Excerpted from the IMA fourth quarter 2019 letter to clients.
Q4 2019 hedge fund letters, conferences and more
The stock market marched higher for the year even though US companies as a whole did not become more valuable, just more expensive, as earnings failed to grow from 2018 to 2019. Earnings are estimated to be up about 5% for 2020 (though these estimates are usually revised down as the year progresses). If you look at the quality of this non-growth, then the rose-tinted glasses of the average stock market investor quickly prove inadequate. Corporate debt is up 5% in 2019, and a good chunk of the increase went into stock buybacks. As stocks become more expensive their benefit from earnings per share growth diminishes.
The US economy grew about 4% in 2019 – good news, except that our national debt grew about 5.6%, or about $1.3 trillion; our debt to GDP is over 100%; and paradoxically, the 10-year Treasury yield dropped from 2.6% to 1.9%. Maybe not paradoxically: The Federal Reserve went from a faint attempt of quantitative tightening (it did not even raise rates, it just talked about raising them) starting in the fourth quarter of 2018, which caused stock market to have a mini crash a year ago, to quantitative easing in the second half of 2019, which arguably caused the market to go up.
Just pause for a second, remove your gaze from the stock market, and think: The Federal Reserve is easing (buying debt issued by the US government, of which the Fed itself is an integral part) even as we are in the tenth year of an economic expansion, at full employment, and interest rates are already nearly at zero. What will the Fed do when we actually go into recession?
Also, though the service economy (which is two-thirds of GDP) is growing, our manufacturing economy has been in a recession for over a year.
Party like it’s 1999 – this was the theme of our IMA annual meeting. This is how the stock market feels to us today. No, there are no dot-coms, though temporarily we had dot-cannabis and dot-fake-beef bubbles which got popped. Near zero interest rates, abundant liquidity, and a perceived absence of risk (and fear) turn money into a crude instrument of bubble creation. This is why the stock market is experiencing a lighter version of the millennial lunacy.
Growth stocks are incredibly expensive. Value stocks have underperformed growth stocks for the last ten years. The last time this underperformance was this extreme was… wait for it… 1999.
Historically, value stocks have outperformed growth stocks by a significant margin. But they have gone through painful bouts of underperformance in the past.
Value stocks have however shown some signs of life lately. (We are whispering – we don’t want to tempt the stock market gods).
Growth stocks have outperformed for several reasons. Low interest rates favor the bird in the bush (distant future cash flows) not the bird in hand (high current cash flows). Negative interest rates paradoxically make $100 ten years in the future more valuable than $100 already in your pocket. (Yes, chew on this.)
Investors in search of yield have driven the prices of just about everything skyward, and especially anything that has even the superficial appearance of a bond. We are talking about dividend-paying stocks (the likes of Coke and Kimberly Clark), which are treated as bond substitutes. Anything that resembles a services stock is trading at a dot-comish valuation. These companies have enviable recurring revenues, of which they trade at a 20-25x multiple, and investors cannot get enough of them. (Not earnings, revenues.) This is another example that bubbles are just a good thing taken too far (in this case a great thing).
Passive investing through index funds and ETFs benefits expensive companies, as they have a much larger slot in the indices that are put together based on market capitalization. This will end in tears: An ever-rising stock market and investor feelings of safety, either through owning iconic brand stocks or diversification by means of index funds or ETFs, results in complacency and thus underappreciation of the risk embedded in the Average Joe’s portfolio.
If economic growth continues to march along at the current rate and valuations go on expanding, then the market terrain will continue to be smooth. A race car (a more aggressive strategy) will finish the race faster than a four-wheel-drive (all-terrain) vehicle. But if the terrain turns rocky, the race car won’t even finish the race, while the all-terrain vehicle plows on through.
The problem is that we have no idea what terrain lies ahead of us, so we’ll always err on the side of durability over speed.
We are not excited about the stock market or the economy; but we don’t own the stock market, we own high-quality companies acquired at cheap to fair valuations. Most of our companies (with one or two exceptions) are non-cyclical. We hold plenty of cash, and where we can we hedge. So no, this is not your garden-variety portfolio, but we believe we are prepared for whatever future terrain we find ourselves in.
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley).
His books were translated into eight languages. Forbes Magazine called him “The new Benjamin Graham”. To receive Vitaliy’s future articles by email or read his articles click here.
