Beware the Madness of the Mobs

by Catherine Trinder Miller, December 21, 2018

“You can’t be a good investor unless you are emotionally stable. Most people are wired with every bone in their body to do the wrong thing, i.e. buy when things are going well for a while and sell when things are going bad for a while, which is the opposite of what (we) should do.”
- Howard Marks, Legendary Investor, Author, and Founder of Oaktree Capital Management

MIT professor Andrew Lo’s book, Adaptive Markets, opens with a description of the perfectly rational economic being -- homo economicus. The two extremes of this being are the perfectly rational group labeled the "wisdom of the crowds" and the emotionally irrational group labeled the "madness of the mobs". Lo goes on to caution, "In the case of irrational investor behavior, errors can compound across individuals, replacing the wisdom of the crowds with the madness of the mobs." The market has not yet determined if the current drawdown is wisdom or madness. Economic fundamentals coupled with resolution to several highly uncertain near term catalysts (e.g. trade and Mueller) will bring clarity.

In an unusual December, the eagerly awaited annual Santa Rally never materialized. Instead of the gift of higher stock prices, U.S.-China trade tensions quickly eroded the short-lived gains following the G20 international forum in Buenos Aires. News surfaced within days that the CFO of leading Chinese technology company, Huawei, was arrested at the direction of the U.S. Department of Justice ("DOJ"). Despite policy makers and the administration’s insistence that the actions of the DOJ were independent of trade discussions (they were simply enforcing the rule of law), it felt to many like poking the bear. Further prods were inflicted this week with two Chinese hackers charged by the DOJ for "extensive campaigns of global intrusions into computer systems." This was a coordinated action supported by U.S. allies. No sanctions were levied; yet, a powerful and important message was sent to China about the zero tolerance policy for these types of actions and the importance of U.S. technology and intellectual property protection in trade negotiations. Both Xi and Trump are incentivized to negotiate a deal. They understand short term what’s economically at stake for both countries and the world. Yet, they must negotiate with the long game in mind. And the March 1 deadline is looming.

I could pile on with concerns about the Federal Reserve’s policy path, Mueller probe uncertainty, and the potential for a hard Brexit, but I won’t. Our media outlets scream these headlines at us daily. Capital markets are increasingly pricing these risks in. Rather, I will focus on what is going right.

In 2018, real Gross Domestic Product ("GDP") in the U.S. accelerated to 3.0% from the tortoise-like 2.3% year over year average post-2008, fueled by tax reform, deregulation, and improved corporate and consumer sentiment (Exhibit 1). While 2019 may drift closer to average (in fact, this is the Fed’s projection at 2.3%), the U.S. economy is still expected to grow.

Exhibit 1

When we look at the components of this GDP growth (Exhibit 2), over 85% is driven by consumer (68%) and government spending (17%).

The U.S. consumer is employed and spending. Unemployment sits at historic lows of 3.7% and is expected to fall further with Fed projections of 3.5% by year end 2019. Household debt payments as a percentage of disposable income have fallen to multi-decade lows (Exhibit 3). The US consumer in aggregate is healthy.

Corporate capital investment, at 14% of GDP, could slow if sentiment deteriorates; yet a near-term resolution to trade concerns may boost executive confidence and reignite investment spending which has strengthened since early 2018.

While government spending must be curbed long term, there are few indications that fiscal discipline will increase in 2019.

Exhibit 2

In valuing capital markets assets (i.e., stocks, bonds, private equity, etc.), earnings typically matter most. Those paying attention to forward looking earnings forecasts could see that the rate of growth would slow. It is the law of large numbers; the 27%, 27%, 33% year-over-year ("y/y") earnings growth we saw for the S&P 500 in the first, second and third quarters of 2018, respectively, would not persist indefinitely. The key was that it did not appear then, and does not appear now, that we are at peak earnings for U.S. companies as represented by the S&P 500. That’s important as valuations (i.e., the multiples investors are willing to pay for earnings) have contracted significantly from nearly 17x earnings at the recent September price peak to 14.8x currently.1 In an even more conservative scenario, cutting those earnings forecasts by 10%, the S&P 500 is trading at 16.5x earnings, still a discount to the historical post-World War II average of 16.7x.2 The market is increasingly pricing in more than just a slowdown; prices reflect fears of a U.S. recession.

One of the best predictors of recession historically has been the Conference Board Leading Economic Index ("LEI"). LEI is a U.S. economic leading indicator intended to forecast future economic activity. Looking back to the 1960’s, the U.S. has never had a recession without the LEI turning negative3. As illustrated in Exhibit 4 below, the LEI is far from negative.

Exhibit 3

Earnings growth for the S&P 500 in the fourth quarter of 2018 is forecast to be 15.9%.4 If we even approach these figures, then Q4 earnings may positively surprise relative to expectations and price momentum could shift to the upside. We saw a great example of this in the earnings of Nike, Inc. (NKE) who reported after the close Thursday. The earnings report and guidance were solid, fueling a strong subsequent rally in the stock price. For asset pricing, earnings matter most.

J.P. Morgan’s Global Market Strategist, David Lebovitz, is conservatively forecasting 5-6% S&P 500 y/y earnings growth for 2019; this follows over 20% estimated y/y earnings growth in 2018. While the rate of growth is expected to slow, any growth off these very high numbers suggests an economy far from stalling.

Exhibit 4

Outside the U.S., the economic picture is more sanguine. It’s been a challenging year for international markets with trade concerns, Brexit, and strong U.S. dollar headwinds taking a toll. The strength of the U.S. economy and trade outcomes will be important in determining the near term fate of international markets. In the last 4+ weeks, international stocks have started to outperform U.S. stocks on a relative basis, with emerging markets showing the greatest relative strength. Should the Federal Reserve pause interest rate hikes in early 2019 or raise just once, the U.S. dollar could weaken creating a potential tailwind to international asset performance. The valuation differential between U.S. and non-U.S. equities is wider than it’s been in decades. While potentially cheap valuations overseas intrigue us, we seek catalysts to drive improved performance. These catalysts reside in the health of the global economy, the resolution of trade disputes, and the slowing of Federal Reserve interest rate hikes. Should the global economy avert recession and pressing trade discussions result in mutually agreeable solutions, this could bolster the performance of non-U.S. equities, particularly if the Federal Reserve slows interest rate increases, potentially weakening the U.S. dollar relative to other foreign currencies.

Essential for a patient and gradual Federal Reserve interest rate normalization policy is modest inflation. Inflation has been extraordinarily stable with the Fed target PCE inflation (personal consumption expenditures) for year end 2019 at 1.9%, within the Fed’s target range. In many respects, this has been gift at this point in the economic cycle. While some were expecting (read: hoping) the Fed would remove forecasts of interest rate hikes in 2019, this may be perceived as irresponsible given current U.S. economic growth and low unemployment which the Fed expects to continue in 2019. That said, Fed Chairman, Jay Powell, was clear in saying, "[the] Policy course will change if the data changes." Some may perceive the Fed’s actions this week as sending a signal that the market is strong enough to stand on its own two feet. Using a biking analogy, it is not uncommon when you take the training wheels off to wobble on the first few tries. There is a strong desire to have the training wheels back, but one must find the courage to forge ahead without them.

In the current environment, uncertainty remains high and diversification is essential. We barely touched on the potential Mueller investigation risks, but I will take a moment in reflection to share that politically driven financial market volatility is usually transitory and not a sound basis upon which to make investment decisions. For portfolios with equity allocations, we remain overweight U.S. equities relative to international, yet see a compelling opportunity unfolding for non-U.S. equity relative outperformance, particularly if the trade tiff de-escalates and the Fed is more gradual in interest rate hikes. A mutually agreed upon deal for Brexit feels too much to ask, but would be icing on the cake. Within our equity exposure, we increasingly focus on quality as evidenced through strong balance sheets and free cash flow. We have increased positions in dividend growers and reduced exposure to mid-cap and smaller-cap companies. As we move closer to the end of the rate hike cycle, we find high-quality fixed income including municipal bonds and short treasuries increasingly attractive. We have cut credit positions which were strong performers in 2018 as we anticipate further widening of spreads (i.e., the difference between U.S. Treasury yields and same maturity corporate bonds). The almost 6% difference between the [nominal] earnings yield on the S&P 500 and the yield on the U.S. 10-year Treasury presents a sufficient premium to compensate investors for taking equity risks.

The high levels of corporate and government debt may come home to roost at some point; most likely in the next recession. We remain vigilant in considering possible unintended consequences; higher taxes and corporate defaults are the two most obvious.

In the words of the legendary Howard Marks, "You can’t be a good investor unless you are emotionally stable." We believe the recent equity market volatility is being exacerbated by multiple factors converging: investors over-risked or over-leveraged in their portfolios, year-end tax loss harvesting and quantitative models, which sell at pre-determined technical levels regardless of the fundamentals. These behaviors are exacerbating volatility despite the fundamentals. We are keenly aware of important technical levels and can be patient in deploying capital. We seek to be buyers when others are liquidating high-quality assets at exceptional values. We understand that equity markets are volatile, yet political incentives to keep economies productive and performing are high. As we are late cycle in this economic expansion, we move forward with appropriate caution. Evidenced in Exhibit 5 below, intra-year volatility for U.S. equity markets is persistently high; the red dots represent the largest intra-year price declines and the grey bars show where the S&P 500 finished each year from 1980 to 2018 to date. In this 38 year period, over 76% of the time, total returns were positive if you stayed invested through year end; the statistics are similar dating back to post World War II.

Exhibit 5

Beware the madness of the mobs. And remember that volatility is not loss unless you sell. It is to be expected, particularly in equity investing, and for an appropriately diversified portfolio, volatility creates opportunities for future gains.

1 Analysts’ consensus twelve month forward earnings estimate. Refinitiv S&P 500 Earnings Scorecard, 12/20/18.

2 Siegel, Jeremy. The Future for Investors.

3 Gundlach, Jeff. Founder and Chief Investment Officer, Doubleline Funds, Asset Allocation Call, 12/11/18.

4 Analysts’ consensus Q418 expected earnings, Refinitiv S&P 500 Earnings Scorecard, 12/20/18.

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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