Investing is very similar to golf: both are ultimately a test of patience. The greats practice their craft religiously. And the best are defined not by how good their best shots are, but by how good their bad shots were. The game is ultimately played over 18 holes and rewards consistency and not heroics. Here we see Jason’s oldest son, Christopher, teeing off…and learning that a round of golf is more than just one shot.
By Jason Lesh, Managing Principal
By nearly all accounts, 2019 was a phenomenal year. Some of our clients welcomed new children while others became grandparents for the first time. Some celebrated new jobs or promotions while others celebrated retirement. Along the way there were houses bought and sold, children leaving for college (a few even returning), and amazing trips with friends and family. Businesses grew and some were even sold. It wasn’t without hard work along the way, but by and large it was a year of growth for which we were privileged to join our clients on.
With 2019 behind us, we begin to look forward to 2020 and a new decade. Our portfolio manager, Nick Fisher, has enclosed his commentary for your review. Despite a phenomenal year, Nick highlights his concerns with the US markets (which, as you know, we are underweighted). If you read to the end, he’ll tip his hand about what he’s excited about and has been adding to portfolios.
I can confidently say that I am proud of our job managing risk and reward while also being thankful to work with those we call clients. We sleep soundly at night knowing their investments are well positioned to continue to grow while preparing for a potential change in the markets.
Here’s to a happy, healthy and prosperous 2020 and if we may be of any assistance to you and your family, please don’t hesitate to reach out.
Warmest regards,
2019 Year-End Review
By Nick Fisher, Portfolio Manager
By most measures, the US stocks had a banner year in 2019. Most investors forget that markets were clobbered at the end of 2018, setting up for the strong performance of 2019. Since the start of 2018, US stocks are up only 6% annualized, the return we believe US investors can expect. We do not expect as generous a return over the next 10 years. To achieve unconventional returns, we must act unconventionally.
We have discussed market headwinds extensively in our quarterly letters. Aside from strong returns in 2017 from corporate tax cuts, US stock returns have been below average. Broadly speaking, we do not see any reason to be excited about the US stock market going forward.
Investors are often prone to influence from recent experience. When markets experienced volatility in 2016, 2018, and mid 2019, the Federal Reserve stepped in to “rescue” the situation. This has never been the Fed’s mandate. To think that a governing body, no matter how independent, can preside over markets as if they could “control” markets, is a bit ridiculous. With the Fed serving as a backstop, investors are buying no matter what volatility may be trying to tell us about markets. Everyone acknowledges US stocks are expensive and there are concerns, but according to current consensus the only thing that matters is the Fed will hold down interest rates and suppress any volatility indefinitely.
To be clear, the Feds actual mandate from Congress is to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." This has been quite broadly interpreted to mean a lot more!
There is no explanation why the Fed would have the Fed Funds rate near all-time lows when we have the unemployment rate at 50 year lows, prices have been stable, and the stock market is at all-time highs. Furthermore, we are currently running massive fiscal deficits which account for nearly all of our near stagnant economic growth.
If the Fed is “controlling” markets through suppressed short-term interest rates and constant “liquidity” shouldn’t we just join in on the fun? With history as a guide, we know things can change rapidly. So, what could happen?
In 1972 inflation was at 2.7% before going to 6% in 1973. The stock market then dropped precipitously. By 1973, valuations had fallen 35% and prices had fallen 20% despite earnings having risen more than 10%. That’s a recipe for significant risk to retirement plans. Let’s think about it in terms of a few scenarios:
Scenario 1 (most likely):
The Fed will attempt to keep actual inflation at 4%. Inflation is reported at 2-3% and short-term rates are kept below inflation bringing the massive federal debt into balance with the size of our economy over the next 30 years. Being unable to earn a risk-free, inflation adjusted return will steadily hurt investors over time.
Scenario 2:
Modern Monetary Theorists will gain mass support and helicopter money will be distributed in some manner. This will change the money supply by immediately devaluing the US dollar by a proportional amount and elevating the conversation around inflation.
Scenario 3:
The House and Senate vote to roll back the corporate tax cuts and the stock market will decline in equivalent value. Over the last year, corporate profits have been in decline. In fact, if you adjust for inflation and corporate tax cuts, profits have been flat for five years!
What does all this mean for investors?
In such uncertain times, we find it helpful to review our core principles. One of them is to buy what is cheap. (We are value investors after all) It is no coincidence that most professional money managers, especially value managers, have struggled in these markets. When you can close your eyes and buy anything, like in 2019, critical thinking doesn’t pay.
We’ve been here before. Similar dynamics existed in the late 90s and managers who stuck with their strategy were rewarded handsomely over the next 10 years.
While buying what’s cheap isn’t the stylish thing to do today, we believe it will always be the most rational way to invest. It begs the question then, what is currently cheap?
Emerging markets & international value stocks – Many global economies are beginning to stabilize after material weakness, or in some cases outright recessions. Valuations are 40-50% cheaper than US markets and, with a stable or falling dollar, these markets will provide reasonable risk adjusted returns.
Energy stocks – Currently trading at 40-year low valuations and probably the most hated area of the market. Institutional capital has fled energy like the plague. Meanwhile, demand for energy, especially the cleaner and responsibly managed variety (especially Canadian), is as strong as ever.
Commodities & commodity producers – Should a change in the inflation climate occur, commodity prices will increase, and commodity producers structured for higher prices will flourish.
Short-term treasury bonds (and possibly long-term treasury bonds) – With recession or US stagnation still a possibility, liquidity will be extremely important. Long-term bonds will typically be weak at this stage in the cycle. However, there will be a time in the near future to increase duration as the Fed steps in and officially begins QE4.
So then, what is expensive?
High yield corporate debt – I heard an analyst recently discuss corporate debt in the frame of “return free risk.” Essentially the cumulative interest received will be wiped out by defaults and/or the repricing of bond risk.
Expensive US growth stocks – From 1999 till approximately 2014 Microsoft stock did nothing despite growing earnings substantially throughout that time. Many great companies in this environment will grow earnings substantially but reward investors with very little return.
Highly indebted US stocks – Corporate debt markets will probably be ground zero in the next “crisis.” Investors should expect it to be more difficult to finance highly levered and liquidity dependent companies.
As 2020 unfolds, don’t be fooled by headlines as the political circus gets underway. As each candidate jockeys to have their sensational reality appeal to voters, there will be a lot of noise. We should expect volatility as a result.
We don’t see recession as a high likelihood this year, but we are paying close attention to any signs of weakness in the economy. We can still provide a satisfactory return with a cheap and diversified portfolio, but a non-conventional approach is needed. We will continue to manage your portfolio as if it was our own.
We thank you for partnering with us in pursuit of your retirement goals. Here is to a happy, healthy, and prosperous decade.
Cheers!
