Relative Strength Newsletter - 2nd Quarter 2019

Q1 Recap (source Dorsey, Wright & Associates)

The Major League Baseball season is underway, the NCAA Men’s Basketball Tournament and The Masters have just reached their exciting conclusions, which means summer is almost here and we’ve closed the books on the first quarter of 2019. Much like the University of Virginia men’s basketball team, which shook off a dismal showing in the 2018 NCAA Men’s Tournament, becoming the first number one seed in history to lose in the first round, only to come back and win it all in 2019, US equities rebounded in dramatic fashion from the 4Q18 sell-off, which culminated with the "Christmas Eve Massacre." Through the first three months of this year, the S&P 500 Index gained 13.07%, its best first quarter performance since 1998, and was accompanied by strong showings from the Dow and the Nasdaq Composite, which gained 11.15% and 16.49%, respectively. The first quarter surge was not limited to domestic equities, as both international developed and emerging market equities gained approximately 10% to start the year.

Similar to the Virginia Cavaliers’ march to the NCAA crown, the markets’ first quarter ascent did not come without a few tense moments. Concerns that the Federal Reserve might induce a recession by raising rates too aggressively were quickly replaced by concerns about an inverting yield curve, as a more dovish stance by the Federal Open Market Committee (FOMC) following its March meeting sent longer-term yields tumbling to 15-month lows and briefly pushed the 10-year US Treasury yield below the three-month T-bill. However, the 10-year yield rebounded relatively quickly, aided by a "Goldilocks" March jobs report with higher-than-expected jobs creation easing recessionary concerns, but, without a significant increase in hourly wages which could foreshadow a pickup in inflation and alter the Fed’s calculus on the pace of rate hikes. Meanwhile, Brexit and trade negotiations remain in the headlines and on the minds of both international and domestic investors. The market reaction to these concerns was relatively muted and as a result, the major US indices are on the verge of matching the all-time highs they reached in September/October 2018.

As we head into the end of the second quarter of 2019, US equities remains the "number one seed," as it is the top-ranked asset class on a relative strength basis. From a style perspective, we continue to see market leadership from growth and the growth-oriented technology sector remains atop the relative strength rankings of US equity sectors. While growth remains the dominant style, there has been some noise under the surface, as sectors that typically tilt toward value, specifically utilities and real estate based investments, have gained relative strength. And as a result, we continue to keep an eye on these sectors, especially with regard to our income-focused portfolios, as utilities and real estate based investments have historically provided above-average dividend yields.

Like the MLB season, which still has about 100 games in store for each team, with about 130 out of 252 total trading days left in the year there is still a lot of action to come before we know how 2019 will play out for the market. However, the strong performance of the first quarter has given us good footing and the outlook for both the domestic and international equity markets has improved markedly from where we began the year.

Delayed Gratification (source: DWA)

Stanford University psychology researcher Walter Mischel famously demonstrated the importance of self-discipline (the ability to delay immediate gratification in exchange for long-term goal achievement) in achieving lifelong success in his well-known "Marshmallow Study." In the study which began in the 1960s, he offered hungry 4-year-olds a marshmallow, but told them that if they could wait for the experimenter to return after running an errand, they could have two marshmallows. Those who could wait the fifteen or twenty minutes for the experimenter to return would be demonstrating the ability to delay gratification and control impulse. About one-third of the children grabbed the single marshmallow right away while some waited a little longer, and about one-third were able to wait 15 or 20 minutes for the researcher to return. Years later when the children graduated from high school, the differences between the two groups were dramatic: the resisters were more positive, self-motivating, persistent in the face of difficulties, and able to delay gratification in pursuit of their goals. They had the habits of successful people which resulted in more successful marriages, higher incomes, greater career satisfaction, better health, and more fulfilling lives than most of the population. Those having grabbed the marshmallow were more troubled, stubborn and indecisive, mistrustful, less self-confident, and still could not put off gratification. They had trouble subordinating immediate impulses to achieve long-range goals. When it was time to study for the big test, they tended to get distracted into doing activities that brought instant gratification. This impulse followed them throughout their lives and resulted in unsuccessful marriages, low job satisfaction and income, bad health, and frustrating lives. I recently came across an old article about Walter Mischel in The New Yorker, which discusses the Marshmallow Study in the context of his long career. It gives a fascinating look into the events and studies that led Mischel to the Marshmallow Study and his subsequent research on the subject of delayed gratification. He is a big believer that people can actually develop the ability to delay gratification through hard work and training. One particularly relevant passage of the article is as follow:

At the time, psychologists assumed that children’s ability to wait depended on how badly they wanted the marshmallow. But it soon became obvious that every child craved the extra treat. What, then, determined self-control? Mischels conclusion, based on hundreds of hours of observation, was that the crucial skill was the strategic allocation of attention. Instead of getting obsessed with the marshmallow the hot stimulus the patient children distracted themselves by covering their eyes, pretending to play hide-and-seek underneath the desk, or singing songs from Sesame Street. Their desire wasn’t defeated it was merely forgotten. If you’re thinking about the marshmallow and how delicious it is, then you’re going to eat it, Mischel says. The key is to avoid thinking about it in the first place. In adults, this skill is often referred to as metacognition, or thinking about thinking, and it’s what allows people to outsmart their shortcomings. (When Odysseus had himself tied to the ships mast, he was using some of the skills of metacognition: knowing he wouldn’t be able to resist the Sirens song, he made it impossible to give in.) Mischel’s large data set from various studies allowed him to see that children with a more accurate understanding of the workings of self-control were better able to delay gratification. What’s interesting about four-year-olds is that they’re just figuring out the rules of thinking, Mischel says. The kids who couldn’t delay would often have the rules backwards. They would think that the best way to resist the marshmallow is to stare right at it, to keep a close eye on the goal. But that’s a terrible idea. If you do that, you’re going to ring the bell before I leave the room.

As discussed in the article, researchers have concluded that although intelligence is very important to long-term individual performance, self-control is even more important. Furthermore, self-control can be developed over time, even if it may come more easily to some than to others. Delayed gratification is, of course, the rationale for investing. It is what motivates people to save for tomorrow what they could spend today. Delayed gratification is what allows people to accept short-term volatility in exchange for the expectation of more plentiful long-term rewards. I would strongly suggest that investors are best served by doing very thorough research about investing early on in their lives so that they can adhere to an overriding investment philosophy for a long period of time. Such research might lead a person to determine a disciplined long-term savings plan. It might also lead a person to a deep commitment to a given number of investment strategies like relative strength, value, and/or indexing. Finally, the key to long-term success is to focus on other things while adhering to those saving and investment principles for the long run.

Tumlin Levin Sumner Wealth Management of Raymond James

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