Dear Clients and Friends,
We’ve been enjoying one of the longest and most powerful US bull markets on record. From March 2009 through April 2019, US stocks (the S&P 500 Index) quadrupled, turning every $1 investment into $4. But are the good times coming to an end? In recent days, the global stock markets have been spooked by the escalating trade conflict between the world’s two largest economies, the US and China. As I write this letter, while the trade dispute may yet be settled amicably and the news seems to change every day, a quick resolution probably isn’t in the offing. (In fact, each side has announced higher tariffs on the other’s imports.) So in just a little over a week, we have transitioned from trade-news excitement to trade-news anxiety.
The market hasn’t taken this turn well. Volatility was already up after the Federal Reserve failed to endorse an interest-rate cut on May 1, even while Washington and Beijing were hinting that a trade deal was imminent. Once the negotiations collapsed in acrimony (a nice example of the Chinese proverb “same bed, different dreams”), volatility spiked. Altogether, between May 1 and May 17, the S&P Index dropped about 3%.
The dispute with China isn’t the only global hot spot. Brexit remains a question mark. Tension between the US and Iran is escalating. Venezuela continues to fall apart. Despite these headwinds, though, asset prices remain broadly elevated worldwide, in part due to “artificial support” from central banks such as the Federal Reserve in the form of loose monetary policy (keeping interest rates low). And so in my view, investor confidence, not asset value, has been the primary force propping up security prices. How long might that confidence last? That’s the context for this letter about what’s going on around the world and how we may make some sense of it.
The Turnaround This Year
The great bull market notwithstanding, if you were an investor in 2018 your portfolio lost money for the year: Cash was the best performer, beating both stocks and bonds for the first time since 1994. Virtually every asset class declined in value. The S&P 500’s -4.4% return marked the end of nine consecutive years of positive annual returns (the only nine-year stretch since 1926, except for 1991 through 1999). Volatility soared in the fourth quarter of 2018, and on Christmas Eve the S&P 500 was off virtually 20% from its all-time high (posted just three months earlier), a hair below the technical criteria for a “bear market.” As far as I’m concerned, it was a bear market. But a small one…
The carnage late last year was particularly notable in high-flying tech stocks, including the so-called FAANGs. Apple slumped 38% from its high; Netflix plunged 44%; and Amazon fell 30%, shedding a remarkable $337 billion in market value – equivalent to the current value of 60 New York Times Cos. Google recently lost 10% ($90 billion of market cap) in a matter of days due to slowing ad sales. All of this was a stark reminder of how vulnerable the market’s tech darlings can be. And there was no refuge abroad. Indeed, foreign stocks performed much worse than their US counterparts in 2018: The MSCI EAFE Index of developed markets slumped 14%, and the Shanghai composite index plummeted 25%.
Then, just when it seemed as if the nine-year bull market had come to a shuddering halt, sentiment abruptly turned. The 16% rebound in world stocks (the MSCI All Country World Index) from January through April of this year was a refreshing change from 2018. And the good news wasn’t only in stocks. While the returns of eight of the most important asset classes we track ranged from flat to negative 15% last year, six of those asset classes showed double-digit gains, and none lost money.
It is always difficult to pinpoint the proximate causes of a sharp market turn (even with the benefit of hindsight), but one key factor for the resurgence in 2019 appears to have been a dramatically dovish shift in US Federal Reserve monetary policy. Acknowledging soft inflation and slower economic growth both in the US and around the globe, the Fed announced (and reaffirmed after its May 1 meeting) that it was putting interest-rate increases on hold this year and would end its balance-sheet contraction by the fourth quarter of 2019. The financial markets, from stocks and bonds to commodities and real estate, loved this unexpected shift away from a monetary-tightening bias.
But is it too soon to celebrate? After all, a hot January-through-April was followed by a chilly May (so far.) Let me begin my comments about evaluating short-term returns by first digging into the turbulence we saw last year.
2018 Bear Market Not a Surprise
As to the market swoon in the fourth quarter of last year: First, the decline should not have taken investors by surprise. Our research tells us that since World War II, there has been a bear market (a decline of 20% or more) every 2.3 years on average. The decade after 2008 was an exceptionally long period of relatively calm market conditions (again, I credit remarkably loose monetary policies around the globe). Broadly speaking, these were glorious years for stocks, bonds, and real estate; as the painful memories of the Great Financial Crisis slowly faded, investors grew more complacent and more willing to take on risk. But the complacency couldn’t, and didn’t, last forever. In fact, the brief bear market we saw at the end of 2018 was pretty much par for the course: In 2011, US stocks fell 19.4% in five months, and in 1998 they slumped 19.3% in six weeks!
Investors who reacted emotionally to market movements by selling assets in last year’s final quarter were humbled when they missed the sharp rebound in 2019 (just as they were after they sold in early 2009 near the market bottom). Volatility and each downturn create the illusion of danger, but that’s the exact environment that spells opportunities for investors who can hold their emotions in check and think analytically. In fact, one of my responsibilities and challenges as a portfolio manager is to keep my investors and myself focused on the long-term picture. Investors who abandon their strategies during periods of market turmoil risk turning an illusion of danger into real danger by making temporary losses permanent in their portfolios. When times get tough, I like to keep a picture in my mind of the long-term rise of stocks and the success of companies that are driven by creativity, innovation, and hard work. (As an entrepreneur myself, I have always felt, every morning, that my day’s task is to create value – for my clients, my colleagues, and my company.) Remember – up to now at least, companies in aggregate have always rebounded from difficult markets and grown in value; the volatility of their stock prices (in sum) has been far greater than that of their underlying businesses.
This discrepancy between daily market price and intrinsic value (the same applies to the distinction between private and public equity, which I will discuss below) reminds me of a long-time client who, in 1995, asserted that his best investment was his home. When I asked him what he meant, he replied that unlike his stock portfolio, his home came with no monthly statements of its value for 30 years. (If it had, he might have sold his home 30 times.) In other words, he derived emotional comfort from not constantly being faced with valuation issues. Not that the absence of regular valuation statements meant that the value of his home was stable. It wasn’t, of course, but he didn’t have to confront the volatility on a daily basis. The lack of daily pricing on his home was for him, and most homeowners, a strong positive.
Though I knew my client’s statement was at least partly tongue-in-cheek, as a reality check I did some research and found a study by the San Francisco Fed that compared annual returns (after inflation) for US stocks versus houses from 1870 through 2015. It turned out that the stocks returned 8.5% annualized over that time period compared to just 6.1% for houses. (Globally, though, home price appreciation edged out stocks 6.9% to 6.7%, respectively.)
Short-Term Results Unreliable
So stocks have been a strong investment over time. As for the handsome market gains of earlier this year, though I will gladly accept them, I would caution investors not to read too much into them. Just as it is not uncommon for large gains to occur after sharp declines, excess returns tend to be mediocre after large run-ups. In addition, high past returns are associated with a higher probability of a market slump: We studied all five-year rolling periods back to 1927 and found that the median five-year return just prior to a 12-month market decline of 30% or more was 11.6%, nearly a percentage point higher than the average five-year return. Perhaps it warrants watching that the current five-year annualized return (as of May 17, 2019) is a relatively elevated 11% – and in fact, the market has been skittish in recent days. But neither the red-letter returns of January through April this year nor the volatility in May should be the focus of investors’ thoughts.
Unfortunately, however, due to behavioral bias, investors do tend to extrapolate recent events into the future. Don’t do it. From day to day, month to month, past returns tell us nothing about what’s to come, and anyone who thinks he or she can predict whether a downturn will continue or a good month will be repeated is likely to guess wrong and undermine the long-term benefits of investing. (For more on the challenge of market timing, see my recent article at https://gersteinfisher.com/viewpoints/does-market-timing-work/.) It is counterintuitive (and emotionally difficult), but wise, to be cautious when the market is soaring and to be hopeful when securities go on sale. This is easy to say, but hard to do; it’s not what we know that counts, but what we do with what we know.
Yellow Lights Flashing: Rising Global Debt…
Returning to the current markets, I’d caution that maintaining today’s elevated valuations will depend on continued investor confidence, which can turn on a dime. I make no economic or market forecasts (I have learned that I am not particularly good at predicting the future), but I do note that the global economy is slowing and that our economic expansion, which is 9½ years old, is aging. One of my principal concerns is the enormous increase we’re seeing in debt worldwide, which leaves governments with limited room to maneuver in case of a crisis (or a recession). And sooner or later, a day of reckoning will come. A friend recently reminded me of an old saying: “Debt doesn’t matter until it does – and then it matters terribly!”
In the wake of the 2008 crisis, central banks slashed interest rates (more than $14 trillion of the world’s sovereign debt currently offers negative interest rates, according to IMF figures) and spurred liquidity through aggressive quantitative-easing policies. Total global debt nearly doubled, to $243 trillion, as of the end of 2018 (Source: Institute of International Finance). That figure was equivalent to almost 300% of global GDP. The global economy and financial system may now be “hooked” on super-low rates (even modest Fed tightening last year probably helped trigger the fourth-quarter selloff) – rates that foster an illusion of low financial and economic risk. Central banks must now also contend with rising nationalism and populism – which challenge their independence from political manipulation – together with the slowing global economic growth and a threat of rising inflation. That threat is increased by tariffs and other forms of trade barriers, which have a whiff of stagflation about them.
The seeds of the next financial crisis may well be found in today’s levels of sovereign debt. Heavily indebted, too-big-to-fail and too-big-to-save (yes, both) Italy – which accounts for 16% of the Eurozone economy – is one potential trigger, as the country’s relationship with the European Union frays. Here in the US, government debt as a percentage of GDP has jumped from 74% in 2008 to above 100% today (Source: Gerstein Fisher Research; Bloomberg). And partly owing to rising budget deficits, our national debt just reached $22 trillion, which doesn’t even account for the tens of trillions of dollars of unfunded liabilities from “entitlement” programs.
Whether it is Uncle Sam, corporations, or households, Americans are not saving and investing enough. One glaring trouble spot is the shortfall so many people are facing in funding their retirements, particularly in light of increasing longevity. Nobel laureate Robert Merton discussed the looming retirement-funding crisis during a recent “Q Factor” podcast with me (you can listen to the podcast at https://gersteinfisher.com/podcasts/robert-merton-a-data-visionary-senses-a-coming-crisis/). Incidentally, since a large percentage of retired Americans have limited savings apart from their home equity, Merton maintains that many will be able to fund retirement only by relying on risky strategies such as reverse mortgages. In addition, due to the current high valuations of both stocks and bonds, pension-fund managers and individual investors alike will struggle (and take more risk) to earn a target return of, say, 7.5%, as demonstrated in Exhibit 1.
As the exhibit illustrates, in 1989, due to interest rates much higher than today’s, an investor could have achieved a 7.5% annualized return with a very low-risk cash and fixed-income portfolio. Fifteen years later, in 2004, an investor would need to allocate half of the portfolio to stocks and accept three times the volatility to achieve the same 7.5% return. Finally, today, an investor needs to keep 96% of the portfolio in stocks, with six times the expected volatility of the 1989 portfolio, to target a 7.5% expected return. Taking on more risk in pursuit of higher returns may not be a good idea for many investors. Some may have no alternative.
And so companies, investors, and households (particularly students) have levered up. To cite a few examples: The lowest-rated investment-grade bonds (triple-B) have zoomed to nearly 60% of the corporate-fixed-income market. The leveraged-loan market, a key funding source for lower-quality issuers, has been on a tear, as investors reach for yield in a low-interest world. Student debt has more than tripled since 2006, to $1.6 trillion, according to Fed data, and is now the second-largest category of consumer loans after mortgages. Recent college-campus visits with my son Josh have made me more acutely aware of the financial burdens we are placing on young Americans. Many may find themselves behind the eight ball: The government has all sorts of tactics at its disposal to collect delinquent loan payments, including garnishing wages and in some states, revoking professional licenses and even drivers’ licenses (Source: Bloomberg News).
The question is, how long can Americans live beyond their means without paying a price for it? Not surprisingly, the upward debt spiral has come during a period of super-low interest rates, an expanding economy, and a robust job market (though gains in personal incomes have been muted). What happens when rates rise – which in itself tends to slow the economy by raising borrowing costs for businesses and consumers – or an inevitable economic downturn arrives? By their nature, investors (and borrowers) become complacent in beneficent times, projecting their recent positive experience (i.e., low rates and volatility) into the future and assuming (dangerously) that the good days will roll on. Mind you, I’m not necessarily predicting a debt apocalypse, but history tells us that periods of elevated debt levels don’t usually end well. So I’m just advising some cautious monitoring in the period ahead.
…And Some Risky Market Trends
Along with rising leverage and the years of artificial support from central banks, I am concerned about some structural trends in the US market. The number of publicly traded US securities has halved over the past 20 years, according to our research (based on data from Bloomberg and Cambridge Associates), whereas newly listed securities are growing in China and in other overseas markets. It’s no coincidence that private-equity assets have multiplied during the same time frame (is private replacing public equity in the US?). PE funds (formerly seen mostly as portfolio diversifiers) have gobbled up many publicly traded companies, increasing the correlations – and blurring the distinctions – between the public and private markets.
Even before this trend took hold, if you placed the word “private” in front of “equity,” it was still equity; if you put the word “public” in front of “real estate,” it was still real estate. Now, though, the price that private-equity investors seem willing to pay for small companies appears to be higher than on public markets, so there may be more incentive for private businesses to sell themselves to PE funds than to list on a public market. Combining a $1 trillion cash hoard (Source: Preqin Private Equity Online) with leverage, PE funds may do another $3 trillion of shopping – a good chunk of it abroad – for businesses, both public and private. Is this a problem? Yes and no. It is helping vitalize the investment markets, but the diversion of so much capital into the less-transparent, riskier PE landscape can spell some trouble ahead for investors. Plus, the high valuations of many private-equity securities may bode ill for their future returns: Even good investments can become bad if you pay too much for them.
Another market concern for me is the dizzying rise of indexing. From 2009 to the end of 2018, the amount of assets in exchange-traded funds (ETFs, many of which are indexed) multiplied 4.5-fold to $3.4 trillion (Source: Investment Company Institute). When I started in the investment business in 1992, ETFs didn’t even exist and there were but a handful of significant index funds. In a November 2018 article in The Wall Street Journal, the late Jack Bogle (index-investing pioneer and founder of The Vanguard Group) tells us that US-equity index funds now comprise almost 20% of the total US stock market capitalization (our research shows this figure as even higher). Bogle sees index funds probably comprising 50% of the market eventually. But even the great spokesman for indexing balked at some of the consequences of this trend. For example, domination of the stock market by indexers could lead, Bogle feared, to a dangerous diminution in corporate governance, since there would be fewer market participants policing corporate executives. I’d also add that in some small-cap ETFs, the underlying securities have poor liquidity and are traded much less frequently than the ETFs themselves: another source of potential risk.
Probably most important, index trading is not value-oriented, but rather is driven by flows of money and market perceptions. (I am working on a research paper with Fairfield University Finance Professor Michael McDonald that will demonstrate that pure indexing is a suboptimal investment strategy.) The impulse to index reminds me of a quip by the great British economist John Maynard Keynes: “Worldly wisdom teaches,” he said, “that it is better for reputation to fail conventionally than to succeed unconventionally.” Put another way, be careful about going out on a limb: Market participants don’t yet fully comprehend the implications or risks of the indexing revolution for market liquidity or corporate governance. It’s something we’re studying carefully.
China Ascendant? (Probably)
As a portfolio manager and manager of risk, I must also pay attention to geopolitical developments. Movements at the extremes of the political spectrum are sprouting around the world (and sometimes winning elections). Harvard Business School’s David Moss (with whom I have had the good fortune to collaborate) joined us two years ago to speak about the fraying faith in democracy. Politicians have been putting their self-interest and party ahead of Constitution and country. As a steward of your capital, I am conscious that widening social divides – which surely will be a core issue in the 2020 elections – pose a risk to our economy and political system.
Continue reading here.
