Time to read: 8 minutes
We’re starting the new decade amid a record economic expansion. While it hasn’t been a particularly strong expansion, it certainly has been durable. The widespread narrative this time last year was that without a trade deal with China, the economy and the market wouldn’t get traction. Clearly that was not true, as unemployment declined from 4% to 3.5% and the S&P 500 advanced more than 30% including dividends.
What’s driving the economy today is a tsunami of technology. Tablets, smartphones, apps, streaming services, cloud computing, the 5G rollout, etc. It’s raising productivity, boosting profit margins and will bolster economic growth in the future. But the question now is, how much of that is reflected in current market prices? After all, corporate earnings were flat in 2019. The market’s advance was almost entirely due to multiple expansion—investors paying higher and higher prices for the same dollar of earnings. Wall Street expects profits to climb higher in 2020. But has that been priced in already?
Although the market had an above-average year in 2019, more people than ever missed out on the gains. According to JP Morgan, investors pulled more than $60 billion from U.S. stock mutual funds and ETFs during the year, while adding nearly $370 billion to bond funds and $475 billion to money market (cash) funds. When financial news outlets talk about swelling investor enthusiasm, I hope they’re not referring to the U.S. stock market, as it has been largely ignored by retail investors since this bull market began.
Phase one of the U.S. – China trade deal has been signed and for now it seems we’re on the path toward continued trade resolution. Never mind that the agreement has no third-party enforcement or oversight—each country monitors its own implementation—but its passing seems to make a case for renewed global growth, especially in the Eurozone and emerging markets which bore the brunt of the trade war’s fallout.
As of this writing, the slowdown risks to the economy, particularly for manufacturing and trade-exposed sectors, appear less threatening. If nothing else, the risks are well-enough understood and not likely to surprise anyone. And that is the key, because the riskiest events, and therefore the most consequential, are the ones we don’t see coming.
Over the last two years, the same risks have been repeated over and over: interest rate hikes, a flattening yield curve, the impeachment, the trade war, and the election. And while people might be worried about these things, nobody should be surprised by them. Business owners and CEOs might be frustrated, but many have prepared as well as they can. Paying attention to known risks is smart, but we should acknowledge that what we can’t see, what we aren’t talking about, and what we aren’t prepared for will probably be more consequential than all the known risks combined. That’s how risk works.
The case for optimism is that we have always muddled through these types of events in the past and we’ll likely always muddle through. The global markets and economies are incredibly adaptive, especially as they become freer and more transparent.
As to the current environment, we don’t attempt to forecast the economy or the actions of the Federal Reserve (certainly an army of econ PhD’s beclowned themselves when the Fed cut rates last year despite unanimous predictions of rate hikes), and we don’t make investment policy out of political speculations. Instead, we accept today’s “givens” and try to act accordingly. By contrast, most people try to adjust their portfolios based on what they think lies ahead. But if they’re honest, they will admit that forward visibility just isn’t that great.
Consider the following: Our economy and markets have been doing well for 11 years. The S&P 500 has quadrupled off the lows and we’re in the longest bull market and economic expansion in history. Recently, prices have risen faster than profits. Few people seem to be worried, as evidenced by very low credit spreads, high stock valuations, large stock buybacks, increasing corporate leverage, lower credit standards, a growing number of profitless IPOs, negative-yielding sovereign debt, record levels of covenant lite loans, and trillions of dollars of new capital raised by private equity funds at a time when buyout multiples are on the high end.
Nothing in the above is a prediction or a statement about the future. But there’s a lot we might infer about the equity, fixed income, and private markets. Mainly that investors shouldn’t expect a repeat of the prior decade’s outsized returns. We’re starting from very different valuations.
On the other hand, if all we saw were weak returns, investor cynicism, plentiful bargains, and a widespread reluctance to invest, we might say it’s a good time to be aggressive. But that doesn’t describe today’s environment.
While we don’t believe that this cycle is over, we’re declining to stretch for higher returns by taking on more risk. The potential reward for doing so is just too paltry. We’ll continue to maintain your target allocation because we know that your mix of asset classes will explain more than 95% of your lifetime returns. Security selection and market timing can be a minor contributor, but it can just as easily be a huge detractor if tampered with too frequently. And in case we haven’t made it perfectly clear, we will never advocate for being all-in or all-out of the markets. Sitting in cash is a recipe for long-term underperformance and nobody in this industry has ever shown an ability to get in and out and back in consistently enough to be meaningful.
The challenge of investing is that there are no facts about the future. Our decisions are always made under uncertainty. Hopefully these communiques help to explain our decision-making framework and the rationale for our current positioning. If you have questions or comments, please let us hear from you.
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