“If you don’t like the weather in New England now, just wait a few minutes.” – Mark Twain
Though Mark Twain’s quote has ostensibly been co-opted by every Midwestern city, it has some relevance to investors (and not just meteorologists). Investors were rightfully frustrated with the market performance of 2018, especially the last quarter. They didn’t have to wait long for their frustration to lift, though, because as soon as the ball dropped on New Year’s, market sentiment shifted seemingly overnight. The question after the 2018 “weather” changed so quickly is: Are we on the precipice of the “weather” swiftly shifting course again?
After a frigid quarter to end 2018, it was comforting to see the equity markets warm up as they rebounded strongly to start 2019. In the fourth quarter, the fundamental performance of domestic businesses diverged greatly from their stock price performance for reasons that appeared disconnected to long-term outlook. In 2018, corporate profits increased 20% for the companies in the S&P 500 but the index itself ended the year down over 4%. A business is worth the sum of its future cash flows discounted back to today, so we believe that type of disconnect cannot be sustained. The market selloff was not tied to fundamental performance or changes to those cash flow estimates but rather hand-wringing over potential macroeconomic events.
The start of 2019 reflected the belief that the selloff was overdone. The S&P 500 closed the first quarter up a little over 13%—its strongest opening quarter since 1998 and best quarter, regardless of timing, since 2009. So does this early year appreciation mean the market is at fair value? Or further, does it mean we are at the top because we are in the midst of a 10-year bull run for stocks? Both of those questions are impossible to answer unless you own a crystal ball. But some underlying data may point in a different direction from what a lot of the financial headlines are saying.
For starters, it is true that the market is currently trading at a price-to-earnings ratio that it is consistent with being fairly valued. That said, it is important to note that at Harris Associates, we do not “buy the market.” We invest in individual businesses and our portfolios are more focused than the broader market. When people talk about “the market,” they’re usually referring to the S&P 500, which has 505 stocks in it. Or perhaps they’re looking at a mutual fund they own, but the average U.S. Mutual Fund has 103 stocks in it. We’re buying in the neighborhood of 15 to 25 stocks for our clients. While the “market” may be at fair value, there are still good ideas available for those willing to dig for them. For instance, while the broad market was down 4%, the Valueline Geometric Index, a measure of median stock in the U.S. stock market’s performance, was down 16% for the year.
Furthermore, financial pundits are wary that we are on the tail end of the longest bull run in US history. Again, this seems like it glosses over some important points. By definition, the market enters into bear market territory when it decreases 20% or more from peak-to-trough. Equity bears says this hasn’t happened since the Great Recession and that we have to see a bear market again eventually, perhaps imminently. But does that really tell the whole story?
In 2011, we saw a drop of 19.4% from the closing high to the closing low on the S&P 500 Index. However, if we looked at
intraday levels, the index was down 21.2% peak-to-trough. We had a similar situation last year when the index was down 19.8% on peak-to-trough closing, but down 20.2% when looking at the intraday numbers. While we technically haven’t seen S&P 500 closing prices down 20% since the Great Recession, it’s not as though investors have enjoyed unfettered prosperity for a decade plus. Looking at the intraday numbers would mean we experienced two bear markets over the last 10 years, which is consistent with what we have seen historically.
Most of the assertions that a bear market is imminent are tied to the belief that the U.S. economy and, perhaps, the global economy are on the brink of a recession. Many of the reasons for December’s market selloff were tied to that belief, including the ongoing trade war with China or Fed Chairman Jerome Powell’s comments about how the Fed would handle interest rates.
Another concern has come in the form of discussion about the yield-curve inversion. The yield curve is a plot of bond yields on maturities of different time horizons. An inversion is when long-term yields dip below yields on shorter term securities. There has been a lot of discussion in the financial media about the recent yield-curve inversion in relation to the assumed impending recession and how the latter is a harbinger for the former. This was another factor mentioned as contributing to the market selloff in the fourth quarter.
It’s true in March we saw the yield on 10 year Treasury dip below the yield on a three-month Treasury-bill for the first time since 2007. Economic bears will point out that this has happened before the previous seven recessions, including the one from the last decade. According to Bianco Research, when we see this inversion for 10 consecutive days, a recession follows an average of 311 days later. So while this is certainly something we’re cognizant of, it does not necessarily portend an imminent slowdown in economic growth. Perhaps this type of indicator is clouding investors’ vision.
However, we are not as bearish on the state of the domestic economy and what it means for businesses. We continue to see positive domestic economic news. American manufacturing recovered in March to 55.3%, anything above 50% indicates expansion in manufacturing activity. Construction spending was up 2.5% in January and another 1% in February. Economists had predicted contraction in February for this indicator, so the positive number was a nice surprise. Also, 2018 saw average hourly wages increase over 3% year-over-year. This was the first time we saw that type of growth since the Great Recession. Approximately 70% of the U.S. economy is driven by the consumer, so more money in their pockets should be a positive.
All of that is to say that we have seen some positive, if not perfect, economic headlines coming off of a year of strong growth. We are not macroeconomists. We believe trying to predict the timing of a recession is a fool’s errand. That’s why we so often talk about our focus on fundamental business value over a long-term time horizon and look past the short-term noise.
There will continue to be more handwringing from the financial pundits about the next recession and its imminence. Our uncertain political environment surely contributes to that lack of certainty. And we will likely see a recession again at some point. To try to predict that, though, is as valuable as trying to predict the weather. Even if you are able to correctly forecast tomorrow’s thunderstorms, wait a few minutes and it could flip just as quickly. At Harris Associates, we will continue focusing on long-term business valuation through whatever business climate we encounter.
On a separate note, we are pleased to announce that earlier this year, Harris Associates signed the United Nations Principles for Responsible Investing (UNPRI). Issues of corporate governance, along with environmental and social impact have always been considerations in our approach to investing our clients’ assets. We signed the UNPRI to further reflect that commitment.
As always, we thank you for entrusting us with your investment assets and your continued support. Lastly, the best compliment we can receive is a referral from a satisfied client. We appreciate your referrals and handle them with the utmost of care.
The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the portfolio managers and Harris Associates L.P. as of the date written and are subject to change without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.
The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. It is a widely recognized index of broad, U.S. equity market performance. Returns reflect the reinvestment of dividends. This index is unmanaged and investors cannot invest directly in this index.
The Value Line Geometric Composite Index is an equally weighted price index of all stocks covered in The Value Line Investment Survey. Geometric refers to the averaging technique used to compute the average. This index is unmanaged and investors cannot invest directly in this index.
Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods.