The Margin of Safety Quarterly Fall 2018
Third Quarter 2018 Key Takeaways
- Larger cap US stocks hit new highs in late September and gained 7.7% for the quarter, while smaller-cap US stocks gained 3.6%
- However, since September 30 through October 18, the NASDAQ is down 7%, the S&P down about 5%, as volatility continues
- Developed international stocks gained just 1.2% in the quarter, while emerging-market stocks (EM) fell 1.7%
- In fixed income markets, the 10-year Treasury yield rose to 3.05% at the end of September, flirting with a seven year high
- Credit sensitive segments of the bond market, on the other hand, performed well
- Our balanced portfolios also continue to hold liquid alternative strategies funds that we believe improve our portfolios’ long-term risk-adjusted return potential
Third Quarter 2018 Investment Commentary
The third quarter was a strong one for the U.S. stock market, as the economy grew, corporate taxes have been cut materially, regulations were reduced and interest rates are still low, resulting in cheap credit. On the negative side this has led corporations to weaken there balance sheets by taking out debt to complete stock buybacks or large acquisitions. Also the Federal budget deficit continues to grow, which is an area of concern for the future.
U.S. large caps were up over 7% for quarter but through October 18, almost all of that return was given back in string of negative returns, including a 5% drop over two days in early October. Through October 11, the S&P declined for six days in a row. We have discussed the prospects for market volatility in recent newsletters. There is no new “news” to speak of in the market but there seems a general concern that rising rates are affecting the attractiveness of stocks.
Foreign stock markets were impacted by poor sentiment, and a rising US dollar was a further drag on returns for dollar based investors. Returns were positive for developed international stocks for the quarter but emerging market equities were down just under 2%. In 2018, US stocks have strongly outperformed emerging market stocks (“EM”), but this level of divergence is not unusual. Still, given the negative headlines surrounding emerging markets, we highlight several points this quarter that indicate EM stocks remain attractive and their long-term growth outlook is intact. On the other hand, US stocks look expensive, and there are reasons to think the near and medium-term outlook for them is not so rosy. The overvaluation of the US stock market represents one of the biggest risks to our portfolios, which is why we maintain a meaningful underweight to US stocks and why we use active funds that can diverge from the index, which we believe is more overvalued than the average US stock.
The core investment grade bond index had a negative return in September and was flat for the quarter. This was good news for our balanced (stock/bond) portfolios, as our tactical allocation to floating rate loans has returned over 3% for the year and our flexible income managers are materially ahead of core bonds as well (nearly 2% loss for core bonds year to date).
Our active bond managers have also outperformed the core bond index for the year. We expect these positions to outperform over the next several years as well, particularly as interest rates continue to rise. The Federal Reserve has raised rates three times so far this year with a fourth teed up for December. Policymaker forecasts call for three more increases in 2019.
Our emerging markets bond manager had a good September, up over 2%, but this was not enough to offset negative returns earlier in quarter, resulting in a decline of just over 2% for the quarter. Our lower-risk, multi- strategy alternatives fund had a good return for the quarter, up 1% and about the same year to date versus the almost 2% loss for US core bonds.
Market trends in the third quarter were largely an extension of what we’ve seen so far this year, with a stark divergence in return between US stocks and EM stocks. This level of divergence in relative performance is not unusual. It is common for US stocks or EM stocks to outperform the other over 12-month periods as shown in the chart. Just last year, EM stocks gained 31.5% and outperformed the S&P 500 by roughly 10 percentage points. That has sharply reversed this year. However, we note that for the period 2003-2017, EM stocks returned around 13% vs US large caps which returned 10%. This is one of the reasons that we believe that EM stocks need to be held for the long term to receive the outperformance that they have provided historically.
As value investors, we believe the focus should be on the long term (not short term) and our somewhat defensive posture will hold back portfolio returns a bit when “momentum” and “growth at any price” stocks are popular. When these cycles change (and they will), the defensive posture provides a margin of safety for the portfolio and ultimately a bigger value to compound wealth going forward, when investors appreciate (again) that valuation matters. Ben Graham noted that in the short run, the stock market is a voting machine but in the long run it is a weighing machine – stocks represent an ownership of a business. The price paid for anything will impact future profits and the higher priced an asset is, generally speaking, the lower the expected future returns. With the return of equity volatility, we will see if this leads to a greater focus on valuation – price is what you pay, value is what you get.
The value philosophy, along with our disciplined investment and planning philosophy has allowed our long term clients to come through the 2000-2003, 2007-2009 bear markets with positive returns, compounding their wealth for them and their families.
We strongly believe that a key element of our investment process and edge is our discipline in maintaining a multiyear perspective rather than overreacting to short-term price volatility, performance swings, daily news flow, and other behavioral triggers. It’s easier said than done, though, especially amidst an unprecedented stock market run and a seemingly unending string of unnerving geopolitical headlines. Rest assured, we remain ever vigilant in analyzing new data and information, and if our analysis warrants a change in our views or portfolio allocations, we will act.
Reiterating Our Outlook for EM and US Stocks
While there are always multiple factors behind short-term market moves, there were two dominant headwinds facing EM stocks in the third quarter: the intensifying trade conflict between the United States and China, and the strength of the US dollar. While neither of these factors presents new or material threats to our analysis of EM stocks, they have impacted our portfolios’ short term returns given the magnitude by which they have lagged US stocks so far this year.
However, there are several points worth highlighting that give us confidence in our assessment that EM stock valuations are cheap and their attractive long term return potential remains intact:
- Our base case continues to be that a full fledged trade war is unlikely as it is in neither country’s best interest, despite the fact that we may be living in a world with an overhang of trade tensions for a while. It’s also not clear US stocks would be less impacted than EM stocks given the former’s global presence.
- US dollar strength has hurt dollar based foreign stock returns, but longer term, there are reasons to think this will reverse. We believe the fiscal stimulus of tax cuts at a time when the US economy is strong will cause fiscal deficits and debt levels to rise—both potential headwinds for the US dollar.
- Economic crises in Argentina and Turkey have made headlines, but these countries’ economies and financial markets are small. We see little risk of contagion to other emerging markets. In contrast to previous EM crises, the fundamentals of most other EM countries are much healthier in terms of debt levels, trade balances, dependence on foreign capital, foreign exchange reserves, etc.
- Within our normalized earnings framework, we apply the historical discount EM stocks have traded at compared to US stocks and they are still attractive. EM stocks are even attractive after adjusting for sector differences between US and EM markets.
As for US stocks, no one knows exactly when the record setting US bull market will end. Despite their unattractive fundamentals, it’s certainly possible US stocks will continue to be favored by investors over the short term. However, S&P earnings growth expectations are now exceedingly high, and the US economy is operating at or near full capacity and full employment. These are unsustainable conditions, and the direction in which they will move next is likely negative for stocks. Also the “punch bowl” of fiscal and Federal Reserve stimulus is just about dry. The Federal Reserve is now trying to raise rates to keep inflation low and further tax cuts seem like a dim possibility given rising government debt.
Our portfolios’ tactical underweight to US stocks is based on conclusions drawn from our fundamental research on historical stock market valuations, earnings growth, and corporate profit margins. From current price levels, our base case expectations for US stock returns over the next five years are nearly zero percent. To put these estimates in historical context, since 1950, the S&P 500 has generated an 11.1% average annual five year (60-month) return.
No matter how we slice it, our analysis suggests the US market is the most expensive major stock market in the world. As a result, it presents one of the biggest risks to our portfolios. This is why we have diversified our portfolios’ stock exposure by investing in foreign markets that, in contrast, look significantly cheaper and offer a much stronger medium- to longer-term growth outlook. But these positions come with additional shorter-term risk, as we’ve seen so far this year. Also, as noted earlier in the newsletter this is why we utilize active managers who are not invested in the index. As we have written in the past, a small group of stocks has driven a lot of the performance of the overall S&P index. This group of tech stocks is particularly vulnerable in a pullback. We are underweight to these particular stocks vs. the overall index.
Outside of traditional markets, we have lower risk alternative investments in our portfolios for their risk management and portfolio diversification benefits. We expect them to shine when US stocks experience their inevitable periods of poor returns. We think these strategies can generate annual returns that are attractive relative to what we currently expect from a comparable mix of stocks and core bonds.
In the summer we posted to the blog section of our website, rcaweath.com, a piece on fake news. The term is very prevalent today and we think investors of all types need to be on the alert for fake news related to investments. Over our more than twenty year history, we have seen an increase in hype and fake investment news during periods of volatility. We thought it would be a good idea to summarize our thoughts on this topic, from our blog posting.
We think investors need to be aware of “fake” financial news and think about the impact this can have on their investment and financial planning. Most particularly, investors may be misled when financial news writers are secretly compensated for touting individual stocks or investment products.
The Journal of Accountancy noted in an article that Americans say that fake financial news is affecting their ability to make retirement, investment, and health care decisions. In a recent American Institute of Certified Public Accounts (“AICPA”) survey of 1,018 adults, 58% of respondents said that fake financial news is a serious threat to their financial decision-making.
Fake financial news also has drawn the attention of the SEC. Last year the regulator announced enforcement actions against 27 individuals and entities that it said were misleading investors into thinking they were reading unbiased, independent analyses on investing websites. Instead, the SEC said, writers were being secretly compensated for touting company stocks, per the Journal of Accountancy article.
The AICPA National CPA Financial Literacy Commission offers the following advice to help consumers identify fake news and we agree with them:
- Look for telltale signs of hoax. If a headline makes a questionable claim, or there are grammar errors and typos in the article, this should give you pause. If you’re unfamiliar with the source, research it and read other articles from that source. Investigate the author. Look for reports from other sources.
- Ensure the news came from a legitimate website and not a “spoofed” or counterfeit website.
- Watch out for sponsored content and advertorials. An “advertorial” is a newspaper or magazine advertisement giving information about a product in the style of an editorial or objective journalistic article. While these articles can look just like a standard news article, they are instead used to sell products.
- Check if the source is known for spoofs or satire.
- While your gut may tell you to react quickly to breaking stock market news, consider that an investment plan is designed for the long term – for your life expectancy (or joint life expectancy if married). We agree with Jack Bogle’s quote about what to do during periods of market volatility (or breaking stock market news, in our opinion!), “Don’t do something, just stand there.”
River Capital News
By the time you read this, the 2017 tax filing season will be over and the 2018 planning season continues from here to year end. We are talking with clients about the new tax law, while also trying to digest the only recently provided IRS guidance related to a number of the more complicated tax changes. Our ability to help clients with their tax, investment and financial planning is something that makes us the exception and not the norm in the financial services industry.
Based on the client survey results noted in our last quarterly newsletter, we will be having our first retirement planning workshop, lead by David Bowers, entitled, What Are You Doing The Rest Of Your Life. The focus of the workshop is on the non-financial aspects of retirement, how to stay engaged and to help in creating passion with the time that was formerly committed to work. We love the quote from one of our clients who said, “I did not realize how little of a life I had when I was working! Now that I have more free time, there are a lot of things I want to do.” The space for this initial workshop is very limited and we emailed our clients recently with additional details.
We hope to see cooler weather very soon and our thoughts and prayers go out to our fellow Floridians who have to deal with hurricane Michael and its aftermath.