Where Could 2019 Take Us? (December Letter)
By Christopher R. English, President of Lumen Capital Management, LLC
The year is quickly coming to a close, and with that, it’s an ideal time to look ahead and prepare ourselves for a new year. Part of that preparation includes looking at our economy and markets overall to see what factors could affect our portfolios as we usher in 2019. Back in October, we saw market corrections at their finest, with stocks dropping 12% from their highs. While there have been losses and gains of around 8% since then, current stock prices are not that far off from where they were just a couple of months ago.
Market declines and volatility usually arrive when investors view the future with uncertainty, and right now, there are three main issues that affect investors: fear of a slowing economy, rising interest rates, and uncertainty about trade policy. Let’s take a look at each one and see how they could impact your finances.
A Slowing Economy
A major concern is that slowing economic growth will lead to a recession in 2019 or 2020. So far, the economic data does give evidence of that happening. Currently, we are experiencing record corporate profit margins, record employment, and over 1 million job openings. While it’s true that many economists expect growth to slow from this year’s nearly 3% pace, these examples of growth {and others I could list if the space permitted} are simply not conducive to a recession being just around the corner. I believe this concern is overblown unless we start to see evidence of a recession in other sectors of our economy.
Higher Interest Rates
Last month, I explained that cash and fixed-income investments are now providing an alternative to stocks. This is partially a response to the Federal Reserve ending its easy money policies of the past decade as well as raising interest rates throughout this past year. There have been signs from the Federal Reserve that a more neutral policy would be adopted for 2019, which could provide a bit of a cushion for stocks next year. Even if rates increase a bit more, I can remember when fixed-income investments routinely yielded between 3-6% and stocks managed to post gains. Of course, we have exposure to dividend growth via our total return ETF strategies. Rising interest rates have not helped this group of investments this year but their recent declines are, on average, not as severe as other parts of the market and, when adjusting for dividends, have provided nice ballast in rough seas.
Trade Policy
The factor that seems to be affecting the markets the most is tensions with China. If we look at market patterns, we see that stocks seem to rise and fall depending on investor’s perception of developments out of Asia and our trade concerns.
I believe there are two issues regarding China. The longer-term problem is an increasing view of China as our rival in the geopolitical sphere. The more immediate issue revolves around trade. I believe that at some point we will make a deal with the Chinese because it is in their interests and ours to come to the table and resolve some of the immediate problems. Unfortunately, this issue will probably not be resolved by the end of 2018. As such, any rally between now and the end of the year will likely depend on the headlines while the volatility associated with the past four months is unlikely to subside until a trade deal is announced.
A Discussion On Volatility
President Trump’s legal issues could also be thrown into the mix of what’s causing market volatility, but the three factors listed above seem to be the immediate concern for investors. I believe that the market has spent this year digesting the gains of the past few years. We’ve seen this pattern of gain followed by consolidation repeatedly since 2009. Markets peaked back in January of this year and have spent months carving out a trading range of roughly 300 points on the S&P 500. Right now, we are trading near the lows of that range. The average stock is down nearly 7% for the year and 12-15% off their most recent highs. However, markets are still 40% higher than their February 2016 lows, not including dividends. By looking at market trends, we can see that, in this particular bull market, periods of consolidation have always led to higher volatility.
Simply put, volatility is the price investors pay for liquidity. It is the market’s reset mechanism. Investors should expect some volatility and should accept that sometimes prices will correct. Equities are never a one-way ticket higher. This current correction is about average in terms of its decline and duration. It may feel extreme due to how much prices have declined in a short period of time. It also feels worse compared to 2017, when we saw some of the lowest volatility ever recorded for stocks.
Volatility, while most often associated with declines, can work both ways. But you don’t often hear investors complaining when they see sharp gains in their investments. Investors mostly dislike volatility as prices head lower, especially when the declines are swift and steep like they are right now.
We have strategies in our playbook that deal with trendless and more volatile periods and we use them in our game plan for client accounts. One of the easiest methods is to have some cash on hand. Since it is unlikely that your portfolios will ever be 100% in cash when invested with us, this will never provide complete protection against declines. Put it this way, if Warren Buffett knows of no way to completely hedge a portfolio against risk, then it is probably impossible to do so. The goal when investing is to be aware when the markets are in a lower probability environment and have enough cash that fits into your risk/reward parameters. Hopefully, you will be able to deploy that cash when markets begin their next advance.
In a period like this, investors must recognize how things have changed and then adapt that change to their portfolios. I have been using this period similarly to other phases where we’ve been trendless to reassess and reorganize client accounts where needed. If evidence indicates the economy is slowing, I could potentially raise cash on rallies to higher prices. Also, as we have indicated before, there are events that might force us to become more defensive, especially if we believe the market was resolving this corrective phase to a lower level of trading.
ETFs And Dividends
However, I have been more interested in trying to find investments via our ETF process where we can find value. In the short-term, this may not play out, but I believe there is value being created in this current decline as long as the economy continues to grow. I am always attracted to ETFs when the current market dislocation has brought the fund down to levels where the dividend is attractive. Many ETFs that specialize in paying dividends are now trading at levels where the dividends are paying 3.5-4%. That should provide a cushion in case of further market declines.
I also want to reiterate why I believe dividends are so important. They are the silent workers in a portfolio. They don’t directly add to value each day like price movement and when they show up in a portfolio they generally arrive with little fanfare, but over time, their contributions add up. Here’s an example: There is a dividend paying ETF that first arrived in the markets in 2003. It started trading at $50 and went below $26 in 2009. Since then, it has appreciated along with the markets and now trades around $94.50. It has paid its dividend every quarter since inception, although the dividend did decline after the 2008-2009 bear market. If you had bought that security at its original price, it would have paid you over $33 in dividends per share since then, with the quarterly dividend increasing nearly 200% since its initial payment. This particular ETF’s dividend should increase over the years as the economy grows. Right now, it is on track for an estimated 12% dividend growth in 2018. Growth like this may be boring to some, but our opinion is that boring works in the long run. Dividends like this can also provide some support in market declines. Markets will rise and fall in value but the cash earned from dividends is yours to keep. (1)
While there are enormous advantages to ETFs, especially during volatile times, they are not immune from market declines. If their underlying index declines, then they will also lose value by something that mirrors the decline in the underlying index. They are also not a panacea for volatility. Recent events have shown they can be whipsawed around like any common stock. However, we can invest knowing we own a diversified portfolio of assets, backed by the value of the securities in an underlying index while removing single stock risk from the portfolio.
The history of equities tells us they can be wracked by fraud, can trade to zero due to a catastrophic loss, or be rendered obsolete by unforeseen technological change. It is an extremely low probability event that a plain vanilla ETF, especially one with a long trading history and based on a well-established index, will suffer such a catastrophic event causing it to lose all value. We say this is a low probability event because nearly 33 years of investing tells us there are no guarantees. However, the inherent value of the underlying assets and the unique creation and redemption process of ETFs make this unlikely. Frankly, probability suggests the only events that would cause the inherent value of a majority of ETFs to trade to zero would be ones where we think most of us would have more things on our minds than the value of our investment portfolios. Because the underlying assets supporting ETFs have value, we can use our systematic approach to creating portfolios and strategies from this asset class.
What About The S&P 500?
Right now the S&P 500 trades 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, at most, valued fairly. If earnings hold up in 2019, then the argument can be made that stocks are now somewhat undervalued. Preliminarily looking out into 2019, I can make the case for an S&P 500 that would have the potential to trade 10-15% higher from current levels, assuming we see no further evidence of economic deterioration. That makes the risk/reward equation more favorable at this point. However, it would not surprise me if stocks wait until later in 2019, potentially in the 2nd half of the year, before they begin their next period of advance while volatility may remain elevated during that time. We will discuss this more in our winter letter. Two things that could derail this view is the possibility that we do not resolve our trade differences with China and President Trump’s political problems spilling into the economic sphere.
Happy Holidays From Lumen Capital Management
Finally, it is my fondest wish for you to have a most joyous holiday season as well as a prosperous and healthy 2019. I am honored to serve you every day and I thank each and every one of you for your continued trust and support. I also look forward to catching up early in 2019. I leave you with comments from Warren Buffett about stocks and volatility since they are as relevant today as when they were first uttered.
“The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities — Treasuries, for example — whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.
Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments — far riskier investments — than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.” (2)
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. 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
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(1) I have not named the ETF mentioned above so as to not be seen as making a recommendation. Feel free to call if you want to discuss this ETF and how it fits into our portfolio strategies. Its information regarding historical dividends and prices comes from sources deemed to be reliable but cannot be guaranteed. We will happily provide the historical information on its dividend and price history upon request. Also, as a disclosure, most clients’ and my personal accounts own this security.
posted by CR English at 1:53 PM
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