Equity Outlook

Adapting to the new economic backdrop

“Living systems are never in equilibrium. They are inherently unstable. They may seem stable, but they’re not. Everything is moving and changing. In a sense, everything is on the edge of collapse.”

– Michael Crichton, Jurassic Park

Mr. Crichton was not arguing that instability portends imminent disaster. On the contrary, the author asserts that the “little wobbles” inherent in living systems indicate health and resilience. Instead of collapsing, a healthy system adapts to change. This period of adaptation is often volatile, but is essential for long term sustainability. We have certainly come through a bit of a wobble in the stock market, but it is a natural reaction to ongoing changes.

A revolutionary in understanding financial markets is renowned MIT Professor, Andrew Lo, PhD. He has been named one of the most influential people in economics and one that Time Magazine described as the result you might expect if you “…had a mind meld with Adam Smith and Charles Darwin.”

Dr. Lo envisions financial markets as living systems and surmises that “Financial markets are the product of human evolution, and follow biological laws…” thus the same laws of mutation, competition and natural selection apply as with any other biological system.

In 2017, Dr. Lo published his influential book, “Adaptive Markets: Financial Evolution at the Speed of Thought,” outlining his theory behind the backdrop of the Global Financial Crisis. As we reflect on the wild ride markets took us on during the fourth quarter, some concepts set forth by Dr. Lo come to mind.

“Financial behavior that may seem irrational now is really behavior that hasn’t had sufficient time to adapt in modern context.”

– Andrew Lo

As we mentioned last quarter, we are in the midst of a changing economic framework. The last ten years of low rates are seemingly behind us, geopolitical issues are more uncertain, and a host of other trends are heading in new directions. As investors act to adapt to the new backdrop, volatility has returned. After reaching historic lows in 2017, last year we saw volatility return to levels we haven’t seen for some time. In fact, we have to go back to 2012 to find a year where the S&P 500 intra-year decline was more than 15%. However, from the peak on Sept. 21st through the bottom on Dec. 26, the market dipped 20% bringing about the worst quarterly return since the third quarter of 2002. Despite the dramatic dive into bear-market territory, the good news is that the market was down only 4.4% for the year.

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Quantitative Tightening (losing hurts more than winning feels good)

As we emerged from the Global Financial Crisis, the meteoric rise of the stock market ran coincidentally with unprecedented levels of Quantitative Easing. Indeed, many market observers attribute a significant amount of market performance over the past ten years to Fed policy. So, shouldn’t it follow that Quantitative Tightening would drive markets lower? We suggest that while monetary policy is an important part of the financial system, the expected results of these changes are not that simple.

In the midst of the Financial Crisis, liquidity and growth were major concerns. Easy monetary policy was the safety net to keep markets afloat as companies adapted to a sharp reset in asset prices and the resulting decline in employment – remember the Fed’s dual mandate of stable prices and full employment. Due to the magnitude of the decline and the tepid recovery, rates have remained low for a historic length of time.

However, as we entered into a period of higher expected economic growth, the need for artificially low rates has passed.

Higher growth and expected inflation should inversely impact multiples. While we have seen the market increase 271% since the market low in March of 2009, multiples have remained relatively tame, until recently. This is because earnings growth has generally kept pace with market prices. However, two things have happened. First, multiples reached their 10-year high in December of 2017.

Secondly, a handful of the largest companies disproportionately impacted that measure. As rates continued their path and concerns grew that increases were on “autopilot”, the market began to adapt by driving prices and multiples lower. Combine this with poor results from some of the largest companies and you got the perfect storm for a correction. However, the recent market rout and global growth concerns have led to a more dovish Fed, potentially putting the brakes on this trend.

In light of the sharp drop in market prices, investors are tempted to focus on lower P/Es as a compelling reason to be optimistic for short-term market performance. As of the end of the year, we saw the Forward P/E ratio dip to 14.4x 2019 earnings – lowest since 2013. However, this conclusion relies heavily on the idea that earnings projections are accurate.

“(Intelligence is) the ability to construct good narratives.”

– Andrew Lo

In light of the sharp drop in market prices, investors are tempted to focus on lower P/Es as a compelling reason to be optimistic for short-term market performance. As of the end of the year, we saw the Forward P/E ratio dip to 14.4x 2019 earnings – lowest since 2013. However, this conclusion relies heavily on the idea that earnings projections are accurate.

When Dr. Lo references good narratives, he is not speaking to things like corporate management telling good stories about their expected results. What he means is, “to generate accurate cause-and-effect descriptions of reality.” In other words, it is your skill in understanding what causes events to happen and your ability to apply that to future situations. In thinking about the certainty of 2019 earnings, one might be inclined to be cautious.

In 2018, we saw significant corporate earnings growth. The first three quarters of the year saw year-over-year growth above 20%, cresting at 26% in the Third Quarter. Preliminary numbers for the fourth quarter are more modest, but are still likely to eclipse 10%. While earnings results are real, a major contributor to the growth came, not from topline growth, but from tax cuts. The embedded expense of doing business was dramatically reduced and benefits went straight to the bottom line.

It is easy to mistakenly extrapolate last year’s results into current expectations. What if economic growth is significantly slower than anticipated? 2019 results are likely to be much more subdued, but more importantly, we believe results are more uncertain. Material costs, higher wages, and slowing top-line growth could all weigh heavily on results in the coming 12 months. However, just as easily, we could see a quicker-than anticipated resolution to these issues and better-than-expected results. While we often offer caution regarding headline noise, we suggest that the trade negotiations with China are the most important factor impacting economic outcomes over the next year.

The Double Coincidence of Wants

We spoke last quarter of the importance of China to the global economy and we remain cautious on its outlook. As the Trump Administration pushes forward with the goal of a new Sino-American trade pact, we have seen notable weakness in the Chinese economy as well as concerns from US corporations on the negative impact to their operations. Additionally, we’ve seen growth slow outside of the U.S. While just a few short months ago globally synchronized growth was a sign of strength, that condition has quickly faded and is now a concern.

With US-China trade negotiations continuing, companies are in a limbo for planning. Like any organism in an ecosystem, with enough time companies will find ways to adapt to the new environment. Raw materials or parts could be sourced differently, or higher finished product costs would be passed on to the customer. However, the lingering uncertainty makes it difficult for companies to plan. The result is a more cautious approach to operations which would likely translate into slower economic growth. The optimistic take is that with weakness on both sides of the table, we would expect pressures to complete a deal to increase.

Volatility is the price that an investor must pay for average returns over time

One thing we know is that historical average returns are not good predictors of future results. While US stocks are still a good long-term bet, average returns over the next ten years may be less than they were over the previous ten. Despite the current trade situation, emerging market investments appear to offer a more robust alternative. Developed markets such as the US, Europe, and Japan have led economic growth over the years, but demographic shifts point to a more subdued future for these economies.

When considering potential economic output, labor growth remains the top input. For developed markets, Ned Davis Research calculates potential real growth at 1.3%, down from near 4% in 1988. The firm points to factors such as declining birth rates and mature economies as causes of anemic growth for the foreseeable future. However, in many emerging and frontier markets we are seeing the opposite.

While population growth is a core component, modernization and a general liberalization of economies in these countries is projected to produce a significant growth in the middle class. Middle class families have more discretionary funds to spend, and places like China realize that their long term competitiveness depends on continuing this trend.

As another example, the IMF projects India to grow its middle class population by over 800 million within the next 15 years, more than doubling the current population of the US. Add in the attractive valuations for emerging market stocks and long term average returns should easily eclipse those of developed markets – just be cautious as developing countries have many unresolved issues, investors are likely to see higher than average volatility tied to those investments.

“The wisdom of crowds depends on the errors of individual investors canceling each other out.”

– Andrew Lo

The volatility we cautioned about in our last Quarterly Outlook arrived with a vengeance. However, our take is that the “wobble” was a temporary correction. While we foresee a time when the current market cycle has run its course, indications are that we are not there yet.

Regardless, a sensible investor insures their portfolio is prepared for change. A focus on quality companies able to weather unexpected storms should be coupled with proven tactics of risk reduction, such as diversification. As markets have evolved over time, managing portfolios has as well. These adaptations and approaches help make them, not immune from volatility or change, but potentially stronger and more likely to survive adverse situations. Like Mr. Crichton so aptly puts it through the words of Dr. Malcom, “Life finds a way” – and markets do too.

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This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary.  Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.

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International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.

Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.

In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.

The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.

Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).