The fourth quarter of 2019 delivered robust equity markets (S&P 500 +9%) as the fundamental backdrop of accommodative financial conditions was catalyzed by relief from trade tensions and indications of firming economic growth.
An overweighting in the preeminent mobile device provider added value as investors concluded that the recent decline in phone unit volumes is ending and that the services segment has reached critical mass. Investments in two semiconductor stocks also contributed to relative performance in the quarter on evidence that chip inventories and pricing are improving. Additionally, a concentration in a money center bank added outperformance as interest rates bottomed. On the negative side, our position in the largest domestic aerospace manufacturer was a drag in the quarter after recertification of an airplane was delayed.
Balanced accounts benefitted from strong equity results and the yield pick-up derived from a heavy concentration in corporate bonds.
Last year’s breathtaking run for stocks begs the question, “is this too good to be true?” or “how long can this last?” in many minds. Underlying this thinking is the Newtonian law that “what goes up must come down.” If we were good at physics, we would probably not be in this business so let’s turn to financial history. Going back to 1950, S&P 500 annual returns in excess of 28% were produced thirteen times. Eleven of those years were followed by positive performance in the next. This does little to inform us on 2020 but it does moderate a tempting bias. On an extremely short-term basis there is plenty of evidence to suggest that equity markets are currently “complacent,” “overbought” or “euphoric” (please pick your favorite). As a result, we do not expect stocks to continue making new highs as an almost daily occurrence. However, that is probably myopic and does not formulate a 2020 investment viewpoint either. We may be better served by framing the question as “what is likely to derail the current bull market?” Let’s try to narrow down the usual suspects.
History leaves little doubt that recessions kill bull markets. The threat of recession may seem like a straw man right now but let’s not forget that the yield curve was inverted less than four months ago and the doom and gloom crowd cited its predictive value for much of 2019. It has been over a decade since the last economic downturn (a record) but expansions do not die of old age. They usually ended when the Federal Reserve tightens to prevent inflationary overheating or in response to exogenous events such as war or oil shocks. Inflation does not appear to be a near-term threat. Measures of inflationary expectations remain below Fed targets and better wage gains do not appear to be percolating into overall pricing. More practically, Chairman Powell was burned by the 2018 Fed Fund rate increases and is likely to be wary of repeating the mistake. Accordingly, “easy money” should be on our side for the foreseeable future.
Turning to exogenous events, there are always plenty of possibilities but our job is to focus on probabilities. We will deal with the November election shortly but non-scheduled events are nearly impossible to see with any lead time or conviction. That said, containment of the recent conflict with Iran is a very welcome development from many perspectives.
A more immediate threat resides in the status of the recent/current mini-recession. The rise in bond yields and the relative strength of economically sensitive equities indicate that financial markets assume the worst is over. Actual economic numbers paint with a much more mixed palette. High frequency data releases show improving breadth but there are plenty of setbacks in the manufacturing and capital goods arenas. We lean towards optimism but are concerned about diminishing efficacy from repeated monetary policy efforts. Said differently, lowering already low rates may not stimulate the economy very much. This concern prevents us from fully embracing cyclical stocks (but more about positioning to follow).
The S&P 500 is now trading at close to 18.5 times 2020 earnings estimates. Historically this is on the high side but comparing stocks to other assets adds perspective. On an earning yield basis (earnings divided by price), the market is returning over 5% which is reasonable given bond yields below 2%. This type of analysis works as long as monetary policy (low interest rates and expanding central bank balance sheets) is on our side. This has been a liquidity driven rally. Although no one is comfortable with that, it can last as long as money supply growth exceeds nominal GDP growth. We plan to keep a sharp eye on that relationship.
Another potential threat would be another flare-up in the trade conflict with China. Clearly much of the stock market’s second half rally was driven by the hope of a trade deal or at least de-escalation of tit-for-tat tariffs. Friction (both economic and political) with China should be present for years if not decades. Nearer-term, the so-called Phase One agreement is yet to be inked so another eruption cannot be completely ruled out. However, the underlying forces motivating the truce remain in place. Simply put, President Trump’s reelection chances are aided by a deal and Chairman Xi’s life is a lot easier with some economic relief.
The November election represents a significant challenge to the bull market on several levels. Without a doubt, political uncertainty is a negative for stocks. How soon will this be discounted and how large a negative are much harder issues to handicap. An old rule of thumb is that the market discounts about six months out. Looking back to 2016, the S&P 500 appreciated through early August and then declined about five percent until Election Day. No guarantees but the above suggest that a window remains open.
Of greater import is whether the election will mark a profound change in the direction of the country. This can represent the structure of our healthcare system, corporate and personal tax rates, and/or environmental policy. We will not know the outcome until after the election but this will not prevent stocks from gyrating with each change in the polls as we close in on Election Day. Rather than predict a specific outcome (most were wrong last time), we will assess the tail risk of a major shift in the environment. As an example, conviction that a centrist Democrat will earn the nomination could be viewed as a reduction in tail risk by investors.
The future composition of the Senate should not be overlooked. A split government with one party holding the White House and the other Congress would provide a safety valve governing dramatic new policies. Senate Republicans will be defending 23 seats while Democrats face 12 challenges. Democrats need to pick up three or four seats to gain control, depending on the Vice President. Whether the Presidency or Congress, it is far too early to have conviction in an outcome which reminds us why equities dislike uncertainty.
Although we recognize that financial markets are never straight lines in either direction, we do not find the above threats sufficient to shift from our fully invested posture at this time. Since we do not see economic growth moving significantly or sustainably from its current trajectory, we are avoiding extremes in the composition of our portfolio. In other words, we have no exposure to the Materials sector (most cyclical) nor weighting in the Utilities (most defensive). We remain overweighted the Information Technology sector with concentrations in software, semiconductors, and financial technology companies. One of the most exciting thematics within this group is the emergence of the 5th generation mobile network (5G).
No discussion of 5G should begin without the caveat that the development of new technologies usually takes longer (but ends up bigger) than expected. Beyond faster data speeds, 5G promises to expand mobile networks to support a vast array of devices and services. New or improved applications include immersive experiences (e.g. virtual reality), mission critical communications (e.g. AI for automobiles), and expansion of the internet of things. Our most direct exposure is through the company that leads in 5G technology but our investments in device and semiconductor stocks should participate as well.
Turning to fixed income portfolios, bond yields remain low despite being up about 0.4% from their September lows. In the absence of geo-political turmoil, we doubt if yields will move much lower. Conversely, given that the Fed appears on hold, do not expect much upside until there is convincing evidence of above-trend economic growth. As a result, our holdings approximate benchmark duration with a focus on corporate exposure.
The New Year is beginning with positive absolute and relative performance. More importantly, we wish you a healthy and prosperous 2020.