Note: Brevity was thrown out the window on this blog piece.
Reading time is 8 minutes. Enjoy!
The term, “throw the skunk on the table”, is a very descriptive way of saying let’s get the bad news out. December 2018 was the second worst month for the S&P 500 in modern times. The market was down -9.20%, second only to 1931’s loss of -14.50%. Every style (growth and value) and every sector of the market lost money in December. From its intraday high of 2940 on September 21 to the S&P 500’s intraday low of 2346 on 12/26, the broad market lost 20% of its value. (Source: Bloomberg)
How difficult was it to make money in 2018? All the world’s major broad equity asset classes and indices lost money in 2019; i.e. US, developed and emerging markets. Virtually all major currencies depreciated against the US dollar. The Bloomberg Commodity Index was down -11.25% with 90% of its individual components negative for the year. In every year end list we reviewed, over 90% of all asset classes lost money in 2018. (Sources: Callan Periodic Table of Investment Returns 2019, JP Morgan Guide to the Markets 2018 4th quarter)
The Callan Periodic Table of Investment Returns provides an insightful snapshot of the investing world. For the first time in 20 years, cash equivalents were the leading asset class for the year returning 1.87%. Interestingly, cash equivalents were the worst performing asset class in 7 of the last 20 years; and in the bottom third of all asset classes in 12 of the last 20 years. (Source: 2019 Callan Periodic Table, Callan LLC)
The broader US fixed income market finished 2018 second with a return of 0.10%. Emerging Market equities brought up the bottom with a 2018 return of -14.58%. A unique year indeed. (Source: 2019 Callan Periodic Table, Callan LLC)
What precipitated the sudden decline in asset values? Fundamentally, we at Abuls, Bone & Eller have said for a couple of years that two things could apply downward pressure on asset prices: rising interest rates and slower earnings growth rates. Rising interest rates make less risky assets more attractive. Money often moves from riskier assets to less risky during this transition.
Equity assets get priced on the expectation of their ability to create money in the future and the inability of companies or real estate or commodities to make more money faster; i.e. earnings growth rates, will alter the perspective of investors as to how much to pay for an asset. If a company slows down in its ability to make more money faster you are willing to pay less for the company (or stock, or real estate, etc.). There were some early indications in the latter half of 2018 that earnings may be near a peak in its cycle.
In addition to some of the fundamentals, political uncertainty with the ‘trade’ wars between the US and China sparked uncertainty. Additionally, recession worries came alive in the 4th quarter. Google searches for ‘recession’ are at their highest rate since they peaked in January 2008. (Washington Post December 24, 2018)
What Would Howard Marks Say?
On occasions, outside of the many talented financial professionals we have the privilege to visit with every year, we will stop and ask ourselves what some of the world’s most intuitive and knowledgeable investors might have to say or do at a given point in time. What would Warren Buffet at Berkshire do? Howard Marks at Oaktree Capital Group? James Lovelace at Capital Group? Jeffrey Gundlach at Doubline?
This exercise is particularly helpful during periods like December 2018; or for that matter much of the last two years. During this period, the prognostications have been many and varied. Confusion is more the end result, than clarity, when you collect all their opinions. Which is why just ‘collecting’ opinions is never enough. You have to possess your own philosophy and process and ‘connect’ them with your own convictions to make disciplined, consistent and constructive decisions.
Coincidentally, Howard Marks’ new book Mastering the Market Cycle came out in 2018. During 2018, we occasionally shared a couple of concepts of Marks that were relevant for the times. One was ‘context and perspective’ which we wrote about in previous musings. The second was the inevitability of cycles in life. Both of these were introduced to us through Marks’ books and we have ran with them in applying them to various aspects of life beyond investing.
Cycles are the graph of the inevitability of change in life. There are ups and downs in all aspects of our lives; momentum in both directions. We are yet to meet a person whose life has been but one success after another, one happy day after the other, one pain-free day after the other (particularly after age 50) or one successful trade after another.
The success in managing through cycles is understanding they do exist, being aware of the attributes that create their formation and an intuitive understanding of where we are at any given moment in the cycle. In doing this exercise, you have developed ‘context’; i.e. where are we today. By providing a frame of reference for today, you hopefully have a better perspective on how the future will unfold, ‘perspective’.
A couple of things to understand about cycles. One is that they are self-correcting. And two, is getting the timing of when they definitively start and end and how fast they will move is impossible to get ‘right’. Because of the fallible and irrational nature of man; e.g. greed and fear, excess and scarcity, etc., the markets and economies will go too far in one direction or another. They will then correct and go in the other direction. Success breeds failure, and failure breeds success.
Timing is the most elusive of investing concepts. Getting timing exactly right is a low percentage effort. For example in the markets, buying in at the bottom and selling at the top. We do not know anyone who is adept at this with a great degree of accuracy.
However getting it approximately correct, or as Howard Marks’ would say, ‘calibrating it’, is a more than worthwhile endeavor. All cycles have common attributes which can be observed and tendencies which can be measured or tracked. Success and failure leaves clues.
For our purposes as an investor, a handful of cycles are very important. The credit cycle which highlights whether leverage and liquidity are accommodative or restrictive to economic growth. The economic cycle which consists of business and government and the economic output of each. The profit cycle which measures money being earned by enterprise through operating and financial leverage. The asset cycle, which tracks the value of assets from under-valued to over-valued. And, the investor psychology cycle which measures attitudes toward risk.
Taken as a whole, cycles help us determine two things. The first is how to calibrate portfolios between conservative and aggressiveness. The second is how to position capital in the asset classes and managers that provide the best opportunities.
Where are we today in these cycles?
Since the Financial Crisis of 2007-09, all of the above cycles have been on a slow and steady progress with the cycle duration historic. The economy has experienced a gradual and steady improvement. The current expansion started in June 2009 and if it lasts through the summer of 2019 will be the longest in history.
The recent stock market cycle was the longest bull market in history. It began with a market bottom on March 9, 2009 and ended December 24, 2018. Earnings and the rate of earnings growth have been increasing during this recovery period. As a result, asset prices are at elevated levels.
Investor psychology has been improving. It has advanced from ‘blood in the streets’ fear to skepticism to confidence.
Credit has been accommodative starting with near 0% interest rates in the fall of 2008. As a consequence, debt levels has increased dramatically. Whether it is school loans, household debt as a % of income or assets, government debt and unfunded liabilities or corporate debt as a percentage of assets or revenue, the world has levered up in the last 10 years. Most economic slow-downs have excessive debt as a cornerstone to their undoing. Which makes this one of the most important areas to follow.
What do we go from here?
Given we are ‘long in the tooth’ in all the cycles mentioned, calibrating to a more conservative posture has seemed warranted. In the Abuls, Bone & Eller investment allocations, this entails the following:
Broad diversification (a balanced 63% equity portfolio is represented by at least 13 different asset classes and US, international and emerging market exposure).
Approximately a 10% underweight to the model’s target equity allocation. For example, a 100% equity model has approximately 90% equities. A 50% model has 45%, etc.
A portfolio tilted more toward price conscious value stocks than growth stocks (e.g. domestic stock allocation is 75% value and 25% growth).
Large Companies represent approximately 90% of the equity portfolio; small companies, typically more volatile, have a 10% allocation.
Our fixed income portfolios are overweight shorter duration and higher quality bonds. We are underweight lower grade and longer-term bonds.
New years’ bring with them a host of predictions. We are always amused at an industry that preaches ‘invest for the long-term’, and provides a million forecast for the coming 12 months. Looking at this cycle long-term we are in a slow growth period. We have aging populations and growing global debt levels. We have high levels of employment and a productivity cycle that is transitioning from the computer age to the information and artificial intelligence age. It is difficult to find a government that is managing its business with stellar grades.
With all of that said, what is more likely than not to happen is that in the intermediate-term interest rates will be in a lower for longer range bound cycle. Equity assets given their above average growth and lofty valuations will produce below average returns. But it does not mean the sky is falling. It could just mean a ‘lower return for longer’ period.
Howard Marks’ wrote in Cycles that three things are important to being a good investor (or we would add a good planner of one’s finances). They are, one, reliable tools for assessing the price of assets; two, the emotional fortitude to live through the markets and your personal ups and downs; and three, taking advantage of time which is one of the world’s great risk reducers. In the coming few years these intellectual and emotional skills may prove to be quite valuable for all investors.
The mission for us, on your behalf, will be to first help you understand how your overall financial plan’s success relates to changes in your personal circumstances, as well as changes and cycles in the markets and the economy. Second, reaffirm your personal risk level. And finally, calibrate a slightly more conservative or aggressive nature to the portfolios and position assets where we can find the best values. We believe that continued discipline in this process will help secure and prosper your portfolios and financial plans.
Thank you for your continued confidence and trust. We will continue to closely monitor your overall financial plan and investment strategy to assure your personal goals are achieved. Do not hesitate to contact your advisor at Abuls, Bone & Eller with any comments or questions.
These are the views of Abuls, Bone & Eller. Views expressed are not necessarily those of Raymond James and are subject to change without notice. Information provided is general in nature, and is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security. Past performance is not indicative of future results. There is no assurance these trends will continue or that forecasts mentioned will occur. Investing always involves risk and you may incur a profit or loss. No investment strategy can guarantee success.