Strategy Update

October 29, 2018

Dow Jones Average: 24,443
S&P 500 Index: 2,641


Divergence

The stock market became highly divergent in 2018, with a handful of technology stocks shooting higher even as many other sectors faded. This kind of disparity in performance is not a healthy sign, and has often ended badly, particularly for those who pay lofty prices for glamour stocks. While many sectors in the market, such as housing and autos, were sliding badly in 2018, the broad market indices were sustained through September by a handful of big tech companies. As has so often been the case, October was the month of reckoning. Since peaking at over $2,000 per share in late September, Amazon has shed more than 500 points, dropping to $1,495 per share as of this writing. Percentage declines have been even worse for other highfliers, such as Netflix, Align, and Facebook. When too many investors have too much of their capital hanging on a few branches, those branches have a nasty habit of breaking.

The outperformance of technology shares also led to a global divergence in which the U.S. market remained high while foreign markets declined. Even before the recent October decline, the broadest measure of foreign markets, the MSCI EAFE Index, was down 4% on the year. This was due to growing geopolitical concerns, but also very much to the fact that the leading edge of our market, large technology companies, is not mirrored overseas. European and Japanese indices are dominated by industrial and consumer staples companies. The gap between the valuation of U.S. equities and stocks in Europe reached record proportions by the end of September.

When gaps in valuation become too wide they have a tendency to revert to a mean over time. Either the assets that are lagging begin to catch up, or the leaders start to fall back to the pack. In the first weeks of October the latter happened, with severe declines in many market leading tech stocks. The broader market also continued to fall as investors generally lost their nerve once the glamour stocks broke down. At month end things stabilized a bit, with the weakest sectors finally showing some resilience, and the high flyers finding at least a temporary floor. For the first time in many months a move toward convergence replaced the wide performance divergence that had marked this year.

Current Strategy

The U.S.-inspired trade war and higher interest rates have undermined investor confidence for much of 2018. Business conditions have certainly weakened in China, which has become a critical market for so many companies around the world. The U.S. economy has been in relatively better shape, with growing employment and somewhat higher wages. Yet many U.S. companies have recently cited profit pressures brought on by tariffs and labor costs. Investors have been reluctant to sell stocks, because U.S. stock indices were still outperforming bonds and there was hope that the trade war would just suddenly go away. It appears that investor patience ran out in October. Once the selling started, a key rationale for staying in stocks, namely the relative outperformance of U.S. equities, quickly evaporated.

While we have made a number of equity sales this year, we wish in retrospect that the sell list had been a bit longer. There would have been more capital gains taxes to pay, but that would have been preferable in some cases to share price erosion. Our exposure to the stock market has been low to modest for most clients, which we think has been the right strategy for this dicey market. As the market declines we are faced with another set of decisions regarding new purchases. A large number of stocks have declined to much more attractive price levels. Many of the concerns and fears that currently trouble investors are reflected in the lower stock prices. Buying opportunities arise when stocks decline on unfounded fears, or all legitimate concerns are properly accounted for by a lower price. With recent market turmoil some stocks are certainly closer to a buyable price.

We have been pleased by the outcome of our fixed income strategy. Over the past few years we moved from buying some municipal bonds to a large number of corporate bonds, and then to shorter-term Treasuries when the Federal Reserve finally stopped suppressing interest rates. We have been able to successfully ride the interest rate rise, earning increasingly higher rates on new bond purchases, while keeping price fluctuations on the bond portfolio to a minimum. We have avoided the longer term bonds that have been hit particularly hard in this period of rising interest rates. We are building a staggered bond portfolio that will mature largely between 2019 and 2023. If interest rates keep rising our plan is to gradually lengthen the maturity of the portfolio.