After the Worst Week, Month, Quarter and Year in Over a Decade, Why Are We Suddenly Bullish on Stocks?

A long time client writes, “No capital gifts this year. Seeing a Dow that is falling like a stone, day after day, does not inspire me. It is acting like 2008 and the economy could not be more polar opposite from 2008.”

Exactly! Yet, US and international stock market performance is the worst since 11 years ago during the 2008-9 financial crisis.

What we are doing right now?

  1. Any client that depends on their portfolio for their monthly draw will receive their regular payout January 2nd and throughout 2019. Clients with draws have a year’s worth of cash in money market securities, and 4 years of cash in bonds. These clients can survive a 5 year drought in equity market returns without a negative impact on their lifestyle, just as we saw back in 2008-9

  2. We are not selling ANYTHING this week. About 4 weeks ago, we harvested tax losses in any households with at least $50K in realized gains so far in 2018. Those funds are sitting in cash, and will be reinvested shortly as soon as the “wash sale” period expires.

  3. We also decided to eliminate the 5% allocation to commodities (oil and gas, metals, foodstuffs) that we have maintained for many years. Commodity prices could not stay up when the world economy was booming due to ever more efficient production, and with the world in a slump, prices only look down for a while. Those funds are still in cash.

  4. Of the many families who came on board since June, our general plan was to invest 1/3 of their stock allocation immediately, 1/3 if prices declined 10% and the remaining 1/3 if stock prices declined 20%. If prices did not decline, we would just scale in after 6 and 12 months. Following this plan we invested a lot of money on December 3rd, thinking stocks were already 5% undervalued and that the traditional “Santa” rally would soon be upon us. However, as December progressed, investors following events in Washington freaked out and dumped stocks wholesale.

  5. For clients whose retirement is still a few years in the future, don’t worry. Our “all-weather” investment strategy assumes that bear markets can and will occur, and yet your retirement will be fine. Indeed, if you have cash on the sidelines, now is a great time to put that cash to work.

A brief history of bear markets

Clients see a chart like this in the news:

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and project that their portfolios will be worth $0 by February. Yet, the stock market is not a stone; it’s a spring! The harder you push to extremes (either down or up, below or above fair value) the faster the rebound.

At this point in time, the following markets are in official (down at least 20% from all-time high) bear market status:

  • US NASDAQ down 23.9%

  • US Russell 3000 – 98% of US stock market down 20.6%

  • US Russell 1000- large caps down 20.1%

  • US Russell 2000-mid and small caps down 26.9%

  • DAX (Germany) down 21.8%

  • Hang Seng (Hong Kong) down 23.4%

  • Shanghai (China) down 30.0%

  • FAANG stocks down an average 36.4%

By sector:

  • Consumer Discretionary down 23.4%

  • Energy down 31.7%

  • Financials down 26.4%

  • Industrials down 25.4%

  • Technology down 24.5%

  • Materials down 26.2%

  • Telecommunications down 22.9%

The S&P 500 (US large caps) down 19.7% is not quite in bear market status, but who cares about the distinction? US bonds are down 0.45% YTD.

The only up markets: US Healthcare (up 1.8%) US Utilities (up 5.6% in classic flight to safety) and the Brazilian stock market (up 12.2% - buoyed by a vast influx of Chinese purchase orders for soybeans as China shifts from US to Brazilian suppliers.)

Our clients are concerned for sure, and yet, a quick review of history shows that, this bear market is no more unusual than any of the other bear markets of the past 95 years. This chart shows how little bear markets matter to your portfolio relative to how important it is to stay fully invested:

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  • Bull markets in US stocks last an average of 9.1 years with gains averaging 480%. The current bull run is nearly 11 years old, so about average in length, with total returns in the S&P 500 of 290%, so light on gains, but still a quadruple..

  • Bear markets occur on average once every 10 years, with an average loss of 41% and an average duration of 1.4 years. If you eliminate the bear market centered on the Great Depression (down 83%) the average bear market decline is 26%.

  • In 2008-9 the S&P 500 declined 55% peak to trough (year end 2007-March 2009), but was at record highs 2 ½ years later (September 2012.)

Clients always want to know if there’s a way to step out right before a bear, and step back in right before a bull market. $3 trillion are invested in hedge funds that claim to have this expertise, but 580 hedge funds closed so far in 2018, 784 closed in 2017, and 1,057 funds closed in 2016 for lack of performance. As we always say, “Hedged against profit!”

Why are investors selling now? The Trump Slump!

As readers of our commentary know well, we don’t hold the current president in high regard. As we wrote two years ago, “If Donald Trump worked for your company, school or church, how quickly would you fire him out of self-preservation.” Unfortunately, short of impeachment (unlikely given the current political composition of the US Senate) or resignation (unlikely given temperament,) we’re stuck with “the Donald” through at least January 2021 and possibly into a second term.

Every week seems to be worse than the week before: Monday – the White House announce an important initiative; Tuesday - something horrible happens; Wednesday, Thursday and Friday – damage control; Saturday – golf.

In March Trump tweeted “Trade wars are good and easy to win.” In the pantheon of “famous last words,” we’ll find this tweet right next to “From the bridge of the Hindenburg: ‘Say Otto, do you smell smoke?’” It took a while for the tariffs (which are a tax on average Americans) to bite into the US economy, but now nearly 50% of US Chief Financial Officers expect that the US will be recession by the end of 2019, and 82% believe that a recession will begin by the end of 2020.

Trump believes that he can bring China to heel on trade by applying tariffs, but he has badly underestimated the other side. China has a host of internal problems, and it is certainly true that China has not “played fair” in recent years, creating artificial barriers to imports while making every effort to expropriate US intellectual capital. However, the Chinese economy is growing so fast as to surpass the US within 20, possibly within 10 years. Economic might makes right!

The United States spends more on defense than the next 7 countries combined; China has invested a similar amount in “soft power,” building networks of highways, ports and sources of raw materials across Africa, South America and the Pacific Rim. China holds $1.14 trillion of US debt and could disrupt US capital markets at any time by dumping a portion of that debt.

Mostly importantly, Trump has underestimated China’s ability to outlast him at the negotiating table. If US unemployment is rising and the economy is in recession in 2019-2020, Trump can kiss re-election “goodbye.” President Xi Jinping of China is potentially president for life, since the Chinese Parliament under one-party control eliminated term limits for the president earlier this year (next election is in 2023.)

Within living memory (1958-62,) China sustained 30-50 million deaths during the “Great Leap Forward.” President Xi will cheerfully endure a couple of years of economic disruption if it hastens the year that China surpasses the US as an economic power.

Chinese negotiators can let Trump dangle in the wind through 2019, settle on favorable terms at leisure.

The Tipping Point!

Through September 2018, it seemed that investors were willing to overlook Trump’s inexperience and lack of strategy. The 2017 tax cut temporarily boosted corporate earnings and therefore stock prices. However, the tax cut “sugar high” is now wearing off, and stock prices are now 8% below levels that prevailed December 22nd, 2017 - the date the Tax Cuts and Jobs Act was signed into law.

Meanwhile credibility matters. It’s hard to take Trump seriously when:

• an average of 70% of Trump’s statements are rated “mostly false” to “pants on fire” by PolitiFact. Trump’s word is not his bond.

• he struggles to staff his administration, losing in two years 9 cabinet members and 62% of senior White House staff.)

• he faces 17 investigations into the management of the Trump campaign including collusion with Russia, foreign contributions to his inauguration committee, fraudulent activity in tax filings, businesses and foundation. The incoming Democratic led Congress could easily double the number of investigations Trump faces in the New Year.

• After forcing the government shutdown this past week, Trump spent the weekend investigating whether he could fire Fed Chair Jerome Powell, blaming interest rate increases for collapsing markets (short answer: no.)

Investors want to know that that person leading the country is capable. Right now, Trump’s decisions and actions are creating serious doubts that he’ll be able to govern at all come January 3rd.

What happens next?

As of December 24th, the S&P 500 is down 14.7% for December and stocks are now undervalued by 14% according to the Morningstar Fair Value Model.

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On a scale of 0-100, the CNN Fear and Greed index is now at 2 – “Extreme Fear.”

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Generally speaking, the combination of undervaluation and extreme fear is the best time to buy stocks, which is why we’ve gone from Neutral-Bearish in July (reread “Stock Market Indicators Flashing Yellow”) to Bullish now.

We don’t expect to buy stocks between now and year end, but we do intend to move aggressively into the market in January. We have received numerous emails from clients asking us not to buy stocks without checking in first. Yes, we will do that.

As we expect many of our clients are looking at their portfolios and wondering whether their financial plan is still on track, we will aggressively schedule annual reviews starting January 7th. We will send a separate email with the annual review agenda.

As always, reach out to us with comments and questions.

 
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David Edwards, President
Heron Wealth
(347) 580-5288
DavidEdwards@HeronWealth.com