The race doesn't always go to the swift or the strong - but that's the way to bet.
- Grantland Rice
... you should invest more when the tickets in the bowl are in your favor. You should invest less when they are against your favor and what determines the mix of the tickets in the bowl is largely where we stand in the cycle.
- Howard Marks Oaktree
Howard Marks is one of the great investors of our time, and he is constantly sharing his thoughts in his famous memos. In a recent interview, he outlined his analogy that investing is like picking tickets out of a bowl. Some are winning tickets and some are losing tickets. The number of winning or losing tickets in the bowl depends on where we are in the economic and market cycle. By analyzing where we are in the cycle, the above-average investor can judge correctly whether there are more winning tickets or more losing tickets in the bowl. The investor doesn't know the outcome of picking a ticket, but understands the probability of picking a winning or losing ticket.
We invest more heavily when we perceive there to be more winning tickets in the bowl than losing tickets. When we perceive that the losing tickets in the bowl outnumber the winning tickets, we still invest, but with a bit more caution. We still invest because we cannot predict the future. It is still possible to pick winning tickets when the odds are stacked against us - it's just less likely. That is why we invest with more caution. We analyze where we are in the cycle and the preponderance of winning or losing tickets. It is then that we manage our aggressiveness and how much we diversify or how much we hedge. So, much like the great sportswriter Grantland Rice, Howard Marks tells us how to place our investing bets.
The Current Quarter
On the heels of the best quarter in stocks in a decade, we must say we would have been impressed if we had only managed to hold on to those gains. We got that and a bit more with equities advancing 3.8% in Q2. This quarter had the added benefit of advancing bond and gold prices. While you might think long-term bonds and gold seem like strange bedfellows, the Federal Reserve saw to their advance through their latest shift back towards a renewed dovish policy. The Federal Reserve's move back towards easier money policies had just about all assets looking up.
It was a positive quarter for risk assets in spite of lower economic numbers, a trade war between the two largest economies on the planet and an inverted yield curve. We do wonder how long asset prices can ignore a global economic slump while pressing ever higher in valuation. Investors have been trained by central banks over the last 30 years to respond positively to loose monetary policy. Markets ignore negative news, and even come to embrace it, as negative economic news means that the Fed is even more likely to ease policy. The market climbs an ever-steeper wall of worry, while continuing to buy assets at a decreasing risk premium.
According to the sharp eyes of Michael Wilson at Morgan Stanley, more than 100% of this rally in 2019 is from multiple expansion - the excess amount investors are willing to pay for the same amount of earnings. At almost 17 times forward 12-month earnings per share (EPS), the S&P is trading at elevated valuations, and those valuations are elevated not due to higher earnings but due to higher expectations or the willingness to pay more money for the same dollar of earnings.
This quarter we saw economic bellwethers such as UPS, Intel (INTC) and 3M (MMM) all have their worst trading days since 2008 Financial Crisis or even as far back as 1987 in 3M's case. These are old line companies that we have used for decades to gather information to assess the health of the global economy and ascertain the next move in the market. We can see further evidence of the failing health of the worldwide economy in JPMorgan's Global Manufacturing Purchasing Managers Index. This widely followed index fell to its lowest level in over six and a half years and posted back-to-back sub-50.0 readings for the first time since the second half of 2012. A sub-50 reading is an indicator of economic contraction.
The global economy seems to be slowing, and bond investors are reacting to that by driving yields lower, but equity investors are partying on - pushing averages back to all-time high levels. However, it does seem that the market averages are being driven by ever-smaller numbers in their leadership, and the echoes of 1999 are being felt as we see big name tech stocks come public. Initial Public Offerings (IPOs) are all the rage, and that should have your attention. When those in the know - Venture Capital owners of these privately held companies- begin to sell, check your wallet. 80% of the IPOs in 2018 had zero earnings, and that is the highest level since the Tech Bubble of 1999-2000.
We continue to see a very difficult investing environment (fewer winning tickets in the bowl) made all the more difficult by stubbornly high valuation levels. Current equity valuations have been seen only twice previously. Those two periods were the 1929 and 2000 time periods, which are widely known for their stock market selloffs. While President Trump is engaging in trade wars with just about all of major trading partners, worldwide economic numbers are falling into a slump. We see a recession on the horizon here in the United States as leading economic indicators foreshadow a slowdown, while the key indicator of recessions - an inverted yield curve - remains inverted. While an inverted yield curve is seen as an indicator of a possible recession, history shows that stock markets can continue to rally once the curve inverts for 9-18 months.
The real indicator to run for the exits is when the curve begins to steepen. That may being to happen next month, as the Federal Reserve has indicated that it intends to lower rates at its July meeting. We find this significant in that the Federal Reserve is adding to the moral hazard in the markets. It is encouraging risk-taking when the stock market here in the US is at an all-time high. Markets have rallied from the Christmas lows back to where they were in 2016, when interest rates were at a similar level. While investors may currently find valuations less than attractive - given a limitless supply of liquidity at historically low interest rates - it makes those valuations a bit more enticing. At some point, investors will see diminishing returns to monetary policy changes and may demand a larger margin of safety to their purchases.
The bond and stock markets continue to be stuck splitting the difference between being a late-cycle market which is richly priced and one that is being enhanced by central bank liquidity. The Fed, once again, is in the business of encouraging risk-taking. Take a look at Bitcoin. Once again it is in the headlines as its rapid ascent catches our attention. While the Fed managed to pop that bubble in 2018, its recent reemergence is directly related to the lack of political will of the Federal Reserve to tighten policy. The rallies in stock, bond and gold markets this quarter are also directly related to central bank largesse. Bitcoin may now be the temperature gauge for risk sentiment in the market.
Last quarter, we mentioned that we perceived investors as looking to rent this rally as buyers in late 2018, and perhaps turn into sellers as the rally prospered. That turned out to be accurate. Most investors are now underweight equities and overweight longer-term bonds. While we would expect equities to retreat from this level, we know from history that when everyone expects something to happen, something else will. Most of the investing world has been caught flat-footed or, at least, underinvested in equities by the flip-flop of the Federal Reserve.
In the last 6 months, US equity fund flows have been the most negative since the Global Financial Crisis. It seems as though everyone in the industry is prepared for a move lower in stocks. Machine-generated algorithms and corporate buybacks have held equity prices at relatively high valuations in spite of economic headwinds, while professional active investors sold equities and collected dry powder in the face of a slowing global economy.
That dry powder could keep equities elevated or give them support in any downturn in the second half of 2019. The Fear of Missing Out (FOMO) on the part of institutional investors could even lead to a spike in the S&P to new all-time highs. If the Federal Reserve cuts rates repeatedly in the second half of 2019, it may begin to appear as though were are in the same environment as 1998, when the Fed cut rates and exacerbated the Internet Bubble. This likelihood is increased further if, after having cut rates, the trade wars were resolved and tariffs were removed. Now you can see why we find this to be such an interesting and difficult investing environment. While an economic slump with markets at all-time highs should lead to a reduction in valuations and lower stock prices, sometimes markets don't do what would make sense. When everyone expects something to happen, something else will.
Where does this market go next? When markets find themselves in a sideways trend, they tend to break out the same way that they came in. It allows time for corporate earnings to increase and justify valuations. In this case, markets are digesting the gains earned in the late 2016-17 time frame. The more time that passes, the less likely the equity market is to head meaningfully lower. Markets rarely trade sideways for years and then suddenly crash (never say never). This market has taken everything thrown at it and stayed within reach of all time highs while investing professionals have taken down risk meaningfully and have cash at their disposal to meet a strong sell-off. It appears that most professionals and pundits see a recession on the horizon, especially in the absence of a trade deal. That recession risk has investors holding lots of cash. A breakout could have investing pros underperforming and force them to put cash to work.
For the past 18 months, our assessment has been correct, as the path in the equity market has been sideways and it has been advantageous to sit and collect our dividends while we took down risk. We saw fewer winning tickets in the bowl at that point in the cycle and felt that it made sense to diversify and hedge in greater numbers. We sit until we see a clear direction to take advantage of, but with each month ticking by, we get closer to putting more risk back into the portfolio. While we can make a long list of negatives - for ten years we have see markets run higher, induced by central bank intervention in spite of horrible economic numbers. If central bankers continue to prod investors to purchase assets by lowering interest rates and adding liquidity, at some point reluctant investors will be forced back into markets.
Again, we are reminded of the 1998 period when markets were riding high and central bankers flooded the economy with cash in response to the Asian Debt Crisis and impending Y2K. That blew the last of the Internet Bubble, before it popped in 2000. It is possible that the recession on the horizon that people are seeing is just a slowdown caused by the global trade war. In that case, the Fed could find itself having overly loose monetary policy in its response to a global slowdown, much akin to its response to the debt crisis in 1998.
You may have noticed the increased presence of precious metals in your portfolio. We talk of seasonal periods from time to time, and find that the most helpful information is when something that performs well when it is in a seasonally weak period may be in for further strength. That asset right now is gold. Gold historically performs poorly in the summer months. The month of June has been very good to the returns of gold investors in 2019. While precious metals cannot be valued by their cash flow and pay no dividends, they are also more valuable in rocky geopolitical times and have higher value in the land of zero interest rates. While subject to more technical market risk (and possibly a shorter holding period), the gold market is seeing its highest prices in 6 years.
The Dow Jones Transports and the Russell 1000 may just be the key to the equity market in the second half of 2019. These two areas of the market have stubbornly refused to participate in the latest rally from the December lows, and their support is critical. The Transports, in particular, are a bellwether of global economic health, and their movement may precede the next leg higher or lower in the equity market. In the past week, both of these areas have started to perform better than the overall market. If they continue this positive action, then perhaps the global slowdown was just that - only a slowdown.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.