Client Letter 1Q 2019
The markets just had their best quarter in a decade. Literally. Given how volatile they were in the fourth quarter of last year and how far down they had fallen (almost 20% in less than three months) it was no surprise to see a rebound. What was surprising was the strength of the rebound. There are many – me included – that think we have come too far too fast. It would not surprise me to see stocks sell off at some point though not likely back to the lows of December and not without a catalyst.
There are many that think we have a catalyst for a severe drop right around the corner. That catalyst’s name is “Recession”. There is a lot of talk about a coming recession. There are several factors that have led to this interest and worry. First, corporate earnings growth is slowing down. Add to that economic data that paints a worrisome if mixed picture – slow retail sales in December, a dramatic falloff in jobs in February and slowing global economies most notably in Germany and China – and you have the seeds of recession anxiety.
The one sign that has set everyone on edge is the dreaded inverted yield curve. I wrote about this in a recent blog (www.aeriecapitalmgmt.com/blog) but will touch on it briefly here again. The yield curve is a measure of what you get paid for buying a bond and holding it until it matures. The longer the time until the bond matures – that is, the longer you are tying up your money – the more interest you will demand. This makes sense. If you think about CDs at your bank you earn more interest in a 2-year CD than you do a 6-month CD for this same reason. The yield curve is looking specifically at Treasury bonds issued by the U.S. Government. When the yield (interest you earn) on a shorter-dated bond is higher than that of a longer-dated bond, we have an inverted yield curve. This first happened back in December when the interest rate on a 2-year Treasury note was higher than that on a 5-year Treasury note. Then, on March 22, the interest rate on a 3-month Treasury bill spiked above the interest rate on a 10-year Treasury bond. Historically speaking the last seven recessions were preceded by a yield curve inversion. On average a recession followed a yield curve inversion by about 11 months.
Pile on top of this evidence the fact that the economic expansion is now approaching its 10-year anniversary which seems, to many people, to be long in the tooth and everyone is afraid a recession is imminent. But what exactly is a recession, and why should we worry? The official arbiter of recessions in the U.S. is the National Bureau of Economic Research (NBER). This is a private, nonprofit, nonpartisan organization dedicated to conducting economic research. The NBER defines a recession as “a significant decline in activity spread across the economy, lasting more than a few months.” It is measured by data tied to “industrial production, employment, real income and wholesale-retail sales.”
The key here is that the measure is not tied to just one or two sectors. Just because retail sales fall for two quarters does not mean we have a recession. And it takes some time for the NBER to call a recession. It took them nearly a year to confirm the last recession (2008) and by the time they confirmed it, it was a forgone conclusion.
Why do we care about recessions? For most Americans job insecurity increases, layoffs rise, company earnings fall, retail and corporate sales slow and stock prices fall. Bear markets – a 20% or greater decline in the S&P 500 Index – are typically tied to recessions. In the last recession, the market fell almost 57% at its lowest point. It certainly pays to be both aware of and wary of recessions. At the very least one can prepare by reallocating your portfolio.
The question becomes – since we have had an inverted yield curve and we are getting some slightly disturbing economic news, should we be worried about a coming recession and should we reallocate our accounts or sell everything and go to cash? The short answer is “no” to both. How do I know this? The truth is I don’t know that we aren’t heading for a recession. I am pretty confidant we are not heading for a recession in the very near future.
The Conference Board, a nonprofit group of 1,200 businesses and organizations from around the world, compiles what is called the Leading Economic Index© or LEI. There are ten components to the LEI and they are leading predictors of economic activity. They run the gamut from the jobs numbers to the S&P 500 Index, the yield curve (looking for an inversion) to orders for “durable goods” (think ovens and refrigerators) to consumer expectations. Each month the Conference Board plugs the numbers into a formula, and they report on the LEI every month. All ten of these indicators tend to foreshadow things to come. For example, if businesses are cutting back on orders this could foreshadow a slowdown in sales which would lead to potential layoffs and rising unemployment numbers and waning consumer confidence and so on. Why ten of them? One or two might send out false signals. With ten, it’s more likely to indicate a true trend. Does this mean every time the LEI falls we are heading into a recession? Based on past history the lead time given by the LEI has ranged from 7-20 months before a recession occurs. However, there have been times when the LEI has given false recessionary signals including in the mid-1960’s, the mid-1990’s, the late 1990’s and even during the recent expansion we are experiencing.
According to the Conference Board, the LEI has been essentially flat since October. It has correctly signaled the U.S. economy is slowing down but it has not signaled a recession yet. In fact, the Conference Board recently issued a report that is cautiously optimistic on continued growth for the U.S. economy. There have been some shifts that may forestall a recession. The Federal Reserve has made an about face from indicating they wanted to raise interest rates at least twice this year to pushing off even one interest rate hike until next year, if at all. Add to this the fact that recessions are usually preceded by major economic imbalances – a stock market bubble as in 2000 or a housing bubble like we had before the 2008 recession or the Federal Reserve sharply raising interest rates to tame inflation.
None of those conditions exist – currently. I say “currently” because this could change in an instant. There are a few things I am watching cautiously. Chief among them is a China-U.S. trade deal. Everything points to both sides wanting a trade deal, but with China’s economy seemingly turning upwards again, I fear they may not need a deal as much as we need a deal. Further, I worry the current administration will see fit to crank up the tariff war if all their conditions are not met in these trade negotiations. I worry this administration will follow through on closing the Mexican border or will implement high tariffs on autos and parts coming in from Mexico. Any of these types of scenarios could tilt us over into a recession. On the flip side if we do get a trade deal and the tariffs come down nothing says we cannot continue this expansion for any number of years. In fact, Australia has gone for just over 25 years without a recession, beating out the Netherlands for the country with the longest post-war expansion. Can the U.S. expansion last 25 years? That is certainly possible. One thing some pundits like to point out is that it is different this time. We seem to be in a period of very low interest rates coupled with little or no inflation. However, I always worry when someone says “it’s different this time” as that usually means that it is not. The bottom line is that I am cautiously optimistic for continued growth.
How are we navigating these waters? Currently we still have a fair amount of cash across client accounts. I did put a little to work when we had the second yield curve inversion and the markets fell around 2% for the day. I fully intend to take advantage of more opportunities like that – adding to core positions when markets fall. Should it look like we are heading into a recession, you can expect me to add more bonds to client accounts. Typically speaking, when recessions hit the Federal Reserve will cut interest rates to entice people and companies to borrow money to invest in new plant and equipment to spur economic growth. As a side effect of this when interest rates fall, bond prices will rise. For example, a 30-year Treasury bond originally issued with a face value of $1,000 back in November 2007 and paying 5% interest, could be sold today for $1,333 on the open market. Why is this? It is because interest rates are about half of what they were at the time the bond was first sold. Given this tendency I would add more bonds and bond funds to client accounts to take advantage of this fact.
In the interim I am sticking with what I know. I have a model that is working well. I am looking for value stocks with momentum behind them, so we can see continued growth in price. When the model gives me stocks to buy I will add them to client accounts. Already this quarter, this model has added two Brazilian stocks in oil giant PetroBras (ticker: PBR) and phone company Telefonica Brasil (ticker: VIV). We also added an oil services company ProPetro Holdings (ticker: PUMP) and a coal company that supplies coal to the steel industry, Warrior Met Coal (ticker: HCC).
In addition to my model I am always looking for special opportunities. We recently added semiconductor company Mellanox Technologies (ticker: MLNX) to several client accounts. Mellanox is being bought by NVIDIA Corp for $125 in cash. Given the price we paid we will earn a reasonably sure 5.7%, which may not seem like a lot. However, if the deal closes by the end of October as we expect, we will have over 9% on an annualized basis.
As of the end of March (I run my screen monthly) there were no new stocks to add to client portfolios. This may indicate that we are at or near fair value on most stocks. If we get any pullbacks, I would anticipate having more stock names hit my list. Until then I am not going to force anything. We are not required to buy every month just because we have cash. As Warren Buffett once wrote, we can afford to sit and wait for that “fat pitch” to come to us. In other words, we can wait for great investments to come along.
We do have a game plan in place for whatever is to come. If the expansion continues, we are going to continue to do what we do – finding great companies trading at reasonable valuations that have the potential to show continued price appreciation. We will also seek out those special opportunities as they come along to enhance our returns. If we do head into a recession then it is bond, bonds and more bonds. But there is no need to panic and rush into bonds or even to sell out and go to all cash just yet. The U.S. economy is still on pretty good footing even if things are slowing down a bit. As long as Congress and the current administration can stay out of the way of business this expansion could easily become the longest on record for the U.S. I will not attempt to predict whether we can make it another 15 or more years to vie for the longest expansion record.
Let me emphasize that it is my job to assist you. If you have any questions or would like to discuss anything, please feel free to give me a call! As always, I am honored and humbled that you have given me the opportunity to serve as your financial advisor.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
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