Last Updated: June 30, 2019

The following reflections were partly inspired by the recent release of the SBH 25th Anniversary Logo1, which has brought back memories of markets past and the realization that several issues we grappled with then are ones we are dealing with today, only in a different guise.

The stock market has been on quite a roller coaster of late. Not surprisingly, the increased volatility is raising apprehensions with many investors. Spirits were depressed at the turn of the year, but enthusiasm rebounded by the end of the first quarter, only to be dashed again by the market’s about-face in May and then revived in June. Perhaps viewing recent experience through a slightly different lens will provide a broader view of what’s really happened with the market over the past year. Assume that for the purpose of this discussion, the market’s year-end for 2018 occurred on September 30, 2018 and that 2019 began on October 1. Consider the table below to see the before-and-after.

Source: ICE. Past performance is not indicative of future results.

At the beginning of 2018, regular readers may recall that our view (which hasn’t changed) was that 2018 would be good for Main Street, but not necessarily Wall Street. This was based on our belief that if the economy was strong, it would cause the Fed to raise interest rates, putting pressure on price-earnings multiples. Alternatively, if there was no pressure to raise rates, it would imply that profits would disappoint. Either way, we saw limited upside in the broad indices for 2018. In this construct, “Alternative” 2018 behaved only partly in line with our point of view: earnings growth was strong, but no one thought the Fed would raise interest rates, so no negative pressure was felt on price-earnings multiples. Then, as “Alternative” 2019 began in October of last year, worries about higher interest rates came to the fore, and a sharp decline in the “first quarter” of the year ensued. In the “second quarter,” concerns about trade issues and weakening global economies eliminated the market’s apprehensions of higher interest rates and the stock market rallied. As a result, “Alternative” 2019 ended the June 30 quarter about where it started the “year,” up 2.5%. Keep in mind that the stock market was achieving new highs around September 30 (times varied depending on the index, of course). Viewing the market through this exercise makes it clear that while the markets have enjoyed a great run in calendar 2019, they are essentially unchanged from last Fall. A lot of running, but just in place.

While the stock market has been strong in the first half of 2019 (thought experiment is over, by the way; we are back to standard calendar references), the gain has continued to be largely concentrated in the large cap stocks of the (broad based) S&P 500® Index. The so-called FANG stocks 2, just over 1% of the number of stocks in the index, account for 15% of its value. The dominance of these high-tech, rapidly growing companies in the Index brings back memories of the Dot-Com boom and bubble of the late 1990s. As those who were around recall, in the last act of the boom, there was a huge issuance of IPOs, all of which were thought to be as equally transformational as Microsoft or Intel or Cisco were considered. More importantly, investors were told to think of new valuation parameters and new ways to think of equity valuations to explain the new paradigm. “Disruptive” is just this generation’s version of “clicks per eyeball.”

When the bubble finally did burst, it is instructive to recall that many of the established names in the “new sector” did indeed produce satisfactory operating results, not as much as had been forecast but still very respectable. Microsoft, just to take an example, saw earnings rise 11-12% annually from 1999 until 2012, a year chosen because it took that long for the stock price to get back to the old highs.

The importance of the preceding observation lies in the following chart, which is usually a chart that comes out only at year-end. Sometimes called a “patch-quilt chart” or a “periodic table chart,” it shows the changing way asset class returns move relative to each other year by year. It is usually intended to show how variable asset class returns can be from year to year. The asset classes that are the best one year can turn to be the worst the following one. What we have done with this presentation is to lock the asset class Large Domestic Equities (generally represented by the S&P 500®) in the middle. While it is “common knowledge” that the S&P 500® is the “asset of choice,” this chart, going back 25 years, suggests that it is the asset of choice primarily in the periods in which technology-driven stocks are doing especially well and liquidity is abundant. In other non-tech-focused eras, see, for example, 2002 through 2009, the S&P 500® generally falls into the bottom half of the standings. Also note that when the S&P line drops out of the top, it generally heralds the end of a bull market.

Part of the reason euphoria reigns and a bull market can run free is that the U.S. Federal Reserve (Fed) is very accommodative in providing liquidity to the economy. It is quaint for us to recall now, but in the last 18 months of the 20th century (mid-1998 on), there was a great deal of concern that the switch from dates beginning 19xx to 20xx was going to disrupt many computer systems and cause the global financial system to possibly shut-down. To prevent the banking system from seizing up, the Fed aggressively pumped money into the system in the quarters preceding the millennial turn. When the calendar turned, and no disaster ensued, the Fed began vigorously draining what it had added to the system. Stock markets reacted, reaching their peaks in the first quarter of 2000 and falling sharply thereafter.

Following 2008, another crisis, but this one far more serious, took place and the Fed and other global central banks cut interest rates to near zero. A global economic collapse was averted, to be sure, but the central banks found themselves with a tiger by the tail which they appear unable to let go, even to this day. Indeed, almost a decade after the global downturn, over $12 trillion of debt globally trades at negative interest rates3, which many believed was essentially an impossible outcome beyond a temporary panic in any rational sense. It is quite likely that when the financial history of this era is written, the policies of ZIRP (Zero Interest Rate Policy) and QE (Quantitative Easing) will be seen as the equivalent of financial opioids for the market. They alleviate the pain of economic downturn very effectively, to be sure, but they are highly addictive. Weaning the patient from dependence turns out to be hard, but prolonged usage of this financial version of opioids is harmful to the patient. The capital markets are unable to provide signals about misallocation of capital, and many projects that should not be undertaken are. The behavior of many market participants changes. They come to believe the central banks can keep the pain away permanently—that markets will never go down—and ever-more risky behaviors are thus encouraged. The process becomes self-fulfilling…until one day when it isn’t. This movie has played before, and it only gets a Rotten Tomatoes score of 17 on the Happy Ending scale.

Over the last 25 years, we have been fortunate to serve a growing number of clients. We have maintained existing relationships and attracted new clients, largely because our philosophy across all the strategies we provide rests on several bedrock principles, chief among which are these two: doing our own fundamental research to build portfolios of both stocks and bonds from the bottom up and to insist that the valuations of the securities put into client portfolios adequately compensate for the risks to which we are exposing client capital. There are rarely times any of us think this is easy, but it is professionally gratifying to shepherd capital clients have entrusted to our management through hard markets. If it proves that we are headed for such a period, keep these two key principles in mind.

1Thanks go to the SBH Marketing Group, and especially Cindy Knowlton.
2 A group of stocks are so named as an acronym: Facebook, Amazon, Netflix, and Google. Other companies are also added to the mix, depending on one’s tastes, including Apple and Microsoft, among others. While the GICS classification system does not call all of them “technology” stocks—Amazon, for example, is in the Consumer Discretionary group— they are all technology dependent, both in operations and (especially) in investor perception.
3 Negative interest rates prevail in almost all of Europe and Japan. The central banks have bought so many bonds and driven the prices of bonds so high that the interest earned to maturity does not overcome the premium over par at which these bonds trade, thus producing a negative yield in investing in them.
The information contained herein is for informational purposes only without regard to any particular reader’s investment objectives, risk tolerances or financial situation and does not constitute investment advice, nor should it be considered a solicitation or offering to investors.