THE MARGIN OF SAFETY QUARTERLY SPRING 2019
First Quarter 2019
- After posting their worst December since 1931, U.S. stocks surged to their best January since 1987, followed by further gains in February and March
- Foreign stocks also rebounded sharply in the first quarter
- Fixed income markets were also strong: High yield bonds gained 7.4%, floating rate loans were up 4%, and investment grade bonds rose 2.9%
- Our lower risk alternative strategy generated just under 4% returns, much better than core bonds but lower than stocks
- The market rebound was predominately due to a U-turn in Federal Reserve monetary policy
- Our experience from prior later market cycles is keeping us focused on the tried and true disciplines of patience, diversification and periodic rebalancing while keeping our clients long term goals in mind
Once again, the markets surprised the consensus and demonstrated the folly of trying to predict short term performance (more on that topic later in the newsletter). Investors who bailed out of stocks during the year end selloff experienced severe whipsaw as the market rallied. Larger cap U.S. stocks gained 13.6% for the quarter, placing it in the top decile of quarterly market returns since 1950. As a reminder, last year’s fourth quarter 14% drop was a bottom decile dweller.
Not to be left behind, developed international markets gained 10.6% and European stocks were up 10.9%. Emerging market (EM) stocks rose 11.8%, after holding up much better than U.S. stocks on the downside in the fourth quarter of 2018.
Fixed income markets were also strongly positive. The 10 year Treasury yield fell to 2.39% during March, its lowest level since December 2017. Our tactical positions in actively managed flexible income funds also generated strong returns. They outperformed the benchmark core bond index as a group this quarter. High yield bonds earned 7.4% in the first quarter, floating rate loans were up 4%, our emerging market bond manager was up over 3.6% and the core investment grade bond index returned 2.9%.
Our diversified alternative investment position also performed well and consistent with its role in client portfolio’s, returning just under 4% that was better than core bonds but below the soaring stock market.
The market rebound was predominately due to a U-turn in Fed monetary policy. After hiking interest rates four times in 2018, including at their mid-December meeting, and indicating further tightening would occur in 2019, Fed officials suddenly reversed course. They emphasized they would be “patient” and pause any further rate increases. And—presto!—stocks are back at their highs of late last summer. Admittedly, there were other positives for the markets as well: The federal government shutdown ended in late January, signals from the U.S.-China trade talks turned more positive, and the likelihood of a “hard Brexit” seemed to wane.
Our portfolios generated strong performance for the first quarter, largely driven by their exposure to U.S., international, and emerging market stocks. Our actively managed domestic, international, and global stock funds also added value, as in the aggregate they outperformed the benchmark indexes for the period.
As a group, our tactical positions in actively managed flexible income and floating rate loan funds (for our most conservative portfolios) also generated good returns, as well as our core bond managers. The alternatives strategy also performed well, as noted earlier, for its role in the portfolio.
We are not making any asset allocation changes to our portfolios at this time.
The obvious question after experiencing such a rebound is, what’s next? It’s easy to be enamored with the U.S. equity market, especially when the Fed is playing its cards face up. However, the reality is the market rebound was due more to improving investor sentiment and risk appetite—caused largely by the shift in Fed monetary policy—than any meaningful improvements in underlying economic or business fundamentals.
From our vantage point, looking out over our longer-term investment horizon, seemingly little has changed after the roller coaster ride of the last six months. The first quarter of 2019 was certainly a nice respite from the losses of 2018, but we remain prepared for renewed market choppiness as the economic cycle gets later and later (and closer and closer to the inevitable downturn).
While the U.S. economy is still arguably the strongest market, growth expectations have been coming down. At its Federal Open Market Committee meeting on March 20, the Fed downgraded its median GDP growth estimate to just 2.1% for 2019 and 1.9% for 2020, citing the effects of economic slowdowns in China and Europe, fading stimulus from the 2017 Trump tax cuts, and ongoing uncertainty around Brexit and trade policy.
U.S. corporate earnings growth expectations also continue to decline. Consensus earnings per share growth estimates for the S&P 500 have dropped from 12% (as of 12/31/18) to just 4.1% as of mid-March. Even with the Fed now on hold, earnings growth will need to improve for stocks to appreciate meaningfully from current levels, given their sharp rebound in the first quarter and high valuations. Investment professionals we respect are indicating annualized return expectations for U.S. stocks are in the low single digit range over the next five years.
On the other hand, there are a number of short-term scenarios that could see further equity gains, in particular in foreign markets. The Chinese government is once again trying to boost their economy via fiscal and monetary policy (including tax cuts, lower interest rates, and expanded bank lending). A revival in Chinese growth would have positive ripple effects across the global economy. It would benefit other emerging markets and Europe in particular, as China is a major importer of their goods. This foreign stimulus, combined with the Fed’s policy U-turn, may enable equity markets to extend their positive run for another few years. This outcome would certainly benefit our portfolio positions in developed international and emerging markets, among other riskier assets.
While we’d prefer to see global growth rebound with continued strong performance, we believe it is wise to be prepared (mentally, emotionally, and financially) for shorter term downside and negative market surprises. If and when a recessionary bear market strikes, we will look to our holdings in core bonds as well as our other higher yielding hybrid and alternative strategies to provide ballast to our portfolios and limit the impact of equity declines.
Any prolonged downturn will also likely present us with opportunities to tactically increase our exposure to riskier asset classes, such as U.S. stocks, at lower prices and higher prospective returns.
Market Timing – A Dangerous Way of Thinking
In music and most definitely in jazz, timing isn’t the main thing, it is everything! Although that maybe true for music, the concept is not appropriate for equity markets. Despite the allure, trying to time when to get into and out of the equity markets has been proven time and again to be a loser’s game. We have written about this in many past newsletters and will continue to do so when we have a period such as the fourth quarter of 2018 and the first quarter of 2019. We continue to write about market timing because individuals do not seem to “get it”. We talked with investors during the fourth quarter and there were a number of them who talked about existing equities, going to cash, to “wait the volatility” out. They also talked about the “attractiveness” of cash – it does not fluctuate in value and yields can be had around 2%. We shared our opinion that doing so would be a colossal mistake and we hope our advise was taken – the first three months of 2019 results in 5-7 years’ worth of cash/CD interest!
Market timing reminds us of the daily vehicle commuter, who keeps switching lanes on the highway during heavy traffic. The driver thinks he or she (and you know who you are!) can pick the lane that will move the fastest. It never works! How many times, when doing this, have you seen the driver who “didn’t get it”, stayed in their lane and they pass the lane changing driver? The great Peter Lynch supposedly commented that over half of the investors in his Fidelity Magellan fund lost money, trying to time entry and exit from his fund. They would buy in after a period of strong returns, selling after a few quarters of poor returns.
We note that Nobel Prize winning economist William F. Sharpe determined that a market timer would have to be right an unbelievable 70% or more of the time to match the returns from a buy and hold strategy. The investment firm Tweedy Browne came to a similar conclusion in an internal paper on this topic back in 1992. They noted that equities are prone to bursts of performance (such as the first quarter of 2019), that occur in very short time periods.
A recent piece by Tweedy Browne commented on one of their investors who put in $200,000 in their Global Value fund on June 17, 1993, two days after the start date of the fund. The investor made a subsequent addition of $100,000 on January 19, 1994, staying invested ever since and has taken a total of $865,673 in cash over the years via redemptions or cash dividends. As of April of last year, the account balance was $702,000, or 2.3 times the initial investment of $300,000. Had there not been the withdrawals of $865,673 over that time period, the total account value would have been in excess of $2.5 million. There were many equity market shocks during this time period, including the 2000 tech bubble and the 2008 financial crisis, with equity market drops of 50% or so. The Tweedy investment is a value fund (of course) and held up better than growth indices but despite the confidence shaking news and market environment, there was no market timing, no going to cash to wait things out. There was patience, discipline and staying with the long term game plan.
Advisor or Sales Person?
River Capital Advisors (“RCA”) is unique in the financial services industry due to our skill set (practicing CPAs and CFP® practitioners), being independent, fee only and financial fiduciaries. Another important distinction for RCA is that we take our clients through an investment and financial planning process, not a sales process. The two approaches are very different and the approaches can also be confusing to individuals. As advisers, we interact very differently with our clients than those who are sales focused. We have developed a document that looks at the different areas of someone’s financial life and how an advisor process works vs. the sales process – see the attachment to this newsletter. For some individuals, a financial product is all that they need. However, for many, they need more than a product, as we like to say buying a product is not financial planning. We hope you find the attachment helpful.
Here at RCA, we are big fans of Howard Marks. We have read his books and his memos. Howard is a deep thinker and provides insights to a number of important financial matters. Below is quote that we would like to share given the recent market volatility since last year:
‘To be a successful investor, at a minimum, you have to survive. Surviving on the good day is not the issue. You have to be able to survive the bad days. The idea of surviving on average is not sufficient. You have to be able to survive on the worst days, so you have to adjust your portfolio so as to limit the risk so that you can survive on the worst of days….If you do not have conviction and you give up on the bad days, then, by definition, you do not participate in the subsequent recovery.
River Capital Advisor News
Another tax filing season has just passed and the new tax law had important impacts on businesses as well as individuals. Tax time is also a good time to assess your current financial situation, goals, emergency cash levels and long term portfolio allocations. Being affiliated with the CPA firm of Smoak, Davis & Nixon helps us to assist our clients in all areas of their financial life.
Here at RCA, three important services that we provide to clients are “asset location” strategies (i.e. deciding on where to invest as it relates to taxable and tax deferred accounts, given the different tax attributes of these accounts), rebalancing and tax loss harvesting. We were busy in the fourth quarter to take opportunities to lower tax bills through active tax loss harvesting strategies, while also keeping the investment plans on track by using suitable investments for the harvested positions. This allowed our clients to generally lower tax bills (when they had a taxable investment account) for 2018 and in some cases to bring tax losses forward to 2019, while also maintaining the investment plan and reaping the benefits of a quick reversal in global equity markets in January 2019.
We appreciate the continued referrals from clients and advisors we trust here in Jacksonville. We will do our best to help individuals, even if RCA is not the advisory firm for them. Please keep the referrals coming, as they are the main source of new clients for us.
We have updated our annual ADV and are including with our client quarterly performance package a Summary of Material Changes. If you would like a complete copy of our ADV, please contact Bradley Miller, CFP®.
Please do not hesitate to contact us about any area of your financial life – investments, taxes, personal planning, risk management, cash flow planning. We are here to help.