The Year Ahead: Climbing The Wall

There are several ways to approach a Year End letter, or for those who have procrastinated a few days, a Year Ahead Letter. The review version is far easier; just parse the headlines for the previous twelve months and you’re almost done. The tricky part will be getting anybody to read it. The Year Ahead letter requires a little more thinking and is theoretically more valuable, the same way an oddsmaker’s newsletter is theoretically more valuable. In reality, Year Ahead letters wind up looking as silly as Dr. Seymour D. Cash’s Lock of the Century (Drew Brees at home vs. Kirk Cousins!), and this one will be no different.  In my own defense, if anyone really knew the future, well, it would be a pretty short week.

For the most part, all we can do as we position portfolios for 2020 is consider the probabilities and a range of outcomes, and this year that leaves us squarely in our default position of being mildly bullish and preaching diversification. What comes to mind is 17th century French philosopher Blaise Pascal’s famous wager regarding the existence of God—Pascal said he wasn’t certain, but given the stakes, he knew which way to bet! 

In the fullness of time, diversified optimism tends to be profitable. This isn’t to say that diversified investors will not trail the S&P 500 during a year like 2019, but for the last 20 years anyway, their odds of earning positive average annual returns increased with the time horizon.

Broadly speaking, the economy is in good shape, with unemployment near all-time lows, low inflation, and seemingly robust capital markets. The yield curve, at least until the unfortunate turn of events last week in Iraq, was steepening again, perhaps the most welcome economic indicator of all. We know we have just entered a presidential election year, which are usually positive for equity markets. Going back to 1928, for each of the 23 election years, only four saw negative returns for the S&P 500. However, a detached observer might agree that this administration has been unusual in some regards, and that we might have front-end loaded the goodies this time. Furthermore, a detached observer might also conclude that attempting to use the political calendar as the basis for an investment strategy is dumb.

During the holiday break, as I mulled potential topics to write about, I considered a paragraph on “If Trump wins.” I considered a paragraph on “If Biden wins,” and even “If the People’s Liberation Army invades Hong Kong.” I did not have a paragraph prepared for “If the U.S. assassinates Iranian Major General Qassem Soleimani.” I admit it—I did not have an index card for that one. 

Unfortunately for us would-be soothsayers, there just aren’t that many naturally occurring normal distribution curves. The real world is a whole lot messier. 

Of course, what’s perhaps more startling to me than the six-sigma event that took place at the Baghdad airport is the muted reaction by the markets, besides the energy complex and a few defense names. Whether the cause is algorithmic trading, passive investing, massive liquidity injections, or a witch doctor somewhere, fear just doesn’t seem to drive price action on a short-term basis these days. I’m old enough to remember when this would have been a pretty big deal! This is a challenging price environment for investors, value investors in particular, and it has been that way for some time.  For the time being, liquidity seems to cure all ills. 

To paraphrase Warren Buffett, it’s a lot easier to predict what will happen than predict when it will happen. Speaking of Buffett, Berkshire Hathaway shares just underperformed the S&P 500 by 18 percent last year—its worst underperformance since 2009 and the company is sitting on a record $128 billion in cash. Is that really short-term bullish? 

Actually, it doesn’t take a lot of effort to find things to be concerned about. 

Stocks are not inexpensive. As of year-end, the S&P 500 was trading at a forward P/E of 18.2x, not quite 12 percent above its 25-year average of 16.3x.  Similarly, at year-end, the index was slightly overvalued on a dividend yield basis (1.93 percent vs. 2.09 percent) and price-to-book basis (3.32 vs. 2.96) compared to its 25-year averages.

Let’s look at what’s going on in the repo market.  The Fed has been forced to intervene in this normally sleepy but critical market where high-quality securities are swapped daily for trillions of dollars of cash, in ways that are much larger than what it was planning just a few months ago. While it is true that before the Great Financial Crisis the Fed regularly provided liquidity to repo markets, it is also true that prior to September, the Fed had been shrinking its balance sheet, then suddenly realized that there wasn’t nearly as much liquidity in the economy as it thought. The Fed then had to scramble to keep the Fed Funds rate within its targeted band of 1.5 percent to 1.75 percent by backstopping the repo market with $400 billion dollars and by committing to buy $60 billion in Treasury bills per month through next June. Does that sound like a market awash in liquidity to you? Yeah, me neither.

Second, credit quality among U.S. corporate debt issuance continues its gradual decline. According to Barclays and Bloomberg, more than half of all investment-grade rated corporate debt now resides just one rung above junk status, and bond duration is at an all-time high (7.9 years vs. the 20-year average of 6.2 years).

Amid that backdrop, due to regulatory constraints, primary dealers are now holding just 0.2 percent of US corporate debt outstanding. Before the Great Financial Crisis, primary dealers held close to 4 percent. Again, I don’t know when this will be a problem for markets, but you don’t have to be Michael Milken to know that it probably will be one day.

Meanwhile, according to the Bureau of Economic Analysis, our federal net debt is expected to explode from 78.9 percent of GDP to 95.1 percent—during an economic expansion—by 2029. Declining birth rates among native-born Americans and lower immigration will results in effectively zero population growth, which means U.S. GDP growth will have to be driven almost exclusively by productivity growth during the next decade.

So, for crying out loud, is there any more good news? Well, yes, I think there is. Sort of.

During the last 25 years, a forward P/E of 18.2x is correlated with positive mid-single digit one-year returns, and positive single-digit 5-year returns, according to J.P. Morgan Asset Management. Of course, at least in 2020, it would appear that earnings multiple expansion would have to be the primary driver of stock price appreciation because earnings growth is expected to be quite muted. However, with the aforementioned issues percolating in the fixed income markets, is multiple expansion not a logical outcome?

I think it’s worth noting that while by most measures stocks do not look inexpensive, there is one measure by which they do—the earnings yield spread. The year-end difference between the earnings yield of the S&P 500 and the spread on Baa-rated corporate debt was 1.65 percent—close to a full standard deviation below its 25-year average. Now, this may be saying more about the particularly unappealing state of the fixed income markets, but on a relative basis, this certainly suggests stocks are attractive.

Finally, environments such as this one tend to excite the gold bugs and crypto enthusiasts among us, but at least at the time of this writing, I would have to characterize throwing money at gold or Bitcoin as speculation, not investing in the traditional sense. 

So, are there market forces to be bullish about? Yes. Are there market forces to be bearish about? Definitely. What will happen? Well, that’s what makes a market. I am now entering my fourth decade of professional market observation (wow, that is just devastating to write) and I have been humbled more times than I can count. All I can advise is this—the market usually squirts away from conventional wisdom in the short-term and follows it in the long term. After all, that’s what a market is. Just a series of probability-weighted wagers. In my experience, optimism has been rewarded more than pessimism. Not absolutely, but more often than not. We can talk about central bank interventions and crony capitalism, but the way to bet is with human ingenuity. 

We climb the wall of worry. Whether we’re Warren Buffett or Blaise Pascal. That's what makes us human. And that’s the way to bet. 

Any opinions are those of Burke Koonce and not necessarily those of RJA or Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. Ratings provided by nationally recognized statistical rating organizations, also called ratings agencies, are appraisals of a particular issuer's creditworthiness, including the possibility that the issuer will not be able to pay interest or repay principal. Ratings are not recommendations to buy, sell or hold a security, nor do ratings remove market risk. Securities with the same rating can actually trade at significantly different prices. Standard deviation measures the fluctuation of returns around the arithmetic average return of investment. The higher the standard deviation, the greater the variability (and thus risk) of the investment returns. Gold is subject to the special risks associated with investing in precious metals, including but not limited to: price may be subject to wide fluctuation; the market is relatively limited; the sources are concentrated in countries that have the potential for instability; and the market is unregulated. Bitcoin and other cryptocurrencies are a very speculative investment and involves a high degree of risk. Investors must have the financial ability, sophistication/experience and willingness to bear the risks of an investment, and a potential total loss of their investment. Securities that have been classified as Bitcoin-related cannot be purchased or deposited in Raymond James client accounts.