It has been a very strong start to 2019. The broad-based S&P 500 Index has advanced nearly 18% in just four short months.
More good news: The S&P 500 Index has topped previous highs (Yahoo Finance). It’s quite a snapback from the gloomy outlook and oversold conditions we saw in late December.
Some of this year’s rebound is simply timing. After a steep sell-off last year, the major market indexes bottomed in late December. Therefor, much of the rally has occurred since the end of December. But let’s not discount the fundamentals.
What has been powering the rally?
With key indexes at or near highs, let me pose a question to you. How were you feeling when shares were getting beat up in December? Before you respond, there isn’t a right or wrong answer.
Did you look past the headlines, recognizing the financial plan was the best path to long-term success? Did the plan enforce discipline, preventing you from making ill-timed investment decisions? Were you comfortable with adhering to the long-term roadmap?
If the answer is “Yes,” your tolerance for risk is incorporated into your approach.
Or, did you get that queasy, unsettling feeling in your gut? Were you rattled by the swiftness of the decline? Did you experience sleepless nights?
If you answered “Yes,” let’s talk. Diversification helps manage risk, but it doesn’t eliminate risk. It’s possible that we may need to make some adjustments to your portfolio that may ease the downside when volatility strikes again.
As always, I’m honored and humbled that you have given me the opportunity to serve as your financial advisor.
Henry Wadsworth Longfellow’s poem, “The Midnight Ride of Paul Revere,” retells the story of a patriot who shouts a harrowing warning to his fellow colonists, “A recession is coming! A recession is coming!”
Well, that’s not quite the story, but given the seemingly non-ending talk about a recession, you might think that economists are channeling Paul Revere’s midnight ride.
Yes, a recession is eventually inevitable, but is it imminent?
The long-running expansions of the 1960s, 1980s, and 1990s gave rise to talk that a combination of fiscal and monetary policy may have ended the risk of a recession. Such talk was premature.
Today, the pendulum has swung in the opposite direction. Analysts and short-term traders have become hypersensitive to any signs a recession may be looming.
Moreover, the public has taken notice. A quick review of Google Trends bears this out. Google searches for the word “recession” have jumped 61% over the last six months versus the prior five years.
Stock market volatility and the steep correction late last year, the recent slowdown in U.S. economic activity, and an inverted yield curve (a more detailed review is forthcoming) have all contributed to worries about an economic downturn.
Plus, the economic expansion is fast approaching its 10-anniversary. If the economy is still expanding in July, and odds suggest it will be, the current expansion will become the longest on record, exceeding the expansion of the 1990s, which lasted exactly 10 years.
Recessions are a part of the business cycle in a free market economy. But expansions don’t simply peter out. Expansions come to an end when economic and financial imbalances arise, such as a stock or housing bubble, or the Fed aggressively hikes rates in response to a spike in inflation.
That brings us to the question at hand.
What is a recession?
Contrary to the more traditional definition, a recession is not defined as two consecutive quarters of negative real (inflation-adjusted) GDP. If that were the case, we would have narrowly missed a recession in 2001. Q1 and Q3 posted negative numbers. Q2 was positive (St. Louis Fed).
Instead, an organization called the National Bureau of Economic Research (NBER) has become the official arbiter of recessions. Founded in 1920, the NBER is a private, nonprofit, nonpartisan organization dedicated to conducting economic research
The NBER defines a [[http://www.nber.org/cycles/r/recessions.html recession]] as “a significant decline in activity spread across the economy, lasting more than a few months.” It manifests itself in the data tied to “industrial production, employment, real income, and wholesale-retail sales.”
These are very broad categories. They are not tied to one or two sectors, which might be experiencing weakness at any given time.
For example during a recession, we’d expect to see declining retail and business sales. This would lead to a decline in industrial production and a rise in the unemployment rate.
It’s not as if the NBER confirms a recession has begun shortly after it begins. It took nearly a year for the NBER to confirm the last recession. By then, it was a forgone conclusion. A similar delay occurs when the economy begins to recover, and the NBER is tasked with calling the end of the recession.
Why do we care about recessions?
There are plenty of reasons. For most Americans, job insecurity increases, layoffs rise, and it becomes much more difficult to find work.
For investors, it’s a time of heavy uncertainty. Bear markets–a 20% or greater decline in the S&P 500 Index–are typically tied to recessions, as corporate profits decline and companies warn about the future.
The canary in the coal mine
Economists have always had trouble forecasting an upcoming recession. A few get it right; most miss it.
But it’s not as if we lack warning signs.
The Conference Board compiles what is called the Leading Economic Index®, or LEI. It’s akin to Paul Revere’s midnight ride. It has historically warned of an impending recession, but the timing is in question.
There are 10 components of the LEI. These are leading predictors of economic activity:
I get the list may seem a little overwhelming and some categories are less familiar than others. That said, the Conference Board plugs each months’ numbers into a formula and reports on the LEI every month.
Why do we call them leading indicators? Simply because they tend to foreshadow future economic activity.
Why 10? One or two might send out false signals. That’s less likely with a compilation.
How do leading indicators work? Take first-time claims for unemployment insurance. When economic activity slows, we’d expect layoffs to tick higher. We might also expect stock prices to decline. And falling building permits would likely signal upcoming weakness in housing.
Given the LEI, why is it so difficult to forecast a recession? Looking back at the last seven recessions (back to the 1969-70 recession), the lead time given by the LEI has ranged from 7-20 months ([[https://www.advisorperspectives.com/dshort/updates/2019/03/21/conference-board-leading-economic-index-expanding-in-near-term Advisor Perspectives]]). That’s quite a range.
Furthermore, there have been times when the LEI has given false recessionary signals, including the mid-1960s, the mid-1990s, the late 1990s, and during the recent expansion.
These “false positives” were temporary downticks. Nonetheless, the short-term declines could have been construed as a recessionary signal.
A cautiously upbeat signal
According to the Conference Board, the LEI has essentially been flat since October. It has correctly signaled a slowdown in the economy, but it has not signaled a recession.
In fact, a [[https://www.conference-board.org/pdf_free/economics/2019_03_13.pdf March report by the Conference Board entitled, “Fading Domestic Headwinds Will Keep Growth Above Trend,”]] is cautiously encouraging.
A shift in the atmosphere and a pivot by the Fed
During the third quarter of 2018, the economy was firing on all cylinders. At the September meeting of the Federal Reserve, policymakers were projecting three rate hikes in 2019–all 0.25 percentage point increases.
The Fed cut its forecast to two rate increases at the December meeting amid stock market uncertainty and signs U.S. growth was moderating.
At the conclusion of the March meeting, the Fed said it sees no rate hikes this year.
Furthermore, Fed Chief Jerome Powell was forced to push back on talk of a possible rate cut this year, arguing at his press conference that he expects “the economy will grow at a solid pace in 2019.”
The pivot is complete.
Kink in the curve–inversion
Recall the list of leading indicators. Number 4: the yield curve.
Normally, the yield curve is upward sloping. As the maturity of bonds lengthen, the investor receives a higher yield. Think of it like this: you expect to receive a higher interest rate on a two-year CD than a six-month CD.
But there are times when the yield curve inverts. Shorter-dated bonds yield more than longer-dated bonds.
On March 22, the yield on the three-month T-bill exceed that on the 10-year Treasury by 0.02 percentage points (U.S. Treasury Dept). That hasn’t happened since 2006.
Importance: the last seven recessions (going back to the 1969-70 recession–using NBER data and data from the St. Louis Federal Reserve) have all been preceded by an inversion of the yield curve. We must go back to 1966, when a brief inversion was followed by a steep slowdown in growth and not a recession.
On average, a recession ensued 11 months later.
An inverted curve is signaling that investors believe short-term rates will eventually come down in response to a weaker economy. It may also hamper lending by banks.
But, is it different this time? “It’s different this time” a four-word phrase that should always set off alarm bells. Usually it isn’t. But are we getting confirmation from other signals?
Recessions have typically been preceded by major economic imbalances, such as a stock market bubble or housing bubble. Or, a sharp rise in inflation forces the Fed to aggressively respond with rate hikes.
For the most part, neither conditions are currently present, lessening odds a near-term recession is lurking. Further, recent market action has been impressive. It’s not as if we haven’t seen some volatility, but year-to-date performance isn’t signaling an economic contraction is imminent.
It’s common practice for the president or CEO of a company to include a letter to shareholders in the annual report. Berkshire Hathaway’s chairman and CEO, Warren Buffett, doesn’t buck the trend.
His annual letter (http://www.berkshirehathaway.com/letters/2018ltr.pdf) captures plenty of attention, and this year was no exception. The focus is on the investments and operating performance of Berkshire Hathaway, but the Oracle of Omaha also includes many sound principles for wealth creation as well as his general thoughts about the U.S. economy.
From 1965-2018, the market value of Berkshire Hathaway has posted a compounded annual gain of 20.5%, more than double the S&P 500’s advance, which averaged 9.5%, including reinvested dividends.
There are two things that pop out here. First, Buffett's enviable record and his ability to create long-term wealth using time-tested principles. Second, the S&P 500’s record illustrates that a well-diversified stock portfolio has been a critical component of a long-term financial plan.
In case you’re wondering, Berkshire Hathaway’s overall gain has been 2,472,627% versus the S&P 500’s still-impressive 15,019%.
One more data point – Buffet continues to perform well, topping the S&P 500 Index in eight of the last 11 years.
Focus on the forest–not the trees
Your financial plan is comprised of many parts. This would equate to what Buffett calls the “economic trees.” In other words, let’s not get to caught up on any one investment.
“A few of our trees are diseased and unlikely to be around a decade from now. Many others, though, are destined to grow in size and beauty,” Buffett writes.
He won’t get every investment right. Neither will we. Berkshire holds a substantial position in Kraft Heinz (KHC), whose shares recently tumbled after the company delivered poor results and slashed its dividend.
But, if we review the portfolio as we’d view the forest, we find a diversity of trees, wildlife, and plants. It’s a work of beauty. Your portfolio is built from the bottom up. Like the forest it’s very diversified, and it is created with your financial goals in mind.
As Buffett says (and I agree), “I have no idea as to how stocks will behave next week or next year. Predictions of that sort have never been a part of our activities.”
That said, how did the 19.8% drop in the S&P 500 Index (September peak to Dec 24th trough) sit with you? With your input, we do our best to gauge your tolerance for risk. If you found yourself fretting over the volatility, let’s talk.
On the other hand, if you slept soundly, it would suggest your investment mix in relation to risk is on target.
“At Berkshire, the whole is greater–considerably greater–than the sum of the parts.” I feel the same way about your financial plan.
The American tailwind
Warren Buffett is bullish on America.
In 1942, he invested $114.75 in three shares of Cities Service preferred stock. At the time, the country was mobilizing for what would be a massive war effort.
If Buffett had invested his $114.75 into a no-fee S&P 500 index fund, and all dividends had been reinvested, his stake would have grown to $606,811 (pre-taxes) on January 31, 2019 (the latest data available before the printing of his letter).
The U.S. was victorious in WWII, but challenges never cease.
We’ve endured the cold war, the divisiveness of the 1960s, OPEC’s oil embargo, double-digit inflation, soaring interest rates, a rising federal deficit, the tragedy of 9-11, the war on terrorism, the financial panic of 2008, the ensuing Great Recession, falling home prices, and more.
Let’s say that you had had the foresight to see the oncoming explosion in the federal deficit, one that is up 40,000% over the last 77 years.
“To ‘protect’ yourself,” Buffett said, “You might have eschewed stocks and opted instead to buy three ounces of gold with your $114.75. And what would that supposed protection have delivered? You would now have an asset worth about $4,200.” Compare that to the performance of the S&P 500!
What is this nation’s secret sauce? The answer is complex and difficult; yet, the overarching theme lies in front of us.
The experiment called the United States has birthed and attracted the best and the brightest. Freedom and opportunity are its calling cards. Today, we are the wealthiest nation on Earth, and we continue to ride the wave of innovation and enjoy the benefits.
But, is that wave about to crash on the shore?
A recent piece by Morgan Stanley entitled, Millennials, Gen Z and the Coming ‘Youth Boom’ Economy, complements Buffett’s optimistic viewpoint. The population of the Millennials will overtake the Baby Boomers this year, and “Gen Z, born between 1997 and 2012, will overtake the Millennials as the country's largest cohort by 2034,” it said. For the U.S. economy, “The demographic tailwinds created by these high-population cohorts could be significant, delivering the kind of ‘youth jolt’ that the Baby Boomers were famous for.”
Sure, we can’t know when the next recession will ensue or some of the challenges we’ll face as a nation in the coming years. Yet, as Buffett sums up his annual letter, “Over the next 77 years, the major source of our gains will almost certainly be provided by The American Tailwind. We are lucky–gloriously lucky–to have that force at our back.”
Bright start to the new year
First, let’s go back to December. A headline in the Street.com summed it up well: "Dow Gains on Last Day of Worst December Since the Depression." Even a 7% bounce in the final week of the year didn’t prevent a performance that was compared to the early 1930s.
When the S&P 500 Index touched its bottom on December 24, the broad-based index of 500 large U.S. companies had shed 19.8% from its September 20 peak. We were barely 0.2 percentage points from officially entering a bear market.
Market turmoil in the fall and December’s action were especially ugly. Steep market corrections are not something we look forward to; they are impossible to consistently predict, but they come with the territory.
As I’ve repeatedly said, your investment plan incorporates the unexpected detours. The disciplined investor, who divorces the emotional component from the investment plan, chooses the best path to meet his or her long-term financial goals.
That said, 2019 has been much better:
• A flexible Federal Reserve has taken its finger off the rate-hike button,
• The economy continues to expand, albeit the pace has slowed, and
• We’ve been treated to headlines saying the U.S. and China are making progress toward a trade agreement.
There are no guarantees a deal will be inked, but a March 4 headline in the Wall Street Journal summed up recent sentiment:
"U.S., China Close In on Trade Deal"
Both countries could lift some tariffs imposed last year, and Beijing would agree to ease restrictions on American products
A trade deal that pries open Chinese markets to U.S. products and services, protects U.S. intellectual property rights, and ends forced technology transfers (and one with strong enforcement provisions) would not only benefit the U.S. economy, but a deal between the world’s largest economies would sweep away one cloud of uncertainty that has plagued investors.
10 years gone
On March 9, 2009, the Dow Jones Industrial Average closed at 6,547. It marked the bottom of the last bear market. On February 28, the Dow finished the day at 25,916, less than 1,000 points from its prior peak.
The bull market turns ten years old this month. How much life is left in the bull? We are in the latter stages of the cycle, but much will depend on the economic fundamentals going forward. With the Fed on hold, inflation contained, and the economy moving forward, the fundamentals are currently sound.
But never discount volatility. Stocks seem to take the stairs up and the elevator down.
In the spirit of the celebrating the last ten years, let’s look at a partial list of the worries that temporarily sidelined the bull, but didn’t sideline those with a long-term view:
The European debt crisis…Greece... global growth worries…U.S. growth is slowing...China is slowing...the dollar is too strong...Japan earthquake/tsunami/nuclear disaster...U.S. debt downgrade...fiscal cliff...Obama will be re-elected...Trump will get elected...Hillary will get elected...the Fed will end bond buys...Fed will start hiking interest rates...falling oil prices...Ebola scare...Russia invades Ukraine...North Korea...ISIS...Syria...Brexit...trade tensions...acrimony in D.C....and stocks have risen too quickly.
Shorter-term risks never completely abate. But Warren Buffett’s message has been consistent. Don’t bet against America.
Let me emphasize again that it is my job to assist you! If you have any questions or would like to discuss any matters, please feel free to give me a call.