My investment team leader in Morgan Stanley sent us a letter tod

 

Following is his letter. Please read carefully if you want to get a clue. 

 

Remember the story of Ferdinand?  That children’s book from 1936, still in print, tells the tale of a Spanish bull who refuses to embrace his heritage and fight to the death in the corrida.  Ferdinand, an icon of pacifism, would much rather lie under a cork tree and smell the flowers.  At the end of the story, after Madrid’s finest picadors and toreadors try –and fail- to goad him into a bullfight, our hero retires to his pasture in peace and tranquility. This classic came to mind these last few months as we grapple with the question:  Can a bull market simply graze away until it dies of old age?  As John Linehan from T. Rowe Price pointed out at Fortune Magazine’s Investor Roundtable, bulls are rarely so lucky.  They’re usually slain either by recessions or by speculative excess- or, in the case of the previous bear market, from 2007-2009, by both. Back then, the housing bubble was the catalyst that reverberated across the entire U.S. economy.  Today, many believe that similar warning signs are starting to form, including rising debt and lofty valuations for U.S. stocks, but they have remained faint enough to foster hope that our current bull- the oldest on record at  almost 10 years- might have a couple of years left to meander among the daffodils. So could this bull market be the exception, the one whose heartbeat just gradually slows until it stops?  It seems possible.  Much of the stock market volatility to date reflects investors’ sense that trends that generated big recent gains are waning, not vanishing.  Make no mistake, big tech is here to stay, but its growth has to slacken someday.  China is a juggernaut, but it’s not invulnerable.  Yes, the U.S. hit 4% GDP growth, but the sugar rush from tax cuts can’t last forever.  In such times, where it is clear that things are changing, but very unclear as to the results of those changes, there is only one certainty, and that is uncertainty.  In prior periods of heightened confusion, volatility and ambiguity, our team and our clients have benefited from three things:  learning lessons from the past, focusing on the data not the noise, and grounding ourselves in our investment principles. Looking back in history to try and find some clarity is one potential salve for today’s angst.  For example, looking back at 1998, we see many similar events that are defining today’s market environment- gasoline prices plunged, the yield curve flattened, the Fed was in a rising rate modality.  These occurrences caused a mid-year decline in the S&P 500 Index of over -18% (compared to -8% today).  However, despite all of this, GDP growth was still +4.5%, the Fed changed course and neutralized their policy, and the S&P ended the year up +27% .  To us, there is a similar divergence between the market movement and the strength of the economy today.  The main differences between 1998 and today are that corporate profits had already shown decline in 1997 and the yield curve had already officially inverted.  Another helpful tool for qualifying any fears about a looming recession is to mine the data for signals.  The signs of slowdown are clear, but it is equally as clear that these signs are of slowing growth, not impending contraction.  There are significant data points that also validate that recessions typically do not materialize at the beginning of a slowdown in the major economic indicators, but much further into the slowing process.  For example, housing starts are weakening, which is a macroeconomic measure Merlin Wealth Management’s investment team tracks religiously.  However, we are also aware that according to Evercore ISI Research, housing starts typically start to weaken 2 ½ years before a recession starts.  Similarly, in our due diligence process on the auto-related holdings we own in our proprietary portfolios, we have observed a weakening in vehicle sales.   Yet, we also note from our ISI Research that vehicle sales weakened 3 years before the 1990 and 2008 recessions started.   Lastly, and perhaps most importantly, we note that after S&P earnings growth has peaked (which many say it will this year), the next recession has been 4 years out on average, with a range of 2 to 8 years, measuring back to 1988 .  Thus, much of the economic sub-cycle data suggest the overall U.S. economic cycle is, age wise, merely beyond its midpoint, which is not typically the time in the cycle that recessions occur. Beyond providing linkages and patterns to help make sense of a volatile time, studying data can also help silence some of the noise that contributes to much of the investor anxiety we see and hear about.  One such item today is the bell ringing about high levels of debt.  Yes, companies and individuals (and governments, too) have been incented to take on debt due to historically low interest rates.  Yet, the growth in debt remains sluggish by historical standards.  Financial debt is growing less than 3% annually, which is well below the double-digit rates we have seen during past expansions.  This lack of debt creation reduces the risk of recession since there are no excesses from which we are retreating.  Further, the bearish narrative would discount this slower debt growth and have you focus on the high level of debt as mentioned earlier.  While total credit market debt of $70.7 trillion is high relative to GDP at 350%, debt relative to net worth has been falling for households and has been relatively stable for businesses.  That is another signal of the lack of excesses that would typically lead to a recession.  To sum up our lessons from past history and from examining the data, it is absolutely natural, even wise, to expect slower economic growth going forward.  By 2020, the fading impact of the economic stimulus from ultra-low interest rates and tax reform could cause U.S. real GDP growth to slow to around 2%.  But that’s a far cry from recession.  During the Great Recession of 2007 to 2009, for example, GDP plummeted by -5.1% from peak to trough.  Finally, if this bull market is not destined to die of old age like our friend Ferdinand, today none of the typical killers of the bull- over-investment, tighter financial conditions, and shocks- currently exist. With this backdrop it is always calming to ground ourselves in our investment principles.  Call it yoga for your portfolio!  As we settle into our child’s pose, we remember that the core of our investment discipline is in the ownership of great businesses.  It is also important to remember that great businesses don’t stop being great businesses when economic conditions slow.  If you are an investor, and not a trader, and a great company’s earnings grow at 7% per year for the next 3 years, instead of 26%, it may very well still be an excellent investment.  The important thing is to keep perspective.  If you invest in solid companies, a drop in earnings growth from 26% this year to 7% for the next 3 years as the tax cut boost is no longer there comparing 2019 with 2018, is still a very good investment.  Over the past 68 years the S&P has averaged EPS growth of just under 6%, for 43 years 6.4%, and for the last 8 years 7%.  So, if earnings growth drops to 7% for the next 3 years that is still above average for the S&P and we should, therefore, still expect at least average market returns from stocks over that period of time.  Since long term returns for stocks (as measured by the S&P over a 40 year period) average around 8% per annum inclusive of 2008viii, and with the expectation that interest rates will likely stay low for the next few years, the risk premium on stocks, accompanied now by an even more reasonable P/E multiple, seem worth it, taking of course into account an appropriately crafted asset allocation. As always, we hope to provide value and comfort to you during all times, but especially during times of heightened uncertainty.  While it is holiday time, and many of us may be traveling, we still want to hear from you if you are in any way concerned or uneasy.  Please call us.  May we all have a happy, healthy and prosperous new year!