By The Advocates
Please enjoy our latest Quarterly Letter. We hope you find it informative (and interesting), and that it provides you with insight into the way we view markets and construct portfolios. Feel free to pass it on to others who also might find it valuable.
Thank you for your continued confidence and trust!
Q2 2018 Quarterly Letter
Our Investment Mission is to help families live their values by earning a consistent, long-term rate of return in excess of inflation as required in their wealth plan.
I could begin this piece with defining what a “correction” is in a few different ways, either through an economic lens or by measuring the distance that the price of an index needs to fall from peak to trough. However, those have already been blasted to you by every financial news site over the last few weeks. Plus, they’ve only refreshed you with the definitions after the correction has already occurred, which gives you no benefit other than to distract you from your work, and increase your heart rate.
My goal is a bit different in that I aim to slow your heart rate, and tell you to get back to work. Most people already know what a correction feels like, but what does one actually look like? And can a visual perspective help calm our fears of a potential worst case scenario event seemingly right around the corner. In all likelihood, that event is in the next 3-12 months and market participants are merely being prudent, and collectively pumping their breaks ahead of this unknown future event, if it were even to occur at all. That’s the beauty of a free market. No single piece of news is going to sway everyone at once, or even in the same direction, but will be weighed by all participants (the “market”) over the course of a full business cycle. But I digress….
What a Correction Feels Like
We all know what a correction feels like, right? We’re sitting in front of our computer screens biting our nails, watching as our account balances seemingly drop like anchors into an ocean of negative red numbers. It’s miserable. But have you ever stopped and thought about how price really feels as it’s going down. Yes, there’s usually an initial impulsive thrust downward in which our animal instincts tell us to run away as fast as possible, but after that period ends, there comes an endless choppiness of up-days and down-days, as if the market is trying to find its’ balance atop a tight rope. Maybe there’s another leg down, or maybe it moves sideways or drips lower for several months or years causing you to think the market is a terrible place to keep your money. More often than not, it’s just taking a much needed rest after years of new highs. Simply finding its’ footing within the scale of a larger trend higher, somewhere, eventually. The point is, the pain felt on the way down is clear, focused, and almost tangible, but as soon price starts chopping, the pain is relieved, and either replaced with feelings of doubt, or less commonly, “let’s buy more!”
To belabor the point just slightly longer, and quote a well-known hedge-fund manager known for his large contrarian bets, George Soros once stated, “Volatility is greatest at turning points, diminishing as a new trend becomes established.” The key take-away here is to already have a rebalancing strategy in place ahead of volatility and new trends, as today’s trends (US Large-Cap Growth stocks!!!) will most certainly not be tomorrow’s, and funds need to be allocated properly prior to such a move.
Certain material in this work is proprietary to and copyrighted by Litman Gregory Analytics and is used by The Advocates with permission. Reproduction or distribution of this material is prohibited and all rights are reserved.
What a Correction Looks Like
To illustrate the feeling of a correction in a visual format, and provide additional perspective as to where we’ve been, specifically the US stock market, and where we may go, or at least what to be cautious about, it’s time to look at some charts!
Our first chart, Exhibit 1, is critical to our understanding of which market moves to enjoy and which moves to be patient with. As briefly as possible, Elliot Wave Theory (EWT), developed by Ralph Nelson Elliot in the late 1920’s, believed that stock markets, thought to behave in a somewhat chaotic manner, in fact trade in repetitive cycles. Furthermore, Elliot proposed that market cycles resulted from investors’ reactions to outside influences, or predominant psychology of the masses, and found that the upward and downward swings of the mass psychology always showed up in the same repetitive patterns, which were then divided further into “waves.” One full market cycle would include 5 Waves up, and 3 Waves down, before beginning a whole new Wave cycle.
Whether you want to believe in the principles of EWT theory or not, we can still use it to help temper our expectations in our own investments. Think back to a specific stock you held in your account for the long-term and remember its’ ebb and flow. Wouldn’t you always have a nice and impulsive-feeling move higher in price, only to be followed by about a 1/3rd retracement of that move? Wasn’t it usually accompanied by feelings of incredible self-doubt, only to see price move higher right before you threw in the towel? Did you ever think of why it always feels like that? The media would like to attribute price movement of stocks to specific news (mainly so you’ll continue to watch their network), however, in our opinion, most all of the information we receive each day is simply noise.
Are we in a Correction now?
I don’t know, but if I were pinned down and demanded to answer, I would say yes. The nature of the most recent move in the S&P500 look like a correction. More importantly, it’s about time! As you can see in Exhibit 2 below, not only has the S&P500 gone up every single month of 2017, but it blew right through the roof, and up and over the channel that’s been in tact since 2009! Exhibit 3 offers a zoomed in look at the S&P500 over the last few months. See if you notice a resemblance to Exhibit 1’s visual of Elliot Wave Theory.
Conclusion / Obligatory Disclaimer Regarding Multiple Outcomes
So where do we go from here? These last few months could be all the S&P500 needs to propel itself into new record terriorty in the coming year, or it’s finally time to face the music and healthily move lower towards the bottom of the channel again (nearer our current FV estimate of 1785, I might add). Either way, my aim was to provide you with a new perspective beyond that of the media’s, and a consciousness of healthy corrections being a necssary piece of every future bull market cycle.
I’d be remiss if I didn’t mention that we have been consistently trimming profits and reducing our exposure to US stocks as we hit trigger points during this wild ride higher, and shifting those funds into assets that are preparing for their next bull market.
Respectfully – Adam Frinsco, CPP®, CMT
Market and Portfolio Recap
Needless to say, it was a bumpy start to the year for financial markets—something we’d suggest getting used to in the months and years ahead. After years of record-low volatility, the 10% market correction this quarter was a reality check for investors: Stocks can go down as well as up!
Equity investors should understand that stock market declines of 10% or more are normal. They’ve happened in over half of all calendar years since 1950. In exchange for their higher long-term expected returns, you must be willing and able to ride through these inevitable periods of decline.
Asset Class Changes:
On March 9th, we initiated a portfolio rebalance to take advantage of the timely volatility. We continue to shift funds from overvalued assets (Large Cap US Stocks), into undervalued assets (Europe and Emerging Markets).
In what was a difficult quarter for most asset classes, our portfolios notably included a handful of positive-returning investments. Our investments in emerging-market stocks and emerging-market bonds benefited portfolio returns the most.
Our active fixed-income positioning also helped to support portfolios during a period when core bonds failed to play their typical “safe-haven” role. Floating-rate loan funds were in positive territory for the quarter, up around 1%, and our multi-asset managers also provided some downside ballast versus stocks and core bonds.
Among the portfolio detractors for the quarter were our trend-following managed futures funds, which started the year with very strong returns but gave them back and then some during the February market correction. Our Specialty Sector holdings (Gold Miners and Oil & Gas Drillers) were also a drag on performance as they spent most of the quarter consolidating due to gains in previous quarters.
Market and Portfolio Outlook
We have two primary observations about the quarter’s rocky ride. First, the declines witnessed serve as a good reminder that markets do not exclusively go up. Until the recent drop, the S&P 500 had rallied for more than 400 days without registering even a 3% decline from its high. That was the longest streak in 90 years of market history. So, from that perspective, the return of market volatility is a return to “normal” market form. We believe investors should be prepared for continued volatility rather than expect things will revert back to the unnaturally smooth markets we experienced in 2017.
Our second observation is that despite the dramatic news headlines and market volatility that might suggest otherwise, the global macroeconomic and corporate earnings growth outlook has not materially changed or deteriorated from what it was at the start of the year. In fact, the economic news that triggered the recent selloff was not a report of economic weakness but one that suggested the economy might be getting a bit too strong, with a tight labor market finally translating into higher wage growth and broader inflationary pressures. Fundamentally, even after the correction, the U.S. and global economies still look solid. Global growth may no longer be accelerating, but it remains at above-trend levels and the likelihood of a recession over the next year or so still appears low (absent a macro/geopolitical shock).
The U.S. economy is getting later, if not late, in its cycle. We are experiencing the unwinding of an unprecedented period of global monetary policy influence, and geopolitical tensions fill the headlines—the latest being the potential for a trade war between the United States and China.
It is not in our nature to speculate on whether any of these factors will trigger more market volatility, and what their impact will be if and when markets react. However, it is in our nature to ensure we’ve properly assessed and managed risk in our client portfolios across a wide range of shorter-term outcomes, while positioning them to capture longer-term returns. With very little portfolio protection offered by core bonds in this flat to rising interest rate environment (i.e., returns more in line with this quarter’s losses), we continue to look to our positions in alternative strategies to behave more favorably during sustained equity market declines and generate returns independent of stock and bond markets.
We also remain defensively positioned in our equity risk allocation and tilted in favor of more attractive foreign and emerging-market valuations. While not table-pounding in an absolute-return sense, the outcomes we see for European and emerging-market stocks continue to be more relatively attractive than U.S. stocks.
Our analysis suggests the positive economic outlook has already been discounted to a meaningful degree in current U.S. stock market prices. So while the economy is strong, the stock market has been reflecting this for a while. The valuation of the S&P 500 is well above our estimate of its fair-value range on a normalized (longer-term) basis. As the valuation multiple comes down, it will be a significant drag on the total return of the market index over our five-year investment horizon, regardless of the earnings outlook.
The Best Defense
As we reflect on the volatility levels we have witnessed so far this year, it’s worth reiterating why we emphasize a five-year or longer time horizon as the basis for our expected-returns analysis. It is over those longer-term periods that valuation (i.e., what you pay for an investment relative to its future cash flows) is the most important predictor of returns. Over the shorter term, markets are driven by innumerable and often random factors (i.e., noise) that are impossible to consistently predict (although that doesn’t stop lots of people from trying).
There are a lot of paths financial markets and the economy can take to reach our base case scenario destination. And there is a wide range of reasonably likely outcomes around that base case. Simply put: markets and economies are unpredictable. But when it comes to the investment world, we are often our own worst enemy. We fall prey to performance-chasing, our natural inclination to “do something,” and other behaviors that may have helped our ancestors, but hurt us as investors. The best defense is a sound, fundamentally grounded investment process like ours that you can have the confidence in to be able to stick with for the long term.
As always, we appreciate your confidence and welcome questions.
Thank you for your continued confidence and trust.—The Advocates (04/16/18)