The stock market began 2018 with a bit of euphoria in January accompanied by many presidential tweets that seemed to tempt fate. After one mid-winter scare it drifted modestly higher until mid-October, and then abruptly accelerated to the downside culminating with December being the worst month since the meltdown a decade ago. We were reasonably defensively postured during the selloff but the sharp declines in Amazon and Apple were particularly damaging. Both have been very profitable long-term holdings; and drawdowns – in both individual names and on a portfolio basis – are an inevitable part of long-term investing.
We did a little better on defense than we did on offense this year and missed some of the upside particularly in the second quarter because the rally was concentrated in a smaller number of stocks than exists in a prudently diversified portfolio. The early part of the year was an unsustainable “growth at any price” environment, and growth stocks out-ran value stocks by an unusually large margin. It was frustrating to see stocks with good dividend yields continue to drop by more than enough to offset those yields. A rally with a narrow base is often a sign of underlying weakness, and that proved true in this case. So toward the end of the year, we focused on limiting drawdowns by raising cash; we were net sellers of $337,000 of stock between mid-October and Christmas. But in retrospect, our numbers would be better if we had sold more Apple and Amazon.
The blame game seems part of any price decline. President Trump blames the Fed. It is hard to imagine a quarter point rate hike alone triggering such a decline. However, certain analysts have been warning for years that as the Fed begins to return its balance sheet to more of an historical norm, some of the Fed-induced asset inflation would reverse course. But that has been a gradual process for some time, and the recent instability has been more sudden and pronounced. The discord and chaos inside the Executive Branch have jarred investor confidence: the loss of Generals Kelly and Mattis, the indictments stemming from the Mueller investigation, threats to the independence of the Federal Reserve, the government shutdown, etc. Signs of economic distress overseas aren’t helping either – whether it is the Brexit mess, demonstrations in Paris, slowing growth in China, more instability in the Middle East, etc. David Gergen, who served five Presidents – four Republican and one Democrat –, recently tweeted:
White House is closing down its adult day care center—the last adults are leaving… Buckle up: these two years could be even more turbulent than the last two.
It is hard to predict the market’s twists and turns, so our research focuses on long-term metrics. We look for companies with solid earnings profiles, including credible projections of growth in earnings. We assess cash flow, revenue growth and debt levels as well. These items factor into a ranking system we use to steer further analysis. We also employ a disciplined regimen to trigger defensive measures to preserve capital during major declines. In so doing, we cannot prevent losses, but we do our best to keep our so-called downside capture to less than the overall market’s decline.
We did the latter pretty well this year. But we had some disappointments as well. We knew that Amazon was pretty fully valued when it blew past $2000 in September. But even at 25% growth, the low end of recent years, that $2000 would translate to $2400 by this time next year – all else equal. So a drop of 10 percent or so was foreseeable and tolerable. We’ve noted that Amazon has had peak-to-trough drops of up to 40% in the past decade while marching to new highs; the move from $2050 to $1307 was within historical parameters but still more than we anticipated. The 36% drawdown in this stock since early September kept us from doing even better relative to the S&P than we did this quarter. But this is a stock that rose 9.5% on one day in December, so getting out to cushion a short-term decline entails the risk of never getting back in properly. And despite the weak fourth quarter, the stock did return 28.4% for the year.
Speaking of 36% peak-to-trough declines, Apple’s selloff of that magnitude didn’t help either. Apple’s return for the year was modestly negative, and some of its growth metrics have slowed modestly in recent years. It is a good example of how cheap can get cheaper, but even modest earnings growth should yield high single digit returns going forward Many other consumer stocks stayed pretty resilient, and consumer spending set records over the holiday season when one could have surmised that the weakness in stocks might have dampened the selling season. Stocks like Visa and MasterCard were relatively steady, and stronger than we expected. We shaved the MasterCard position just slightly.
An unanticipated disappointment was AT&T. We bought a lot of it when the dividend yield got above 6%. We thought it would provide some stability in rough waters. The franchise seems solid for the long term, and management has a credible plan to manage their considerable debt while investing in growth and maintaining a dividend payout ratio of 50%. But the stock continued sliding even as “value” began to outperform growth. AT&T may be perceived as trying to compete with the likes of Amazon, Netflix and Disney on the content side – which invites concern about a financial black hole on uncompetitive content creation. On the other hand, we might look back in a year from now and say wow – a 6% yield and modest appreciation to boot provided a great total return.
Speaking of “safe” stocks, General Electric had a “AAA” rating up until March 2009. It was one of six American corporations in that category. GE is a good example of why “buy-and-hold” is a good strategy – until it isn’t. The Wall Street Journal ran a long article on December 15 chronicling the decline of this once-mighty firm: “GE Powered the American Century—Then It Burned Out”. The piece noted that GE “Capital also gave General Electric’s chief executives a handy, deep bucket of financial spackle with which to smooth over the cracks in quarterly earnings reports and keep Wall Street happy. Sometimes that meant peddling half a parking lot on the final day of a quarter, or selling a part interest in a power plant only to purchase it back after the quarter closed.” It makes us wonder: where is Sarbanes-Oxley when we need it? The stock has been our biggest mistake in recent years.
Who knows what is safe anymore? Utilities are supposed to be safe, and they generally are. But California has huge wildfires and we learn that Pacific Gas & Electric may be liable for billions in damages because power lines may be responsible for starting certain blazes. Utilities are also generally hurt by rising interest rates. Pharmaceutical companies and consumer staple companies are supposed to be safe; we need health care and personal care products. Like baby powder. And then Johnson & Johnson falls 10 percent in a day on concerns that there may be traces of asbestos in baby powder and that the company may have been less than forthcoming with what they knew. In comparison, JNJ sold off 17% on the Tylenol news on Sept 29, 1982. So two points. First, even defensive investing has no guarantees of safety in the short term – one of many reasons why we diversify. But second, you could have bought JNJ during the Tylenol scare for under $2.50 per share – for an 11.6% average annual appreciation ever since.
Microsoft has been safe even though their CEO unloaded one-third of his own stock last August. It was a bit unnerving. But we now interpret it as more of an instinct that the entire technology sector was getting overheated, and that has proven to be the case as Microsoft has outperformed the technology sector.
Our system continued to identify good stock picks this year despite the second quarter being a terrible outlier when many junk stocks or overvalued names had an abnormally strong period. We could go on about our individual holdings but let’s turn to the future.
In our last letter, we raised the issue of “whether the best possible news is already reflected in prices”. Was the recent decline a harbinger of recession accompanied by continuous downward revisions in earnings estimates, or was it just another panic akin to the taper tantrums and other mild panics of recent years? After all, the first signs from What about the shape of the yield curve and recessions?
We will watch economic indicators carefully, but as noted, the first signs from the holiday selling season were very positive. And the yield curve does not necessarily foreshadow recession.
Interest Rates and the Yield Curve. It is not illogical to associate an inverted yield curve with the prospect of recession. Banks make money by lending for long periods and financing that activity by paying short-term interest rates – which are normally lower. When this “spread” disappears or goes negative, the incentive to lend goes with it. So credit tightens, and that contributes to a recession. However, according to Alliance Bernstein, “While the US has never had a recession that wasn’t preceded by an inverted yield curve, not every curve inversion has been followed by a recession.” Often, a flatter yield curve is caused by short-term interest rates being too high. But presently, “real” interest rates (i.e., adjusted for inflation) are still very low or negative. Some observers feel that long-term rates are artificially low due to net buying pressure from quantitative easing. Long rates may also be depressed because European rates are considerably lower than ours, rendering treasuries as a good relative value on a global basis. The bottom line is that monetary policy per se is not choking the economy. But while interest rates themselves should not cause an economic slowdown, a decline in bank lending could.
What does the historical evidence show? There were six years in the last 20 in which the yield curve was either negative or barely positive (i.e. less than 0.25%) at year-end. In the following twelve months, our GDP grew by an average of 3.1%, with a low reading of 1.0% in 2001 as the tech crash was unfolding. So economic fears associated with a flat yield curve may be overstated. Of course, there may be more of a lagged effect; when rates are on the way up, there may be a rush to borrow, a flurry of spending, and then a slowing in such activity. The curve was most inverted spring 1980, staying flat to slightly inverted through summer 1981. The depth of the recession was spring 1982. And then the bull market launched in August of that year.
Low interest rates are particularly good for certain industries such as utilities and industrials. On the flip side, there is no clear evidence of an imminent decline in bank earnings associated with a flattening yield curve, which suggests that the year-end selloff in bank stocks is probably overdone. For example, JP Morgan fell from $118 to $97, and now has a PE of 10.5 versus 2018 expected earnings.
Trade and China. The other major risk relates to trade tensions. There is a general consensus that China has gotten away with some unfair trade practices for too long. Even so, a trade war that hurts everyone (rather than a diplomatic solution that all sides can live with) remains a risk. The danger of government leaders misjudging the reaction of counterparts – particularly the Chinese – remains high and is unsettling. Meanwhile, the issue of debt levels in China is another matter for concern but some keen observers feel that the possibility of a debt contagion is quite low.
Corporate Earnings. Corporate earnings grew by an estimated 20.3% in 2018. It wasn’t just the Trump tax breaks. Current estimates are that revenues also grew by a very healthy 8.9% percent – the best reading in seven years. Many companies credit a less arbitrary and more predictable regulatory environment as one key to a strong growth environment. This bullish ingredient is unlikely to change very much in 2019, even with a Democratic House. The bigger risk may be the Trump Administration unsettling the markets with either antitrust actions or new regulations on either the pharmaceutical or technology industries.
We will obviously continue to monitor relevant news and pay particularly close attention as corporate earnings news begins to roll in during mid-January. But if earnings estimates hold reasonably steady, this is an opportunity to take some positions at better valuations than we have seen in quite some time.
We believe that our tax management capability was a major value-added this year. We were able to take some profits during the summer highs, and those sales saved us a significant sum as the market sold off. But those sales also resulted in some large realized gains. We used the year-end weakness to offset those gains to the extent practicable. The cash raised is being recycled into stocks that seem to be the best relative values now.
As always, we welcome any questions or comments. We also welcome and encourage conversations about asset allocation. There is a strong argument to become a bit more conservative and focused on capital preservation more than growth as we get older. Thank you as always for your continued confidence in us.