“Now is the winter of our discontent
Made glorious summer by this son of York;
And all the clouds that low’r’d upon our house
In the deep bosom of the ocean buried.”
Richard III – William Shakespeare
Winter is often used in literature as a metaphor for difficult times and right now feels like just one of those times. The recent declines in stock prices are unsettling and when added to economic and political challenges — tariff negotiations, the current government shutdown, the return of campaign politics, Brexit uncertainty — this volatility leads to worry about the future.
Winter is here
The natural world moves in cycles, in changing seasons marked by weather and activities, and one can observe financial markets following a similar (albeit less regular) pattern. There are periods of growth and expansion that can evoke feelings of the ‘glorious summer’ referenced in Richard III, followed by fall when leaves turn their brightest colors before falling and corporate earnings hit a peak; eventually the cold winter frost arrives and the world lays dormant until spring returns and it is time to plant seeds. Right now, we are in winter.
We are not pessimistic about the markets … we are cautiously realistic.
We are not pessimistic about the markets, though; rather we’d say we are cautiously realistic. One year ago, in our January 2018 commentary, we said: “Our sense of opportunity is tempered … both by the historically high level of prices relative to earnings, and by the potential for inflation and rising interest rates to dampen real growth.” Over the course of the year, many of our expectations were met. Equity valuations see-sawed and ultimately fell, bringing valuation metrics back to a more appealing range for investment. Short-term interest rates increased, growth-dampening tariffs were put in place, and we saw a continuation of political uncertainty both domestically and abroad.
As the summer progressed into fall, 2018 equity markets experienced two separate corrections. The S&P 500 declined -10% in late January, and then again by -14% in the fourth quarter. Losses weren’t limited to the US stock market – interest rate increases helped the dollar rally against foreign currencies, exaggerating declines in non-US securities. The EAFE developed international stock index slipped -13.8%, and emerging markets as a group fell -14.6%.
Will winter be over soon?
The beauty of winter, of course, is the productive quiet of dormancy, the soil regains vitality, and root systems of plants and trees enhance their ability to respond to the warm conditions that arrive in the spring. In stock market parlance, we are concerned with security valuation (low valuations allow more potential for price growth) as well as economic conditions (which allow fundamental growth in business value).
As that re-valuation of expectations for business profitability proceeds, we will be watching for opportunity to develop.
As value investors, the vitality we favor is business productivity. That means responsible management that ensures a business is strong financially – without too much debt. It means quality products and services, and an emphasis on retaining existing customers for continuity and stability of income and profits. During an economic downturn when natural growth in revenues can be difficult to achieve, retaining customers and having minimal debt obligations can allow a business to grow in strength relative to weaker competitors, and to increase its value more substantially when an economic recovery comes.
Before spring comes, we are likely to see a spate of weak corporate earnings. There will be both difficult comparisons with the ebullience of early 2018, as well as actual slowing economic conditions. A lack of clarity will take the forefront, like today’s jobs report in which new jobs created exceeded expectations – but the unemployment rate also rose. Investors are likely to become more cautious, bidding stock prices down further. As that re-valuation of expectations for business profitability proceeds, we will be watching for opportunity to develop.
Spring will come again
We are already preparing some seeds based on market conditions. We are keeping an eye on stocks – both domestic and international – as areas of potential opportunity in the coming year if current declines continue, as well as watching for opportunity in certain segments of the bond market now that we are less concerned about rising interest rates. Markets are now anticipating no rate increases in 2019, a view echoed in changes to the Fed’s own forward-looking interest rate projections.
At present, we remain concerned about economic growth and believe a Fed misstep on interest rates, protracted tariff impacts, and slowing growth globally could lead to a recession in 2019. There is a lot of chatter in the financial press debating whether or not a recession is imminent. Our view is that growth is fragile enough to potentially turn negative and that the press most likely won’t confirm a recession until it is already well underway.
we diversify because we cannot predict the short-term.
In managing portfolios we do not have a crystal ball, of course, so we diversify portfolios to withstand a wide range of economic environments – we diversify because we cannot predict the short-term. Our client portfolios are weathering the current transition well, and our overweight allocation to cash and short-term bond positions should support both your distribution needs in the coming months and years, and allow liquidity for growth investments at lower prices.
We wish you and your families a happy, healthy, and prosperous 2019. We look forward to continuing in partnership with you in the year ahead.
 Defined as a 10 percent or greater decline in market value.
 Blackrock Benchmark Comparisons as of 12/31/18: MSCI EAFE Index and MSCI EM Index