Monday, January 6, 2020

Celebrating Our 40th Year Serving Clients And Thankful For One Of The Best Stock Markets Of All Time

From the Desk of Joe Rollins

In this posting I will reflect back on my first 40 years serving clients, and what I anticipate should be another upcoming good investment year. In 2019, we had one of the better stock markets of all time. The S&P 500 Index was up 31.5% and over the last ten years has averaged 13.6%; quite an outstanding performance. Over the last decade the S&P 500 Index is up 189.7%, and the Dow Jones Industrial Average is up 175.1%. If you look at the tech-heavy NASDAQ Composite, it was up almost twice those amounts at 366.9%. The gain in the Dow of 175% is the fourth-best decade in the last 100 years. By any definition, this last decade has been an unbelievably good run for investors. When I hear people talk about flipping houses and buying real estate in IRA’s and other exotic investment schemes, I almost laugh at how ludicrous that really is. Absolutely no asset class has outperformed stocks over the last decade. 

Partner Eddie Wilcox and his family in Tampa, FL

In this posting I would like to reflect back on our first 40 years and the great financial markets we had in 2019. As I always do in the first posting of a new year, I will give you my projection for the current year. Last year, I projected an S&P at 3,000, but the market was so strong in the fall I increased that threshold to 3,100. The market actually closed at 3,230.8, which was a few percentage points greater than my projection. If you compare those projections with so many other financial experts on the stock market, you will see that almost no one except me projected a stock market as strong as it ended up being.

I will cover all of those more interesting subjects later in this posting, but as I always do, let me give you the excellent results from 2019. The Standard & Poor’s Index of 500 stocks was up 31.5% for the year 2019. For the five year period it averaged 11.7% and was up 9.1% in the final quarter of the year. The Dow Jones Industrial Average ended the year up 25.3% and has averaged 12.6% over the last five years. In the final quarter of the year, it went up 6.7%. The NASDAQ Composite was the winner of all the indexes; up 36.7% for the year 2019 and averaged 14.9% for the five year period then ended. For the final quarter of 2019, it was up a sterling 12.4%. Outstanding performance for all three indexes.

As a comparison, the Barclay’s Aggregate Bond Index was up an excellent return in 2019 for a bond index at 8.5%. However, if you compare the numbers above, this index averaged only 3% per year over the last five years. In fact, in the last three months of 2019, that index barely broke even at 0.1%. I often comment on the lack of performance of bonds, and this was an excellent example of how stocks vastly outperformed bonds, even in the fabulous year of 2019. I anticipate bonds for 2020 to either be marginally profitable or negative for reasons I will explain later in this posting.

Eddie, Jennifer, Harper and Lucy Wilcox 
exploring Boone, NC

There are a lot of interesting subjects that we need to discuss in this posting, but I want to focus on the bad news that you received all year from the so-called expert forecasters. The economists told us that tariffs would create inflation and recession. Boy, were they wrong on that subject. The so-called experts that told us the inverted bond yield would almost surely create recession. Have you noticed that the inversion has moved in the opposite direction and, in fact, has steepened significantly in recent months? The so-called inverted bond yield was supposed to bring recession and send shock waves to the financial markets. As I commented here, this is only a temporary adjustment in interest rates and hardly means anything for the economy by itself. You have to consider all of the components of recession before you can draw a conclusion by only one indicator. The financial commentators on Wall Street did not bother to look at the other indicators.

As I reflect on the first 40 years of this Firm, it has been an interesting ride. I began in 1980 in the front room of my small house in Fairburn, Georgia. I only had one client at that time, and obviously, there was not a lot I could do for that one client in a given day. I often would call the telephone operator to make sure the phone was working since it clearly was not ringing with clients. I began teaching at Georgia State in the Master’s program of Taxation to occupy my time. I would always try to keep myself busy during the day, but inevitably at 4:00 pm I would end up watching MASH on TV. I think I have seen every episode of MASH multiple times, and every time, it tended to amuse me.

During those days, there was no financial news. It was very rare indeed that you even got a stock market update, much less any significant business news. I received The Wall Street Journal by mail, which often got to me two days after the fact. I would read The Wall Street Journal from cover to cover since I really had nothing else to do and I enjoyed learning about finance and business. Those were reflective years, but I did not even contemplate my future, given that I was a CPA and doing tax work. I never really thought about being in the investment world, but yet after 40 years I am still here.

The Schultz family enjoying Christmas break

The turn in my thinking came in 1987 with the horrendous stock market crash in October of that year. As you may recall, on Black Monday the market fell 22% in one day, dropping it all the way down to 1,720. Many asserted at that point that would be the last of the investing world since investors would flee the market and never return. Ironically, as we sit here today, the market is at 28,538, so those people that forecasted the gloom and doom in 1987 were clearly incorrect.

At that time, I would send my potential investment clients to various stockbrokers around town. What I found was that the industry was full of conflicts of interest, and they were doing a major disservice to my clients. Not only were they not interested in making my clients money, often times because of the high commissions and conflicts of interest with their investment groups, the clients lost money and quickly learned to despise the individuals behind the recommendations. Stockbrokers rarely made money in those days except for themselves and rarely clients.

At that time, I made the decision that it was time that I would invest clients’ money since I could hardly do no worse than what the brokers were doing, I had no conflicts of interest and only had the best interest of my clients’ futures. As I began to organize in late 1989 to open for business in 1990, I sent out a notice to my clients that if anyone would be interested in investing money that I had set up a company and would help them. To my amazement, checks started flowing in for clients’ investments. I had no staff at that time, no computer background or computer program to account for the money; just a desire to be helpful. That is where it all began in 1990, and who would have thought I would be here 40 years later?

Over the holidays, I had an opportunity to actually spend some time doing one of my favorite pastimes of reading books about business and the stock market. While I have read literally hundreds of books on investing and stock market performance, I was interested in going back and reading some of the books that told the stories of the disasters and what people did wrong. One of the books I read was When Genius Failed: The Rise and Fall of Long-Term Capital Management. This was a most interesting book on the rise and fall of Long-Term Capital Management. This was a group of PhD’s and scholars who thought they knew how interest rates would move and invested their clients’ money accordingly. In 1998, when Russia defaulted on their debts and the emerging markets imploded, their entire fund went to zero. The partners who had net worth in excess of $5 billion lost every dollar of it in five weeks.

Caroline and Reid playing with their balloons

Another book I read that was very interesting, was The Smartest Guys in The Room. This is a story of Enron and the accounting disaster that took a wonderful company basically to zero over a relatively short period of time. At the end of the day, the Enron story was one of fraud rather than business, but it was very interesting to see and hear the story play out of very rich people doing very wrong things to the detriment of investors. Very smart people did some very dumb things.

Another book that was quite interesting was Too Big To Fail, which was the story of the 2008 debacle that occurred on Wall Street and the housing crisis. It included every major Wall Street firm and almost imploded the financial markets and the American economy. What was truly interesting about this book was how the bankers had manipulated the markets to the detriment of investors and, along the way, destroyed housing throughout America. When bankers abuse clients, bad things happen. It was really bad in 2008

All three of these books were interesting, but were driven by one human frailty. All of the people involved in these incidents were seeking out personal enrichment to the detriment of investors. Greed is the underlying concept that ran through each of these interesting books. In many cases, it was outright fraud, but the larger picture was that they were trying to manipulate the markets in such a fashion to the detriment of investors to gain a little more wealth for themselves. Each of the principals involved were outrageously wealthy anyway, but their desire to gain more wealth destroyed the companies for which they worked.

I look back on those books and think about the interesting coincidence that happened. For the Long-Term Capital Management, they imploded in 1998 due to the wild fluctuation in the bond market. At that time, the market sold off and the world appeared to be heading in unison to recession and disaster. However, in the following year in 1999, the markets roared back with a phenomenon that forced the markets to unprecedented levels that they had never reached before. Long-Term Management was just a small blip in the world of investing that only took 12 months to recover. If you reflect back on the 2008 financial disaster on Wall Street, you have to reflect on the recovery that we have all enjoyed. On March 9, 2009, the S&P 500 Index closed at 666. Today, that same index is 3,230, up almost 400%.

Ava, Dakota, and 35-year clients 
Gerry and Allen Davidson in Florida

What I have learned from reading these books and watching financial markets is that you do not have to be a genius to understand equity pricing. What you really need to understand are the three basics that make stocks go higher. The most important component of any stock market valuation is interest rates. Today, we enjoy unprecedented low interest rates. In 1998, when Long-Term Capital imploded, they were shocked to find that the 30-year treasury had dropped to the unprecedented low level of 5.5%, the lowest it had ever been since the government started issuing 30-year bonds. Today, that 30-year treasury rate is 2.3% (60% lower). By any definition or any standard in valuating interest rates, we are enjoying the lowest rates ever in the history of American finance. That is great for stocks – bad for bonds.

The second component to stock valuation is the economy. The one absolutely undeniable factor that will make stocks go down is recession. If the economy is continuing to grow and people are employed, corporate America will do better and stock prices will rise. Today, we have an economy that is in a “goldilocks” environment. Not too hot, not too cold. The economy is growing nicely at above 2%, not overheating, and seems to be well under control by the Federal Reserve that is clearly watching and making the right moves for the economy. In addition, today we have more Americans working than ever in the history of American finance. The more people work, the more businesses are supported to better the economy. The secret of a good economy is keeping people working, and the fact that employers cannot find qualified employees is the best indicator you could ever have of a very strong economy.

The third component is corporate profits. Corporate profits continue to grow, and with the favorable income tax rate cuts of 2017, corporate earnings are now at record levels. Even today, they are forecasted to be higher in the year 2020 than they are in 2019. If you look at the estimated earnings for the coming years, you will see a gradual, but positive increase over the next three years.

Ava sitting with a giant light up reindeer
 at Tropicana Field 

I reflect back on the ‘90’s when the stock market was hot and cold and up and down, and interest rates were all over the board. I have often criticized then Federal Reserve Chairman Alan Greenspan and his control of the economy during that era. If you look back at the wild moves he made in interest rates that affected the markets, you also have to evaluate his desire that stock market derivatives be unregulated. Due to his desire to have more derivatives in the economy, we saw wild swings in the market that led to undisclosed liabilities by Wall Street banks of literally trillions of dollars. While the Federal Reserve could have stepped in and regulated the derivatives, since Alan Greenspan was an advocate of no regulation, he prevented any regulation from going forward. That proved to be a serious error of judgement in 2008.

Now, we have the economy in good shape, interest rates at low levels and corporate earnings going higher. Those that fear recession are not being realistic in their valuation. While there are many on Wall Street that say recession is a natural byproduct of the American economy, they clearly are mistaken. Did you realize that the decade that ended in 2019 was the only decade ever in the history of American finance that there was no recession? There is no reason to believe that recession is an inevitable outcome of any economy. Many factors lead to recession, none of which are currently present where we sit today. Those that are forecasting recession are assuming some huge geopolitical or military event. You cannot invest based on a presumption that something negative is going to happen because if you do, you will miss huge gains.

I often quote Peter Lynch, the famous fund manager of the Fidelity Magellan Fund. He has given us many words of wisdom about investing that we should all take advantage of. The one that rings true to me is his statement that the average investor does everything wrong. When they have a good stock that goes way up, they sell that stock to buy a stock that is going down. In fact, you should do the exact opposite. You should ride the good stock and sell the bad stock. Most people refuse to sell bad stocks because that would be an admission that they made a mistake. Since no one has access to your portfolio but you, why would anyone care how you feel? Ride the winner – dump the loser.

Markets are much the same. When the market is going up, it tends to go up until something prevents it from going up. The old saying on Wall Street is, “a trend is a trend until the trend is broken.” There is no presumption that markets will go down just because they have gone up a great deal. What makes markets go down are when the three factors above are violated. When you see interest rates progressively going higher because the economy is too hot, then the markets tend to fail. When you see the economy turn to recession, then almost assuredly the markets will go down. When you see corporate earnings start to fall throughout all segments of the largest companies, almost assuredly lower stock prices will follow.

We are fortunate today where none of those events are even remotely in the horizon. The economy is great, interest rates are low, corporate earnings are high and getting higher, and the Federal Reserve has a firm hold on the economy and is controlling it professionally. I see nothing but positives as I write this posting, which almost assuredly will lead to higher stock prices in the coming months.

Dakota, Ava, Santa, and Joe having a Merry Christmas

One of the best things that we have going for us in the year 2020 is that the Federal Reserve has indicated they intend to hold interest rates steady throughout all of 2020. As further encouragement, they indicated they would even cut interest rates, if necessary, to keep the economy accelerating. When it comes to stock market performance, such a commitment by the Federal Reserve is the most powerful statement of all.

Every year I project what the upcoming year should hold. I do not use this forum to come up with some wild prediction based on the changing of the moon or the length of women’s dresses. I actually think about this a great deal and attempt to make an estimate that is based on some sort of reasonable calculation. Hopefully I will be as close this year as I was last year.

The basic calculation of fair value of the market would be some sort of multiple of expected earnings as compared to interest rates. The 25-year average P/E ratio is 19.34. That means the market on average sells at 19 times projected earnings. Using this simple formula, you can actually calculate what you think the value of the market would be at the end of 2020. Currently, estimated earnings for 2020 are expected to be $180 per share. If you round up somewhat due to low interest rates to a multiple of 20, at the end of 2020 the S&P 500 should be at 3,600. Since the closing balance is at 3,230, that would be an increase of 370 points over the course of the year, or an 11% gain. If you add that to the dividend yield of approximately 2%, my formula would indicate that the market should go up 13% in 2020.

Those of you that are skeptical that a market could gain 13% in a year where it just finished up 30% are not much for studying history. Since 1950 when the S&P was up 20% or more in any one year, the following year has an 83% chance of a gain and that average gain is 11.2%. As you recall this year, the S&P was up over 30%. Even more interesting, if you have a year when the NASDAQ is up 30% or more, the following year is positive 78% of the time with an average gain of 14.2%. Most any reasonable investor would readily accept those odds of potential gains in 2020.

As mentioned previously, I am concerned about the valuation of bonds going into 2020. First off, the yield on bonds is certainly not very appealing. The current yield on the 10-Year Treasury, as of Friday, January 3, 2020, was 1.793%. Currently you can almost get the same interest rate on high-yield money market accounts as a ten-year bond. Therefore, if the bond stays steady throughout 2020, the gain you will make barely exceeds the no-risk cash balance. If, however, the bond would move up only marginally to 2.25% during the year, your gain would be totally wiped out, and you would be in a negative position. If you think that the bond cannot move to 2.25% this year, remember that in September 2018 (15 months ago), the 10-Year Treasury was yielding 3.25%. Therefore, it seems to me that the odds of making money in bonds in 2020 are extraordinarily small and a risk I would not be willing to take.

What I think will change in 2020, unlike the last five or six years, is that the international markets will likely outperform the U.S. market. Not that their economy is better or that things are more robust in Europe or Asia, but rather that they have lagged so far behind the U.S. for so long that surely their day in the sun is coming.

There it is; my simple projection for 2020. I project the S&P will end the year at 3,600, that bonds will make little or no money in 2020, and that there is a high likelihood that international markets will outperform U.S. markets. Simple and sweet, but the same basic concept. Equities will continue to be the best performing asset class of them all in the coming decade.

On that note, come 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

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