The Investor’s Relentless Search for Answers
“The wise investor recognizes that success is a process of continually seeking answers to new questions.” Sir John Templeton
First Quarter 2019 Market Review and Commentary
Wow, the first quarter turned in a blistering performance with the markets having the best quarterly results since 2009. What made it noteworthy was that it followed the worst December since 1931 and a fourth quarter that witnessed a decline of 13.5%. Importantly, this was a global rally that seemed to ignore the generally slower pace of economic activity throughout the developed world. Domestically, the S & P 500 Index, representing large cap stocks, advanced 13.7%. In terms of style, growth outperformed value in all capitalization categories, a trend that has persisted for much of the last ten years. For the quarter, all sectors advanced with Information Technology, Real Estate and Industrials were the strongest performers. In contrast, Health Care, Financials and Materials were the poorest performers. In other areas, Emerging Markets rose 9.9% and the MSCI EAFE Index (developed non-U.S. equity markets) advanced 9.0%. In the fixed income markets, the Bloomberg Barclays U.S. Aggregate Bond Index (representing investment grade U.S. bonds) increased 2.9% for the quarter. Overall, the first quarter was a remarkable period in which everything seemed to go right for the capital markets, begging the question of “what comes next?”
Before turning to address that important question, it may be instructive to look at the environment that produced the impressive gains of the first quarter. As 2019 was coming to a close, the Federal Reserve raised short term interest rates for the fourth time in 2018 and indicated that two more rate increases were on “autopilot” for 2019. The markets, already in a funk, continued to decline, reaching a bottom on Christmas Eve. The outlook was uncertain, to be sure, as the New Year dawned. Then, the unexpected happened when Jerome Powell, Chairman of the Federal Reserve , in a noteworthy monetary policy “pivot”, said that the market’s action in late 2018 was correct in suggesting that the weakening economic environment was exacerbated by the recent rate hikes and the shrinking of the Fed’s balance sheet (quantitative tightening). Furthermore, he added that the Fed would be patient and await other economic reports before taking any further action to raise short term rates. As the quarter progressed, the Fed also announced that its plan to reduce the Fed balance sheet would be concluded by September. All this news combined with encouraging information regarding the progress of trade negotiations between the U.S. and China provided further impetus to the stock market’s advance. Lastly, in March there was news that the Brexit deadline for Britain to leave the EU had been delayed, thereby removing, at least temporarily, the possible trade disruptions that might be caused by a “messy” exit from the European Union.
As earnings are reported, investors will be carefully watching the reports with particular attention on revenue and earnings guidance issued for the remainder of the year.
So, here it is the beginning of the second quarter with many wondering what’s next for the equity markets. This question is a vexing one as it comes at a time when the markets are approaching their all-time highs while the global economies are showing signs of diminished growth. In the U.S, the economy has slowed from the fairly strong growth shown for most of 2018. Recently released data indicates that GDP grew at a 2.2% rate in the fourth quarter of 2018 and appears to be on pace for a similar performance during the first quarter of 2019. With the 2017 tax cuts having worked their way through the system, the U.S. appears to be returning to a more modest rate of growth which could make it susceptible to a more pronounced slowdown in the global economy. At the same time, corporate profits are becoming the focus of investor attention as earnings season is in full swing. Currently, Wall Street analysts expect a decline in corporate profits in the first quarter of 2019. As earnings are reported, investors will be carefully watching the reports with particular attention on revenue and earnings guidance issued for the remainder of the year. While no one can anticipate the response to corporate announcements, investors will be tested on their willingness and ability to endure less than optimal forecasts for the immediate future.
With the equity markets already richly valued by most commonly used historical measures, the months ahead holds three distinct possibilities: 1) moving sideways to allow economic and corporate profitability to “catch-up” with the advance that appears to have outrun the fundamentals; 2) continuing the market advance as investors focus their vision across the valley of weakening growth and sift corporate profits and look to the resumption of growth after a pause; or 3) coming to grips with the realization that expectations were too optimistic and that their euphoria was misplaced, leading to a correction, the severity depending on economic fundamentals and the outlook for corporate profits.
Frankly, no one can accurately predict which direction the markets will head in the months ahead but we can, at least, look at the possibilities. Scenario #1 is plausible and probably the one most desired by the Federal Reserve. To this end, the Fed has already made significant adjustments to its monetary policy and there is a good likelihood that the Fed may even cut interest rates this year should there be additional signs of weakness in various economic data. Should the Fed do the impossible and successfully engineer a soft landing for the U.S. economy, the markets would likely respond in a positive fashion. Scenario #2 would be a more difficult one to achieve due to the prospect of weak corporate profits and already high valuation levels. However, several Central Banks from around the world have indicated a willingness to reduce rates as much as needed to help revive the slowdown in economic growth. Of course, making borrowing cheap does no good unless there are users of credit willing to take on the loan obligation. So, a critical element in this scenario would be a level of consumer and business confidence that makes borrowing a viable venture. And, finally there is scenario #3 is which the markets are confronted by a deteriorating economic environment accompanied by declining corporate profits in what may be a perfect storm of bad news for the capital markets.
As the saying goes, “you pay your money and you take your chances”. From a prospective gained from more than forty years in the business of managing client assets, scenarios #1 and #3 make the most sense. Perhaps it’s a flip of the coin as to which one comes to pass. Undoubtedly, unexpected news, either positive or negative may be the catalyst that proves to be the deciding element in moving the markets one way or the other. Frankly, with everything appearing to go right in the first quarter, it would not be surprising to see the markets endure a reality check that calls into question the optimism that appears to be propelling the markets higher.
As a closing thought, financial advisors and investors who were lamenting their market exposure in the fourth quarter of 2018 have been granted a reprieve. With the sharp “V” shaped bounce back in the first quarter of 2019, those advisors and investors have been handed a second chance to rethink their asset allocation as well as the type of equities held in their investment portfolios. Now may be an ideal time to review their portfolios, consider the economic fundamentals and make necessary changes that may serve them well in whatever environment that lies ahead. In this regard, our Strategies at MVP are based upon an in-depth analysis of company fundamentals looking at the balance sheet and income statement through the eyes of a business owner. We build concentrated portfolios of companies that have strong financials, capable managements and a business plan to compete in an ever-changing world. Importantly, our portfolios have valuation metrics that suggest our strategies are more reasonably priced than their benchmarks. In addition, we believe our strategies make sense in a challenging “mindless” investing world and have the flexibility to take advantage of opportunities as they unfold within the marketplace. We are grateful for you confidence and support and stand ready to answer any questions you may have about our strategies and individual holdings.MVP 1Q19 CIO Letter4(002)
Stephen K. Kent, Jr., CFA
Chief Investment Officer, Co-Founder
Steve has over 40 years of experience in virtually every aspect of investment management from equity and fixed income research through economic analysis, investment strategy, portfolio management, new business presentations and client servicing. During his fifteen years with Carl Domino Associates and its successor, Northern Trust Value Investors, Steve played a key role in the growth of assets from approximately $325 million in 1992 to $5.2 billion at year-end 2006. During the last five years of that association, Steve was Senior Vice President and Chief Investment Officer managing a team of 12 investment professionals.
Steve is a graduate of Washington & Lee University with a B.S. in Commerce and a major in Business Administration. He was awarded the CFA designation early in his career and served as President of the Philadelphia CFA Society. Currently, he is a member of the Los Angeles CFA Society.