is used always beats a great or even perfect portfolio that is abandoned. And we abandon great portfolios with alarming regularity because they don't seem to be working today or simply because we want to trade. We're crazy enough to think that we can and should do better. "There's an element of the speculator in everybody," says Rob Arnott, chairman of Research Affiliates, whose strategies are used to manage about $195 billion.
As Tim Richards has persuasively argued, we are both by design and by culture inclined to be anything but humble in our approach to investing. We invest with a certainty that we've picked winners and sell in the certainty that we can reinvest our capital to make more money elsewhere. We are usually wrong, often spectacularly wrong. These tendencies come from hardwired biases and from emotional responses to our circumstances. But they also arise out of cultural requirements to show ourselves to be confident and decisive. Even though we should, we rarely admire those who show caution and humility in the face of uncertainty.
What should we do about that? It isn't practical simply to implore investors to stick with the plan, even a great plan. Most of us just aren't built that way. Legendary investor Benjamin Graham advised strictly segregating speculations from investments. His key idea in this regard was to set up a "mad money" account where you can take a flyer, if you must.
The "annual" ideas that follow are my "flyers" – ideas that I think are good ones that (if you must!) you may use in your "speculations" bucket, over and above your globally diversified, multi-asset class, perennial "investments."
Lean Toward Value. Historically, value stocks have outperformed growth stocks. That doesn’t happen during every period, of course, and value has been lagging for a while now. It was more of the same in 2018.
This may be a good time to get back into value.
Growth stocks, that are expected to grow faster than average, have more to lose than value stocks in the president’s trade war, as they sell more of their wares overseas. On a weighted average basis, companies in the S&P 500 Growth Index generated 58 percent of their revenue from foreign sources, while it was 48 percent for companies in the S&P 500 Value Index. As Nir Kaissar reported for Bloomberg, growth stocks have outpaced value by 4.5 percentage points a year over the last decade through 2018, which has stretched their relative valuations. The growth index’s price-to-earnings ratio has averaged 21 since 1995, based on 12-month trailing earnings per share, compared with 16 for the value index. Those numbers are now 23 and 14, respectively.
A big part of that difference can be attributed to technology companies such as Apple. According to the most recent S&P 500 global sales report, technology companies generated 57 percent of their sales outside the U.S. in 2017, more than any other sector. And technology stocks tend to be growthy. They account for 25 percent of the growth index, compared with just 15 percent of the value index. Value always looks cheaper than growth. Today’s cheapness looks like a buying opportunity.
Foreign Stocks. Even after the recent sharp correction, the worst it has suffered since 2011, U.S. stocks have still outpaced their global counterparts by more than 100 percent this decade. As reported by Jason Zweig, through August 31, the S&P 500 has outperformed international stocks, as measured by the MSCI World ex USA Index, over the past one, three, five, 10, 15, 20, 25, 30, 35, 40 and 45 years, according to AJO, an institutional investment manager in Philadelphia. Had you put $10,000 in each in 1973 and reinvested all your dividends, your U.S. holdings would be worth $1.06 million; your international stocks, $356,000. And things didn’t get any better for foreign stocks in the fourth quarter.
However, the “U.S. was among the worst-performing stock markets worldwide in the 1970s and the 2000s; it also earned lower returns than the average international market in the 1980s.” Mean reversion alone suggests some added focus of foreign stocks. Moreover, because global companies headquartered here in the U.S. and a part of domestic stock indexes tend to hedge their exposures to foreign currencies, that hedging tends to overwhelm whatever benefits the companies get from being global, meaning that investing in the plethora of U.S. firms that do business overseas isn’t likely to provide the desired advantage.
European stocks were a popular recommendation as 2018 opened, out of a belief in mean reversion if nothing else. Europe’s stock-market performance, compared with the U.S.’s, has been terrible for more than a decade. Every time it seemed to be turning, as was the case a year ago, it reversed. It makes me nervous, but I think foreign stocks are a good bet in 2019.
Emerging Markets Stocks. Don’t limit foreign exposure to developed markets. A hawkish Fed, higher U.S. bond yields, and a stronger dollar all have a well-documented tendency to inflict pain on emerging-market assets. However, Research Affiliates, among others, is reiterating its recommendation to buy developing-nation equities.
Emerging market stocks have badly underperformed U.S. stocks over the past decade. Although developing countries are typically more volatile than developed ones (Brazilian stocks are more volatile than Canadian stocks, to pick one example), mean reversion suggests that emerging markets having performed so poorly could cause them to outperform the U.S. going forward. Jeremy Grantham of GMO is among those who have made this argument: “Let me add a point on the performance of EM equities in a major market break. Everyone expects that these assets would drop like a stone, worse than their U.S. counterparts. But historically that is not how it works. Yes, beta is very important in a bear market or any market when explaining relative performance, but so is value.”
Infrastructure. I have argued before that the easiest "best idea" to propose was infrastructure because President Trump had promised more infrastructure spending, because Democrats want it too, and because it was so desperately needed. The American Society of Civil Engineers has estimated that the U.S. needs to spend $3.6 trillion by 2020 just to put the infrastructure we have in good working condition. According to the think tank Smart Growth America, current road maintenance spending is only about a third of what it needs to be in order to maintain adequate quality. Moreover, the longer we postpone repairs to roads and other infrastructure, the more expensive it gets. Finally, although state and local government investment in roads, bridges, buildings and other infrastructure hasn’t returned to its previous peak, it's finally showing signs of a real recovery.
However, we suffer from an enormous state of dysfunction in American infrastructure and its management. There will surely be major disputes about how to spend infrastructure dollars. Some projects suffer from embarrassing defects (like California's Bay Bridge) and outrageous cost overruns (like New York's Oculus). Meanwhile, construction-sector productivity is lower than it was 50 years ago and a bridge being lifted on its own foundations (in Bayonne, New Jersey) requires 5,000 pages of environmental review. Even so, the need is urgent, before factoring in the potential benefits to blue-collar men, who are disproportionately out of the workforce and have disproportionately supported the President.
With an even more fractured relationship between the president and Congress due to Democratic control of the House, infrastructure might be one place everyone can agree, at least generally. Private-equity firms are on track to raise a record amount for infrastructure investing in 2018. They collectively raised $68.2 billion for infrastructure investment in the first three quarters, 18 percent more than in the year-earlier period and $2 billion more than in all of 2016, according to Preqin. Projects like the two new headquarters developments for Amazon add to the demand. The big bets on the need to upgrade and expand the likes of railroads, natural-gas pipelines and data centers come despite a lack of progress on infrastructure legislation, promised by President Trump. Even though, two years into his presidency, President Trump hasn’t fulfilled his infrastructure promise, I still like the sector.
Back to Basics
We live in interesting, challenging, and difficult times. That isn’t news, of course, and the idea is implicit in one of my late mother’s favorite gospel songs, In Times Like These
When markets are difficult, in times like these, it is important to be anchored to good financial advice, a good financial plan, and good financial commitments.
If there is good to be gained from the stock market turmoil of the past few months, it is that investors should have a far more realistic idea of how much risk they are truly willing to take and a better appreciation for what portfolio diversification means. The fourth quarter rout of the S&P 500, -19.8 percent from its September high to its December low, wasn’t quite enough to meet the traditional definition of a bear market (unless you’re rounding up), even though it felt like one, and stocks have climbed back about 10 percent since. Still, after a bull market of almost a decade’s duration, fear of missing out has finally turned into fear of losing out. Some investors are taking a serious look at the risks in their portfolio for the first time in a while.
And that’s very good news indeed.
In the context of volatile markets and a negative year for most investors, it is important and helpful to restate some first principles about investment advice and what it can accomplish.
- · The performance of a portfolio, especially relative to some arbitrary index, is not of primary importance. The only benchmark you should care about is whether you are on track to achieve your financial goals.
- Volatility is not the same thing as financial risk. Real risk is the likelihood that you won’t achieve your financial goals. Your assets should be invested to try to minimize that risk.
- Goal-focused investing is the recipe for long-term financial success. This recipe doesn’t change when the market changes. In a world of seemingly limitless information, patience and discipline provide an enormous advantage.
Therefore, here are eight crucial things on which to focus (h/t Georgie Loxton).
- 1. All stock market corrections (declines of ten percent or more from recent highs) in our lifetimes have been temporary. Each one ended with the resumption of the long-term uptrend.
- Back-to-back down years for the stock market are rare. There have only been four instances since 1929 when the S&P 500 declined two or more years in a row. Most of the back-to-back declines came during big global macroeconomic events like wars and major economic depressions.
- Since the end of World War II, over 71 years, there have been 59 corrections in the S&P 500, an average of about one every fifteen months.
- During that same 71 years, there have been eleven recessions (a decline in U.S. GDP lasting for at least two calendar quarters), an average of about one recession every six and a half years. Those recessions lasted, on average, for 11 months, meaning that the U.S. economy was in recession about 14 percent of the time and was growing about 86 percent of the time.
- Over those same 71 years, there have been 11 bear markets (a decline of 20 percent or more from a recent high), an average of about one every six-and-a-half years (and 16 if you count 19 percent drops that felt like bear markets, including 2018 – about one every four-and-a-half years).
- Two of the four largest market crashes are within recent memory – since 2000 – so it’s understandable that investors might be afraid that they will lose half their wealth every time the market swoons. However, history suggests that such enormous market collapses are rare.
- Since World War II, of the 11 (or 16) separate bear markets, only three of those periods produced losses exceeding 40 percent, and there were three separate downturns in the 30 percent to 40 percent range. The median drop was roughly 25 percent. A major crash is always possible, of course, but your default assumption about a bear market shouldn’t be a major meltdown.
- During those same 71 years, when the S&P 500 was correcting 59 times and going through 11 bear markets, the S&P 500 went from 15 to 2,506. Its value multiplied more than 150 times.
The returns provided by stocks are very, very good. Over the 30 years ending December 31, 2018, stocks (the S&P 500) returned roughly 10 percent annualized versus barely 6 percent for bonds (10-year U.S. Treasury notes) and 3 percent for cash (3-month U.S. Treasury bills). Other investment choices do not have nearly so long a track record, but so-called "alternative investments" have generally returned less than bonds while fixed index annuities can be expected to provide returns roughly equal to bonds, perhaps a bit better.
Everybody can see that the differences are significant, but it's easy to miss just how significant they are. Over those same 30 years, $100,000 invested in cash would have returned less than $250,000, bonds less than $700,000, while stocks would have earned nearly $2,000,000. That's an enormous difference, especially if you are saving for retirement. Don't forget too that (a) bonds had a fantastic run over that 30-year period, so the return gap will often be much wider; and (b) bond returns can also have substantial volatility. Other investment choices offer important benefits, including crucial diversification benefits, of course, but avoiding stocks to avoid volatility has an enormous opportunity cost.
Still, market volatility is enormously stressful. Investing successfully over the long haul is really, really hard. There is certainly no certainty. There is no technocratic Nirvana, no quant-generated (or otherwise generated) safe harbor. Historical interrelationships between valuation and price, various correlations, and ongoing market cycles are neither consistent nor uniform. Good ideas work for a while. Great ideas persist but bumpily and uncertainly. Our best strategies, approaches and ideas work...but only until they don't anymore.
The problem with arrogance is that the truth eventually catches up. The first rule of the Dunning-Kruger Club is you don’t know you’re in it (and we’re all in it at least some of the time). The trouble with markets is that eventually they will go down, as in 2018. When they do, there is always some supremely confident person telling you that the bad markets can be missed without sacrificing upside. The first rule investing, as the great Jason Zweig warns, is that “[t]he advice that sounds the best in the short run is always the most dangerous in the long run.”
Great interpretations of difficult data sets, especially those involving human behavior, require more sculpting than tracing. Portfolio optimization is a wonderful scientific ideal. But portfolio optimization alone pays insufficient attention to the needs, desires and vagaries of the investor who owns it. At best, any Outlook is no more than the roughest of outlines. Your mileage can and will vary. Keep your attention focused squarely on specific needs, goals, and what you can reasonably expect to control about your portfolio and its results. In volatile times, it helps to get back to basics and that’s about as basic as it gets.
As AQR founder Cliff Asness stated succinctly, "The great strategy that you can't stick with is obviously vastly inferior to the very good strategy you can stick with." If we can't cope with our human failings and shortcomings, we can't and won't get very far. I trust that this 2019 Investment Outlook, my eighth annual, has provided you with an effective coping mechanism.
I sincerely wish each of you a safe, happy and prosperous New Year.
Robert P. Seawright
Chief Investment & Information Officer
Madison Avenue Securities, LLC
(858) 207-2140
Twitter: @RPSeawright
1 A tribunal of judges in a special trade court raised constitutional questions over President Trump’s expansive regulation of trade, focusing on a national security threat law he has used to justify imposing tariffs on imported goods. This issue bears watching.
Securities and advisory services are offered through Madison Avenue Securities, LLC, a member of FINRA and SIPC, a registered investment advisor.
This report provides general information only and is based upon current public information we consider reliable. Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any securities or other investment or any options, futures or derivatives related to such securities or investments. It is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities or other investments, if any, may fluctuate and that price or value of such securities and investments may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. Diversification does not guaranty against loss in declining markets.