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Investment Review/Outlook

Current Investment Outlook

Long-time readers of our quarterly letters know that we have held a bullish view for the entirety of the market rise from its lows of November, 2008 and March, 2009 to its new highs in 2019. And they know that we predicted more volatility in 2014 (leading to about a year of sideways movement) and that we reinforced that focus on volatility in 2018 and 2019, a period in which the market has been both sideways and volatile. Finally, they know that, while we were surprised by the depth of the decline in late 2018, we picked the timing of the recovery in 2019 almost to the day. All of that, of course, is of no value today. What is our current view?

Our view today is that the market outlook is not particularly compelling. Instead, it is more “allowing.” Sometimes the positive earnings prospects, low valuations, and negative psychology lead to a circumstance where future gains are highly probable. Today, those gains are more likely to be highly possible. There are many reasons why this is the case. First, we have had an extremely long market expansion (although it has worked through major correction periods in 2011-12, 2015-16, and 2018-19). Second, while corporate earnings have had a burst of growth, they have slowed in 2019 and may or may not recover strongly over the next few quarters. And, finally, valuations of stocks are at above-average levels, easily justified by the level of interest rates, but concerning nonetheless. Investor confidence is mixed and cautious, which can allow strong growth if earnings are good and rates don’t rise sharply from current levels. So, let’s examine how we get to this good, but not compelling, outlook.

The Federal Reserve has made itself a major market factor in recent years – and spectacularly in the 2018 fourth quarter and the 2019 first quarter. Along with other Central Banks, the Fed is now easing. The Fed has cut rates 50 basis points and may cut rates one or two more times this year. They have started to buy bonds again, reversing the year-ago unwinding of the Fed balance sheet. Our rates are low, but they are much higher than interest rates available to investors around the world. Our 10-year Treasury hit 1.45% and now sits at 1.74%. Worldwide, interest rates have become punitive, with some $17 Trillion at negative rates. This punishes savers and forces them to consider putting their funds somewhere else. And, when rates finally rise, that is very negative for longer-term income investors. So, the interest rate backdrop is rare and abnormal – and has the potential for unhealthy outcomes.

Because of the length of this economic expansion (admittedly from the depths of the financial crisis), observers have been expecting a recession for some time. A typical precursor of a recession is the inversion of the yield curve (short rates higher than long rates), suggesting that the economy is getting a little too hot and needs to cool down for a few quarters. The yield curve has done just that a few times in recent quarters, but we think the indicator is less reliable now with such low, and sometimes negative, interest rates. The inverted yield curve is, however, a possible predictor of a recession some 20 to 24 months from now.

Our domestic economy remains strong, though slowing, due to the benefits of tax cuts and significant regulatory reform. Unemployment has hit a 50-year low at 3.5% and wages are growing at a robust 3% rate. The consumer remains in good health and is spending. However, capital spending and manufacturing have slowed, in part due to the trade war. The ISM indexes have recently showed contraction for manufacturing and modest growth for services.

In contrast to the U.S., global growth is slowing considerably. The Central Bank easing in Europe, Japan, and China has not seemed to help much in spurring growth. Further, the China Trade War is starting to take hold, and this has brought China back to the table. Many U.S. corporations have moved manufacturing out of China – or will do so in the future. We are right to have concern about the global effect of slowing in China, but they have to be worried about a near collapse. The Hong Kong protests (or riots) could spread to the mainland if there is a perception or reality of economic contraction. The Chinese leadership has to be worried. And it is showing. Threatening bodily harm to your own people is not typically a good way to govern.

The U.S. political elephant in the room is the Impeachment story. It is not really a new story, as Democrats have used that word almost every day since the Trump election in 2016. It is virtually certain that the President will not be removed from office by the Senate, but at this point, it is not even clear if the Democratic-controlled House will have the votes to Impeach. For that reason, the proceedings today continue to be done in secret and behind closed doors. How much more drama we will have on this point is impossible to say. We will, however, soon have a report on the findings of the Barr/Durham/Horowitz investigation into the FISA warrant against the Trump campaign. We believe that there will be more significant findings here than there were in the Mueller investigation. One way or another, we should learn fairly soon.

Corporate earnings ran ahead at a 24% rate in 2018 and were expected to slow significantly in 2019. However, earnings have now declined modestly in each of the first three quarters. But, if they reverse course and gain in the fourth quarter, the full year may turn positive and bring us to the longest expansion in U.S. history, at 124 months. Global growth is slowing as more than half of the major world economies are now in recession. While worldwide growth is under pressure, U.S. GDP is expected to grow a healthy 2.0% this year. With low inflation, record low unemployment, and healthy wage growth, we have a strong U.S. economy. Low mortgage rates should help give a boost to the housing market. Beyond the trade uncertainties, our domestic economy is in very good shape.

We feel obligated each quarter to make mention of the excessive amount of debt around the world. Central Banks have added trillions to their balance sheets, injected stimulus into their economies during the financial crisis over ten years ago and long after, and in many cases driven rates deep into negative territory. Low rates have induced corporations and other borrowers to raise huge amounts - and probably unsustainable amounts - of debt. When rates rise, many of these debtors may not be able to pay. In that ugly circumstance, every investor will want to have chosen wisely in terms of the credit-worthiness of all debt and equity investments.

As we routinely point out, higher interest rates generally lead to lower valuations of stocks. A concern about this prospect caused the sharp decline in the market in the fourth quarter of 2018. Now, we are back on a path toward lower rates, and this is good for stock valuations. At this point, we expect corporate earnings to resume growth in the fourth quarter and follow through with more growth in 2020. The economy continues to expand, rates should stay low for the foreseeable future, and the prospects for stocks are generally good.

Our outlook remains positive, with a continued and strong dose of caution. The market now trades at 16.8 times earnings, but with rates this low, a PE could be justified at 19 times. An expanding economy and reaccelerating earnings create a positive environment. With a particular focus on credit quality, attention on individual stock selection is key. The best sectors in the past quarter were utilities, real estate, and consumer staples – each generally defensive in nature. We see good opportunities in all corners of the market and expect its tone to become more oriented toward growth stocks once again.

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