Quarterly Commentary

Q1 2019

What a turnaround! December’s plunge left stock market investors uncertain and cautious at the start of the new year. A responsive Federal Reserve and some positive economic data brightened the mood and the first quarter saw stocks recover much of 2018’s losses.

In our last report, we expressed our view that prices had fallen to levels that reflected the gloomy outlook and that some encouraging news would help move stocks higher. That happened faster than we thought, and there are still nine months left in the year. In the balance of this note, we discuss the dynamics behind a market panic, assess the situation today, and offer a few thoughts on our investing strategy.

What happened? 
The December decline can be categorized as a panic. With markets pausing after registering new highs in September, three issues escalated from “worry” status to “a threat to the market” level. The Chinese economy, for years the world’s economic engine, was struggling, and its many trading partners were starting to suffer too. Trade talks between the US and China had broken down, further darkening the outlook for global economic growth. Perhaps most critically, the US Federal Reserve appeared to be ignoring the gathering storm, fixed in its resolve to tighten financial conditions by raising interest rates and reducing its bond holdings.

There are always plenty of opinions, positive and negative, about markets. However, the most alarmist views are the ones that make good headlines. There is no shortage of journalists and bloggers willing to deliver messages of doom. “Clicks” and ratings matter more to them than being right or wrong. Rarely discussed are the probabilities that might be attached to these worst-case scenarios. Bold forecasts are frequently offered without consideration of generally more likely and more benign outcomes.

Observing how investors zero in on a worst-case scenario is key to understanding how panics evolve. If a bad day for the market is accompanied by an attention-getting headline, it is easy to assume that the story is causing the decline. A run of bad days intensifies the cause-and-effect association. The story is picked up and retold with urgency, often with the implication that the “smart money” is getting out. The panic subsides as the market finds its footing and the alarmist narrative loses its urgency.

Not worse was good enough.
US stock indexes were already rising off their lows as the new year began. We opined, “We don’t need or expect solutions to these problems, just to feel that they won’t get worse.”  That is how the quarter unfolded: Economic data from China revealed that stimulus has been gaining traction. The Shanghai stock index jumped 24% during the quarter. The US Fed executed a complete about-face, indicating that further interest rates increases are on hold and that quantitative tightening will end in six months. A trade deal with China looks imminent, with the potential to lift a cloud over the global economy while still providing intellectual property protection for US interests. While the Fed’s pivot provides definitive support for markets here and abroad, economic growth remains a worry.

Hold the confetti.
Will stocks keep rising? Our answer - the market can go higher, but we don’t know if it will go higher.

A continuing bull market is fostered by the existence of things to fret about. As the saying goes, “markets climb a wall of worry.” Here are a few:

  • The bond market seems to be signaling that a weaker economy is close at hand. The 10-year Treasury note yielded less than a three-month Treasury bill at the end of March. This was the inversion market watchers had been dreading, because the history is compelling: an inverted yield curve has preceded each of the last seven recessions.
    BUT – the inversion only lasted five days, not long enough to be considered meaningful.  
  • Corporate earnings will grow less than expected in 2019. Just last fall, S&P companies were forecast to report an 11% increase in 2019 profits. By January, the growth rate was reduced to 7% and today the forecast is for a modest 3.7% increase.
    BUT – The current weakness may be attributed to the government shutdown and many observers expect better results in the second-half of the year.
  • IPO volume could set a record in 2019 – Lyft recently made its debut and Uber, Airbnb and Pinterest are expected to follow soon. Current valuations approach 10x sales, nearly triple the 10-year IPO average, and Uber and Lyft may still be years away from turning a profit. IPO booms may be indicators of overenthusiastic investors.
    BUT - The 2019 candidates are larger and more established than has been the case in the past. 
  • Congress and the president are about to begin haggling over next year’s budget. The president has proposed a 9% reduction across non-defense discretionary, which, if enacted, could slow the US economy by an estimated half of one per cent.
    BUT – Congress ultimately has responsibility for setting funding levels, and these cuts are likely to be rejected.     

As worrisome issues such as these are identified and assessed, market participants take them into consideration, so the potential impact is reflected in asset prices, gradually or otherwise. This helps explain how one invests with confidence in the face of what can go wrong – market prices reflect the news before it happens!

Looking at the situation today, we observe that expectations seem to be reasonably balanced, in contrast to last summer’s exuberance and December’s fear.

Don’t try to time the market!
The December panic illustrates the danger of getting caught up in the market narrative. Selling out as stock indexes fell would have been a costly mistake. While we try to gauge current market psychology, we believe inflection points can be reliably identified only in retrospect.

Building portfolios one stock (or bond) at a time.
Our investing strategy is not predicated on knowing where the market is headed. We would rather try to “time” the purchase of individual stocks and bonds. Our time is spent analyzing and valuing businesses, not reading tea leaves.

Of course, even the most carefully selected portfolio is not immune to the market’s mood swings, indeed it is often market volatility that leads to the opportunity to buy or sell at a favorable price. The benefits of active investing are generally revealed over “the long run,” a measure of time that spans the ups and downs specific stocks as well as the overall market.

We are long-term optimists. We’ve learned that things have a way of working out and that a sound strategy produces results over time. We are also short-term realists. Being prepared allows us to survive the panics and take advantage of the swings from optimism to pessimism and back again.