Adapting to Change

As anticipated, all the pundits who have been bearish suddenly turned bullish after the market concluded one of the best weekly and monthly advances in nearly a year. Most of these “experts” now state that the market probably bottomed right after Christmas. Hah! Isn’t that looking in the rear-view mirror rather than anticipating change which should be their expertise? Maybe Jack Bogle was right stating that passive management is the right way to go. Remember, not all managers are alike. Jack was a visionary who disrupted the status quo of the money management business forever.

Paix et Prospérité is on record for not only reinvesting our out-sized cash reserves over the last few weeks but also changing the composition of our portfolios from defensive stocks, which significantly outperformed in the fourth quarter, back to economically sensitive stocks that were selling at recession level valuations. The primary reasons for having changed our investment outlook include:

  • The Fed is clearly out of our way such that we no longer fear a recession in 2019 and 2020
  • President Xi of China and President Trump are moving from being combative against each other to recognizing that both need to resolve trade conflicts for economic and political reasons
  • The risks of a hard Brexit are lower than earlier feared
  • Japan and the Eurozone are moving to conclude trade deals with the U.S.  
  • Cash levels and investor pessimism are extremely high
  • Stocks remain significantly undervalued especially with the Fed out of way

Unfortunately, there was no change in our view that we have a dysfunctional government. As we’ve said before, maybe it is time for term limits.

Let’s look at each one of these topics and how it influenced our investment outlook.

First and most importantly is the change in our Fed outlook. The Fed finally capitulated, clearly hitting the pause button. The government shutdown will only extenuate the near-term economic slowdown which was caused by the Fed hiking rates one too many times already. While economic activity will return to around 2.5% once the government reopens, we would still expect a sequential deceleration in growth for the remainder of the year into 2020 unless trade deals are reached and some certainty/confidence returns to corporate boardrooms. We were impressed that the Fed finally acknowledged that long-term inflationary pressures may be less than earlier anticipated due to global competition, disruptors and rapid technological advancements; second, the Phillips curve may no longer work; and third, that the Fed must consider what is occurring globally when setting policy. Welcome to the real world!

Second, it is equally clear that there has been a major shift in trade negotiation/policy between the U.S. and China last week. Commentary from both D.C. and Beijing show a major change from the hard lines/threats that occurred just a few weeks ago. The simple truth is that both Xi and Trump need deals now for economic and political reasons. China went so far as to offer a path to eliminate the trade imbalance over the next six years. While we don’t believe that will occur, the change in trade negotiations and desire to reach a deal are clear cut. We would expect the 90-day time frame to negotiate a deal to at least be extended for another 90 days removing trade with China as a major impediment to the markets over the foreseeable future.

Third, it was fascinating to watch Britain’s Parliament last week vote down PM Theresa May’s Brexit plan while still giving her administration a vote of confidence. Her administration will begin work anew to negotiate a new Brexit plan that works both for England and the ECB. The bottom line is that both sides need a deal, so don’t believe all the rhetoric to the contrary. A hard Brexit is a no-win proposition.

Fourth, the U.S. has opened formal trade talks with the ECB and Japan. We are optimistic that a deal will easily be reached with Japan but not so with the ECB. The ECB offering a carrot of no tariffs on cars is a non-starter as it really does not help America that much. America’s threat on added tariffs on Eurozone car imports is, however, very significant as over 550,000 cars are imported here each year. The ECB economy will stagnate without a trade deal with the U.S so we do believe that one will eventually be reached down the road. It is important to note that both the BOJ and ECB finally acknowledge that monetary policy must remain extremely accommodative as growth is slowing and inflation remains much too low.

Fifth, it is not surprising that investor bearishness rose to near record levels recently. It is demonstrated by cash levels currently exceeding $3 trillion dollars, a level not seen since 2010, with stocks down significantly as a percentage of portfolios. We suggest listening to Larry Fink’s recent comments on investors and the market as he is the head of the largest firm managing investor assets. Basically, he commented that all investors have taken risk off and have NOT yet reinvested in this market. It is not unusual that max selling occurs at the bottom while max buying is at the top.

Sixth, we continue to find the financial markets significantly undervalued today despite the recent rally. While we are loathe to put an upside target for the market, it is clear that the market is cheap as S & P earnings are likely to exceed $170/share in 2019 and $178/share in 2020 with the current 10-year treasury bond yielding under 2.8%. We do not expect 10-year rates to rise to over 3.2% over the next year unless trade deals are reached which will lead to accelerating economic growth and higher earnings forecasts. It is important to note that financial liquidity and capital ratios continue to increase reducing any chance of any systemic risks. Here again, we suggest listening to JP Morgan and Bank America’s earnings calls to hear for yourself how strong our financial system is.

A successful investor must be always open to change if the facts dictate. We shifted our portfolios back in October taking risk off, raising a significant amount of cash, as well as buying defensive stocks and then, over the last three weeks reversing both prior moves. We pride ourselves on our willingness to shift our investment view but only after completing in depth research on global economic, financial and political policies.

We are humble enough to understand that corrections can occur at any time. Nonetheless, we concluded weeks ago to put risk back on as the wind is now behind our backs rather than being in our faces as was months ago. The real risk today is not being invested in the market as it is clear that the Fed is out of the way and trade deals appear likely to occur this year that will lead to an acceleration to global growth in 2020.

Our portfolio composition includes healthcare stocks with above average volume growth due to new product flow; capital goods and industrials with significant unit growth and pricing power selling at recession valuations; technology used to increase corporate productivity selling at  low valuations to growth; industrial commodity companies with strong balance sheet, positive cash flow and above market dividend yields, domestic steel companies that will benefit from lower imports and a probable infrastructure program down the road, and finally, special situations where internal moves will close the gap between real value and current market prices. We still believe that the dollar has peaked and bond yields will stay contained until the Fed lowers rates or trade deals are reached.

Remember to review all the facts; pause, reflect and consider mindset shifts; change your asset mix and risk controls as needed; do in depth proprietary research and…

Invest Accordingly!

Bill Ehrman

Paix et Prospérité LLC


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