Equity Outlook

Listen to Wisdom

If I have seen further it is by standing on the shoulders of giants.

- Isaac Newton

While Isaac Newton was not the originator of the axiom, he held that all modern knowledge was made possible only by building on the discoveries of our predecessors. Investing wisdom is likewise elevated by learning from past experiences. The last two decades each started at very different points in valuation and investor expectations. While over-optimism abounded at the start of the 2000’s, over-pessimism dominated investor psychology at the start of the 2010’s. As we start the 2020’s, history teaches us to be mindful of valuations, stay diversified, and question the crowd.

“No one knew when the tech bubble would burst, and no one knew what the extent of the correction could be or how long it would last. But it wasn’t impossible to get a sense that the market was euphoric and investors were behaving in an unquestioning, giddy manner. That was all it would have taken to avoid a great deal of the carnage.” – Howard Marks 

By the time the terrorist attacks happened in September of 2001, the internet bubble had already popped, sending the S&P 500 down over 27% from the market peak in March of 2000. In November of that year, Howard Marks, the leader of Oaktree Capital, wrote his famous letter to investors titled “You can’t predict. You can prepare.” At that point, the stock market still had another 30% to fall before bottoming. As a contemporary assessment of mistakes just made, one of Mr. Marks most important lessons found in that letter is not to base extrapolations on over-exuberant markets. 

“You cannot ignore the market – ignoring a source of investment opportunities would obviously be a mistake – but you must think for yourself and not allow the market to direct you.” - Seth Klarman 

After the financial crisis, we started the 2010’s uncertain the worst was behind us. In reality, we had already begun the longest economic expansion since at least 1900. While an impressive era in terms of time, annualized economic growth was frustratingly slow at 2.2% per year over the last decade. Despite anemic growth, easy fiscal and monetary policy set the conditions for a bull market run characterized by extraordinarily low volatility. 

Since the market low in March 2009, the S&P 500 has posted a cumulative total return of nearly 500%, or about 18% per year. During this time, investors have resoundingly favored companies capable of capturing the excitement and dollars of the consumer through innovation in products and delivery of those goods and services. 

Companies like the FANG stocks emerged as market leaders. (F)acebook, which didn’t even IPO until 2012, went from 430 million subscribers to nearly 2.5 billion. (A)mazon left the market in its wake, returning nearly 37% per year. (N)etflix introduced streaming in 2007 and chilled its way to a 46% annualized return. (G)oogle became Alphabet halfway through the decade and became a dominant player in the flow of information around the world.

One common trend to all of these companies is that they are all service companies. While manufacturing remains the backbone, services continue to grow in importance globally. Indeed, according to Deutsche Bank, nearly 90% of the US employment is in the services industry, yet nearly 70% of earnings come from manufacturing. Even the once commodity-laden Emerging Markets Index now boasts Technology as its biggest sector.

While it was an extraordinary decade, it had its bumps. Despite holding the distinction as the only decade in US history without a recession, we have seen two major global slowdowns. Both of these events were led by cyclical manufacturing declines. However, global recessions were avoided, in both instances, by slowed but consistent growth of services. As we end the decade, we are seemingly in the middle of a third such slowdown. 

“...analysts are called analysts, not forecasters, for a reason...It is far better to focus on what really matters, rather than succumbing to the siren call of Wall Street’s many noise peddlers.” – James Montier 

Market Returns


2019 began with experts forecasting recessions and the end of the bull market, but the year, ended with record highs seemingly everywhere. Setting numerous records, the S&P 500 ended the year up 31.5% in total return, small cap companies increased by 25.5%, and as was the trend late last year, Cyclical and Quality stocks lead the rally. Defensive and high-dividend stocks, which you might expect to lead in uncertain times, lagged, posting returns of 21.4% and 22.5%, respectively. 

While stock returns were broadly strong, below the surface two major themes emerged: (1) a slowdown in global economic growth and (2) the resulting reversal in US monetary policy from hawkish to dovish.

Behind the headlines of massive stock returns, however, 2019 brought the first earnings recession since 2016. In fact, if consensus estimate projections for the fourth quarter of 2019 are correct, the S&P 500 will post four consecutive quarters of earnings declines for the first time since the third quarter of 2015. At the time of this publication, estimates for fourth quarter growth for the S&P 500 earnings are -1.5%, but if historical upward revisions hold true, we still have hope we may well indeed break the trend and actually see positive results.

With the tailwinds of a sweeping reduction in taxes for individuals and corporations, expectations began to build in 2019  for accelerated economic growth. As a result, by the fall of 2018, analysts prognosticated three interest rate hikes in 2019 from the Fed. However, like an unexpected summer storm, global weakness, primarily in Europe and China, forced the Fed’s hand. As a result, the year ended up looking a lot like a mirror reflection of the decade as whole – slow growth, yet exceptional market performance fueled by easy monetary policies.

“All of investing consists of dealing with the future...and the future is something we can’t know much about.” – Howard Marks

Inherent to the positions of Messrs. Marks and Montier is the idea that expert forecasts are often accepted with too little critique. Additionally, while investing is fundamentally about the future, what we know about companies today is irrefutably more valuable than projections. So, as we enter a new year and decade, there are reasons for optimism, but investors cannot ignore concerns such as high valuations and continued slowing economic growth. With this in mind, a repeat of last year is unlikely, and as we get the next decade underway, the market may need some help to continue supporting current levels.

Congruent with increasingly accommodative monetary policy, the primary source of stock market returns in 2019 was multiple expansion. As a result, no matter how you view it, the market looks expensive today. For instance, the forward price-to-earnings (P/E) ratio expanded to 18.6x from 14.3x earnings at the beginning of the year. The price-to-book (P/B) also increased to 3.3x from 2.7x. Even more concerning, the median price/sales (P/S) ended at an all-time high of 2.7x – yes, higher than both 2000 and 2007. While investors certainly benefited from the double-digit returns, we start the year off with valuation concerns.

As we progress through 2020, corporate earnings results will matter. With such high valuations, stocks seem priced for perfection, and misses are likely to spook investors. Regardless of a decline in earnings growth, operating margins are near peak levels, but have declined recently. Should we see continued shrinking of margins, earnings are likely to follow suit, compounding the problem of currently high valuations. 

PE Ratios

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Prior to the Global Financial Crisis in 2007-2009, corporate operating margins peaked at 21.6%; across the peaks prior to recessions, the historical peak margin has been 18.2%. In March 2019, margins hit a decade-long high of 21.3%. Since March, we have seen margins decline slightly to 21.0%. While certainly not a clear sign margins have peaked, clearly a data point to keep on the radar.

“Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earning power through economic changes or deterioration in management.” – Benjamin Graham

Benjamin Graham, who is arguably the investing world’s original Orion, consistently extolled investors to see a stock as an investment beyond the fickleness of Mr. Market. This year, headlines are likely to cause short term volatility, as they always have, but the long-term outcome for investors is built on more fundamental inputs. The meaningful impact of the upcoming election will fall more to future years than this one. Not to say there won’t be some bumps – high valuations and breathless reporting make for a volatile combination.

Past experience can once again inform us on how to prepare for a pickup in volatility. Diversification can mean your friendly neighborhood portfolio manager is likely apologizing for the short-term underperformance of one asset class or another. However, as a cornerstone to sound investing principals, investors should continue leveraging the risk-reducing benefits of diversification. Furthermore, adding non-traditional assets with a demonstrated history of lower- correlation to the broader equity markets can help create a portfolio with better risk-adjusted returns. While short-term underperformance in some asset classes may cause angst, diversification combined with portfolio rebalancing is a reliable component to long-term portfolio outperformance.

Despite lagging domestic markets recently (here’s where we would be apologizing), holding international stocks not only adds diversification, but may also offer some additional upside potential. Although valuations abroad are also high compared to historical numbers, they appear less stretched than domestic stocks. Should China and Europe find some floor to current economic weakness, holding these names could add value to portfolios.

“Be fearful when others are greedy and greedy when others are fearful.” – Warren Buffett

Maybe the most recognizable investor of all time, Warren Buffett stood on the shoulders of Benjamin Graham to reach his achievements. Embracing the concept of approaching investing as an analyst instead of a speculator has served him well. Understanding the value of a company and seeking out quality stocks in this world marked by high valuations may also help us avoid some of the pitfalls faced by Messrs. Klarmon, Montier, and Marks.

What is to happen in this new decade is unknowable, but these fundamental lessons from our predecessors are shoulders which we should happily sit on to help us travel along our path. 

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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.

Indexes are unmanaged and investors are not able to invest directly into any index.

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).