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Strategy Update

A Melt-Up in the Making

In 2019 the stock market sailed higher, recouping its losses from 2018 and then some. The shift in investor sentiment from one year to the next was dramatic. As the year progressed it became increasingly apparent that the market was being driven more by emotion than corporate fundamentals. The overall gain in corporate profits was minimal in 2019, but investors decided to pay much more for those earnings. The simple explanation for the radical change in sentiment was the Federal Reserve cutting interest rates three times over the course of the year. In addition to that move, the Fed started pouring money into the financial system again, a practice called “quantitative easing” that it had halted in 2018. With interest rates so low, investors felt forced to buy some of the larger, dividend-paying consumer stocks. The buying then spread to tech companies, industrials, and medical companies. Investment bankers took advantage of the buying binge by bringing many new companies (initial public offerings) to market. And now the most speculative, money-losing penny stocks are attracting attention.

The term market meltdown is well known, and refers to a period where panic selling takes stocks down in a waterfall fashion. The reverse of that phenomenon is a market melt-up, which is characterized by relentless buying, with almost no pullbacks in price. It has now been over seventy days since the market pulled back by even one percent. The markets are in a melt-up phase. Both extremes are driven by a large dose of investor emotion that takes precedence over thoughtful analysis. Markets can collapse when fear of losing money becomes paramount, and stocks can soar in price when fear of missing out on gains grips investors. In late 2018 the market suffered a mini-meltdown as it dropped 20% in a matter of weeks and many hot stocks lost twice that much. Within nine months that fear of losing money switched to fear of missing out, leading to robust returns in 2019.

An emotionally charged market can be rewarding as assets appreciate, but investors have to be cognizant of an eventual inflection point. If the market reaches a high enough valuation, nearly any catalyst will suffice to trigger a correction. Investment analysts have repeatedly raised price targets on stocks, even when the underlying business results remain largely static. Stock prices are becoming increasingly disconnected from earnings. By the key ratio of price to earnings (P/E), this market is the most expensive since early 2002. We are not sure when the price advance will stop, but when it does a decline in P/E ratios to historic averages could take stocks down by a painful 15-20% from the current level. Even in high markets one can sometimes find an overlooked company that is just starting to gain traction with a new product or service. However, on balance we think this is a time to be cautious about putting additional capital into stocks that are richly valued in most cases.

Current Strategy

Investors were beset in 2019 by a host of global worries and responded by pouring money into the biggest of the big stocks. It did not matter if the companies were doing great or not; they just seemed like the best refuge in a world where democracy was under attack, trade wars dragged on, Saudi oil fields were bombed, the UK moved closer to leaving the European Union, articles of impeachment passed, climate change was unchecked, and negative interest rates became more widespread. And this is just a partial list of domestic and international issues. The Trump administration’s legal efforts to block California’s auto emission standards, forcing the state to accept more gas guzzlers on its roads, typified the authoritarian, regressive policies gripping much of the world. Around the same time, and with significant lobbying efforts, the government granted specific exemptions to Apple within its ongoing trade dispute with China. In retrospect, it is not altogether surprising that investors decided to align their money with companies big and powerful enough to take on governments.

For the first seven months of 2019 the stocks we had chosen for clients matched, and in many cases exceeded, the gain in the market indices. Our selections were a mix of smaller, mid-size, and some very large companies spread across the technology, medical, and industrial sectors. In the latter part of 2019, as the biggest companies, particularly in technology, continued to march ever higher, our group of holdings made further progress, but did not keep pace with the largest tech companies. We still feel that small and mid-size companies hold the greatest promise for growth and long-term capital gains, but that did not prove to be the case in the latter months of 2019. Our recent purchases have been largely in consumer staples, healthcare, and communications, which have historically been more resilient than the overall indices during market corrections.

The bond rally that kicked off last January stalled out in the closing months of the year. There are some indications that inflation is picking up. With a strong jobs report for the month of November also came news that wages were growing at over 3%. This is all good news for the economy, but not so for bond investors. There is nothing more feared by bond investors than rising inflation. In the past ten years the Federal Reserve has engineered asset price inflation by way of historically low interest rates and quantitative easing. If that inflation morphs into consistently rising wages and rising prices for goods and services, the inflation genie will be out of the bottle, and the Fed will have to respond by raising interest rates. It would be a good day for holders of cash and short-term bonds.

We believe the stock market is running on euphoria as of late. In turning towards some traditionally defensive sectors within the stock market and holding a larger position in income-producing money market funds, we are preparing for a moment when emotion may shift yet again.

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