And so, a new year begins. And with it, a sense of hope and new beginnings, as well as a realization that most of the concerns that worried us in 2018 remain with us today: the government shut-down; the absence of calming, coherent and competent leadership in Washington and elsewhere; the flailing stock market and recession fears; the trade war with China; the Brexit vote; and the Mueller investigation. Happy New Year.
On television, it seems that the World is in a growing state of disarray, which has unnerved investors and displaced the pervasive complacency we warned about last year with pessimism today.
The reality is somewhat different than it appears on TV, in some ways worse and in other ways considerably better. As always, it is important to step back and take a balanced and longer-term view of things, beyond the current 24-hour news cycle, informed by facts and history and common sense.
The global economy is slowing, but it is also currently still growing at around 2% a year. In the U.S., our economy is also slowing, but it remains relatively strong, with economic growth this year projected at between 2% and 3% and unemployment under 4%. The headlines about steep market declines and predictions about recessions create a sense of economic weakness that is out of step with the current facts. There is an important difference between slowing and declining economic growth.
Meanwhile the prices of stocks and other financial assets have declined significantly in recent months to reflect lower expectations for economic growth and corporate profits, and to reflect the current climate of uncertainty. Last year, almost every market and asset class posted negative returns. In the U.S., the bellwether S&P 500 index declined almost 20% from its peak in September and ended the year down 4.4%. Outside the U.S., European and Emerging market indexes declined almost 15% for the year. Gold and other commodities were down, as were most bonds. There were few hiding places other than cash.
Whereas a few months ago we felt that markets were overvalued and expected returns looking forward were not attractive, we now feel that stock market valuations are much more reasonable and in some cases, very attractive for new investment. We are not saying that things can’t get worse in the near-term, but a lot of bad news is now reflected in current prices. If prices fall further, then risk assets will become even more attractive for long-term investment.
Things can, and will, eventually improve: problems tend to beget solutions, but the journey can be long and messy. If any of these issues are resolved favorably, especially trade talks with China, markets could move higher very quickly.
We know from experience that investments made when valuation levels are low – typically when things are messy and investors are fearful – have historically produced attractive returns over subsequent years. Conversely, investments made when valuation levels are high – typically when everything looks wonderful and investors are optimistic - historically have produced unattractive returns.
The challenge and opportunity for long-term investors, which includes most people and certainly all of our clients, is to actually take the long view. This involves looking beyond the current set of concerns, separating the noise from the substance, considering fundamentals and valuation levels, and investing portfolios with a view of what the world will look like in five to ten years, rather than tomorrow, or next week.
It is typically a fool’s errand to predict short-term market moves. The market has a way of defying widely held expectations. This seems particularly true today, with the hyper-focus of the news media on every market move, data point, presidential tweet, or utterance from or about the Federal Reserve Bank chairman. Small things can produce big swings in markets that are disproportionate to their long-term significance.
The economy is much more durable than people give it credit for being. Moreover, there is a normal ebb and flow to economic activity. Economic and market data tend to fluctuate and can be influenced by temporary factors. Every rise and fall in the data or markets does not typically portend the start of the next bull market or great depression.
Corrections are not the end of the world. They are not fun to endure but are a normal occurrence and serve a useful purpose in wiping out speculative behavior and bringing prices back in line with fundamentals. Most importantly, they provide an opportunity to buy good things on sale.
Recessions are not the end of the world either. They are a natural part of the economic cycle and we will inevitably have one in the coming years. We are 114 months into the current economic expansion, the second longest since 1900. It has been said that expansions do not end of old age but rather because of some significant economic imbalance, such as the housing bubble in 2007, the dot.com bubble in 2000, a misstep in monetary policy, or some other exogenous shock.
A significant part of the current expansion has been fueled by extraordinary monetary stimulus from Central Banks in the form of very low interest rates. Fiscal stimulus, including the Tax Jobs and Recovery Act, passed last year, also provided a boost to the economy. Now, it has largely run its course. It is natural that the economy would slow as monetary and fiscal stimulus recedes, and that assets would be repriced to reflect this slowing.
At the moment, we do not see any significant economic imbalances that would cause an imminent recession. Consumer debt levels are low, banks are well capitalized, and business fixed investment is about average. Corporate debt levels are high but manageable. Barring an exogenous or self-inflicted shock – such as a further escalation in the trade war with China or political crisis in the wake of the Mueller investigation - we would expect growth in the U.S. and other economies to slow but not turn negative.
Given this baseline outlook, we think that stocks look considerably more attractive for long-term investment than they did a few months ago. Global equity valuations are below average, especially in emerging markets where they are in the bottom quintile of their historical valuation range. U.S. stocks sell at the smallest discount to their historical valuation range, reflecting the strength of the U.S. economy relative to the rest of the world.
Within the U.S. stock market however, there are pockets of value and opportunity that look particularly interesting. Financial stocks underperformed throughout 2018, and technology and biotechnology companies moved from being overly loved to being overly hated.
We have therefore started to redeploy some of the capital that we have been harboring in cash and other defensive investments back into equities, especially into areas that offer the most compelling combination of value and growth potential such as technology, life sciences, and emerging markets. We have been doing this incrementally and have additional room to add should market levels decline further.
We continue to invest with a global focus, balancing investments targeted at areas of long-term growth and innovation with more defensive equity, alternative and fixed income strategies to mitigating volatility and risk.
Finally, we want to remind everyone that as of the beginning of the year we have moved and now have two offices in the Bay Area, one in San Francisco’s Embarcadero Center, and a new main office in Lafayette. The addresses of both locations appear below. Our phone numbers and email addresses all remain the same.
As always, we welcome your comments, questions, and referrals.
Jurika, Mills & Keifer,