Client Letter 4Q 2019
The stock market roared this past year, gaining over 28% and serving up the best performance since 2013 when it gained over 29% for the year. There are a lot of things driving that performance. The recovery, now over ten years old, is one of the longest on record here in the U.S. Unemployment is at a multidecade low. Real wages are climbing, and consumer confidence remains solid. Corporate earnings continue to grow albeit at a slower pace than past years. Interest rates remain at historic lows and this trend looks to continue for the foreseeable future.
However, all is not necessarily smooth sailing. There are a few clouds on the horizon. If you will recall at this time last year the Federal Reserve changing their tone from “we need to keep raising rates” to “we will cut if needed”. This sparked a rally from the nearly 20% decline we saw through late December of 2018. The Fed did cut interest rates during the year, largely in response to economic weakness surrounding the ongoing trade war. In addition, we had a warning signal that flashed in late March. This was of course the notable “yield curve inversion” which occurred when the interest rate on a 2-year Treasury note was higher than the interest rate on a 10-year Treasury bond. Historically speaking, such inversions have been harbingers of recessions within the next 12 – 18 months.
And yet the market kept plugging along despite these warning signals and bad news. In August we had the trade war ramp up with an increase on existing tariffs and new tariffs implemented, though the administration did back off on the last round of threatened tariffs on most consumer goods until mid-December. This delay coupled with an additional interest rate cut forestalled the possibility of an imminent recession. And the market kept plugging along. In December we were given a “phase 1 trade deal” that really does not seem to have gone very far. It offers up some agricultural purchases and a few hints at intellectual property protection but is not nearly the sweeping reforms that were called nor needed when this trade war began. And the market continued to plug along.
Where are we at now? Are we in for more of the same in the coming year? Or will that recession that was forecast in March and many feel is overdue finally make an appearance? While earnings are expected to actually fall for the 2019 fourth quarter, most analysts expect earnings to rebound slightly in 2020 at low single digit growth rates. This leads to an expectation of stock returns in the high single digits for the coming year. As for me I can honestly say that I have no idea. At the risk of sounding like a broken record I am cautiously optimistic. Until we see more definitive signs of the economy breaking down, I have no reason to not be invested in stocks. But there are a few warning signs that I am paying attention to in the economy and the markets.
One warning sign for me is the lack of capital expenditures by companies. Capital expenditures refers to investments back into a company to promote future growth. This would be things like new plants or new equipment which would presage more growth down the road. One benefit that was supposed to come from the massive tax cuts corporations received at the end of 2017 was an increase in capital spending leading to higher growth in the economy. This was how the tax cuts would end up paying for themselves. The higher growth would lead to higher tax revenues. What we are seeing though is falling capital expenditures and only marginal earnings growth. This worries me. Companies shy away from making capital investments when they think there is a lot of uncertainty about the future growth prospects. When we had the ongoing trade war it could be argued there was a lot of uncertainty about future growth prospects. In theory though this has been resolved. Unless we see a significant pickup in spending in the next few months, I would argue there is still a lot of uncertainty surrounding growth and we are more likely to see a recession than an economic boom.
Another warning sign for me is also a Warren Buffett favorite. As you may know a key measure of how our economy is doing is the Gross Domestic Product or GDP. This measures the value of all goods and services we produce in the U.S. annually. The Wilshire 5000 Stock Index is the broadest index of stocks in the U.S. The St. Louis Federal Reserve bank tracks the total value of the stock market relative to the GDP of the U.S. The growth in the stock market should somewhat parallel the rise in GDP. Stock prices should rise as earnings for the underlying companies increase and earnings should increase if the total output from the U.S. economy is growing.
With data from the St. Louis Federal Reserve, we can track this ratio back to 1971. For most of the 1970’s though the mid-1990’s, this ratio was below the 80% level. This means the total stock market value was at or below 80% of the total value of the U.S. economy. In 2000, this ratio peaked at 134% only to fall back below 80% by 2003 in the recession. This ratio rose again through 2007, where it was over 100 again before plunging to 60 in early-2009 during the Great Recession. Why do I bring this up? Currently this ratio stands at an eye-popping level of 153% as of 2019 year-end. In other words the value of the stock market has increased much faster than the value of our total economy. Can this high valuation continue? Sure. However, I fear this trend is not sustainable.
There are three possible outcomes to this ratio. The first is that that economy heats up and “catches up” but this would not be good for stocks. If the economy started growing that rapidly it would likely bring with it much higher inflation which would lead the Federal Reserve to hike interest rates which would hurt stock prices. The second possible outcome is that stock prices plummet – as in a market correction. This has already been the result to two past peaks – 2000 and 2008 – and a third correction is not out of the question. The third scenario is some combination of the two – the economy grows faster while stock prices either stagnate or fall some but not tumultuously leading to a closing of this gap. Given these possible outcomes, you can see why I keep the ‘cautious’ in ‘cautiously optimistic’.
Another caution flag that is waving is coming from the Federal Reserve itself. While the Fed signaled that rate hikes were not imminent, there was a notable sound of concern that came out of the December Federal Reserve meeting. Several Federal Reserve members expressed concern that low interest rates might encourage “excessive risk taking” in the financial markets. I would argue this sentiment is long overdue. There are many who think we are in an “asset bubble” caused by the low interest rates for such a long period of time. The longer we maintain low interest rates, the more investors are pushed to invest in riskier assets for some sort of return. With all the uncertainty in the markets and an administration that governs by tweets and gut feeling raising interest rates would only choke off whatever small investments are being done currently.
Pile on top of all these issues an election year with a very uncertain Democratic field and you have a recipe for, at the very least, a fair amount of volatility. As I write this letter, we are in the midst of tense times with Iraq, Iran and the U.S. There are threats from both sides for strikes and retaliations. Typically speaking, this would lead to a sell-off in stocks, but the market keeps shrugging off the bad news and inching ever higher. Barring extraneous circumstances such as an outright war or a resumption of the trade war with China I do not see a recession on the horizon this year. I think the Federal Reserve will do everything they can to push that possibility off as long as possible. I think our economy will essentially continue to muddle along at a 1 - 2% growth rate.
This mix of good news and cautionary news means that we are not making any significant changes to portfolios. Last year, I indicated that I was reallocating client accounts, using a fair number of mutual funds when and where appropriate. I have not given up on the individual stocks as that has served us quite well. In fact, many of the stocks we have owned this year have done very well. For example as of year-end shipping company Seaspan Corp (ticker: SSW) has returned over 39% for us; Kenon Holdings Ltd (ticker: KEN), a holding company that holds interests in different businesses around the world, is up over 35% for us and homebuilder Meritage Homes (ticker: MTH) gave us a 45% return before we sold out of it completely in late-December.
In my last letter I mentioned that I am using options a bit more strategically now. I specifically referenced two different trades – one on Sanmina Corp. and one on Dick’s Sporting Goods. The Sanmina options trade finally expired on us in late-December. In the end, we earned just over $139 while only risking $2,900 in total. This doesn’t sound like a lot, but it means that we invested $2,900 and earned a 4.81% return on the money. That is not too shabby. As for our trade in Dick’s Sporting Goods that one did not quite work out the way I had planned. We had obligated ourselves to sell Dick’s at $40 only to see the stock pop dramatically from just under $40 in late-November to well over $46 per share in one day. We chose to buy back the option we had sold, which resulted in a loss, but we kept the stock which has continued to work its way towards the $50 per share mark. Perhaps at some point again we will sell more options against our position if the timing is right.
We are continuing with this theme of strategically using options on stocks we want to purchase. We recently entered a trade that obligates us to purchase shares of Discovery, Inc. (ticker: DISCA), the owners of the Discovery Channel, Animal Planet, Food Network and other cable channels, for $30 per share. We have taken in just over $80 in premium for this obligation which gives us a 2.7% return on the amount we are risking. We may end up earning a bit more if we extend our obligation. We have a similar strategy in Chipmos Technologies (ticker: IMOS), a maker of integrated circuits. This strategy has earned us a 3.94% return so far and, again, we may end up with more if we extend the timing of our obligation. We won’t always resort to options when we have stocks we want to purchase, but if the strategy seems appropriate and earns a reasonable rate of return it makes sense to go this route.
The mutual funds we own did reasonably well adding stability where we wanted it and growth where we needed it. For example, the Janus Henderson Multi-Sector Income fund (ticker: JMUTX) is a bond fund and would have a much more muted return than something like the Parnassus Mid Cap fund (ticker: PARMX) which we also own. During the fourth quarter, the Janus Henderson Multi-Sector fund gained 1.65% while the Parnassus Mid Cap fund grew 3.42% for the same period. However, the bond fund was not purchased for growth. Rather it pays a current dividend of 3.35% while the Parnassus fund which is designed for growth only pays a measly 0.50% in dividends but grew over 28% for the year. On the surface you may wonder why we didn’t just put everything into the Parnassus fund (or something similar) for the growth. The simple answer is there would be entirely too much risk in doing that. Rather than try to “time” the market it is far better to have a reasonable asset allocation that matches up with a client’s risk tolerance. The goal is to end up with a more stable return that exceeds your individual needs. Towards that end, we are continually looking for ways to improve the results for you without taking on additional risk.
As always, we truly appreciate the trust you have placed in us, and the opportunity you have given us to manage a portion of your assets. If you have any questions or need to discuss any issues, please feel free to give us a call.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
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