Ups, Downs, And What's Ahead [Fall Letter]

By Christopher R. English, President of Lumen Capital Management, LLC

October has been a month chock full of market corrections and many may be wondering why are they happening and what all these ups and downs mean for the future. My first thought is that we are consolidating the substantial gains we experienced in 2016 and 2017. My guess is that this process is not over and our markets could remain choppy well into next year. But despite the headwinds facing the market right now, I still think it’s possible to see a total return between 6-10% from stocks by year-end and potentially the same kind of return next year. I will intently watch any rally we see in the coming weeks for clues as to whether I am right about this. Markets are definitely in correction mode, but the current evidence does not indicate we are anywhere near a decline comparable to 2007-2009. Here’s why:

The Evidence

Since market volatility has picked up and the pace of the markets is always high, the data quoted below may be outdated by the time you read this. But as of October 24th, 2018, many major U.S. indices are down between 9-12% from their most recent highs and have given up most, if not all, of 2019’s gains. Many growth-oriented names and companies with foreign exposure are down closer to 20% and this is the number that Wall Street typically uses to gauge the start of a bear market. Some international markets are down even more than that. By most measures, this October has been the worst month since 2008 or 2009.

Markets have spent the last decade feasting on low interest rates, which have started to dry up this year on a global scale. Investors also worry about peak profits at U.S. companies, ongoing trade wars and rising tensions with China, inflationary concerns arising from tariffs on foreign imports, and the uncertainty around our upcoming elections. Due to all this, there was already a higher probability for a period of consolidation and potential weakness, starting last winter. I first discussed this in our Winter Letter and also in February, when I wrote a post on what I thought was the “Highest Probability Scenario for the Rest of the Year”:

“I think the most likely scenario is for stocks to spend much of 2018 consolidating their gains from the past two years. The positives of underlying economic growth we are seeing plus gains from the tax cuts runs into the worries of higher stock valuations, higher interest rates, and higher inflation. Also, as the year ages, we may need to weigh political risk into the equation for the upcoming midterm congressional elections. Once we get into the fall and once the outcome of the elections is priced into stocks, there is a possibility we again attack the old highs from January.  Now obviously, it is unlikely the year will pan out exactly as I've drawn the lines. Still, it seems there is a higher probability that a scenario similar to this could unfold. In that kind of environment, investors should prepare for higher volatility and a possible retest of February's lows at some point.”

In reality, stocks did retest their lows in April, advanced through the summer months, and reached new highs on the major indices before the recent sell-off began. We’re now on our second retest of last winter’s lows. What we’re currently experiencing isn’t that unusual. I’ve been in this business over 30 years and there have been many times when stocks have given back much of their earlier gains and even gone negative, only to recover as the year advanced. My best guess about what’s ahead is that we’ll see unstable markets until the elections are over. At that point, there is a higher possibility that stocks could rally.

What About Next Year?

What happens after the midterm elections are over will depend on the 2019 economic forecasts. Many in the industry are concerned that the market is sniffing out a slowdown in earnings or perhaps even a recession. There is evidence that the torrid pace of recent U.S. earnings growth might be slower than what we’ve seen in the past two years. Still, Wall Street currently thinks earnings will advance around 10% and we’ll see 6% revenue growth. We’ll have to see how those estimates hold up as the fourth quarter unfolds. Since markets function as a discounting mechanism for a stream of future earnings, at some point the decline should run into levels where stocks can find their footing based on valuation. It’s possible we could see stocks trade in the sideways range we’ve currently carved out for some part of 2019. However, I still believe that in the long-term, there is too much positive evidence to say that this current bull market is over.

The S&P 500 is currently trading with a PE ratio of around 15, a dividend yield of 1.85%, and an earnings yield of roughly 6.6% based on the next four quarter’s estimates. These levels suggest that the market is fairly valued. While fairly valued does not have the same meaning as cheap, it is also not trading at levels suggestive of a market that is extremely overvalued. One thing that has changed is that cash and fixed-income investments are providing an alternative to stocks, something that hasn’t occurred in over a decade. There are many in this business who started their careers when there were no portfolio alternatives to stocks, but I can remember when fixed-income routinely yielded between 3-6%. Stocks managed to advance in that environment. This may require a reorientation in some portfolios and it is something I am happy to discuss. Of course, we have exposure to dividend growth via our ETF strategies while the current decline has also made many sectors of the market more attractive as well.

Long-Term Optimism

I am unchanged in my long-term optimism about the economy and the markets, as discussed in previous letters and on my blog. The reason I’m so positive has to do with the pace of technological advancement, which is still increasing exponentially and is unlikely to slow down in the foreseeable future. Again, we are seeing fantastic advancements across many frontiers and disciplines. I’ll invite you to go back and read what I’ve said on this subject instead of listing examples. Just know that these previously discussed trends are advancing more rapidly than before. Behind these ideas are new businesses, jobs, and economic advancement. But, as we know, markets are never a one-way ticket higher and corrections will happen. I still think we may be only about 40-50% through a longer-term secular bull market, one every bit as powerful and durable as the rally that lasted from 1982-2000. However, even that bull market had periods where it paused to catch its breath. There were at least five declines in excess of 10% back then. There were also periods where stocks did not advance. We’ve also seen periods like that in our current run, most recently back in 2014-early 2016. I think we’ll review this period in the coming years as one of these pauses.

Currently, the indicators I use are becoming very oversold and the amount of negativity on both Wall Street and in the financial press is reaching a crescendo. Thus, the risk/reward ratio is becoming more favorable if for nothing else than a short-term move higher. I have recently made some purchases in client portfolios based on what my systems have indicated and based on cash positions in client portfolios. This was also done according to the client’s individual mandates and based on their risk/reward profiles. Only time will tell if this positioning is correct, but I feel better about buying ETFs within my disciplines that are down,  in many instances more than 10%, than trying to justify purchases when stocks are making all-time highs. I like to buy assets on sale. While there is no guarantee that this strategy will work in the future, historically, it has been profitable for clients, especially since my time horizon is 6-18 months from now and not what happens tomorrow. One of the other things I think is important is to realize is that many of the ETFs we’ve been purchasing or that you already own in your portfolios pay dividends. Some of these are specifically designed to factor in stocks with attractive dividend payouts. Some of these pay dividends well in excess of 3% and will also participate in any future growth on stocks. In my opinion, dividends make ETFs similar to owning a piece of rental property as they provide you with cash. Most of these also raise their dividends every year. Markets may go up and down but you get to keep the cash these securities pay out. ETFs like these also aren’t down nearly as much as more growth-oriented parts of the market.

I will also be paying attention to the economic evidence we see and believe the economy could grow between 2-3% next year. Should this hypothesis start to falter, then a more defensive posture might be warranted. The higher probability scenario is that, while we should rally over the next few months, markets might be stuck in this trading range for some portion of 2019. What that range might be and where we might trade will be determined by where we finish this year.  I still think it’s possible for major U.S. stock indices to show a total gain between 6-10% this year and a similar rate of return may be possible in 2019. I’ll update my thoughts on that in January. Based on what we know today, the robust growth of our economy, and the lack of speculative excess and monetary controls on financial institutions, I think it is unlikely that stocks are on the cusp of a decline similar to what we saw in 2007-2009. Back then, there was systematic failure brought about by speculative excess and stock valuations that were too high, and that’s not the case today.

The Short-Term

Finally, nobody knows where the market will go in the near term. As Warren Buffet’s mentor, Benjamin Graham, once famously quoted, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”¹ This means that the price of a stock or ETF is little more than a popularity contest in the short-term. It is subject to investor’s passions and fears at any given moment. Right now, it is easy to be afraid when listening to the media, whether they are talking about the markets, politics or global warming. Good news doesn’t sell papers and it doesn’t get readers to click on a website or watch a video or a certain news program. Good news doesn’t make you worry about your job, your portfolio, the president, or what your neighbor might be doing. Instead, good news arrives quietly in miracle drugs, in new services and technologies. It also arrives quietly in markets. Stocks didn’t go up 300% in the last decade on bad news, even as the press consistently poured out the negative headlines. Much of the news we’re hearing these days is negative, but the quiet story of things improving continues. It may not continue every day and stocks will still roil from time to time, just as they have many times since this bull market began in 2009, but the underlying fundamentals remain positive and that in turn should support stocks in the coming weeks. If we see evidence of this prediction being wrong, we’ll trot the defensive team out onto the field.

Below, I’ve given you a few things to think about in this current environment. Please contact me if you want to discuss this or anything else.

Some Things To Think About When Markets Are Unsettled

Given how far we’ve come over the past few years, it’s reasonable to ask if anything has truly changed. The easiest way to start is with this exercise: Open your September 30th account statement, which was sent out before the latest sell-off occurred. Take that account value and cut 10%, assuming that is the minimum amount you could see your assets decline at some point in the next 12-18 months. If your account is worth $200,000, assume it could be worth $180,000. If it’s worth $1 million, then assume you could see a value of $900,000. Remember again, this is normal, even a bull market! These may be hard numbers to look at, but if this causes you to have trouble sleeping at night, then we should talk. It might be that we need to review your current risk/reward criteria.  

You make sure that you're comfortable with where you’ve invested any money you might need in the next 6-18 months. Choppy markets have a habit of seeing the highest volatility when you need the money the most. For example, if you have a child entering college next year and you've been able to save enough to pay for your share of the bill, then you might want to make sure that at least the first semester's tuition is invested in a way that won't be subject to a market correction. Putting this money aside is a bit easier now as cash is finally paying you something. An easy way to evaluate this is to ask yourself what hurts more. Would it bother you more to miss a 10% increase with money you need right away, or would the opposite hurt most? If losing that 10% stings the most, then think about getting more defensive with that part of your portfolio.

Finally, the fact that, for the first time in over a decade, you can earn something in more fixed oriented investments may mean a discussion is warranted. Please let me know if your personal situation has changed or you want to revisit your risk/reward criteria.

In closing, I’ll reiterate what I wrote in March in my “What Do We Need To Accept About The Market in 2018?” post:

“Accept that things may have changed. Accept that there's a higher probability that stocks are not going to go straight up like we saw last year. Accept that there's a higher probability of more volatility and that stocks may have seen their highs, if not for the year, then at least for some period of time back in January.  Accept that consolidation of gains is part of the process and just because we are not going up right now doesn't necessarily mean the bull market is over for stocks. Learn to live with days where the major indices can drop 2-3%. Again, understand this is part of the process and the press will play this up. A 500 point drop or even a 1,000 point drop today in the Dow Jones Industrial Average gets a lot of headlines but doesn't mean what it once did in terms of percentage gains or losses.

Accept that you could take a look at your portfolio some time this year and see it down 10-15% or perhaps even more. A 10-15% decline is historically what has been considered normal volatility for stocks. It's been so long since we've seen that sort of drop that investors could easily be spooked if it should return or if we see something worse. A decline of that magnitude would not necessarily mean the bull market is over or that we are necessarily going to see a larger drop in stocks. Like everything else, it would need to be viewed in the context of how it occurred. Just know this is possible and a much more probable event given the current trading environment.

Accept that things may be changing in terms of market leadership. We may not know if that's the case for many months. If so, then there should be time to address such a change unless we get some unexpected event over the transom. Use market volatility to your advantage to either rebalance or reposition your portfolio if necessary.”

Please contact me if you want to discuss this or anything else. Call my office at 312.953.8825 or email us at lumencapital@hotmail.com

About Chris

Christopher R. English is the President and founder of Lumen Capital Management, LLC-a Registered Investment Advisor regulated by the State of Illinois. A copy of our ADV Part II is available upon request. We manage portfolios for investors, developing customized portfolios that reflect a client’s unique risk/reward parameters.   We also manage a private partnership currently closed to outside investors. Mr. English has over three decades of experience working with individuals, families, businesses, and foundations. Based in the greater Chicago area, he serves clients throughout Illinois, as well as Florida, Massachusetts, California, Indiana, and other states. To schedule a complimentary portfolio review, contact Chris today by calling 312.953.8825 or emailing him at lumencapital@hotmail.com.

Christopher R. English is the President and founder of Lumen Capital Management, LLC.-a Registered Investment Advisor regulated by the State of Illinois. A copy of our ADV Part II is available upon request. We manage portfolios for investors and also manage a private investment partnership. The information contained here is taken from sources deemed reliable but cannot be guaranteed. Mr. English may, from time to time, write about stocks or other assets in which he or other family members has an investment. In such cases appropriate disclosure is made. Lumen Capital Management, LLC provides investment advice or recommendations only for its clients. As such the information contained herein is designed solely for the clients or contacts of Lumen Capital Management, LLC and is not meant to be considered general investment advice.  Mr. English may be reached at Lumencapital@hotmail.com.

¹ https://news.morningstar.com/classroom2/course.asp?docId=142901&page=7

* “Winter is a Season,”  January 25, 2018 and “The Highest Probability Scenario for the Rest of the Year”, Solas!,  February 16, 2018.

**”What Do We Need to Accept About the Market in 2018?” Solas!, March 20, 2018.

Long ETFs related to the S&P 500 in client and personal accounts.