In our quarterly newsletter that follows, the two feature articles are titled: “A Great Story Never Told” and “Flying on One Engine”. The first discusses the prevailing skepticism, or even outright pessimism, that may best characterize the consensus of investors’ psychological mindset relating to what is now the longest bull market in US history. The second article explores what are the polarized and opposing views of how the economic and corporate fundamental “tea leaves” are being interpreted and highlights what we see are the biggest risks threatening to halt the progressing bull market. We encourage you to review the full articles contained in our quarterly newsletter below. The full printer-friendly document can be downloaded here: NVEST NSIGHTS 3Q
A GREAT STORY NEVER TOLD
Following a tug-of-war market experience during the first 6 months of 2018, stocks surged ahead during the 3Q with the S&P500 up +7.2%. It was the fastest advance since late 2013. Combined with the first half, the accumulation brings the YTD rise to just over +10%. Company earnings and economic growth are rising at the fastest pace of this current cycle and expanding the current Bull Market run, yet these facts remain a great story never told. Few want to acknowledge this Bull Market is now the longest running ever. Also, few will acknowledge that the current economic rebound will shortly become the longest running ever. This current run approaching 10 years remains unloved for a variety of reasons, including the fact that many investors experienced 2 Bear Markets in 15 years. Those two experiences eroded investor portfolio values and family wealth, and wreaked havoc with investor confidence. In reality, the only situation where the length of this economic rebound and/or market advance is cited is when stating its age as a compelling reason to anticipate the current trends must soon end. Many continue to hold a keen aversion to owning risk assets even today.
A survey of professional investors, taken at 3Q-end offers additional perspective on “unloved:”
- Stock market performance expectations through year-end are minimal; nominal at best. And return expectations offer a dim view and higher bond yields through the end of 2019.
- Investors are most worried that the Fed will overdo-it as it normalizes (raises) rates.
- Another fear relates to a brewing trade battle with China.
- A recession is somewhat unlikely in 2019, but viewed as increasing toward 2020, and a higher expectation by 2021.
- Professional investors maintain a more positive expectation for US/domestic stocks, expecting outperformance compared to Europe, Japan, and/or Emerging Markets. Again, performance expectations are subdued.
Entering the 4Q with strong corporate earnings and economic growth, we expect that the current rally and Bull Market should keep going. This backdrop is a key factor why investors should look past the continuing trade spat between the US and China. The economic backdrop provides the Bull Market’s foundational support.
How though, should one personally think about investing when entering the home stretch of 2018? And, how should 2019 be approached? It’s concerning to read so many investors, including professionals, are skeptical, cautious, and guarded about investing. Investors see the shot clock running, and no one wants another bear market experience. Can history offer any advice or guidance? History shares it can be tough to “fight” the upward performance tendency found in the final 3-months of the year. During the last 25 years, the S&P500 gained an average of +5% over the final 3 months; 80% of the years produced a positive returns. Second, mid-term election years can produce an increase in volatility, but 4Q performance is often stronger than a typical year (uncertainty is removed regardless of who wins). Third, when the markets conclude a strong 3Q, history indicates the action bodes well for market performance through the next 3 and 6 months. Last of all, be aware that 4Q often provides some market leadership reversion (in October-November), as laggards can work. One should not ignore 4Q historical market action.
In August, our monthly commentary was titled, Extremist. Recall that it cited the market action and performance over the last year or so, revealing a big contrast between what is working very well and just okay. It shared that growth style stocks were significantly outperforming value. It also revealed that foreign stocks were a portfolio performance drag since year-end. And, diversification used to manage risk was slowing overall portfolio performance due to tactical exposures that include large and small, value and growth, and international. Concentrated exposure to growth provided the highest returns.
From a valuation standpoint, the opposite perspective is also extreme. Domestic stocks, which more investors favor, are more expensive than foreign. Value is decidedly more attractive (for risk) than most growth stocks. In essence, valuations are stretched between many competing assets. Investors can expect that the performance divergence between growth and value should normalize – they generally travel a similar chart path.
The extremist perspective offers that when two historically linked items move apart in almost opposite direction, they only diverge so far before abruptly reverting back to normal paths. Almost like the image of a shark’s mouth opening wide. Once opened wide, it ultimately snaps closed quickly. Extremist markets cause some investment strategies to advance slowly while others shine. Some asset types become expensive (maybe irrationally exuberant), while others are undervalued (irrational exasperation). When both asset types are used in a portfolio for diversification, the performance results often look soft or slow compared to the “market.” Key to remember though, the jaws will close; out-of-favor styles will revert to their mean (value/foreign for example will perform well again). It is only a matter of time before “style” shifts, which no one can correctly anticipate. Thus, diversification does provide benefit, because it manages risk. As top performing investments become expensive, it is appropriate to rebalance their exposures. Failure to rebalance or manage risk can cause portfolio values to undergo wild or bumpy rides when high-priced styles move out of vogue; long-term performance can be rocked. It is important to own various investments to diversify risk and smooth investment portfolio values.
A great story is being told. The current Bull Market is advancing because of fundamental (economic conditions and rising corporate profits) support. To fully experience it, we advocate being a long-term investor – being “time in the market.” Nvest adjusts the tactical strategy over time, due to valuation differences between styles – domestic and foreign, growth and value, even small, medium and large. Portfolio tactical strategy changes are generally small, gradual and reversible. All are designed to manage risk.
FLYING ON ONE ENGINE
A September 28th Reuters headline, “Flying on one engine, global growth exposed to turbulence” creates a good analogy about the current global economic environment. The US may be responsible in part, when in January the Administration started tariff talk. Financial markets were immediately rattled. Growth in many European, Asian and Emerging Markets started to slow, with some even stalling. Like engines on a jet plane, one engine stalls and can strain another. Soon, the plane is flying on only one engine. The US is increasingly the main engine behind the global economy. And, the biggest economy is under scrutiny as some consider the current economic boost is due to fiscal stimulus and tax cuts, making it too on borrowed time. As one economist wrote, “When the downturn in the US economy starts, the effects (on share prices, interest rates, capital flows, emerging countries, exchange rates, global trade and global growth) will be pronounced. This downturn… is inevitable as the US is returning to full employment.” In essence, the jet (world economy) will soon lose its one engine (US), and then bad things can be expected. The world’s economic conditions are divergent – the US doing well, while elsewhere (in many instances) conditions are soft.
Recent strong US economic growth and company earnings powered the stock market in 3Q. But this rally comes at a cost with US stocks being increasingly expensive compared to other major indexes around the world; valuations and recent performance are stretched. US stocks trade at a 12% premium to foreign (22 developed markets and 24 emerging markets). That’s the biggest gap since 2009, and makes it hard to imagine that the divergence in valuation is sustainable. Nearly 50% of investors believe the divergence in the global economy will end with US growth decelerating. Another 28% think the divergence will end because growth in Europe and Asia will accelerate. The US is basically leading the world in growth (economic and company earnings), while other areas of the world look more attractively priced. But, what if….?
Here in the US, the economic outlook is polarized by opposing views. One camp offers – economic growth is reaching its zenith after a slow grinding 9+ year expansion via zero-rate interest policy. The peak in economic growth (and thereby peak in company earnings and stock prices) is at hand as the Fed pushes forward to normalize interest rates; because the yield curve is flattening (may invert); and trade tensions escalate. These factors can collude to pull the stock market lower (the last jet engine fails). Across the divide, to the opposing view – economic growth is on firm footing, consumer confidence is at fresh highs, corporate profits are strong and will continue because of tax cuts/reform, repatriation of foreign earnings, and other fiscal spending stimulus. This backdrop would advocate a continued lift of stocks and portfolio values. So, which is it?
This confusion leads many investors to hide – avoid being too risky until uncertainty (economic and political) becomes more clear. Please recall, tax reform boosted and will keep economic growth strong, providing above historical trend growth near 3%. Domestic interest rates are rising, echoing that view (meaning Fed will further raise rates). The risk of a global trade war appears receding, for now. Just Sunday the US said “Goodbye NAFTA! Hello USMCA!” with the announcement of a modernized trade agreement between the US, Mexico, and Canada. This change comes at a time when the US economy is booming. And when the US does well, its two closest trading partners should also prosper. At the same time, inflation is expected to remain managed and low; not accelerating too fast.
The US Treasury yield curve is now in the hands of the Federal Reserve – too much more upward adjustment to interest rates, too fast, could quickly alter the pace of domestic growth. The Fed recently concluded its “negative real interest rate” policy (keeping interest rates below inflation). As it institutes additional rate increases, the Fed enters a new era of “normal real rates” with interest rates at/above inflation. The Fed needs to keenly avoid a policy mistake of raising interest rates too much above the inflation rate. Such action, if raised too fast, too much, could cause the current flat yield curve to invert – a condition wherein short maturity bond rates are higher than long maturity bond rates – and initiate an economic downturn and end of the current Bull Market. It appears the US economy can take higher rates as it continues to grow at 3% or more; but it is uncertain if the financial markets can.
We continue to watch the economic and interest rate environment closely. Stocks should be powered past trade talks, though continuing tariff and trade-spats with China may make the financial markets shake (see interesting related chart on the bottom of page 3). Fed policy must be slow and careful to avoid tightening until something breaks – a policy mistake. Client portfolios are invested to benefit from a continuing run of the current Bull Market. We monitor divergent valuations of asset types to guide our tactical strategy – risk is “dialed down.” That means owning more exposure to attractive undervalued asset types than expensive ones. We believe the market divergences will revert to normal relationship, and we expect this strategy provides better risk/return characteristics for the long term.
Author: Bill Henderly, CFA – October 8, 2018
Note: Printer friendly version includes additional pages including “Benchmarking” and “Selected Mutual Fund Performance” data, as well as an interesting chart depicting trade war rhetoric and its impact on the US and Chinese stock markets. We encourage you to take a glance.