February 6, 2018 – As this letter was being finalized, we experienced the spike in market volatility and a pullback as predicted. The market, as measured by the Dow Jones Industrial Average, fell 667 points on Friday, February 2 and then 1175 points on Monday, February 5, a record for the largest one-day point drop in market history. While those point totals seem staggering, on a percentage basis, the pullback is not unprecedented. We have discussed the possibility of a correction to volatility, almost straight up market of the last few months, but a pullback never feels predictable or normal when it happens. The market retreated to early December levels, indicating a normal correction if the selling ends here. Still, this market event is ongoing. Usually, equity markets will take a few weeks to recover and one should expect the same in this situation.
The Pitcairn team is staying abreast of the developments in the day-to-day market events and, at this point, we see no change in the economic fundamentals that have driven the secular rally. Economic growth and corporate earnings remain strong and actual inflation is still at a very manageable level. In short, this market pullback is not an event that the long-term investor should react to.
They’re the four most dangerous words in investing – “It’s different this time.” Given the extraordinary set of circumstances this bull market has undergone, from unprecedented action from the Fed to the question marks that accompany a Trump presidency, some may think the market will do something it’s never done before. But any study of market history is enough to remind us that’s just not the case.
Investors may finally be warming up to this bull market. (See Chart A.) Many who wanted nothing to do with equities a few years ago are now more interested in adding to portfolio risk in an attempt to chase returns. We certainly see this investor psychology as a milepost, but not yet an indication of investor euphoria run wild. Investor sentiment is running strong right now, but as the inflection point in sentiment was just last summer, that emotional component of investor psychology is not yet showing signs of exhaustion.
This market constantly challenges investors to think, “It’s different this time.” We feel that a good deal of that pressure comes from messages created by the investment arms of the large banks which have historically been compensated by transactional volume rather than client success. If an investor feels that all lessons of market history hold no value, then he is more likely to make large changes to a portfolio based on the current marketplace fad of the day. Conversely, we feel that this market has followed the normal path of all bull markets, perhaps a little slower to evolve than most, and that a portfolio that is strategically positioned to benefit from that fact will succeed. Nonetheless, investors have been and constantly will be bombarded with many predictions that seem logical and are most definitely fear-inducing, but which turn out to be untrue.
For example, most analysts assumed that 2009 would usher in an age of austerity in which consumers would spend less and ultimately corporate earnings would suffer. Americans today are, by some measures, wealthier than ever and continue to spend their money in much the way they did before the recession. That assumption never came to pass.
Likewise, many have assumed that once the Fed began to raise interest rates and reign in the bond buying program that some felt supported the bull market in an unhealthy way, the equity market would immediately plunge. The strength of the market in both 2017 and now 2018 belie that assumption. The market has not gone down. In fact, it’s done the opposite.
What we are seeing unfold right now is a transition from solutions based purely on monetary policy to a structure, whereby increased fiscal policy attempts to take economic growth beyond that which can be achieved by monetary policy alone. The recent tax legislation, combined with the consistent loosening of regulatory constraints by the Federal government, is designed to give a supply-side shock to economic growth. This has been attempted before with the Bush tax cuts of 2003, driving a boost to GDP in 2004 and 2005. It is not normal to apply this kind of stimulus eight years into an economic and market cycle. While we are seeing growth forecasts markedly improve currently, critics of this late-cycle, supply-side solution maintain that such growth will be short lived and the specter of runaway inflation threatens to blunt any positives that growth may bring. We tend to take a bit more of an optimistic “wait and see” approach to the ultimate effect of the policy.
Here’s a deeper dive into how we see these trends playing out in specific sectors.
Strong Fundamentals in Global Economy
The strength of the global markets is another indicator that this continued upward market is not driven by the Fed or US actions alone. Global growth and a reasonably weak dollar have maintained those “Goldilocks Conditions” we highlighted last quarter almost uniformly around the world.
Another way of looking at that strong global economy is through the viewpoint of the world’s central bankers. If they feel comfortable with growth prospects, then they don’t have to prime the pump with interest rate cuts. The below chart shows that none of the top developed market central banks cut rates in 2017. (See Chart B.) Looking back at 2017, particularly in emerging markets, growth remained strong with China’s GDP growing at 6.8% compared to 2016 and India’s GDP at 8%.
While there were no interest rate cuts in 2017, the story for 2018 will be divergence in monetary policy for the world’s central banks. The past several years have been marked by unanimity amongst central banks in easy money policies meant to spur growth in the wake of the Great Recession. As economies improve, central bankers will begin to look at inflationary risks as the US Fed has already done. Countries at fuller employment levels such as the US, the UK, and China may divert from their dovish path, tightening rates to avoid unexpected inflationary shocks, while central banks still struggling with getting to full employment, such as the European Central Bank (ECB), will be under less inflationary pressure and will most likely keep rates low.
As we look for potential risks or red flags across the globe, we see more risks of a political nature than in the Goldilocks economic environment we just detailed. In 2013, we saw opportunity in emerging markets and it was politics, combined with a stronger dollar, which made that call premature. China embarked on an anti-corruption campaign that was so much more far-reaching than initially expected, it curtailed growth. Brazil found itself mired in a scandal so significant that it destroyed confidence in the government and the economy. As those two cornerstones of emerging markets stumbled, so did investments in emerging markets as a class.
Today, there is the potential of a military flare up in North Korea that could hurt the strong Asian economies, populism in Europe, and the risk of politically-based trade conflicts. All of these factors could impact global economies and global markets. While such events are always hard to forecast, the probability is that the global economic momentum that reigned in 2017 will continue throughout 2018.
US Economy – All Eyes on GDP
In the midst of this handoff from monetary policy to fiscal policy, we’re seeing an uptick in GDP growth domestically that caught many by surprise. We expect that to continue, driven in no small part by consumer confidence. As we pointed out earlier, just a few years ago we were treated to fear-inducing stories about the American consumer never again being able to drive economic growth in the way that he/she had in the 80s and 90s. The US finished 2017 with a strong holiday season, housing prices are at all-time highs, and household net worth is approaching $100 trillion – a record level.
Research shows that when consumers feel wealthier, they spend more money. We’re seeing that play out. Consumers feel good about spending money and have money to spend. That’s due to a number of factors, including the recent tax cuts. After a tumultuous path through Congress, the final bill ratchets up opportunities for supply-side growth. That’s going to lead to strong corporate earnings and a lot of optimistic conference calls between now and April. Hopefully, those earnings will be funneled into capital expenditures which will, in turn, build the capacity for future economic growth. As US corporations have had access to cheap capital for the past few years, but not the confidence to make meaningful CapEx decisions, we hope that the increased confidence of the current environment incentivizes decision making that will lead to increased economic capacity and increased economic growth.
As we have previously stated, nominal GDP growth, or lack thereof, will dictate the magnitude and length of the remainder of this economic cycle. Ultimately, however, it’s hard to think of a time when the fundamentals of the US economy looked better. Assuming we hit GDP growth close to 3% in the year to come – and we are beginning to see outlier forecasts above 3.5% – we foresee continued strength domestically.
Discipline Pays off in Global Stocks
It will be tough to beat the foreign returns our clients were able to realize in 2017, though the 2018 fundamentals look quite strong. A global market like this is where Pitcairn’s philosophy of being strategic vs. tactical really shines. The MSCI Emerging Markets Index rose by 37.3% in US-dollar terms. We were able to capitalize on that rise by strategically positioning portfolios to let valuations come to fruition. Few predicted a weaker dollar, or that the Trump presidency would result in low volatility and consistently rising markets. The benefit of relying on long-term strategic allocation as a bedrock of one’s investment philosophy is that when these positive surprises occur, as they have repeatedly throughout economic history, the portfolio automatically benefits in a meaningful way. Just as our clients benefited in 2017, they will benefit in the future when circumstances conspire to shock markets to the upside.
Uncertainties will continue in 2018. Political factors will always be at play, and we’re continuing to monitor the steady rise in investor emotion that could impact this market. But we’re doing our homework to better understand individual markets. This year, our collaboration with the Wigmore Association, a group of eight family offices from around the world, will take us to Shanghai to get a first-hand look at one of the most influential economies in the world.
We remain committed to our belief in our global approach to investing, and 2017 was a banner year for global equities. This leads to the inevitable questions of what comes next. The answers are not easy, but more than ever, now is the time for investors to stay disciplined. We think there’s still more opportunity in the global equity market, and we’re positioning our investments to best capitalize on that potential. That said, the portfolio management fundamentals of rebalancing and gauging overall risk levels to the long-term investment policy are keys to success in markets such as these.
US Stocks – When Does This End?
In 2017, the S&P 500 was up in every month of the year – the first time that’s ever happened in the 90 years we have been keeping records. That growth continued into 2018 with the S&P notching six consecutive records in the first six trading days of the year. That’s the first time that’s happened since 1964. In surveys and roundtables, we’re hearing a complete abandonment of the negativity that we saw a few years ago, replaced by a chorus of bullishness. That is a contra indicator if we have ever seen one and an example of the milepost in bull market patterns that we are going by.
The big question on every investor’s and advisor’s mind is, “When does this end?” We’re focused on the warning signs, but still don’t see indicators that the end is imminent. Certainly, the change in market psychology is a sign but, as pointed out earlier, those patterns can take years to play out. Earnings continue to keep up with price, which means that price to earnings valuations, while clearly high by historical standards, are not what we would consider extreme. As earnings continue to grow quickly, it moderates the valuation measure. Other measures of valuation are at historically high levels. Economic activity is on the increase, and there is no recession in sight. These are the three indicators that we wrote, so many years ago, would signal the end of this cycle and they indicate a continuation of the current climate.
In looking at sector dynamics in the US equity market, 2017 reversed the small cap dominated trend we saw in 2016 with large growth stocks outperforming their small value counterparts.
We are watching what could turn into a pretty interesting trend in the year to come. During the Obama administration, big tech companies grew at astonishing rates with little regulatory pressure. Institutions, like banks and the energy complex, faced increased oversight and notched more modest growth. Today, we see President Trump obviously easing some of those regulations. At the same time, society has started talking more about these tech giants and their social responsibilities. It will be interesting to see if increased regulations or political pressures start to play a bigger role in Silicon Valley and what that would do to the FANG stocks (Facebook, Apple, Netflix, Google) and other tech equities.
The market has not pulled back in any meaningful way since the spring of 2017. Therefore, we do see signs of short-term excess and would not be at all surprised to see a pullback of some sort in the near term. It’s tough to maintain double-digit returns, and the market may simply run out of room from a valuation or sentiment standpoint. That pullback does not have to signal a secular shift in market dynamics. Even a 6% pullback, significant by any measure, would only put investors back to December 31, 2017. One should expect a pullback as a natural consequence of the incredible run that we have had and not jump to any hasty conclusions when it happens.
Diversification – The Key to Fixed Income
Fixed income posted solid numbers to close out 2017. Tax exempt bonds rose 5.5 percent and taxable bonds were up 3.5 percent annually. REITs hit nearly 4 percent. Infrastructure was the significant outlier, achieving a near 20 percent uptick. Outside of that spectacular infrastructure number, these numbers are what we would expect to see from a diversifying asset complex regardless of equity market performance.
Looking toward 2018, discipline will be key. These asset classes act as insurance for different economic climates. Rebalancing from successful categories into asset classes that haven’t done as well takes commitment to a strategy that we believe will ultimately pay off in the long run.
An Eye toward the End – Dialing Down Risk in a Smart Way
As we look forward to 2018, we do believe the market is primed for a short-term pullback. It’s gone straight up since our last letter, and really since the start of last summer. Given the overall economic picture, we still see any trading pullback as a buying opportunity.
This is a challenging environment for a long-term investor. While it is tempting to meaningfully reduce risk, especially if the one has benefited from the long bull market, clearly this market could continue upward for months, if not years. Missing out on upward moves such as that are mistakes we have seen many investors make. The massive momentum the market is exhibiting combined with the length of the cycle and increasing signs of risk lead to a high level of uncertainty.
Pitcairn’s answer to this uncertainty is to be prudent and follow proven, disciplined portfolio management techniques. Stay focused on strategy – rebalance, buy what’s cheap, trim what’s expensive, and continue to look for opportunities. Right now, we’re seeing continued opportunities particularly in global stocks. The fundamentals are strong, and the risks are largely political in nature. Those risks aren’t going away. Given the US and global climate, it’s hard to imagine volatility staying so low over the next several quarters.
Pitcairn’s philosophy has always included an inherent trust in the long-term power of equity markets and belief in the idea that adherence to a well thought out investment policy is the best way to tap into that power. We stay away from “It’s different this time” thinking. We view capital markets as a way to achieve success over generations. As we anticipate and wait for what 2018 holds, we recognize the value of staying true to these principles more than ever.