The Most Important Thing

by Catherine Trinder Miller, August 10, 2018

“Investor know thyself. How much pain can you take on the downside?”
- Joel Greenblatt, Investor, Author, & Professor at Columbia University

One of my favorite books on investing is the legendary Howard Marks’, The Most Important Thing, Illuminated. The book is full of annotations including the quote above by another legendary investor, Joel Greenblatt. Greenblatt’s wisdom stands out among so many great insights. It is remarkable not because I sense a bear market is coming. Those of you who know me well, know I’m not in the business of predicting future outcomes. By seeking out what is important and knowable today, and gathering evidence to challenge and support these views, informed decisions can be made. The quote is remarkable as it’s perhaps the most important thing we can understand about ourselves as investors in any environment. Reflecting on this question in good times can be particularly powerful in building an investment strategy that allows you to take advantage of opportunities in bad times.

As shared in my August 2017 memo, You Must Be In To Win, the opportunity cost of risk aversion in the latest economic cycle has been huge. Moreover, in the past 20 years, equity investors have suffered through two of the biggest bear markets since the 1930s, yet those who stayed the course are still up over 300%. [Exhibit 1].1

Exhibit 1

Consider the intra-year drawdowns along the way. Taking a subset of this 20-year period for the S&P 500 [March 2009 - May 2018 (i.e., the current bull market)] and graphing the low point each year demonstrates the frequency of U.S. equity market declines [Exhibit 2].2 Would you have had the conviction to stay the course?

Exhibit 2

Better yet, do you have lower risk investments or sources of cash flow outside your investment portfolio that you can deploy into great assets at great prices when these sales occur? The irony is, emotionally it can feel the worst to buy when logically the opportunity for strong future returns is the greatest.

Investor know thyself.

In early June, I hopped a plane to NYC to see Howard Marks in person at Wharton’s Global Forum. Marks voiced concerns around the potential risks and unintended consequences of passive investing. Marc Rowan, Co-Founder of Apollo Global (also in attendance) expressed similar unease. Their concerns centered on liquidity and price. In one example, Marks highlighted the price momentum that over-weighted, liquid, large-cap stocks have experienced in the current upcycle fueled by buying of passive vehicles. Per Marks in his most recent memo, “these passive vehicles don’t have the option to refrain from buying just because a stock is expensive.”3 He continues, “…in a market down cycle, these positions that were disproportionately bought may be disproportionately sold fueling their downward momentum.” Rowan shared, “…if you can provide capital in these environments, you will have outsized returns for the following ten years, maybe more.” Both investors make a compelling case, in our view, for diversification of risks among asset classes (stocks, bonds, cash) and products (mutual funds, exchange-traded funds, and individual securities). Like Marks and Rowan, we continue to emphasize the importance of fundamental analysis, price discovery, and active management of risks and returns.

Also in attendance at the Forum was Jon Gray, President of Blackstone. When asked how long this recovery can last, Gray focused on the price multiple investors are willing to pay for earnings at this point in the cycle. In late cycle recoveries, such as the current one, when the Central Bank (“Fed”) is tightening, price multiples (i.e., the multiplier investors are willing to put on earnings to determine a fair value) are less likely to expand. Therefore, stock price increases are much more dependent on earnings growth. Earnings in the U.S. are growing strongly. For second quarter 2018 (“2Q18”) to date, with 88% of S&P 500 companies having reported, earnings and revenues are up year over year more than 24% and 9%, respectively. This follows +26.6% earnings growth and +8.4% revenue growth in 1Q18.4

Positive earnings momentum in the U.S. remains strong and fueled, in part, by the shift from monetary stimulus (i.e., central bank) to fiscal stimulus (i.e., tax reform, deregulation, government spending). This is perhaps the most important shift in the last decade. And this shift is not just happening in the U.S., but increasingly in other markets around the world.

Exhibit 3

According to J.P. Morgan’s Global Market Strategist, David Lebovitz, $200 billion in foreign profits have been repatriated to the U.S. since tax reform passage, with significant amounts flowing into share buyback, dividends and strategic acquisitions. Yet, Lebovitz estimates the positive effects of tax reform (pulling growth forward) will fade in the second half of next year.

Exhibit 4

The uncertainty around trade may catalyze financial market volatility and business confidence disruption. Thus far, the effects appear muted. Earlier this week, the U.S. Trade Representative announced that the remainder of 25% tariffs on $50 billion of Chinese imported goods, reported June 15, is scheduled to take effect on August 23. Around this date, unless compromise is reached, China is expected to retaliate by imposing tariffs on already-announced $60 billion of U.S. imports. Let’s not forget, China controls $1.4 trillion in U.S. Treasury Securities and critical global supply chains for many U.S. companies. The U.S. has another round of 25% tariffs on $200 billion of Chinese imports announced, yet not implemented. As investors, we must expect this escalation to continue in the near term, potentially increasing short term financial market volatility. It’s estimated that two-thirds of the trade deficit with China is centered in the apparel and computer categories.5 We’re increasing our vigilance in capital deployed across these sectors. While uncertainty around China trade policy remains high, EU and NAFTA discussions show positive momentum.

Exhibit 5

And then there’s the Fed. We know definitively that with each federal funds interest rate hike, we are one step closer to the end of this economic cycle. They have increased rates 0.25% twice this year, after three hikes (0.25% each) in 2017, and expectations are that we will get another 0.25% each in September and December. Neither inflation (increasing, but gradual) nor employment (extremely tight) -- the two components of the Fed’s mandate -- give them reason to slow the pace of rate hikes. Yet the absolute level of rates remains low with the U.S. Treasury 10-year bond at 2.96%.6 While the Fed remains data-dependent, we could see as many as four additional 0.25% rate hikes in 2019. The pace of inflation, given tight labor markets and potential tariff-related price escalation, must be monitored vigilantly given its influence on the path of monetary policy tightening.

Exhibit 6

Global central bank policy divergences, with the U.S. leading developed markets in monetary tightening in 2018, have pushed the U.S. dollar higher against many other currencies. The strengthening dollar, combined with trade uncertainty, has sparked relative underperformance of non-U.S. versus U.S. equities this year. While earnings growth has slowed from strong 2017 levels for the Eurozone, China and others, second quarter earnings reported to- date appear solid. The Eurozone, as represented by the Stoxx 600 (containing both Eurozone and UK shares), is showing 12% year-over-year growth, the Japanese Topix at 8% growth, and Chinese earnings growing double digits.7 Central banks for these regions continue to stimulate the economies through low interest rate policies. Fiscal stimulus is also rising. Yet valuations for these regions do not reflect the fundamentals. This presents opportunity for patient investors. Non-U.S. equities, as represented by the MSCI ACWI (“All Country World”) ex-U.S. stock index are trading at 13.2x future earnings, 20% below the S&P 500 P/E multiple of 16.5x. This is 2x the average discount to U.S. stocks over the past 20 years. In addition, the dividend yield for this index is 3.3%, 64% higher than the yield on the S&P 500.7 As it becomes increasingly challenging to find undervalued assets in domestic U.S. markets, international markets may present opportunities for stronger returns in the long run.

In summary, equity market volatility is expected to remain high as global central bank policies diverge and trade outcomes are uncertain. U.S. equity market valuations are currently supported by strong earnings growth. This year’s economic expansion may be at the expense of future years as fiscal stimulus pulls growth forward. The Federal Reserve is tightening monetary policy consistently, albeit from low levels. A higher cost of capital will increasingly challenge growth in 2019. The pace of inflation is uncertain and could significantly influence the performance of equity markets should it accelerate. International equity performance has lagged the U.S. this year. Given continued monetary and fiscal stimulus, and compelling valuations, non-U.S. equity markets may close this performance gap in 2019. In portfolios with equity allocations, we remain overweight U.S. equities while maintaining exposure to non-U.S. equity markets given compelling valuations and stimulative central banks and governments. Short-term U.S. Treasuries, senior loans, and select municipal bond strategies have proven productive risk hedges. As the U.S. deficit increases (see Exhibit 6), and growth begins to slow, the tools available to stimulate the economy in the next downturn are less clear. Diversification matters.

Investor know thyself.

Your behavior, particularly in periods of market volatility (read: opportunity), remains the most important thing.

1 Source: J.P. Morgan’s Guide To the Markets, 7/31/18. Cumulative returns are calculated using historical data. Stock returns are based on the S&P 500, bond returns are based on the Bloomberg Barclays U.S. Aggregate Index and cash returns are based on 3-month U.S. Treasury bills. 1-year returns are 20-year average annualized return from12/31/97-12/31/17 for each asset class. 5- and 20-year returns are cumulative over that time period based on the annualized return. Past performance is not indicative of future returns.
2 Source: Batnick, Michael, The Longest Bull Market Of All Time? 8/5/18
3 Source: Marks, Howard, Investing Without People, 6/18/18.
4 Source: Thompson Reuters Earnings Scorecard, 8/8/18.
5 Source: McVey, Henry, KKR Global Perspectives, New Playbook Required, 6/28/18.
6 Source:; Data as of 8/8/18.
7 Source: Kelly, Dr. David, J.P. Morgan Global Strategist, Organizing the International Desk, 8/6/18.

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Catherine Miller and Teri Benson and not necessarily those of Raymond James. Investing involves risk and you may incur a profit or loss regardless of strategy selected. No investment strategy can guarantee success. Past performance may not be indicative of future results. Investing in the energy sector involves special risks, including the potential adverse effects of state and federal regulation and may not be suitable for all investors. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary.

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