Quarterly Commentary

4Q 2019

One year ago, the Fed was intent on raising rates, world leaders were talking tough on trade, and stocks had just recorded their worst December performance since 1931. The suddenness of the decline was shocking and many worried that a recession was imminent.

The year started with investor expectations as low as we’ve seen since 2009. US stocks quickly found their footing, however, helped by supportive comments from Fed Chairman Powell, and proceeded to gain 18% by the end of April. Relative calm ensued until renewed doubt about the economy touched off an August retreat. This time it was the bond market sounding the alarm – investors found it hard to ignore an inverted yield curve, generally thought to be a reliable harbinger of an economic downturn.

As summer gave way to fall, many wondered if a repeat of 2018’s year-end collapse might be in store. Again, it was the Fed to the rescue, with additional rate cuts administered in September and October. The trade war cooled, the yield curve steepened and, shazam, the S&P 500 pushed to new heights, returning 9% over the final three months of 2019 and an extraordinary 30% for the year!

Can stocks provide an encore in 2020? Here are some intriguing observations.

  • Great performance (as in 2019) has usually been followed by good performance – since 1950, years when the S&P 500 delivered 20%-plus returns were followed by years averaging 11%, and the subsequent-year returns were positive on fifteen out of 18 occasions. Years following 30%+ returns averaged 20% and were positive in all five instances.
  • We continue to be in a market-friendly phase of the Election/Presidential cycle. History tells us that the most lucrative year of a presidential cycle is the third, followed in order by the fourth, second, and first. The reasoning goes like this: The newly elected president works to fulfill campaign promises, but the details surrounding new policies bring uncertainty, and stocks loathe uncertainty. As the next election approaches, the incumbent pivots to promoting an agenda popular with voters, and the Fed accommodates. The economy gains strength and the stock market performs well.
  • A number of sentiment indicators are worrisome, among them CNN’s Fear & Greed Index, which remains within a whisper of an “extreme greed” signal.

This stuff is interesting. For some people, it reinforces a view that there are special insights that can help one “beat the market." Of course, US stocks have returned an annualized 11% since 1950. Any rule of thumb that equates to buy-and-hold has worked very well over most time horizons.

 However, there are problems with investing based on surveys, data patterns or New Year’s predictions. They presume that people will always behave the same way, which they don’t. Major events, particularly those of a (geo)political nature, can invalidate this kind of analysis in a heartbeat. Consider August’s yield curve panic, for example. Those who sold stocks because of the well-publicized association between a yield curve inversion and a subsequent recession missed out on the year-end rally. In fact, US investors were net sellers of $200 billion of stock ETF’s and mutual funds during 2019, even as stocks pushed to successive all-time highs.

We consider the tools that other market participants may be utilizing but ultimately prioritize our own process. We are inherently optimistic, a desirable trait for long-term investing. Key to our strategy is the assumption that the economy and markets will be “normal” most of the time – and, we have the patience to sort through the inevitable turbulence.

We count ourselves among the cautious as 2020 kicks off. It’s true that central bank easing is fueling the upward momentum that has been in place for the past three months. That trend can easily continue in the weeks or months to come, but not indefinitely. Global economic indicators and corporate earnings remain closely watched question marks.

However, for the most part, we are not deciding whether to be in or out of the market but rather what to own. At times like the present, when much of the market appears fully valued, we seek out opportunities that may not be on others’ radar screens. This means looking for laggards, underfollowed companies, special situations with idiosyncratic drivers, and favorable risk/return along a company’s capital structure, the latter of which would include convertible bonds or preferred stock. At the same time, we work hard to avoid falling in love with our winners – knowing when to part ways can be as important as knowing when to buy in.

Another important part of our process is what we refer to as responsible investing. (There are many versions and many names, sustainable and ethical among them.) Whatever it’s called, this is a trend that is gaining strength, already underpinning trillions of dollars of investment assets. It is also highly subjective, often hinging as much on disclosure as actual business practices. Here, as well, we have our own way of doing things.

In the simplest terms, we look for well-defined corporate governance. We care foremost about good decision-making and if it is not there, the rest – even the most promising innovation or technology – may not matter. We then consider if the company’s interaction with society is a net positive. Is it consistent with the future we hope for? If there are blemishes, are the company’s governance and societal impact at least moving in the right direction? Can involvement on the part of investors like us hasten that process?

These are not black or white issues. Consider Volkswagen that five years ago hoodwinked us all about the fuel efficiency of its diesel engines yet is now poised to become one of the biggest manufacturers of electric cars. What matters more?

In the end, we believe companies that subscribe to good governance practices are less risky, because they are less likely to experience negative events that impair their investment value. For us, responsible investing is not a strategy in and of itself but rather an integral part of doing good research, as important as identifying value and catalysts that will unlock it.

Stock investors started 2019 worried about a recession that didn’t materialize. Today’s share prices anticipate healthier business conditions. Whereas an economic surprise to the upside led to outsized equity returns last year, even a slight miss versus expectations in 2020 may lead to disappointing results.

Yes, cycles and trends are worth watching – not as decisive indicators, but as part of an effort to understand the overall investing context. In part, this is due to the attention that other investors may give to them. If enough people are paying attention, they can become self-fulfilling prophecies – for as long as that attention lasts. While some market participants are busy reading the tea leaves, we will be looking for opportunities with strong fundamental underpinnings.

Best wishes for a healthy and prosperous 2020!