Kool and the Gang!
4Q 2017 Quarterly Letter – Written 1/31/18 and annotated on 2/5/18 (All annotations are in parentheses and italicized font, with final comments at the end of the letter)
Happy New Year, indeed! The euphoria reminds us of the Kool and the Gang song, “Celebrate.” There are indeed many reasons to celebrate. Markets moved sharply higher in the 4th quarter on the back of steady economic growth, solid corporate earnings and the passing of a $1.5 Trillion tax cut. That upward velocity has increased in January, and we rest near all-time highs in most of the major stock indices. Regulatory reforms have begun to filter through to have a positive impact on most private and public businesses. Companies large and small have begun to share anticipated tax savings with employees in the form of cash bonuses and increased wages. Many companies have announced increases in their capital expenditure plans, which will lead to accelerated hiring plans, creating jobs and growth opportunities for their current employee base. Merger and acquisition activity is increasing, which is buoying valuations in many sectors, and there have been significant proclamations made by large companies that they plan to bring back enormous amounts of cash from overseas. They also plan to bring jobs back to the U.S. with that cash. Unemployment is reported to be 4.1%, a level that most consider to be near “full employment,” and wages are expected to accelerate as the slack continues to be removed from the system. There are certainly many things to celebrate.
The comments we made in our special update to investors on December 24th, which detailed our thoughts on the passage of tax reform, should provide a good snapshot of our thoughts at that time:
We have been very skeptical that Congress was going to reach this point and, while we are not overly excited about all the details included in the final product, we are pleasantly surprised that they got this law passed. As stated above, we view this as positive for the economy and asset prices.
Markets have rallied nearly 10% since that date, as investors have responded positively to all this good news. We have actually had several “firsts” in the last year. One of those was the fact that 2017 was the first time the U.S. stock market did not experience a pullback of more than 3%. Think about that for a minute. Most of us are old enough to remember many DAYS where the market declined by more than 3%…. much less to go 448 days without a peak to trough decline of 3%!! That is where we stand as of this writing, nearly a year and a half without a correction of 3%. Hard to imagine, but that illustrates precisely how steady this rise has been, and how little volatility we have experienced. It is truly remarkable, and a period that we will look back on with wonder in the years to come.
(Hard to believe how much can change in 3 trading days…. We went more than 440 days without a 3% correction. Today, the market declined by nearly 5% and the two-day decline in the S&P 500 was nearly 6.5%. See comment below about speed of declines…)
There have been some subtle negatives that we have had to stomach over the last year, but nothing that would come even close to derailing the celebration. The steady climb in long-term interest rates would be an example of something that is probably a negative, but the population has elected not to become concerned about this…yet. Since September, the yield on the 10-year U.S. Treasury has risen from less than 2.07% to more than 2.75% as of today. That more than 32% increase in borrowing costs came off an extremely low base, but increasing rates are a drain on cash flow for borrowers, nonetheless. The reason for the rise is expectations of an accelerating economy, which is a good reason compared to other causes, but it is something to watch. The Federal Reserve is expected to increase rates three more times this year, possibly four, and we are likely to see the Prime Rate surpass 5% for the first time since the financial crisis. Eventually, higher rates could impact economic growth and become a meaningful competitor to stocks for capital, which may lead to asset allocation shifts and a decline in stock valuations. We are on record saying that we think we could possibly see an inverted yield curve sometime in 2018. This is a strong possibility if we see inflation stay moderate and the Fed increase short-term rates three times. One can look at history to see how inverted yield curves have been very reliable as a “canary in the coal mine.” This is one of the main things investors should watch carefully in 2018.
With the exception of an increase in rates, is there anything that can derail this celebration? It is hard to see, absent any geopolitical event, which would be completely unpredictable. Certainly, the drama in Washington D.C. could always trigger instability but what could really slow down this economic engine that has now moved out of neutral and into 1st gear? In fact, that acceleration of growth is probably the most visible risk that could throw some ice water on the party. If the economy kicks into 2nd or 3rd gear and we see significant “wage push” inflation (accelerating wages that create inflation and rapidly rising prices), it is very possible this could hasten the increase in interest rates, which would invariably lead to a reduction in stock market valuations. This is where the chink in the armor could present itself, as valuations are rich by any possible standard. The celebration is the cause of this overvaluation, and it is a “high level problem,” but it is a concern and creates a headwind of statistically significant proportions.
(There is rarely a definitive reason that markets experience sharp moves like we saw the last two days. In this case, there are varied opinions bantered about but ultimately it comes back to the overly simple, but true, statement that there were simply “more sellers than buyers…”
But what definitely started the sell-off on Friday was the better than expected employment number announced early that morning, along with a very sharp increase in interest rates across the yield curve. The concerns we discussed above are what started the ball rolling and then market participants just all tried to get to the exits at the same time. That, coupled with fewer liquidity providers in the markets, combine to remind us of the adage we quote below regarding speed of declines…)
Time for Willie Nelson?
Someone could interpret that last statement to imply we are tuning up to play Willie Nelson’s song, “The Party’s Over.” This is not what we are saying, and we can see a lot of reasons for the celebration to continue. But it is certainly getting really late in the evening and we all tell our children, “nothing good typically happens after midnight…” We believe investors have to be realistic about their expectations and not get caught up in market euphoria. Furthermore, they should be consciously determining how much risk they are willing to take at this point in the cycle, and where they should be taking those risks.
If this sounds confusing to the reader, that’s because it is! Quite simply, things are going very well right now, and most everything is expensive as a result. Investing 101 states that it is best to buy into fear and sell into euphoria. What Investing 401 would say is that it is really hard to know the difference between optimism, for good reasons, and euphoria. This is where investors have been stuck for the last 15 months. Did they blindly believe that the change in control in Washington D.C. would lead to positive results, or was that optimism unfounded and likely to disappoint? If they approached the new political dynamic with caution, it led to missed opportunities. If, instead, they proceeded with strong faith in a positive outcome, they were richly rewarded. Investors find themselves in a similar place today, albeit with more definitive data at their fingertips. Tax and regulatory reform have created meaningful fiscal stimulus which should infiltrate the economy more and more each quarter. This creates many reasons for optimism. So, the question becomes whether we have reached the euphoric stage, which would mean investors would be much better off as sellers.
This is where investing becomes more art than science and why long-term asset allocation decisions are so critical. Investors are in an absolute pickle. Whether they realize it or not, they have virtually no statistical likelihood of achieving their investment return objectives over the next decade. (Stop and read that again.) What happened to the celebration? Sorry to put a damper on the party, but the numbers state what the numbers state, and we will illustrate them below. Before we do that, though, we want to provide some critical clarity to the way that investors should utilize the CAZ Scale. It is designed to illustrate to investors what long-term return opportunities look like, and how much risk exists in the markets at a particular point in time. The scale ranges from 1 – 5, with 1 being the most cautious and 5 being the most optimistic. The way the Scale is rated is based on that combination of long-term return outlook and the risks that are prevalent to investors’ capital. We are not forecasting corrections, rallies, bull markets or bear markets, but we are informing investors as to what they should be thinking about as they make long-term decisions within the constraints allowable within their asset allocation thresholds. Simply stated, if we are a 5 on our Scale, we believe investors should be in full “risk on” mode and taking as much risk as their allocation permits, and if we are a 1 on the Scale, we believe investors should be at the lowest threshold of risk in their allocation range. Ultimately, we are absolute return investors which means we want to make money. Relative returns are important in certain contexts, but ultimately, we care about getting our money back and earning a competitive rate of return for the amount of risk we are taking. So, with that background, we are a “1” on the CAZ Scale today, because we believe that returns from stock market investments are likely to significantly underperform expectations over the next 10 years. The probability of U.S. stock market investors making a positive “real” (after inflation) rate of return over the next decade is nearly nil.
Whoa, one might ask, I thought there was a lot to celebrate? There is, but we also know that by the time investors realize the party is over, there will be significant destruction of capital that will have already occurred. Never forget that stock prices have proven they go down much, much faster than they go up, and by the time the Willie Nelson song is heard by investors, there will have already been a rush for the exits. We don’t want our investors caught in that stampede. Therefore, have a stock market allocation you can live with if the party ends, and focus on investments that can help you achieve your portfolio return objectives without having to rely on public stock prices to defy overwhelming odds.
(This is what we referenced above that resonates so loudly at such a time as this. Stocks always go down faster… It only took the market two days to wipe out nearly two months of stocks going up almost every day. And this pullback is not even officially a “correction,” as it takes a decline of more than 10% to receive that title. Fear is a more powerful motivator than greed, and we need to be realistic to understand we need to follow the adage we quote as much as any other, “sell when you can, NOT when you have to…”)
Do Statistics Lie?
Statistics are fallible and should only be used as guideposts to make decisions. Fortunately, they can eliminate emotion, and they allow us to evaluate things without bias. Statistics are also documentable and provide us with the ability to eliminate much of the noise we hear on a daily basis. We pride ourselves as a firm, in that we look at the forest, not the trees, and historical data provides us with a tool to help us do that in a much better way. For those who attended our Themes for 2018 event, we spent some time on stock market valuations and the outlook for investors. The feedback was incredibly positive, and we felt it would be helpful to utilize a few slides we showed at the event, as well as one slide that was not shown because it gets deeper in the weeds then was appropriate for that forum. Slides are provided below, along with commentary.
First, you will find a chart that we have shown in past quarterly letters which illustrates how the U.S. stock market is very expensive by historical standards, regardless of which well-respected metric one uses for the evaluation. Notice that the chart goes back to 1900…
The next chart shows the Shiller Cyclically Adjusted Price to Earnings Ratio (“CAPE”), going back to 1881, which utilizes the average inflation-adjusted earnings for the prior 10-year period, instead of just the last 12 months of earnings. This provides a much smoother result and a longer-term view.
Now, we look at a really busy chart, known as a scattergram. This illustrates the results of EVERY 10-year period since 1871. It shows the 10-year average “real” (after inflation) rate of return and plots that return in conjunction with the CAPE ratio at the beginning of each 10-year period. The red line plotted on the chart is where we started calendar year 2018. The blue dots to the right of the red line are each and every 10-year period where the CAPE has started out more expensive than we were on January 1. If you look very carefully, there are only three dots that are to the right of the red line that are above the Zero line on the horizontal axis, which indicates a 0% average annual real rate of return for a 10-year period. Every other dot that is to the right of the red line is below the Zero line, which means that U.S. stocks have generated a negative average annual real rate of return every other time we have started a 10-year period at a higher CAPE ratio. (Read that line again, please.) Thereby, of every single rolling 10-year period since 1871, there have only been three times when we have had a higher CAPE ratio than today where investors actually made money in U.S. stocks over the next decade, and they were all less than 3% average annual real returns.
That chart shows the absolute numbers, and is very busy, so let’s show the averages, which will smooth the data and make it easier to digest. The next chart shows the Total Real Return for U.S. stocks for every decade, since 1871, when they started the 10-year period at a CAPE ratio of less than 10, 10 to 20, 20 to 30 and greater than 30. As the frowny face clearly indicates, when U.S. stocks start a decade with a CAPE ratio above 30 (reminder that we are at ~33 today) the Average Total Real Return, for the entire 10-year window, has been a loss of -22.25%. That means, if the averages of the last 146 years were to continue, investors in U.S. stocks would be expected to look up at the end of 2027 with a portfolio loss of 22%. This is why we are a 1 on the CAZ Scale.
When we look at the world, there are still opportunities to generate returns, but pretending that static long-term U.S. stock market exposure is going to provide satisfactory returns requires investors to ignore overwhelming statistical evidence. This does not necessarily mean an investor should have zero U.S. stock market exposure. It simply means that we should not expect broad-based U.S. stock market exposure to make us money! The rest of your portfolio will need to do the heavy lifting, and we strongly recommend that investors focus their attention, and their investment dollars, in those other areas.
It is sometimes difficult, but we continue to find unique opportunities to deploy our personal capital. We feel much more comfortable at this stage in the economic cycle investing in idiosyncratic situations that have specific factors that will determine their success. As we identify those investments for our families, we will keep you informed and provide you with the opportunity to invest alongside our team.
We wish you and your family all the best in 2018, and we look forward to seeing you soon!
(While the environment changed rapidly in the two days since we wrote this letter, the message we want investors to take away is the same. We know this letter gets deeper “in the weeds” than we normally try to get, but we feel it is critical that all investors spend the time to be informed so they can make the right allocation decisions. There is likely to be a bounce from this two-day interruption of the party and we hope that all investors will be diligent to position their portfolios at the right risk tolerance level. We are happy to answer any questions you may have.)
All our very best,
The Team at CAZ Investments