Warning: Christmas cheer is sparse in this update. But we want to give it to you straight. Ultimately, we believe an honest assessment of the situation coupled with prudent financial management leads to peace of mind and solid financial decisions. That combination will make for many future Merry Christmases.Market Gloom
The stock market has turned sharply negative for the year. The S&P 500 is now down 10% for the year, plummeting nearly 20% from its peak. As we approach the holidays, a palpable gloom has descended on the market, and the prospects for the world economy have dimmed. This week, the selling became indiscriminate. Investors are nervous, the markets skittish and ready to take further offense. In this psychological climate, good economic news is now mostly ignored. Bad news is magnified. One analyst said in a research note this week, “The tone isn’t so much bullish or bearish but rather defeated and demoralized. The Fed on Wednesday was the (market’s) last hope for 2018. And with the decision disappointing, there isn’t a single towel not now lying on the mat, bloodied and exhausted.” (1)
A dismal assessment. But accurate in describing the market’s current mood.Gloomier Still- The Market is Worse than What the S&P 500 Indicates
The market’s true performance is actually worse than what is recorded by the most widely followed broad index. A brief lesson and some quick facts on the S&P 500: First, it’s actually 505 stocks that currently make up the index. The index is market cap weighted. This means that larger companies dominate the index. At June 30, these were the top five companies and weightings that made up the S&P 500 (2):
- Apple: 4.0%
- Microsoft: 3.3%
- Amazon: 3.0%
- Google: 2.9%
- Facebook: 2.0%
The impact is that the S&P 500 is no longer a broad representation of the market. It has become dominated by what we call the FANGs, an acronym for Facebook, Apple, Amazon, Netflix (0.7% of the S&P 500 at June 30) and Google (Microsoft screws up the FANG acronym so it didn’t make the cut). When you look at the S&P 500 in 2018 you are not getting a broad representation of what’s happening in the market. It’s more like peering through a porthole. What you see is mostly what’s happening to the FANGS (all technology companies). The five stocks listed above by themselves make up more than 15% of the index. By the time you get to the midpoint of the S&P 500, a company in this position (and certainly below) in market weightings has an extremely limited impact on the direction of the index. Let’s take the company in position 250 for example; Boston Properties (BXP). BXP has a weighting of 0.086% on the S&P 500. So by comparison, the impact of Apple (the most heavily weighted company as of 6/30/18) on the S&P 500 was 47x greater than midpoint company, Boston Properties.
Conclusion: the S&P 500 is designed as a broad index. Usually, it is a good broad indicator. But in 2017 and 2018 it became narrowly dominated by a few technology names. Here’s a sampling of some other YTD indices:
- NYSE Composite: -13.8%
- Russell 2000: -15.9%
- Dow Jones Total Stock Market: -10.5%
- KBW Bank: -22.7%
- NYSE Energy: -20.3%
So, as you can see, the (now) narrow S&P 500 may not be giving an accurate picture of the depth of the weakness in the market. Certain sectors (most notable financials and energy are down more than 20% for the year). In fact, only two of the more than 50 major indices we follow are up for the year. Healthcare is +2.6%, and Pharmaceuticals are barely positive for the year at 0.7%. The rest are all in the red for the year.
See the attached image provided by BlackRock. The chart shows the S&P 500 (green dots) versus the median stock (blue bars). Note the close correlation in most years. Now, note the separation that began in 2017 and widened in 2018 (3). Why the divergence? It’s due to the domination of the FANGs. This handful of market leaders drove the S&P 500 index to ever increasing highs over the past several years. But in 2017 and increasingly in 2018, the average stock holding did not mirror the FANGs.The NYSE as a Better Comprehensive Indicator
What’s really happening in the market is better shown by the NYSE Composite Index (NYA). This index is comprised of more than 2,000 stocks, mostly American, but also includes foreign companies. Unlike the S&P 500 at present, the NYA is not dominated by any one group of companies and the four largest constituents represent four different sectors of the economy. What’s happening with the NYA this year? It’s down 13.8%. Unfortunately, this is a more realistic view of performance of the broad stock market in 2018.Is There No Joy? Is all Hope Lost? Are We on the Brink of Financial Ruin?
By now, you may be thoroughly depressed. It’s ugly. We don’t want trivialize it. But there are solid reasons to take comfort, for the U.S. economy in general, but particularly for our clients. While the speed of this market decline late in the year has been breathtaking, it did not catch us entirely flat-footed. We took steps in advance of the market decline to protect our clients. Make no mistake, we have suffered sharp account value declines in sympathy with the general market. But the benefits of the moves we made (mostly) in advance of the market carnage will begin to manifest themselves through the course of 2019. Let’s discuss. It will be more enjoyable reading.Is This 2007 / 2008 All Over Again?
In short, no. It’s our firm belief that the U.S. economy does not sit on the precipice of an imminent financial collapse as it did in those days. But in part, we believe the zeitgeist of The Great Recession of 2007 / ’08 is driving sentiment now. This generation of investors lived through those dark days. But then, we had a systemic flaw in our financial system. The subprime crisis was so large and so misunderstood (until after the fact) that it threatened to overwhelm not just the U.S. economy, but the entire world. To be sure, the world has economic problems now as well. But we see no equivalent concentrated systemic risk as existed then. We cannot tell you with certainty this doesn’t get worse before it gets better. Market sentiment is horrible, and in the short term that may drive values. But, there are important facts that should begin to be factored into the market, and which may bolster your confidence as you enjoy the holidays:
- U.S unemployment is at generational lows.
- The U.S. Consumer has been spending money. Black Friday, Cyber Monday, and the indications of the Christmas buying season all indicate robust commerce.
- Stock are not fundamentally overvalued. Certain sectors perhaps (elements of the FANGs in our opinion) but not as a whole. There’s value in the stock market. Let’s develop this last point.
Historical Norms Indicate the Stock Market Is Now Oversold
There is a difference between a market correction and a recession. Earnings may slow without the economy slipping into a recession. That remains to be seen. But the key point is the market has now priced a recession in as a foregone conclusion. Here’s where we stand on the valuation of the market:
- 2018 consensus market earnings as measured by the S&P 500 is approximately $165. That represents more than 20% growth over 2017.
- Consensus expectations for 2019 earnings have come down moderately from $177 to $175. That represents a 13.8x multiple on earnings; well below the 16x historical average.
- Today we sit at the lowest valuation we’ve seen in multiple years. Market fundamentals don’t justify the extent of this selloff.
Returning to the historical valuation norm would mean stocks will rally about 20% upwards from these levels. Will that happen near-term? Probably not. Too much psychological damage has been done for the market to just immediately snap back to normal. But make no mistake, there is now significant value for intrepid investors at these levels. Any further significant selling, in our view, would be irrational and driven by fear as opposed to logic. A quote by legendary investor John Templeton may interest you, “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.”
This is clearly not what euphoria looks like. It’s possible that we will reflect on December 2018 as a healthy, though painful, correction. To be clear, we’re not committing ourselves to that thesis. We’re in a somewhat conservative stance. But we acknowledge that fundamentally, stripping away the fear and emotion of marketing sentiment, there are reasons for the market to stabilize at minimum, and rally at best. Fundamentals support that direction.A Move from Growth to Value
Turning to our firm-specific moves for our investors, in advance of this market selloff we made significant moves in the makeup of our client’s portfolios. We did not, of course, have foreknowledge that the market would sell-off as much as it has as quickly as it has. But believing that we were in a late cycle bull market, we identified this year as one in which the risks of the bull market ending were increased. As such, we transitioned the bulk of our holdings from growth to value stocks. A brief discussion of Growth versus Value may be helpful here. In general, here are the characteristics of each:
- Growth Stocks: Carry higher relatively higher valuation multiples (PE ratios, book values, etc.). Have more upside and generally lead the market in good times. Generally are most vulnerable to a market decline. Often don’t pay a dividend. Usually sexier names. Example names: Netflix, Amazon.
- Value Stocks: Carry higher relatively lower valuation multiples. Generally lag the market in good times, but can be more resistant to market declines. Often pay a significant dividend. Usually less sexier, often more mature companies. Example names: AT&T, Ford, CVS.
Consistent Dividend Payers- A Place of Refuge
Do names like AT&T, Ford, and CVS bore you? Understandable while the market was making new high after new high. But these quality dividend payers are just a few examples of names that we believe will serve as places of refuge and provide stability with solid on-going cash flow. Here are the current yields of those three stocks as an example: AT&T: 7.1%, Ford: 7.3%, CVS: 3.0%. The cash flow you see in 2019 gives us some flexibility to not be reactive. We have the luxury of acting with cool heads in accordance to the actual data we see, not to the emotion of the situation.Summary Impact of Topics Discussed:
- Negative – Market has sharply corrected. December has been the worst month since the Great Recession.
- Negative – It’s worse than the S&P 500 indicates. Broader indices show greater market weakness.
- Mixed – Market sentiment is dismal. Short-term this is a negative. For the intermediate term this serves as a positive catalyst as sentiment will likely improve from the depths of despair.
- Positive – This is not 2007 / ’08. We see no indication that we are on the brink of systemic economic collapse akin to the Great Recession.
- Positive – The underpinnings of the U.S. economy are solid. Cooling perhaps, but still strong.
- Positive – Trade / tariff negotiation with China. Not discussed above, but our view is both nations need a resolution too badly for there to be a lasting impasse. We see this as potential positive catalyst for the first half of 2019.
- Positive – Our firm has made specific moves to conservative investments; specifically in the move from growth to value stocks and our move to quality dividend payers. We believe the benefits of these moves will materialize through the course of 2019.
Conclusion and Broad Counsel
This is a time of heightened concern. For our clients we recognize you count on us. This Saturday was a work day for us as we pulled our thoughts together in light of the market uncertainty. In the coming weeks we will be diligent in continuing to work on your behalf. As always, much of our counsel depends on your time horizon. Let me break it up into three categories:
- Extended: If your time horizon is extended (generally speaking greater than two years) then I would recommend that you simply proceed as normal. Let’s review according to our normal quarterly or biannual schedule as you desire. Enjoy your holidays and try as much as possible to ignore the financial headlines (unless you enjoy show). Fundamentally, not much has changed. This is primarily a fear-driven event. This too shall pass. We’re optimistic on the return we will see as we reinvest the cash flow produced by your accounts into the current pricing environment.
- Nearer-term: If your time horizon is more limited and you have a near term goal, we may need to adjust. We believe market sanity will return in 2019, but there is no guarantee that there is not more near-term volatility in store before stability resumes. Let’s talk soon to make sure we are in synch on the potential risks and rewards as well as any necessary adjustments.
- Uncommitted capital: Meanwhile, for those of you with uncommitted capital and some time to see it grow, we see more opportunity in these turbulent times than when the market was smooth. Again, returning to John Templeton for wisdom, “The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”
- Todd Blackwell (843) 290-9172
- Jonathan Boyd (843)540-1149
- Edward Taylor (843) 263-4426
(1) Source: JP Morgan
(2) Source: Siblis Research
(3) Note that this chart was published October 4th. In the short time since publication, the market has sharply declined. An updated chart for 2018 would show a sharp decline in both metrics for 2018.
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