It’s Always Darkest Before the Dawn
A perfect storm hit the financial markets last week: the fed raised rates once again signaling two more hikes next year while maintaining $50 billion/month reduction in its balance sheet, ECB ended bond purchases, the trade war with China over stolen IP escalated, there was a partial shutdown in our government, Trump’s administration is in disarray, and finally investors liquidated stocks at record levels during a seasonal period of low market liquidity.
It’s always darkest before the dawn.
We are ending the year with just the opposite view than we began it a year ago. There was total optimism on every front which is now ending in total pessimism. We went from a synchronous upturn to a synchronous downturn; from fears of accelerating inflation to fears of deflation; from accelerating profit gains to little or no profit growth forecasted in 2019; from concern about trade wars to actual tariffs and escalating trade tensions; from rising business, consumer and investor sentiment to declining sentiments; from a Republican-controlled Congress to a split one; from stable leadership (?) to total disarray. It’s not surprising that the financial markets hit their highs early in the year only to end on a low note.
We, too, began the year with an optimistic view but, fortunately, made a 180 at the beginning of October. We sold the vast majority of economically sensitive stocks including all the financials; bought defensive, high-yielding stocks and raised more cash than we have had in our 5-year existence. Our performance has suffered as systematic trading takes no prisoners but far, far less than the market averages. And we have a lot of dry powder to buy when we deem the time right.
We have said that systematic trading, which accounts for over 50% of the daily stock market volume, takes no prisoners. As Kara Stein, a retiring SEC commission said, “systematic trading is like a driverless car.” She also rightfully asks “how do you regulate computers?” It is not surprising that some of the great investors of our time, like my former partner Stanley Druckenmiller and esteemed colleague Leon Cooperman have decided to only manage their own money, a la Buffett, for long-term capital gains rather than being under the scrutiny and pressure for daily performance.
The big event of the week was the Fed decision last Wednesday. The Fed raised rates 0.25%; lowered its economic forecast for 2019 slightly to 2.3% real growth reaffirming that the economy was strong; showed two more rate hikes next year in its dot plot; and maintained running off its balance sheet by $50 billion/month. Powell did not do a good job at the press conference following the decision which led to Fed member Williams giving an interview the next day softening the message showing more flexibility if the economy weakens. The simple truth is that the Fed had gone too far already as the global economy, including the US, is weakening while inflationary pressures have already peaked for the cycle as evidenced by falling industrial commodity prices including oil. What is the Fed looking at after all? Employment and inflation are their two major areas of focus. Employment is up while inflation is down.
We believe that the next decision by the Fed will be cutting its Fed funds rate due to domestic weakness which along with further weakness abroad which will lead to rising fears of global deflation. We have been commenting week after week that the Fed just did not get that global competition, disruptors and technology has lowered the long-term outlook for inflation. We have created millions of jobs over the last 4 years with an unemployment rate near record lows under 4%, but wages still are not growing much more than 3% per annum before productivity gains. Should the failure of the Philips curve send a message to the Fed? What is this illustrious body worrying about? Rather than looking in their rear-view mirror, it’s time to look through the windshield and take notice of the financial markets. Stocks are hitting new lows and bond yields have fallen like a rock. Can you just imagine the impact on business and consumer sentiment? Corporations will hold back on hiring and spending for sure as they have long memories of past downturn. We expect corporations to enter very cautiously which will limit the magnitude of economic weakness as there will be no excesses or chance of systemic risk. We now see real growth for the year close to 2.0% and operating earnings up 5-7% which is no disaster by any stretch of the imagination.
Should we prefer economic weakness so that the Fed lowers rates and possibly pauses on reducing their balance sheet or do we root for continued economic growth such that the Fed hikes rates which causes eventual slowing down the road? Is it possible that the Fed wakes up and recognizes that growth may not cause inflation to move much above the 2% threshold? That is a real possibility especially if inflation statistics trend lower below 2%.
We believe that the economy will slow down sequentially as we move through 2019 and that the Fed will lower rates at least once and pause on reducing its balance sheet. Markets normally rally big time after the Fed cuts rates which could occur by mid-2019.
We continue to believe that trade deals will be reached with Europe, Japan, Australia and India over the next 6 to 9 months. The economic, financial and political consequences of not reaching deals are unfathomable. It is hard now to imagine that Trump will impose added tariffs on China. We expect him to most likely extend the talks well beyond the initial 90 days. We were pleasantly surprised to see that Europe and Japan joined our complaint against China stealing IP. If we can close deals with our allies then we will have a unified front negotiating with China which significantly increases the odds of a real trade deal that includes protecting everyone’s IP.
Trade deals are key to our economic outlook along with Fed policy. We know that Fed and ECB policy will be headwinds to growth for the foreseeable future; but if trade deals are reached during the year, it will increase business confidence and unleash a global round of hiring and capital spending. If so, the outlook for 2019 and 2020 would improve rapidly, and inflation will not be a problem as tariffs/barriers are reduced lowering prices/costs. The Fed can ease up then too. If stocks forecast events 6 plus months in the future, we would expect global stocks to rebound big time in the second half of 2019 as long as the Fed pauses and possibly even lowers rates as inflationary pressures are weak.
The total failure of our politicians, especially our President, to act like adults and put country over self-interests has clearly negatively impacted consumer, business and investor sentiment. Listening to our President, Pelosi and Schumer fight on the air about the Continuing Resolution and the Wall was like watching children fighting in the school yard. It is clear that nothing will pass Washington when so much is needed to make our country and the world a better place for all. Don’t expect an infrastructure program or further action on healthcare despite the fact that both sides agree to move on both. The one good thing is that elections come up in less than two years and hopefully we throw out the bums and get adults running our nation once again.
What do we do now?
The stock market is undeniably undervalued today with great companies selling at unheard of valuations. However, we see nothing near term that will change such that the market will have anything more than trading rallies. But if you look out over the valley, as an investor would, a lot of money will be made even from these levels. Stocks are discounting a deep recession and a sharp drop in earnings which we DO NOT see. But, short-term valuations are impacted more by sentiment than fundamentals. And it is hard to imagine how sentiment can get much worse than now. Some Christmas rally! This is the worst December in the stock market in over 50 years.
While markets climb walls of worry, there is so much to deal with now that we prefer to be patient, watch events unfold and make prudent changes to our portfolios as events and valuations dictate. We are investing our excess cash in CDs of the strongest banks and two-year US Treasuries yielding over 2.6%.
Our portfolio is concentrated in healthcare, consumer non-durables, cable with content, technology at a low price to growth, and special situations where internal changes will create substantial added value over the next year or two. Our overriding theme is to own great companies with excellent management with proven records of success over long periods of time; with strong top and bottom line growth; with pricing power; with strong cash flow; with above 3% dividend yields which will go up annually; and with large buyback programs out of free cash generation. Our cash levels have continued to rise as we have pruned our portfolios reducing risk while giving us the flexibility to add slowly as prices reach our buy points. We are neutral the dollar and own no bonds. We continue to suggest reducing private equity and real estate holdings that remain inflated by today’s market valuations.
We are confident that investing today at these price levels is a winning strategy over the longer term as it was even if you bought the day before Lehman folded. But patience and liquidity are a necessity. Do not use leverage at all! And maintain above average cash levels so you can take advantage when others panic. Our shopping list is ready to go and we fully expect to be adding to our portfolio in the New Year.
We hope you have a healthy and happy holiday season. Regardless of what is happening with the market, It is a time to be grateful for so much and to commit to working together to make this world a better place to live. The purpose of Paix et Prospérité has always been the creation of wealth to be used to benefit mankind.
We want to thank all of you for taking the time to read our weekly blog and giving your feedback.. If we can assist you through your investment strategy, reach out to me directly. I answer every email. We sincerely remain optimistic that our best days are ahead of us.
Remember to review the facts; pause, reflect and consider mindset shifts; look carefully at your asset mix with risk controls; do in-depth research and …
Paix et Prospérité LLC