Q3 2018 Investment Commentary

I.             Reviewing Our Position in U.S. Stocks

The domestic economy shows no signs of a lag. Commercial and residential real estate prices, especially in the Bay Area, are reaching dizzying heights. The S&P 500, Nasdaq, and Dow Jones indices are also setting new records.

Against that backdrop, it is understandable if this year’s lackluster returns are a headscratcher. If everything appears to be going well, then why are the portfolios not making money?

Our globally diversified portfolios house a variety of themes, including a preference for value stocks, a dedicated emerging markets stock allocation, and a selection of flexible bond managers.

Certain themes have worked well in 2018 (e.g. flexible bond managers). Here, we want to explore a theme that has not: a lowered allocation to U.S. stocks.

We’ll start with a discussion of stock market valuations, one of the primary considerations that pushes us away from U.S. stocks. Then, we will caution against a couple of investing traps we’ve witnessed people fall into: conflating the economy and stock market and letting FOMO inform investment decisions.

U.S. Stocks: Thriving Despite Elevated Valuations

Our concern heading into 2018 and continuing through today is that U.S. stock prices are elevated. Stocks have risen since March 2009. Corporate earnings and profit margins are historically high. And the nine-year bull market has investors more confident than at any time since the Great Recession.

We did not expect a crash or doubt that U.S. stock gains could continue. Rather, our concern was that optimism had inflated prices leaving less room to grow and more room to disappoint. In other words, we saw U.S. stocks as risky relative to their expected future returns. 

Stock market valuation is a major consideration in our approach. Valuation measures the relationship between price and value. For example, a stock with a Price-to-Earnings valuation of 10.0 costs $10 for every $1 of earnings. Valuation has been a reliable predictor of long-term returns, but a poor indicator of short and medium-term returns.

CAPE – Cyclically-Adjusted Price to Earnings ratio – is the most widely-used valuation tool and tracks markets over the previous ten years. As you can see below, when CAPE has been high (richest), the subsequent decade has produced lower returns. This makes sense: the more you pay for an investment, the lower your expected return.

as of Sept 30, 2018

as of Sept 30, 2018

In January, U.S. CAPE had only been higher in the years leading up to the tech bubble. The median historical CAPE is 16.2. Nonetheless, nine months later, valuations remain just as high, in the 97th percentile of historical CAPES. 

as of September 30, 2018

as of September 30, 2018

When constructing our portfolios, we start by deciding how much to allocate to equities. Then, within that equity allocation, we elect how much to invest in each stock market. We are seldom completely in or out of any market. Rather, we shift to or away from markets depending on risks and opportunities. Hockey great Wayne Gretzky sums up our approach to valuations and CAPE: “skate to where the puck is going, not where it has been.”

As the U.S. stock market steadily climbed in recent years, we gradually moved away from U.S. stocks and to foreign stocks. In 2017, that approach added value. This year, although nearly half of our stock allocation remains in the U.S., our position is lower than in previous years.

as of Sept 30, 2018

as of Sept 30, 2018

Because we invest for clients with a long investment horizon, valuations are a useful guide for adding value. Still, because momentum and sentiment can carry the day in the short-term, a valuation-based strategy will endure periods of underperformance.

Though we are experiencing such a period today, our outlook hasn’t changed. U.S. stocks – while still an important part of our portfolios – present a likelihood of low long-term returns. With capital intended to support clients’ long-term needs, today’s conditions favor a cautious approach to U.S. stocks.

Volatility reminds us of how stressful investing can be. Perhaps, now would be a good time for us to review and reaffirm your investment goals. 

Stock Market ≠ the Economy

This year’s headlines have delivered upbeat news about the economy – strong G.D.P. growth, low unemployment rates, and little sign of higher inflation. Concurrently, the U.S. stock market has climbed higher.

We have heard clients draw a straight line between the economy and stock market. The two are interconnected. Strong economic growth feeds into corporate earnings, thereby driving stocks higher. Conversely, in a recession, less economic activity hurts corporate earnings and therefore stock prices.

Yet, the relationship between the economy and stock market is not as strong as many expect. Economic data is backward-looking; it uses what has already happened to estimate where the economy is.

The market is forward-looking. Today’s economic data is already reflected in stock prices. Expectations and emotion (fear and greed) drive short-term stock prices far more than economic fundamentals.

For example, if Apple reports a record number of iPhones sold but the market expected that Apple would sell more, then unmet expectations would likely cause Apple’s stock price to drop. The record iPhones sales would reflect well on economic data but could have a negative effect on the stock market.

From 2009 to 2012, the economy was recovering from the Great Recession. Unemployment fluctuated between 7-10%, and GDP growth was unimpressive. Yet the S&P 500 was up 72%. Lowered expectations drove prices down, creating a great buying opportunity.

If you knew what was going to happen in the economy, you still wouldn’t necessarily know what was going to happen in the stock market.
— Warren Buffett

The economy and stock market have a weak short-term relationship because price matters in the market. There is no asset so good it cannot be overpriced. There are few assets so bad they cannot be underpriced. A mansion can be a horrible investment at an inflated price while a rundown home can be a great investment at a depressed price. It’s not what you buy, it’s what you pay.

Moreover, economic data is fickle. Economists did not discover and verify the Great Recession until December 2008, a year after it started, or the March 2001 recession until November 2001.

There is an old joke that economists exist to make weathermen look good. Economic data informs us about forces that have shaped the stock market. Economic data is not a useful input for developing a forward-thinking investment strategy.

Tech Stocks Breed FOMO (Fear of Missing Out)

Thus far, we have discussed the U.S. market broadly, but that approach obscures much of the story. One market segment – the U.S. tech sector – has driven a preponderance of returns. Its strength is distorting perceptions of the broader U.S. market.

The S&P 500 index has gained $1.7 trillion this year. Just five tech companies have contributed over $1 trillion of those gains.

as of Sept 2018

as of Sept 2018

Gap, Chipotle, and Harley-Davidson could go bankrupt tomorrow and only knock 0.1% off the index. If Hormel Foods tripled in value, it would generate the same gains as if Apple gained 0.4%. 

It is not unusual for a handful of stocks to lead the market. The largest few companies of the S&P 500 are much less of the total market than they have been in the past, particularly in the 1960s and 1970s.

Some investors may recall the Nifty Fifty, which was a popular strategy that called for owning just the fastest-growing blue-chip stocks. The Nifty Fifty dominated the market in the late 1960s and early 1970s. The strategy then famously blew up. Investors who bought the Nifty Fifty at its 1972 peak lost two thirds of their investment by 1975.

What is unusual is the concentration of market stars in one industry (technology) and area of the country (Bay Area and Seattle). Anyone near that industry or geography is at risk of FOMO.

We have noticed FOMO reemerging in ways that remind us of the pre-2000 dot-com bubble. It is hard enough to remain a disciplined, diversified investor through rough patches. It is especially difficult when those around you seem to be prospering.

FOMO misguides investors into assuming there are simple ironclad strategies to achieve consistently high returns. Typically those strategies involve chasing investments that have recently performed well.

Our point is not that the stock market is dangerously narrow or that today’s tech industry will suffer the fate of the Nifty Fifty or the 2000 dot-coms. There are in fact many reasons to believe that U.S. tech will continue to thrive.

We want to caution people against the narrative that one area of the market can comprise an investment strategy. The market has a history of humbling investors who believe that a simple approach will work all of the time.