Argent Quarterly Investment Commentary – December 2018
“It is not the head but the stomach that determines the fate of the stock-picker.”
– Peter Lynch
It was a great year in 2018 for the American economy; arguably its best year in over a decade. Unemployment dropped, wages grew, and corporate earnings soared to record highs. In harsh contrast, almost all the markets worldwide – both stock and bond – limped into 2019 battered and bruised. Following up on a strong third quarter, the S&P 500® Index posted its worst quarterly performance since 2011. Volatility also spiked, with significant stock market swings happening daily. There were ten moves up or down, unfortunately mostly down, of one percent or more in December alone!
In our year-end newsletter last year, we were most worried about tariff issues, which we surmised would limit stock market gains to mid-to-upper single digits in 2018. We were wrong, as large cap U.S. stocks lost 3-7 percent. With hindsight- and in the business world the rearview mirror is always clearer than the windshield – we clearly underestimated the impact of rising interest rates at a time of global trade unrest. Having said that, this year these factors seem to already well-represented in current pricing. Thus, even in the face of slowing economic growth, we believe valuations present an excellent opportunity for stock gains. With some reasonable trade agreement with China, which would likely be to the advantage of both countries, these gains could be even more attractive.
To be fair, there are plenty of concerns for 2019. The current trade conflict between the U.S. and China tops the list. There is a lot riding on striking a trade deal with that country sometime soon. President Trump and his negotiators say they expect his tough stance to lead to more exports and investment in the U.S. What the markets are telling us is another story – that investors are skeptical and see a more severe global economic slowdown resulting instead.
Of course, there are other red flags. The era of central bank induced ultra-low interest rates is coming to an end. As part of this, the Fed raised U.S. short-term interest rates a fourth time for 2018 in December, and its ninth time since 2015. While it is not a mandate of the Fed to monitor and drive positive equity markets –unemployment and inflation are the primary mandates – we need the Fed to be prudent, showing some restraint to avoid tightening too aggressively.
In its defense, the Fed leadership team faces a formidable challenge. They believe they need to normalize interest rates while at the same time unwind much of the “quantitative easing” program begun ten years ago. Quantitative easing had the Fed purchasing huge quantities of government bonds – a strategy designed to drive down interest rates and encourage investors to invest in equities and real estate to stimulate the economy. It did work, but the Fed is now left with the task of trying to wean the market from ultra-low interest rates at the same time global economic growth is decelerating.
A third red flag is slowing corporate earnings growth. In 2018, corporate earnings grew by over twenty percent, with approximately half of that growth due to the Trump tax cut. A slowdown is to be expected coming off the tax-cut induced gains, but the percentage of the decline has some worried. There are numerous indicators to suggest this a valid concern, including large declines in key commodity prices for things such as oil (down from $75 a barrel in October to $43 a barrel at year-end) and copper. Commodities are used heavily in construction and manufacturing, so they are important barometers of economic health to watch.
Finally, we have politics to worry about. (When did we not?!) In the U.S., the big threat is that President Trump will face a hostile House of Representatives. Should they maneuver to seek impeachment, we will face a constitutional crisis of sorts, and markets could react poorly to the uncertainty. Overseas, unfortunately, the political situation boasts more of the same – riots in France, a lame-duck leader in Germany, the BREXIT impasse in England and a fiscal nightmare in Italy.
So, with all that, how can any investor feel good about the outlook for stocks? Well, as Warren Buffett frequently reminds us, “It’s almost impossible to do well in equities over time if you go to bed every night thinking about the price of them.” That is because there is so much “noise” on a day-to-day basis that it is easy to lose sight of the forest for the trees.
Perversely, it is critical to remember that bad stock markets such as we have experienced spawn a much richer opportunity set of stocks to like. Based on current expectations for U.S. corporate earnings growth in 2019, large cap U.S. stocks now trade, on average, at a little over 14 times earnings. That is their lowest multiple in five years. Unemployment remains under four percent, banks are profitable and healthy, and virtually all businesses we talk to are doing relatively well. Interest rates also continue to be low relative to longer-term norms, and they are likely to stay there. Importantly, consumer spending has been solid.
Thomas Jefferson wrote, “Nothing gives one person so much advantage over another as to remain always cool and unruffled under all circumstances.” That is particularly true in the investment world, where nervous energy has always been the great destroyer of wealth. Investing well requires patience, in addition to conviction and lots of humility. (We struggle, of course, the most with the humility part.) While last year was a sober wake-up call to investors, 2019 has the potential to get back on track, although investors should keep their expectations modest pending a more long-term resolution of issues with China.
(c) 2019, Argent Capital Management
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