2018 Review: “A Tale of Two Markets”
For the first nine months of 2018, all major market indices experienced strong returns. The Tax Cuts and Jobs Act of 2017 reduced tax and regulatory burdens across the economy, feeding optimism of robust corporate earnings growth, accelerating consumer spending, continued low inflation, controlled interest rates and improving employment across a broadening range social-economic demographics. The economy, which was already experiencing improvement, built momentum and drove 2nd quarter GDP growth to 4.2%, the highest level seen since the recovery began nearly 10 years ago.
As mid-term elections approached in September, optimism began to wane as investors anticipated a more balanced government structure. Trade issues, especially with China, became center stage and pessimism grew with concerns that GDP growth peaked and was beginning a glide path back to the 2.0-2.5% range. Importantly, the Federal Reserve signaled a gradual continuation of increasing short-term interest rates. A brief inversion of the yield curve fueled recession predictions for 2019 while political turmoil intensified. With the markets trending down, tax-loss selling exacerbated the weakness. The S&P 500 posted one of the worst 4th quarter returns in recent history. Smaller stocks were the worst performers, down over -20% (Footnote 1) in the 4th quarter.
Behavioral Economics and Fundamental Analysis Applied
Markets can overreact to positive and negative news with excessive euphoria and pessimism. It seems like we witnessed a little of both in 2018.
In the mid 1970s – 1980s Daniel Kahneman, Amos Tversky and Richard Thaler (Footnote 2) began researching, publishing and expanding a body of work called Behavioral Economics, which is a method of economic analysis that applies psychological insights into human behavior to explain economic decision making, including the psychology of investing. While the body of work continues to grow, one of the key conclusions found that investors often form heuristics (Footnote 3) and biases that cause them to make illogical choices while simultaneously believing they are totally rational. A simple, classic example is investors tend to be overly optimistic when markets reach new highs and tend to be overly pessimistic when markets approach new lows. These resulting heuristics and biases often result in “buying the top” and “selling the bottom”, despite a very large body of evidence that they should be doing the opposite.
So how do you minimize illogical investment choices? In begins with recognizing, knowing, and understanding your heuristics and biases. But it’s more than just that. One needs a sound, time-tested fundamentally based process that systematically minimizes heuristic and bias creep into the investment decision process. Repeatedly following this process minimizes illogical choices and provides the opportunity to exploit market inefficiencies on an individual security level (especially in smaller stocks) and irrationality on a broader market level.
Our fundamentally based process is built to minimize heuristics and bias by focusing on three key building blocks: 1) a valuation framework to measure the cheapness and richness of individual securities, both on an absolute and relative basis; 2) a strong, supportive capital structure; 3) a direct assessment of management and evaluation of the Board of Directors – Will they be good partners?
On a broader level, at closing levels of 2018, the closely followed S&P 500 was valued at approximately 14.5x 2019 earnings per share. This seems a bit low given a 10-year U.S. Treasury yield of 2.75%, controlled inflation, current equity risk premiums and a low probability of a significant decline in economic growth in the foreseeable future.
That said, we don’t try to “call the market”. There are simply too many factors that influence the overall price level and determining which are the most significant is ripe with heuristics and bias. As with any statistical equation, analysts often try to isolate and limit the number of important factors to find those with the greatest significance. A handful of variables are usually identified as the “most important”, but in reality are often recognized only in hindsight. Without a systematic way to minimize the heuristics and bias, there is a lot of “noise” and acknowledging exogenous unforeseen events must be anticipated.
Thoughts on 2019
Market volatility returned and will likely continue in 2019, but we don’t anticipate the magnitude experienced in the 4th quarter of 2018. We expect earnings to grow, but at a slower pace as seen over the past 12-18 months. As mentioned, overall valuations seem reasonable, and importantly, we continue to find attractive smaller capitalization equities that fit our fundamentally based investment process. Our base case investment thesis does not call for a recession in 2019, but we recognize that global growth slow down and continued trade tensions may take their toll. That said, at an October group session with Ben Bernanke he commented that “Expansions don’t die, they’re murdered”. He went on to explain the most common causes include (1) inflation acceleration, (2) financial stress, (3) geopolitical issues, and (4) current policy tools that are not at levels to dampen downturn.
Tightening labor markets and improving wage growth are helping expand labor participation across a wide range of demographics. The next step we’re watching is improving productivity to help offset the inflationary pressures of wage growth acceleration. With the U.S. consumer about 70% of the economy, continued confidence is also important.
Both Brexit and the general increase in global debt levels across the world are also worth watching. The people of England have spoken; it’s now a matter of the British government to answer. Further turmoil in the European Union would affect trade and growth across the globe. Additionally, the growth of sovereign, corporate, municipal and consumer debt outstanding in the U.S., Europe, and China warrants attention.
Wealth Management Portfolios and Small Capitalization Equities
U.S. equities remain attractive relative to fixed income and international securities. We encourage a diversified portfolio across market capitalizations with a tilt to later economic cycle domestic companies such as large and mid-capitalization companies with predictable growth (non-cyclical), strong capital structures, favorable valuations, and a tilt towards dividends.
Exposure to international markets should reflect both developed and emerging markets with an increased emphasis toward emerging markets due to valuation and growth potential. A generally small allocation to gold is also recommended. In fixed income we are emphasizing shorter duration investment grade bonds and adjustable-rate bonds. The risk-reward in long duration bonds remains unattractive given the current term structure.
Importantly, we continue our long-term allocation to U.S. companies with market capitalizations below $1.5 billion which is the most inefficiently priced segment of the small cap market. This is another market segment where behavioral economists have found anomalies. We invest in companies with attractive valuations, good capital structures, and strong management teams and whose stock price does not reflect the intrinsic value of the company.
Thank you for your confidence in White Pine Capital.
Your investment team:
1 Returns for broad market indices are the respective ETF return as a proxy for the index
2 Richard Thaler was a Professor at Cornell University when Mike Wallace and Tim Madey attended his courses in 1992-93. Subsequently, in 2017 Thaler won the Nobel Prize in Economics. Kahneman won the Nobel Prize in Economic Sciences in 2002 (unfortunately Tversky passed away before the award).
3 Heuristics: a method of solving a problem for which no formula exists, based on informal methods or experience, and employing a form of trial and error iteration