Wakeup Call

The sharp drop in equity prices and bond yields during December has clearly been a wakeup call for all politicians, businessmen, consumers and investors around the globe. We believe that a new reality and fear has set in that will lead to positive change on many fronts including the Fed.

Fear of a global synchronous downturn along with deflationary pressures has been rising for months which we have highlighted since October. Maximum pressure seemed to have peaked this week, but we won’t see real change until the Fed reverses course and/or trade deals are reached. Whether the markets stabilize and move up soon remains to be seen, but we are hopeful and pleased that 2018 is ending along with maximum tax-selling pressure.

Let us reiterate once again that our stock market is significantly undervalued today even if you assume that operating earnings are flat in 2019 which we do not see at this point. In fact, the economic outlook both here and abroad stand to benefit big time by the precipitous drop in oil prices. The world consumes approximately 34 billion barrels of oil per year which includes 7.3 billion barrels/year consumed in the US. The $35 to $40 per barrel price drop since October translates to a global savings of $1.4 trillion dollars including approximately $290 billion here. Quite a tax cut for all while also a major depressant on inflation which gives the Fed cover to lower rates which we still envision as their next move.

Stop listening to the pundits who mention that the stock multiple today is at the low end of its historical range because current 10-year bond yields are 400 basis points lower than their historical range and liquidity ratios are up. Today’s market is cheap by any measure for the investor willing to look over the dip in the valley. We finally began to add to our portfolios mid-week expecting tax selling to abate and new money to enter the market next week as portfolios are rebalanced and 2018 401 money was invested.

We can’t believe that the Fed will continue to turn deaf ears to rapidly declining global growth and rising deflationary pressures. These are supposedly very smart guys who say that they’re data dependent. Well, inflation is running well below their 2.0% target and is still not reflective of the huge decline in energy and industrial commodity prices. What are they looking at?

The Philips curve is outdated, and there is significant downward pressure on prices including labor caused by globalization, disruptors and technology. The Fed should promote growth and declare victory, while their real fear should be snowballing synchronous downturn and deflation. Since the BOJ and ECB are virtually powerless to ease much more and their governments are powerless to act too, it is up to the Fed and China’s government to stimulate their economies to right the global economic ship away from further weakness.

China has started to act as its economy is weakening at an accelerating rate. Did you happen to notice their most recent industrial output report? It actually declined year over year! And consumer sales are weakening too. So, the government has reacted with massive tax cuts, monetary stimulus and reduction in tariffs to stimulate demand. It may stem the decline, but don’t expect to see 6+% growth anytime soon until there are trade deals. Don’t believe the rhetoric out of China that they can withstand a trade war. Not true!

Economic growth continues to slow in the US too, as evidenced by weakening industrial production, housing/auto sales, and business/consumer sentiment. It was no surprise that Christmas sales were strong increasing over 5% over last year but retail profit growth will be held back by higher labor and shipping costs. The stock market swooning big time in December will penalize both business and consumer sentiment as we enter 2019. It does not help that no additional trade deals are close to being reached and that we have a government in total disarray. What would you do under these circumstances? We fully expect businesses to maintain tight controls over hiring, expenses and spending in 2019 well remembering past periods of economic weakness. We expect any economic weakness to end quickly as the Fed is ready to react, cut rates and possibly freeze its reduction in balance sheet assets. We also expect Trump to accept trade deals more readily if he expects to have a chance running in 2020. His re-election clock is ticking.

The sharp declines in all the financial markets have clearly been a wakeup call for all. Positive change is in the air!

So, what are we doing?

We entered the week with the highest level of cash since we began anew in 2013. The sharp decline on Monday and early Wednesday was such that many of our buy points in many stocks were hit so we finally pulled the trigger adding new names and adding to existing positions. We also felt that investor sentiment was near its low point; tax-selling would end soon to be followed by portfolio rebalancing adding equities; and finally, new 401(k) money would be invested in January. We ended the week still with a lot of cash and dry powder to take advantage of any further weakness in the markets.  

The bottom line is that we feel somewhat better about the future than we did even a week ago. The global meltdown has been a clear wakeup call for action finally to those in position to enact positive and needed change in policies. Will the Fed finally capitulate, declare victory on inflation and lower rates? We think so! Will China enact even more policies to stimulate domestic growth? Yes, we think so! Will trade deals with Europe, Japan, Australia and India finally be reached in 2019? We think yes! Will the trade ceasefire be extended with China until an all-inclusive deal can be reached down the road? Yes, again! Will our government including Trump act like adults and put country over party? Doubt it!

No one rings the bell at the bottom, so we took our first baby step by raising the equity portion of our portfolio mid-week by several percent. It is hard to imagine investor sentiment getting any more pessimistic than it is now or values getting much better too. Remember that the current perception of the future is likely to differ from its ultimate reality. When we can pick up great companies selling below market multiples with excellent management; market dominant positions; strong top and bottom line growth; excellent finances with growing free cash flow; with dividend yields in excess of the 10-year treasury rate and finally with large stock buybacks, it behooves us to act as true fundamental investors with a one to two-year time frame. We are humble enough and have been there before to know that we may be early and that the current environment is still risky so we are still holding significant cash reserves to take advantage when/if others panic. Systematic trading is the bane of fundamental investors like us.

Have we hit bottom? We truthfully don’t know for sure but it is clear that the wakeup call went out to all in December. Change is in the air, and many stocks are just too cheap.

Our portfolios remain concentrated in healthcare, consumer non-durables, technology at a low multiple to growth, cable with content including Disney, domestic steel, special situations and industrial commodity companies. Corporations will continue to spend on technology as it is a huge enhancement to productivity reducing costs. We expect industrial commodity prices to bottom over the next six months as selling prices cannot stay below cash costs for long without large cutbacks in capacity which will lead to higher prices down the road. Some of these companies are generating record free cash flow even at this point in the global economic cycle so their huge dividends and large stock buybacks won’t be cut. We own no bonds and are flat the dollar although we expect it to weaken this year. Finally, we still recommend reducing real estate and private equity holdings as their prices remain inflated compared to equities.

We want to wish all of you a Happy, Healthy and Prosperous New Year.

Remember to review all the facts; pause, reflect and consider mindset shifts; always look at your asset mix with risk controls, do independent research and…

Invest Accordingly!

Bill Ehrman
Paix et ProspéritéC LLC


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