Thursday, January 3, 2019

Don't let the machines lie to you - Trust the fundamentals, not the hype!

From the Desk of Joe Rollins

Back when I wrote the blog on November 6, 2018, Everyone loves a great conspiracy theory, I have one…, I really did not have an answer to the market’s volatility. I suspected (and expressed so in the blog) that there were forces creating the volatility that made no sense and certainly did not represent the fundamentals of the U.S. economy. I was not given the answer until December 26, 2018, the day after Christmas, when the Wall Street Journal published information that supported the theory that I had previously proposed.

Yes, it was a very disappointing year from virtually all financial aspects. Even though the U.S. economy was strong and continues to express strength going forward, the major market indexes finished negative for the year. And yes, I recognize that this negative performance was well below my forecasted gains for 2018. I believed then, and I believe now, that the fundamentals were very strong and will continue to be strong into 2019. What I did not adequately forecast, nor had any reason to believe, is that the machines would spoil our Christmas season by creating losses that were unwarranted by the fundamentals. Hopefully, I can explain all of this to you in this blog, not in the spirit of sour grapes, but rather as an educational process to learn more about how the markets react to given conditions rather than react to basic fundamentals.

Lucy & Harper Wilcox with Santa

Robby, Danielle, Caroline & Reid Schultz

On a seasonal basis, the period of time from November through May of any given year is historically supposed to be the best time of the year to invest. That is particularly true for December, mainly due to pension funds reallocating their assets and putting money into plans to meet their year-end funding requirements. For that reason, it is particularly unusual to see such a huge draw down in the markets for the month of December.

In fact, it is now said that December 2018 was the worst December in the equity markets since 1931. To really understand how absurd that comment is, you would have to compare the economics from today with those from 1931. This year, we are enjoying 3.7% unemployment, while in 1931 and 1932 the unemployment was 15.82% and 23.53%, respectively. GDP in 2018, the difference in those numbers is not even close. It is anticipated for the entire year of 2018 that the GDP will grow roughly 3%. In 1931 and 1932, the GDP was -6.5% and -13.1%, respectively.

So, in 2018, we had truly extraordinarily high growth numbers and low unemployment, while in 1931 and 1932 we had huge unemployment numbers and negative growth. To assume they are even comparable certainly creates a conundrum in my mind.

As I scan through the financial advertising that you see on the internet, I am always baffled by the headlines that attempt to scare investors into investing in safe products by stating that stocks could go down 75% next year. As I read those advertisements, I reflect on the fact that over the last 16 years the market has only been negative two times. If you do the math, that is a win rate of close to 88%. Given the chart, where the compounded annual rate of return over the last 16 years has been 8.96% and the average at 10.33%, I always wonder why clients have such fear of the equity markets. Clearly, over this timespan, no asset class has even come close to performing as well as equities.

After an outstanding year in 2017 with the S&P 500 up 21.8%, I guess you could expect a pullback in the performance. This really happened with vengeance in the fourth quarter of 2018. There is nothing good to say about this performance since several of the indexes fell into bear market territory and a selloff occurred in all asset classes. The Standard and Poor’s Index of 500 stocks ended the year down at 4.4% for 2018. The NASDAQ Composite ended the year down 2.9%. The Dow Jones Industrial Average was down 3.5% for 2018. Since the 2018 numbers and the one-year period are identical, you end up with exactly the same numbers for the one-year period then ended. If, however, you stretch out to the three-year period, the S&P ends up with an annual return of 9.3%, the NASDAQ Composite up 11.1% annualized and the Dow Jones Industrial Average up 12.9%. Just for the purpose of comparison, the Barclay’s Aggregate Bond Index was exactly even for 2018 and has only realized a 1.9% annualized gain over the preceding three years.

As pointed out previously, the markets have only been down twice over the last 16 years. However, the fear expressed in the financial publications would lead you to believe a much higher percentage of losses. As indicated in the chart above, do not be misled by the hype, but rather evaluate the actual numbers and see that over the last 16 years you had an 88% chance for profits.

Needless to say, I was really disappointed to see the markets sell off during the final quarter of 2018. At the end of the third quarter, the market was up a sterling 10.6% and it looked like we were on track to have another great investment year. However, in the first of October, the Federal Reserve Chairman gave a speech that rattled the markets. In his speech, he indicated that he would like to bring interest rates up to a neutral level. And what really rattled the markets was when he said, “We’re a long way from neutral...” At that point, despite the very positive fundamental aspects of the U.S. economy, the markets sold off indiscriminately. As I then pointed out, I was not exactly sure why the market was going through such huge swings, but now we have an answer.

In an article published on December 26, 2018, the Wall Street Journal quoted the following: “Behind the broad, swift market slide of 2018 is an underlying new reality: Roughly 85% of all trading is on autopilot – controlled by machines, models, or passive investing formulas, creating an unprecedented trading herd that moves in unison and is blazingly fast.” So, as my post on November 6th was speculating, there was in fact a true conspiracy theory that was affecting the markets. I highly recommend that you read this article and others on the subject. It is very important to understand that this type of trading has nothing whatsoever to do with fundamentals, but rather momentum. So, when we had the original sell-off at the beginning of October 2018 with a sharp move down due to the Chairman of the Federal Reserve’s comments, the program machines kicked into action trading on the momentum. As the Wall Street Journal quoted, “When markets turn south, they’re programmed to sell. And if prices drop, many are programmed to sell even more.”

So, as I suspected during this time of high volatility, we were seeing massive program trading affecting the market rather than there being some actual fear of recession or any other type of financial concerns in the economy. As I expressed in the blogs during that timeframe, there clearly just was not any type of reasonable fear for recession in 2019 and all other major fundamentals of stock market investing continued to be strong. I guess I have to admit that this type of program trading clearly interrupted what would have been otherwise a fabulous investment year and scared our clients into believing that something more dangerous was at hand. Remember that the machines do not trade based on fundamentals; they trade based on momentum. Since momentum and direction were down in the fourth quarter, huge sell programs overwhelmed the market that had low volume and participation during the holiday season and created huge swings both up and down, but the upside was much less regular.

Another thing that really irritates me about the performance in 2018 is that I was not wrong. I correctly assessed the economy and correctly evaluated all of the components of higher stock prices and reported them to you. What I did not and cannot project is how the machines will react to current information. You cannot reason with a machine – it trades because it is programmed to do so, not because of the strong fundamentals of the economy. However, with that said, it gives me a new opening to project strong earnings for 2019. 2018 was a year when interestingly cash exceeded the performance of all other asset classes. That has actually only happened four times in modern history.

CiCi and Ava on Christmas morning

It is very rare indeed that both bonds and equities would fall in the same year, but 2018 was that year. Interestingly though, when you have that unusual circumstance of cash outperforming other market indexes, it bodes well for strong performance the following year. In fact, average performance in the 12 months that follow cash exceeding all other asset classes have averaged a total return of 15.7%. Even more interesting, there is a 75.9% frequency of those gains actually happening. It does not mean that the market will be 15.7% better in 2019 than it was in 2018, but it does mean that gains we should have realized in 2018 will rollover and be fully transparent in 2019. That is exactly what I predict going forward.

I generally do not like to bog down these postings with lots of numbers that make the readers’ eyes glaze over. However, it is important to understand the fundamentals of investing, something in which the machines have no interest. The major component of valuating whether prices are reasonable is the multiple of current earnings. At the current time, the Dow Jones Industrial Average is selling at a multiple of 13.6 based on 2019 earnings. The Standard and Poor’s index of 500 stocks is trading at 14.5 based on 2019 predicted earnings. Both of those multiples are significantly below the multiples realized over many years of investing.

If you read all of the projections of the eminent disaster that were reflected in the financial news over the last quarter, you would assume that earnings for 2019 would be falling off a cliff. In fact, earnings are actually projected to increase next year, defying those projections that are so often wrong. At the current time, earnings for 2018 are projected to finish out at 156.97 for the S&P 500. Projected earnings for 2019 are currently at 172.10. Simple arithmetic indicates that the Standard and Poor’s corporation is projecting earnings to increase 9.6% in 2019. Certainly, if anyone was forecasting a recession or any type of downturn in the economy, it would be unlikely that this growth in earnings would be realized.

A more normal multiple of earnings over the last 75 years is somewhere between 17 and 18. If you assume the halfway point between those two numbers, which is 17.5 times projected earnings of 172.10, you would be looking at a year-end projection next year of 3,011. If you take the difference between that number and the closing of the S&P 500 on December 31, 2018 at 2,507, you see that the market has the potential to go up 504 points during 2019, simple arithmetic indicates that is a return of 20%. Maybe that is high, but still higher.

Now, is it realistic that the market could go up 20% in 2019? Arithmetic is a set answer, but obviously none of us know what the machines are thinking. If it does go up 20% as projected, I think the more realistic answer would be that this is a two-year return, not a one-year return. Since the machines forced 2018 into a negative year, the rollover of that gain that we should have realized in 2018, along with the gain in 2019, might very well reflect this type of 20% gain in 2019.

Painting of Ava by Stevie Streck,
one of our talented clients

Currently, there is a lot being said currently about the worldwide downturn in the economies. Certainly, China is realizing a downturn due to the issues regarding tariffs and internal political issues. If you look at the rest of the world, much has actually improved over the last several years. It has been several years since the emerging markets have been a positive influence for performance. For 2019, I see these emerging market countries will get on firmer economic ground and their stock market performance should improve. I do not see a recession for Europe in 2019, and clearly, China is just at a slowdown and not a recession. If, as I anticipate, the tariff issue is resolved in the first half of 2019 and China uses its economic power to stimulate their own economy, you could see a major upcoming turnaround in Asia. I am very optimistic about the U.S. economy, and in my way of thinking, the world economy will be dragged by the U.S. kicking and screaming. So, I see the 2019 year being extremely profitable in the U.S. and it also looks like the international community could follow. Strictly on a valuation basis, the international markets are cheaper in the United States but as was reflected in 2018, the U.S. financial markets outperform the world markets by a significant percentage.

The most dangerous market in the world might very well be what an average investor might consider the safest. The U.S. Treasury bond market is considered by most to be the safest investment that you could make. Although it is absolutely true that you will get your money back, it is not necessarily true that you can make money on the investment. The most important bond issued by the Federal Reserve is the 10-year Treasury note. On December 31st, that rate closed at 2.686 %, which was one of the lowest rates of the year. Interestingly, as recent as October, the same bond traded at 3.248%, and therefore suffered a significant decline during this 90-day cycle. That type of decline in the benchmark 10-year Treasury is unusual and should be analyzed.

As mentioned above, the machines were heavy sellers during the fourth quarter of 2018. The typical trade would be to sell out of equities and move into Treasury bonds. You saw this occurring during the entire fourth quarter of 2018 when the equity markets moved down and the yield on the 10-year Treasury also moved down. When you have a large demand to buy the bonds, as we had in the fourth quarter, you see the rates move down accordingly.

What is unusual about this movement of the 10-year Treasury is that the Federal Reserve has actively moved up the federal funds rate throughout 2018 and has indicated a desire to move up twice in 2019. So, the short-term Treasury fund rate is moving up to the mid 2.25% level, when the 10-year Treasury is only yielding 2.686 %. Much has been said this quarter regarding the inverted bond-yield, but my assessment is that this 10-year Treasury is unreasonably low and is likely to move higher. There is no question that the move down in the price of oil has positively impacted inflation for 2019, but in my opinion the price of oil is only temporarily depressed. Therefore, if the 10-year Treasury begins to move higher as I project, many investors relying upon this level of financial security will see heavy losses. I also see that happening in the high-yield bond market, which is vastly overextended, and in other types of investments that rely on interest rates, such as utilities and real estate funds. I am thinking that in 2019 there is a high likelihood of a reversal of rates that would impact all of these asset classes negatively.

You do not have to be a Philadelphia lawyer to realize what occurred in the fourth quarter. A substantial sum of money moved out of equities and into bonds during this quarter. If I am correct and these trades were based upon the quantitative analysis of the machines, the trade is very likely to reverse in 2019 if the market moves higher. It is only common sense that if machines trade on momentum to the downside (as they did in the fourth quarter), there is a high likelihood that the machines will trade to the upside if this movement occurs. In order to exploit that move, they will clearly have to sell bonds to buy equities. While it appears to me that the equity markets are underpriced, I fear the Treasury market might be the real upcoming loser.

From my son, I received the latest book written by John McCain, The Restless Wave, which was written right before his death. I have never been a huge fan of John McCain, and I certainly do not agree with all of his politics, but parts of his book were very interesting. He described in detail the problems in the 2008 election when he ran for President of the United States and the mistakes that were made. It is pretty interesting to hear his reflection on what we on the outside perceived as being total chaos. He also went into detail regarding his sickness, which ultimately led to his death last year.

The only reason I mention this book is that there is a section on immigration that is worthy of your reading. It is a mystery to me why politicians cannot get this very important subject under control. I recognize the fact that the Democratic Party would prefer that we have open borders, not for any reason that makes sense to me other than it is assumed that such a minority would vote Democratic, and therefore it would be beneficial to their political goals. On the other hand, Republicans are just as obstinate on the subject, refusing to accept the fact that many of the illegal aliens that are living in this country have been here for at least a decade and are hardworking, taxpaying citizens. It is hard to believe that the two parties cannot reconcile these opposite opinions, so we continue to have total chaos on the border where the laws are uniformly ignored and the politics make matters worse.

For those of you who do not recall history, one of the staunchest Republicans of all time issued a blanket amnesty in 1986. Ronald Reagan realized that it would be impossible to deal with immigration issues since many of the undocumented immigrants had been living in the United States for many years. Even though he supported tough immigration laws, he realized that dealing with the people that were already residing in the United States could only be dealt with where they would register and become citizens based upon several criteria. At that time, it was believed that there were 4 million illegal immigrants living in the United States and roughly 3.2 million of those applied for immigration with various levels of success.

Today, it is believed that there are 11 to 12 million unregistered immigrants in the United States at the current time. The problem since 1986 is that the enforcement of immigration has basically been a joke. There are certain administrations that have practically ignored the laws, and then there are certain cities that allow for sanctuaries for illegal immigrants, even though they are clearly in this country unlawfully.

Regardless of how you feel about the matter, at some point, we have to deal with the issue. I thought John McCain had a very reasonable explanation that might actually work. Essentially, it allowed undocumented workers that had already been here for 10 years, that had not committed any crimes, to apply for citizenship, pay back taxes, and basically to get right. There was also a very interesting part about a temporary work permit. Basically, this work permit would allow for a three-year trial period whereas they could work in the United States and be accounted for, but would have to return after three years. I am not exactly sure why this plan did not pass in Congress, but it certainly seems to be a reasonable approach to the immigration issue in America today.

One of the most annoying aspects of immigration to me is that we really do not even attempt to deal with the issue. We all know that there are millions of undocumented workers in America that are hardworking, taxpaying citizens. Of those millions, the number that are criminals and against the American public is a small percentage. It would not be that difficult of a matter to close the borders to future immigration, but dealing with the people that live here would be a monumental feat. What is more baffling than all of that is the inability for Congress to even have a basic discussion on the topic. If you get a chance, read these few chapters on immigration and see if you agree with the policy that is laid out. I am sure the hardliners would say no amnesty under any circumstances and the liberals would offer blanket amnesty. Obviously, the answer is somewhere in between and must be addressed from a system that is fair, yet can administratively be dealt with.

Despite being a steadfast conservative, even Ronald Reagan realized that a compromise to solve the issue was required. Designing of the immigration amnesty was revolutionary in its concept and application. At least Ronald Reagan had the good sense to compromise on the matter. However, enforcement of the laws is worthless if we do not stop illegal immigration.

There will always be illegal immigration in this country, as there has been since the beginning of time. It is good, it makes us better and certainly the laws exist that would allow it. What we cannot deal with is open borders where anyone can enter the United States at will, without authorization. Maybe the bill that John McCain proposed would actually accomplish that goal.

I am very optimistic for 2019 – not based on what I expect the machines to do, but rather on the fundamentals. You cannot invest based on the wild fluctuations that the machines bring us. Over time, fundamentals always win, and currently, the fundamentals are quite excellent. While we certainly have no way of knowing what will happen when the machines start to do their thing, as was evident in 2018, we do know that eventually fundamentals will outperform all other types of valuation of future stock prices.

As always, we encourage you to come in and visit with us and discuss your goals and financial plans. If you are interested in discussing your specific financial situation, please feel free to call or email.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins