July 2019 – Quarterly Letter

Congratulations everyone! You are part of the longest economic expansion in U.S. history. No one said it would be easy. Since the credit crisis bottomed out, we’ve endured the U.S. debt ceiling crisis, the Greek debt default crisis, Brexit, and now a trade war with the Chinese. We’ve had a few severe corrections, but the S&P 500 hasn’t dropped more than 20% from it’s high in over ten years.

The stock market bounced back big from the sell-off in late 2018. Year-to-date our stock portfolios are up nearly 20%. Over the last three years, our balanced portfolios are up about 25% and our equity portfolios are up almost 40%. These performance numbers are higher than our long-term performance projections, but not excessively so.

Last year I projected that the S&P 500 would be worth 3,000 at the end of 2018. It didn’t quite trade at that level, but it now seems to have found its footing slightly above 3,000. The S&P 500 trades at 18.6 times the next twelve months earnings. This multiple is slightly below the last five-year’s average of 18.9. Analysts project 11% earnings growth over the next twelve months. For now, earnings forecasts show no sign of an impending recession.

Rising earnings should support the stock market over the next twelve months. It is very rare for returns to go negative when earnings are increasing. Over the last five years, the range of the S&P multiple is 16.3 at the low end to a high of 21.5. Investor sentiment is neutral today, at least relative to the last five years. If sentiment moves to an optimistic extreme, at 21.5 times the next twelve months earnings, the S&P could gain as much as 30% over the next year. If sentiment stays as it is, which seems most likely, we would expect total returns of about 13%. If sentiment takes a turn for the worst, and valuations fall back to the five-year low of 16.3, stock returns would be around 0 over the next twelve months.

It’s reasonable to assume that since this is the longest the economy has gone without a recession, that a recession is right around the corner. There has been a lot of discussion about the “inverted yield curve” and its record as a leading indicator of recession.  Inverted yield curves are tricky. They do generally precede a recession, but the timing varies. Here is a table showing all the prior inversions going back to the ‘60s. On average, one-year returns are modestly lower, but the range of returns is huge! You can also see that five-year returns are better than the long-term average.

Some investors are speculating that this inverted yield curve is not as valid, as long-term rates are held “artificially” lower by global central banks buying massive amounts of long-term U.S. Treasury bonds. The corporate bond market does not show a similar inversion. My take on it is that I’m a little skeptical of the validity of the current inversion signal. Even if it has perfect foresight about the likelihood of a recession, it doesn’t tell us the time frame in which this recession will occur. In three cases out of eleven, stocks gained more than 20% in the twelve months following a yield curve inversion.

Interest rates on lower risk assets are so low (1%-2%), that there aren’t many productive alternatives to stocks. There are some signs of an economic slowdown, but there are few indications of the kinds of excesses that prevailed prior to the past few recessions.

A moderate decline in confidence is enough to impact capital investment decision making. A recession is possible even in the absence of a bubble like the real estate bubbles of the late eighties and late aughts, or the technology bubble of the late nineties. Without these imbalances, a recession would likely be shallow and short.

Uncertainty around trade policy with China could be the cause of the current manufacturing slowdown. A trade driven recession should be relatively manageable. It will take six to twelve months for U.S. supply chains to adjust their operations away from China.

Dollar strength relative to our trading partners could also be a source of corporate anxiety. A rising dollar makes U.S. exports less competitive. A strong dollar today has less to do with U.S. policy and more to do with the instability of our largest trading partners.

The possibility of the U.K. leaving the European Union without any trade deals in place is causing the dollar to dramatically appreciate against the pound. A dollar today buys 35% more in the U.K. than it did five years ago. If you were ever thinking about a trip to London, now is the time to do it. The downside is that U.S. goods and services are much less affordable to the British. Political instability and economic weakness is impacting the European currency. The Euro is about 20% cheaper relative to the dollar since 2013.

Pounds per Dollar

We have no way of showing dollar strength on your performance reports. It’s not how many dollars you have that matters, what ultimately matters is the quantity of goods and services you can buy with your dollars. Put another way, assume the amount of dollars in your portfolio is the same today as it was five years ago. On a trade weighted basis, the dollar is about 17% stronger versus the rest of the world. This means that a dollar buys 17% more today than it did five years ago, but also that our exports are 17% more expensive than they were five years ago.

Euro Per Dollar

President Trump’s objective to reduce our trade deficit will be very challenging to achieve. Tariffs are a  tax on imports. This tax reduces U.S. consumer demand for foreign goods and services.

The quickest way to increase foreign demand for U.S. goods and services is to devalue the dollar. I have no idea if bringing down the trade deficit is worth devaluing the dollar, but as we move into an election year, I assume that the Trump administration is considering it. A dollar devaluation would cause U.S. stock prices to fall, and foreign stocks to rise in value.

At some point, the dollar will decline in value.  This probability alone warrants maintaining substantial exposure to international stocks. Allocating a portion of your long-term investment portfolio to non-dollar denominated investments is the best way I know to reduce risk without reducing the expected return of your portfolio.

Without the ability to correctly time the next recession, the best course of action is to stay with the asset allocation that is most consistent with your long-term investment objectives. I am increasing the portfolio’s allocation to companies that should maintain earnings growth despite economic weakness. Companies that are taking market share through innovation will continue to succeed even when the economy slows. These companies should come out of any recession just as strong as they were before.