Interview with Tom Lee: Advisors Should View 2019 Like the Start of a New Bull Market
Tony Sirianni, AdvisorHub CEO, and Craig Cmiel, Head of AdvisorHub Boutique, recently discussed the state of the markets with Tom Lee, Managing Partner and the Head of Research at Fundstrat Global Advisors.
[Tony]: What should advisors be doing and how should they be talking to their clients?
[Tom]: I think the best advice to give anyone today is to make sure investors play the long game. It’s a mistake to make dramatic changes to portfolios based on developments that either have only recently taken place or only are expected to last less than a year. As contrary as this might sound, the shutdown isn’t something that should influence investor portfolios. It’s also true for the trade war. There again, a mistake to make dramatic changes unless someone really has insight and thinks the U.S. and China just don’t come to a resolution. Both sides are going to end up proclaiming it’s a great deal when it gets announced, and everything that people liked before will be the stocks that they will want to buy again. Short term trades might make them feel good emotionally, but they’re mistakes tactically.
[Tony]: What sort of rationale should an advisor give clients about reinvesting given the fact that maybe they pulled out?
[Tom]: There are two things that come to mind. Firstly, as bad as it is to abruptly sell everything, it’s also tough to put money back on in one chunk. It’s hard to do “Risk-On, Risk-Off”. I think if someone has scaled out of the market they should try to scale in, the shortest over four months, or split it into two quarters.
People must keep in mind that the market makes most of its returns in just a handful of days every year. I think it’s 5 days a year that account for most of the return for the S&P so that means the other 220+ days just don’t even matter. Secondly, when people get nervous, and especially on days when the Dow is down let’s say 1.5%, that’s just noise – and if we’re going to be up 15% this year that down day is the day you should be buying not selling.
That’s not how most people think, and that’s also not the advice you get from most sell side firms. A lot of money managers want you to think you should trade every day and every second, but I think a down 1.5% day would be a day to add.
[Craig]: It’s the last 10 years when we saw the very benign move in the broad S&P 500 which left a lot of investors scratching their heads thinking how they could keep up with that. And then, suddenly, starting 4 months ago, we saw a lot of volatility.
[Tom]: The last 10 years have seen a very strong rise in equity prices. It is a rise that few people had the foresight to see and few people the stomach to hold through, and if there’s any lesson to be learned from the last decade, it’s that stocks continue to be a lot more resilient than people realize. If we think back, there were a lot of people in that 2009-2010 period that were saying that the new normal is that economic growth wouldn’t recover after the financial crisis.
Remember that book called “This Time is Different”? The implication from that book is that the economy and stocks are going to have a horrible decade, and in fact a lot of pundits who were famous bond managers were making that same case, but it turns out that stocks were fantastic.
I think 2018 echoes back to 2015 in the sense that there was a shock delivered to markets and we had big drawdowns. It’s a critical decision point because a lot of people now say there’s a new bear market beginning, and that things have changed. If they are correct then we shouldn’t be owning stocks right now. If they are right, then cash is your only real alternative.
But if this is 2015, then every bearish piece of advice that someone has been given in the last six months is going to prove to be catastrophic because that means you will have sat out the remainder of this bull market. I am in that latter camp: the biggest issue last year were the policies carried out by central banks. That’s really the core of why the markets did so badly.
[Craig]: You have said that we’re in the middle of a 20-year bull cycle, but when you look at the whole view, what are the conviction points that make you feel optimistic about the economy and the markets?
[Tom]: There are several reasons. One is capital spending. When you look at private investment as a percentage of GDP since the 1950s, we have not peaked in the business cycle until that number has reached 27%. That’s the lowest number it’s reached before. The cycle peaks and right now we’re at like 24%. The reason that number has bearing in private investment is that inventories and commodities are the only reasons you would ever have a contraction, right?
Because a negative inventory cycle or a commodity shock can hurt the business cycle, ultimately the real driver of the business cycle is, “does incremental investment have negative returns?” It only reaches that point when it’s a high percentage of GDP. Because of the financial crisis, spending, private investment, and private sector investments have been quite muted whether it’s construction of homes, purchases of durable goods. Even capital spending outside of R&D has actually been quite muted. It feels like we’re more mid-cycle.
The second reason I think stocks aren’t late cycle is that you can still generate a pretty attractive total return owning equities right now. We have a muted inflation environment, but if inflation picks up, earnings start to accelerate. The price-earnings ratio (PE) isn’t demanding if you look at past peaks, whether it’s the late ‘60s or the late ‘90s. PE peaked approaching 20 times forward earnings, and we are roughly 15 times right now.
The third reason is demographics, the unsung hero in explaining market cycles. If you define generations in roughly 20-year age groups, there are six living generations today. The peak of the Greatest Generation was 1930. The peak of the Silent Generation was 1974. The peak of the Boomers was 1999. The peak of Gen X was 2018. And the peak of the Millennials is 2038.
Interestingly, the first four peaks coincide with major market tops, and that’s why we had the big draw down last year. In a strange way, not to sound too glib, because the Millennials are now essentially driving the economy – I think we have a 20-year runway.
[Craig]: Going back to stock picking, you recently said that you think this is one the best equity picking environments that you’ve seen in six years. What are you looking at?
[Tom]: As a general observation, one way to really appreciate why it’s one of the best environments for stock picking is that today the percentage of stocks with a PE less than 15x is now 40%, the best ratio since 2012. You haven’t been able to buy cheap stocks for more than six years.
We think one of the regime changes that’s taking place, assuming this is the mid-cycle of this bull market, is that every midpoint like 1962 during the 1948 to 1973 bull market was a shift in leadership away from defensive towards inflation sensitive. In 1987 midpoint, during the 1974 to 2000 bull market, the pivot that took place then was really a market that went from defensive to cyclical.
The leadership that we have seen the last 10 years has really been this insatiable overweight of growth stocks. The pivot that’s going to take place is with investors discovering value style investing and maybe more specifically finding value on the balance sheet of company with hidden assets, rather than companies that are asset light and generate money through units.
[Craig]: What type of advice are you giving institutions these days?
[Tom]: People are licking their wounds. Bloomberg just did a survey that showed that 60% of hedge funds lost money last year, the highest ratio since 2008. Something did happen last year that really caught a lot of institutional managers by surprise and when you look back, it’s because we had a critical policy made by the central bank with almost all of this decline which took place in December.
There’s a lot of confusion because when people see a change in behavior of a stock or market like this, their normal instinct is that something meaningful has changed, and people tell themselves that the cycle is over. Clients are spending a lot of time this year trying to figure out how much corporate earnings are recession discounted, how much are shutdown discounted, how much of the trade tensions are discounted. Has the Federal Reserve changed its tune, or is the Fed still going to be a massive risk? The Fed was a huge risk last year.
[Craig]: All right, so they’re confused and there are these questions looming. Do you tell the average institutional clients to hold their asset allocation and risk levels, is it more like art?
[Tom]: Our advice sounds contrary to their common sense. The odds of double-digit gains in 2019 are the highest since 2009. This year is setting up to be a year that will defy conventional expectations because most people are expecting the market to consolidate, and it’s logical given all the technical damage and that there’s a lot of earnings risk. There are earnings downgrades coming but in the face of that the key question is, the markets are going to prove to be more resilient or less resilient than consensus. And this is a year where it’s going to be a lot more resilient.
[Craig]: You have partnered with Reality Shares, and Reality Shares is intrigued with the DQM model and index. Without talking specifically about the ETF, can you bring us up to date in terms of that particular investment model, strategy and index, and what you have to say about its current approach to investing?
[Tom]: The ETF DQML tracks an index produced by our Doctor Quant Model or “DQM.” DQM uses a multi-factor quantitative approach and it had previously been only made available to our institutional clients. It’s exciting that DQM is now available to retail investors. The difference between what our quantitative model is versus traditional quant is that the majority of our 43 factors are purely fundamentally based.
Instead of trying to find momentum in a factor, the traditional focus of a multi-factor model, and overweighting that, whether it’s price-to-book or price-to-sales, our DQM model finds where positive divergences are developing, whether it’s in credit spreads or analyst revisions or movements in price targets or liquidity generated on the balance sheet versus reported cash flow.
These are viewed as leading indicators to true momentum. It’s a smarter version of multi-factor because it’s trying to look at the factors before they become momentum based. It has worked well, and it essentially ends up buying roughly 1/5 of the S&P. You’re not getting sector biases, and over time our back-testing indicates that it generates roughly 20% more upside on up days while it only has 85% of the downside on down days over the aggregate of those respective periods.
The reason you’re making money is that you’re losing less on down days, but you’re picking up additional return on the up days. It’s a good all-weather strategy for folks. Like if someone said they want to own the S&P, but they want to eliminate some of the bad stocks. This is a way to do it.
[Craig]: How is DQM positioned right now, and how do you see the leading indicators, that we might see the next couple of months, alter weighting’s or allocations?
[Tom]: DQM, if you look at the most recent rebalance, is not choosing between growth and value at the moment. It is actually overweight quality, meaning it is essentially saying that growth stocks, even though they’ve gotten cheaper, are not as attractive as quality stocks, and value stocks, even though those are cheap, don’t have the same fundamental visibility as quality. It’s recommending investors stick with a quality cyclical approach.
A group that probably is going to ultimately be safe to hold through all seasons, and this may be famous last words, is technology. People continue to view health care as an all-weather sector, and that’s true for the most part. But technology is becoming increasingly a secular growth story, one that even grows in inflationary environments, through labor tightness. And then it obviously grows when there is a business expansion.
[Craig]: When you look globally what are the most interesting trend you are seeing right now?
[Tom]: One of the most important developments at the end of last year was the message coming from the high yield market. High yield bonds posted a decline in total return last year. It’s rare for high yield to have negative return years because the coupon is so strong but last year was a negative year and high yield has never posted two consecutive declines in a row.
That’s quite bullish because stocks generally follow credit and high yield is poised to have a positive return year. That’s good for equities. In fact, the average stock return in the year after high yield has had a negative return is 21%. Assuming high yield and equity are cousins, high yield is telling us the stock market is going to be up double digits this year.
The other equally important message that people must take away when they look at the world, is the center of gravity for global growth has really shifted. For the last 10 years China and emerging markets were the center for global growth, so it’s important for investors to have exposure there; but that’s because China use to grow at 10% or even higher and it was a tenth of the size of the U.S. Now that China’s economy is not so small anymore, in dollar terms it is going to grow more slowly than the U.S.
The U.S. in the next decade could generate more dollars of global growth than emerging markets and China combined. That’s important because it means investors need to realize that drivers of growth stories could end up being more, you know, domestically oriented. What are the Millennials going to do? How are shopping habits going to change? These are the things that will drive global stories rather than the story for the last 20 years which was there’s all this cheap labor in Asia and that everything’s would be about Asia.
[Craig]: You talk about being in the middle of a 20-year bull cycle that this is as good of a stock investing time as we’ve seen in six years. There are a lot of people on the sidelines who are saying that there’s a bear market coming, it seems that you’re either cautiously bullish or fairly bullish when you kind of look at where we are today versus where we’re likely go over the next, you know, five to ten years?
[Tom]: I don’t want to dismiss 2018 because 2018 was a strong message to investors. The biggest message was that central banks are still as important today as they’ve always been, and policy errors can be catastrophic for the near term, but the mistake anyone would have made last year is selling in December.
The S&P was 300 points lower than it is now and you should almost treat today as the start of a new bull market because that’s essentially what happens after a mid-life crisis. Look at other periods of history when the bull market experienced a mid-life crisis. The Compound Annual Growth Rate (CAGR) of the stock market from 1948 to 1962 (Kennedy crash) was essentially identical to the period from post-1962 to the 1972 (Rising Inflation), and the CAGR from 1974 to midyear 1987 (Black Monday). And finally, from the 1987 low to 1999 (dot com bubble) these periods compounded at roughly the same rate. The stock market that had about 10% plus returns for the past decade is still going to deliver these types of returns, but it’s probably from a different set of stocks.