What Would Buffett Do Now?

When you experience a market like last week, you must step back and review your core beliefs and underlying fundamentals. After all, the stock market is comprised of real companies with sales, earnings, cash flow and balance sheets. And price is forecasted by discounting a stream of future earnings.

Granted, interest rates play a major role in this analysis so fears of higher interest rates and a return to normalcy absolutely play a major role here. But not overnight nor with such extreme volatility. The transition to higher rates, which we continue to forecast, will put downward pressure on market multiples over time. But don’t forget the other side of the equation: earnings. We are forecasting out-sized gains in earnings. The tug of war is one against the other.

Our conclusion is that the stock market still has significant upside over the next year or two. But here again, not all markets or all stocks are alike. It is our ability to separate the wheat from the chaff that separates Paix et Prospérité from the pack. However in a panic environment like last week, everything gets hit, total confusion ensues and there is a rush for liquidity. No one is immune to that. We step back, pause, reflect consider mindset shifts and do our work. We concluded that this as an opportunity to profitably invest with a one to two year time frame. We always maintain excess liquidity and never use leverage.

So what happened last week?

How could we move from extreme optimism to extreme pessimism over night? Fears of inflation were clearly exacerbated by the last employment report showing hourly wages accelerating to a 2.9% year over year gain along with a poor productivity report. Both data points may be flawed, however. One thing that we have learned is NEVER over react to one or two series of government statistics, especially if they are in January. They are notoriously wrong and always revised!

So what happened last week?

You should listen to Leon Cooperman’s interview on CNBC last Thursday to gain some insight from a brilliant investor. He commented that there are leveraged, synthetic instruments out there that no one really understands nor have real economic value. They are highly leveraged volatility and velocity indices, ETNs and leveraged ETF’s that few, if any, fully comprehend that blew up, putting extreme margin pressures on the financial markets. Did the value of the S&P really deserve to fall nearly 10% in five days? Not likely! And the decline was indiscriminate. Yes, the 10-year treasury yield has risen to over 2.8% after the labor report but that move alone can not and should not cause such a violent market reaction.

Record inflows into funds in January turned into record outflows last week. If you believe that the retail investor is always one step behind then you should assume that we are near a bottom and the next leg is up. But that is technical work and we are fundamentalists.

So why are we not overly concerned and maintain a positive outlook?

It really stems from our analytical work on the global economy and listening to dozens of corporate fourth quarter earnings conference calls. Corporations are doing just great! Best in years. Also, managements are maintaining a conservative bias, which will serve to extend the recovery as long as the financial authorities stay one step behind, as we believe. Let me again state that we believe that rates are moving higher, the yield curve will steepen but inflation will stay contained due to global competitive pressures, rapid technological change reducing costs, boosting productivity and disruptors are popping up everywhere.

Did you notice that Amazon would begin operating a delivery service with its own fleet of planes and trucks competing against UPS and Fed Ex? Transportation costs are apt to decline. And there is so much more to come from the disruptors. And did you happen to notice what happened to the price of oil last week?

Do you really expect long-term inflation to get out of control? Could it get to 2% or slightly more? Absolutely but that in of itself is incredible. Take this from someone who remembers double-digit inflation and interest rates. Are you really worried if treasury yields rise to 3.5% or 4% due to global growth and a return to normalcy? We can live with that and thrive. Yes, the market multiple will decline but earnings will increase even more. Worry when/if the yield curve inverts!

We were disappointed that Congress passed a budget resolution increasing defense and general spending by hundreds of billions of dollars. Clearly the U.S. budget deficit will grow to a trillion dollars over the next few years just as the Fed is reducing its balance sheet. Notwithstanding, Ed Yardeni, a brilliant economist whom I have known for decades and respect, commented that interest rates are impacted by inflation, not deficits. Ed does the work. He, too, is optimistic that inflation will stay contained and that the 10-year treasury bond yield could rise to 3.5% over the next two years as global growth accelerates. In fact, Christine LaGarde commented yesterday that the IMF continues to forecast 3.9% real growth in 2018 and 2019. She continues to call for more reforms.

Nevertheless we are bothered that Wall Street firms have created highly leveraged synthetic instruments that no one really understands that can create short- term havoc in the marketplace. Many of these instruments went bankrupt last week causing panic/confusion as margin calls went out all over the place. Trillions of stock market value was destroyed. Never be on leverage so you can weather downdrafts like this and be in position to buy/profit. Selling was indiscriminate, as no one really knew what was happening. And it happened so fast. Step back, pause, reflect and go back to your core beliefs. Invest, don’t trade!

Wall Street is not meant to be a casino where you can bet on virtually anything. For instance, you can actually bet on the number of time outs in a football game. What does that have to do with the score of the game?  We invest based on fundamentals: our view of the global economy, geopolitical issues, corporate earnings/cash flow, inflation, interest rates and the dollar to name a few of the variables that we monitor at all times. We are cognizant of volatility and velocity indices but they do not influence the longer-term intrinsic value of companies. They are technical indices, not fundamental. Do you believe that Warren Buffett invests based on fundamentals or technical data?  I can assure you that he was buying with both hands last week as the market gave him a great entry point. He invests. After all he would tell you that the earnings yield is much higher than bond yields even at 4%. The choice is clear cut… stocks over bonds.

The Sky Is Not Falling

After all:

  1. Global fundamentals are excellent.
  2. Interest rates are rising, and the yield curve is steepening as global growth accelerates. We continue to forecast a 3.25% 10 year treasury bond by year end.
  3. Inflation will stay contained but move up to 2% over the next few years. Expect productivity to improve keeping a lid on unit labor costs and disruptors are popping up everywhere.
  4. Earnings and cash flow gains will surprise on the upside bolstered by volume growth, cost containment and tax reform. S&P earnings will exceed $150 per share in 2018 and $165 per share in 2019.
  5. We forecast that the S&P could exceed 2900 by year-end with further gains in 2019.

The bottom line is to stay the course. We continue to emphasize the financials, global industrial and capital goods companies, low cost industrial commodity companies, technology at a fair price to growth and special situations. We were able to add some new names last week including pharmaceuticals that got hit hard for no reason.

So remember to review all the facts; pause, reflect and consider mindset shifts; analyze your capital allocation and risk controls; do in-depth research and…

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

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