Perspectives

On the surface, it is irrational for people to clamor to buy stocks at their highs, and avoid them at their lows: same stocks, same companies, different prices. The change in investor’s expectations can only understand this irrationality. When prices are rising, the expectation is that prices will continue to rise. When they fall, investors expect them to fall further. Logic would dictate that neither position can be true over time. The value of the stock market will not rise to infinity, or fall to zero. Thus what is needed in these times is the ability to think independent of the crowd. Warren Buffett said as much in his 2017 letter to the shareholders of his firm, Berkshire Hathaway. In that letter he quoted excerpts from the poem If–, by Rudyard Kipling:     If you can keep your head when all about you are losing theirs…     If you can wait and not be tired by waiting…     If you can think—and not make thoughts your aim…     If you can trust yourself when all men doubt you…     Yours is the earth and everything that’s in it. Academics like to claim that the market is efficient. It is nothing of the sort. If it were efficient, it would not fluctuate as much as it does. Are fluctuations a reason not to invest? Not if your time horizon exceeds the periods of excesses, positive and negative. Much is made in market lore about buying at the bottom and selling at the top. Such stories forget that the top and bottom are set only in retrospect. When the market makes a top or bottom, nobody rings a bell. With so much emphasis on the short-term, perhaps value can come from looking at the longer-term. Focusing on industries, the larger airlines, for example, there is little doubt that they will continue to garner their share of domestic and international travel. Oil prices have gone down and come back at least six times in the past decade. No doubt they will do so again. Affluent retirees will demand better lifestyles and healthcare. Someone will profit from providing it. Demography is destiny if you research it right. Government is a source of anxiety, but it always is for someone. However, historically from a market perspective, a divided government (when one party holds one branch and the other party the other) is shown to be the best environment for stocks. As for issues like the deficits, they will be resolved during some crisis, which is really the only way to change a system of checks and balances. Someone will have to come in and reset the scale. Is the world in bad shape? Compared to when? There are now more people living in middle-class surroundings than ever before on the planet. Not all countries are democracies, but perhaps not all should be. It takes a certain evangelical perspective to decide that the rest of the world should be just like us. Maybe they should decide what they need to be, and be just that. There is all manner of human suffering in the world. With modern technology, we can witness it in a way that was not previously available. However, awareness and action are two different issues. Unless the United States is going to become the world’s police, there is a limit as to what we can do. What we need to make sure of is that we are not aiding and abetting the policies of others that are contrary to our nature, by providing the arms or resources to carrying out suffering. Finally, the immigration issue is not going to go away. Politicians on both sides of the aisle have used it as a way to raise campaign contributions and rally their base. It is time for us to decide if we need the workers, how to enlist them, and whether and how to grant them citizenship, and under what terms. With labor shortages everywhere, the matter of not permitting immigrants unless they hold advanced degrees is preposterous on its face. How many individuals with a PhD wants to cut the grass, or clean the swimming pools? The current labor market is tight enough for all levels of employment. Make the workers register so that they are paid in a manner that collects taxes for the government. Give them the rights that accrue with being a worker in this country, and arrest employers that pay them less or provide less safe conditions for employment, or do not pay the government employment taxes. Have a set time with a workers visa (which would renew with continued employment), and provide a pathway to citizenship within a certain period. One step to providing more workers has come from the changes to the status of former prisoners in the United States. Hopefully, with greater opportunities after incarceration, and fewer automatic sentences dictated by law, this group will be able to find itself back in the mainstream of society. For the young who found themselves rounded up for victimless crimes like marijuana use, this will hopefully be a new lease on life. The Economy Economic activity is slowing, but not contracting, as expected after the sugar high of the tax cuts in 2017 that mainly went to corporations. Greater economic growth going forward will depend on domestic worker growth, net exports, and government demand. With a trillion dollar deficit projected, government growth is limited. Exports are hostage to the trade war and its resolution. Domestic workers will depend on the above penal and immigration reforms.  There is some talk of trying to stimulate the economy in 2019 by creating an “infrastructure bank” that would lend funds to states to improve roads and bridges and collect interest and principal on the loans. This arrangement may mean more toll roads, which is better than no roads at all. Inflation Inflation continues under the radar as it shows up more in services than in goods. With the tightness of the labor markets, it seems a matter of time for higher wages, as more people retire and fewer enter the workforce. Immigration and penal reform will help address this, to an extent yet seen. Interest Rates Interest rates are slated to move higher. Recently, the head of the Federal Reserve Jerome Powell said that while the rate of increases may slow in 2019, the shrinking of the availability of credit in the form of the redemption of bonds held by the Treasury is on “autopilot.” Therefore, the amount of credit taken out of the economy will be in the neighborhood of $150 billion per quarter for some time. While this will mean higher interest rates, it will also mean more income on bond investments. Often overlooked is the extent to which the low interest rates impacted the elderly, and as a result, forced them into the stock market. As interest rates return to their normal range of 4-6 percent, look to see more retirement funds diverted to bonds from the stock market. The Stock Market The stock market exists in a state of confusion. There are some owners of index funds that have no compunction dumping them, as they have no real knowledge of what they own. The last of the market sectors to decline; utilities, consumer staples, and healthcare, all have gone south in the past ten days. With almost the entire market down, a case can be made for a rally of some caliber in the near future. Longer term, competition from higher interest rates and slower earnings growth for most sectors will make it more of a market of stocks, as opposed to a stock market. Warren M. Barnett, CFA December 20, 2018

On a typical day, about one half of one percent of all shares of stock in this country changes hands. Depending on whether there are more sellers than buyers or more buyers than sellers, the result projects the value of the other 99.5 percent of stocks that did not trade that day. For the past seven weeks, we have witnessed more sellers than buyers, overall. The market’s decline, which has wiped out most of the gains of 2018, has occurred in an environment of positive economic data, low inflation, and meddling economic growth, which is about average for an economy of our size. Some people believe the stock market’s decline is a harbinger of an economic recession, although the relationship between market declines and economic direction is no better than a coin toss. Half the time, markets predict economic declines and half the time they do not. Sometimes you just have more sellers than buyers. Is there anything that stands out about this correction? A couple of things. First is the accelerating demise of hedge funds. There were, at the peak, 10,000 hedge funds in this country. People tried to capture inefficient returns until there were none left. Since economic opportunity is finite, but the amount of money chasing signs of growth is almost infinite, it would stand to reason that returns would be driven down to zero. Some hedge funds are closing their doors. Since this decline has begun, at least eight hedge funds of $1 billion or more in assets have announced they are liquidating. The culprit is the success of the concept. Hedge funds, who use increasingly esoteric strategies to try to earn excess returns, are less able to beat the market when they are the market. Hedge fund strategies range from momentum to smart beta. None of the strategies work when there is no one on the other side of the trade. As investors bailed out of hedge funds, the redemptions triggered significant selling, which caused hedge funds to underperform even more. The golden age of hedge fund investing was generally up to 2006. While many hedge fund operators presented themselves to the world as investment wunderkinds, in reality, much of the return was the result of competing with the exchanges who were still using humans to execute trades. Given the computing power obtained by the hedge funds, competing against human floor traders was like shooting fish in a barrel. It was as lop-sided as the outbreak of World War II when the German mechanized infantry went up against the Polish Calvary, which then still used horses. After the great real estate bust of 2007-2008, hedge funds as a group began to underperform their corresponding indexes. Once everyone, including the exchanges, had computers, the advantage of the speed of execution diminished. Added to that was the fact that as funds grew in size, there became fewer investment opportunities in a size that would supposedly allow for liquidity. In this case “liquidity” refers to the ability to get out of a position without moving the market. One popular strategy of hedge funds was to use momentum, which is the rate of change in the price of a stock relative to an average, to find investment “winners”. If a stock was going up more than the overall market, hedge funds crowed in, making the stock go up more, and vice versa. Hedge funds, for the most part, invest for the short-term. They generated billions in commissions, which made them popular with brokers. However, as time went on, investors grew disgruntled with returns at best no better than the market, for a far higher fee. This fall, some investors began to exercise their right to cash in their hedge fund investments. As the number of redemptions rose, the momentum stocks went into reverse, as the funds sold them to raise cash. As few were buying compared to the number selling, prices began to buckle. Caught up in all of this are the owners of index funds. Most people who buy index funds believe they are getting diversification, and that such diversification reduces risk. The problem is that, at its peak, almost a quarter of all index funds for the Standard & Poor’s 500 Index invested in five stocks: Facebook, Apple, Amazon, Netflix, and Google. As the liquidating hedge funds sold these stocks, indices took a hit. If five stocks made up 25 percent of the fund’s value, then 495 stocks account for the 75 percent balance. While such diversification has reduced risk compared to some hedge funds which have been wiped out, it has not this year generated positive returns, which some investors have come to expect. From a historical perspective, the correction is long overdue. Markets go both ways, which creates an opportunity for those who have courage and convictions when others do not. Markets also go up over time, in tandem with the economy overall. The challenge is to determine how companies are doing and invest in them. Hedge funds, with their algorithms, were trying to find opportunities that may exist only for a second. Investors have a time horizon far longer than that. When will the correction end? That is hard to say. Hedge fund selling should be abating by year-end. Whether owners of mutual funds and ETFs will sell next is anyone’s guess. The bottom will only be seen in retrospect when it happens. Thankfully, this is occurring during a time of economic prosperity, rather than a financial meltdown like 2008. When markets are this nervous, people tend to focus on the risk to the downside. When markets are at peaks, people look at the potential for further upside. Sort of the opposite should be done. The Economy Economic activity is continuing to look good. Employment gains are solid, and retail sales are doing well for the holiday season. Certain sectors like farming and energy, both of which have sustained collateral damage from the administration’s policies of a trade war and encouraging higher international oil production respectively, have seen some weakness. Hopefully neither is a permanent state of affairs. Next year, however, is expected to be a year of slower economic growth than 2018. The lack of a tax cut, lower export demand, and a lack of follow through by businesses to invest in capital goods with their tax savings, will all conspire to lower earnings growth to 8-10 percent, or about half the rate of 2018. Inflation Inflation’s latest damper has come in the form of lower oil prices. The 30 percent decline from the peak earlier this year has led to lower inflation rates, potentially even to the point of impacting the cost of living adjustments for 2020. Other commodities have also fallen, including lumber and grains. Steel and aluminum, in contrast, are still up 18 percent since the tariffs on imports were imposed. Steel, in particular, is needed for the infrastructure program that is slated to be announced early next year. Interest Rates Interest rates are still expected to rise again in 2018 but may get a reprieve in 2019. The Federal Reserve has noted that the rest of the world has not done as well as the U.S. in maintaining economic growth. This may be laying the groundwork for a hiatus from further increases until the rest of the world catches up to the U.S. regarding economic growth. The Stock Market While not in a panic, investors feel like 2018 was taken away from them. How this sentiment plays out with additional selling from here is anyone’s guess. At some point, the market will find a bottom and will advance from there. As stated before, a not-yet-named sector will lead the way. It could be airlines, infrastructure, or any number of other groups. Warren M. Barnett, CFA November 27, 2018 Tags: Perspectives

Regarding the overall market averages, October undid most of the progress for stocks for the calendar year. Regarding the stocks that have led the advance over the past five years, the declines were more significant. For Facebook, Apple, Amazon, Netflix, and Google (collectively referred to as the FAANG stocks for their initials), losses have been as much as 25 percent. Of this group, only Apple has anything that approaches an average market valuation of around 16x earnings. The rest are valued far higher than the market overall. Growth stock investing tends to focus on rising revenues on the expectation that earnings will eventually manifest themselves. A true growth stock is usually in a nascent industry. Analyzing their potential demand and profit tends to be more art than science since there is no context to correlate their demand relative to the larger economy. For this reason, any earnings forecast, no matter how far-fetched can be acceptable. This is how growth stocks take off. In this cycle, growth stocks are aided by the reluctance of policymakers to raise interest rates back to a level that cash can earn a legitimate return. Because the return on “safe” investments like savings accounts and certificate of deposits has been minuscule, even risk-averse people have been forced to look for returns in the form of appreciation. Since most growth stocks by definition have revenue growth higher than the overall economy, they become the vehicle of choice when the other component of return (cash flow) falters. Now the environment is changing. Interest rates are going up, which provides competition from more passive investments. Credit is tighter, as the Federal Reserve sells off its investment portfolio and takes funds out of circulation in the process. Inflation, which in an advanced economy is more in services, is advancing faster than the official rate, which tends to focus on goods. There is some concern about the economy, but more concern for the stability of the future. In an election year, politicians advance the concept of a hostile world that only they can defend us against, and only if re-elected. If the events of October and prior portend to a correction in market leadership, then at some point new investment concepts should unfold. While it is a bit early to say just what they will be, the implication is that they will not be leaders of the last advance. Research has shown that the leaders of one market cycle have less than a one in twenty chance of leading the next market upswing. This is why often successful growth stock investing consists of jumping off the train before it leaves the tracks, then finding the new concept to jump onto. One group of investors in growth stocks, who are probably oblivious of their participation, is the investors in index funds. At one point, the FAANG stocks described above counted for over a quarter of the value of the Standard and Poor’s 500 Index. As these stocks fade and others take their place, expect erratic behavior out of the indexes and the corresponding funds. Into the vacuum left by the stories of growth are value stocks. In contrast to growth securities, value stocks do have earnings and dividends. They may, by their legacy, be unable to paint the picture of Jack and the beanstalk growth that their newer brethren do, but they do not hit a wall and leave no skid marks either. As volatility becomes a more pervasive thing, knowing that a company makes real money, pays real dividends, and has real assets give investors the anchor they need to withstand the crosswinds. The philosophical difference between growth and value investing is that value tries to know the bottom, with the upside unknown or undefined. Growth tends to look for the upside, with the downside undefined. In a choppy market, the two styles can give the appearance of being similar. When liquidity dries up, neither growth nor value strategies tend to work. Over time, the knowledge that value has a base becomes reassuring, until the next Pied Piper growth story. Then we are off to the races with the growth concept. Based on what has transpired, it would appear that things will recover towards year end. After that, what happens is a function of fear and hope. This is true of all financial markets. The Economy Economic news is good, which is a wonder why Republicans do not mention it. Productivity is up; wages are finally rising, the unemployment rate is at a 49-year low. Only the recent stock market reversal is a skunk at the garden party, especially for a president who campaigned on the idea that the recent record stock market rally was his validation. While there are many worries, from tariffs to relations with trading partners, it seems the default path is for a somewhat stronger economy going into 2019. However, without the sugar high of the tax cuts enacted in 2018, expect slower growth in profits and the economy going forward. Interest Rates Like almost every politician before him, Trump has criticized the Federal Reserve for raising interest rates. Politicians do not like high interest rates, as they can impair an economy in a way the politician gets blamed. The posturing aside, interest rates will keep going up. By historical standards, interest rates are still low, which enriches the speculator and investor at the expense of the saver. There needs to be a better balance here. Inflation Inflation is a matter of whom you ask. Purchasers of services contend inflation is strong, while purchasers of goods marvel at stable prices. That separation in the inflation rate between goods and services will disappear once the tariffs take hold, which unfortunately for most families will be right before the Christmas shopping season. The tariffs, enacted to bring more manufacturing to the U.S., will at least in the short-run lead to higher prices for imports from China and other targeted importers. A classic case of being careful what you wish for. The Stock Market Stocks have slid in October, taking most of the gains for the year with them. Once the elections are over, we hopefully can reunite the country behind one set of values, which is a different hope from being united behind one political party. November and December are the months that investors begin looking at 2019 earnings estimates. To the extent that markets thrive on hope, this tends to be the elixir for markets going forward. Warren M. Barnett, CFA November 1, 2018