The fourth quarter of 2018 proved to be one of the most negative quarters for financial risk assets since the current bull market began in March of 2009. The S&P 500 finished down 13.5% and commodities were down an even worse 22.6%. As one might expect, safe haven assets performed well. Long-dated United States Treasury bonds returned 4.6% and gold rallied to close the quarter up 7.5%.[1] In fact, the quarter-long move understates the violence of the sell-off: from its all-time high on September 20th through the low on December 24th, the S&P 500 lost 19.3%.
For the full year, there was no place to hide: the S&P 500 lost 4.6%, commodities were down 13.9%, and while less dramatic, long-dated Treasury bonds and gold were both down for the year, 1.6% and 1.9% respectively. Global equities performed even worse than domestic equities with the MSCI All Country World Index down 9.1%.[2] As we write, Christmas Eve appears to mark the (at least, short-term) low. From the close on December 24, 2018 through the recovery-high on January 18, 2019, the S&P 500 rallied 13.7%.
What caused the sell-off? Was it the Federal Reserve rate hikes on September 26 and December 19 despite a flattening yield curve? Could it be the downgrade of General Electric debt in October by both Moody’s and Standard & Poor’s to one notch above “junk,” signaling that the increase in overall corporate debt and covenant-lite underwriting has reached a point of danger? Perhaps it was the ongoing “trade war” with China and/or the (partial) government “shutdown?” It is impossible to know for sure.
Rather than trying to divine the proximate cause of this or any sell-off, we aim to keep two things in mind. First, we are attentive to asset class valuations as they both determine long-run return expectations and influence market resilience or vulnerability to external shocks. Second, we monitor specific indicators of investors’ willingness to take risk. These data points, more than anything else, guide our propensity to use market weakness as a buying opportunity or a signal to become more defensive.
We have frequently, and in detail, commented on the topic of asset class valuation in these letters. In summary, we agree with the analysis that most financial assets are expensive – that is, most financial assets will provide meager returns, relative to their historical averages, over the next 7-10 years.[3] In addition, the high valuations increase the potential for violent sell-offs. When valuations are high and indexers and trend-followers abandon buying, much lower prices are required before fundamental value investors step in. Unfortunately, the last 10 years have proven valuation is not a tool for timing buy and sell decisions for broad market indices.
The second factor, indications of investors’ risk preference, is much more informative on a shorter-term basis. In the context of the recent equity market correction, two specific data points highlight the type of analysis we do on this front. Credit spreads began to widen all the way back in December of 2017. As it relates to investor’s willingness to take risk, this was a yellow light for sure. However, it is important to note that the widening was modest in both its degree and rate of change (it never got that wide, and it never widened at too quick a rate). Spreads between Moody’s BAA and AAA bonds reached their widest point in 2018 at the end of December, but were still only 1.15% apart. In comparison, in December of 2015, this spread was at 1.48% and was 60% wider than six months earlier. Therefore, while wider, the spread today is not yet reason for heightened concern. The economic consulting firm, HCWE points out that spreads need to get wider than 1.4% to begin to signal even a mild recession.
The other risk-preference data point worth highlighting is market breadth, and specifically the advance/decline line. This line indicates how many of the underlying stocks are participating in a market (or index) move. It is possible (and common at significant market peaks) for a market capitalization weighted index (e.g. the S&P 500) to make new highs while a majority of securities in the index are beginning to decline. When this occurs, it is a warning sign. Conversely, when a new index high is confirmed by the advance/decline line, it indicates investors are broadly willing to engage in risk taking and no particular market segment is sounding an early warning. In fact, when the S&P 500 made a new high on September 20, 2018 the advance/decline line also made a new high.
Given the weak caution from credit spreads and an “all clear” signal from the advance/decline line (among many other factors that would overcomplicate this explanation), we felt comfortable using the fourth quarter sell-off to increase our equity exposure. Fortuitously, we had raised significant cash earlier in the year when our investments in both Express Scripts and Zoe’s Kitchen were acquired. Further, as we describe below, we also raised cash by trimming our TripAdvisor position after excellent earnings and a 125% price increase from the last 2017 low.
*****
Fata Morgana: a complex form of superior mirage that is seen in a narrow band right above the horizon.
It seems to us, the fourth quarter sell-off was a Fata Morgana. At first blush, it looked like the beginning of a new bear market. Like the unique conditions caused by rays of light bent through layers of different temperature air, modern market structure – increased programmatic trading, decreased relevance of market makers, and the growth of indexing – is adding volatility to what historically were shallower market corrections.
From a superior vantage point, the mirage dissolves. Market internals provide additional, critical information that the price indices leave out. As we wrote last quarter, despite the recent market volatility, nothing that has proven useful historically is signaling we should become significantly more defensive. This could change quickly – even in the next few weeks. The recent volatility created an opportunity to add to many of our favorite positions. We still maintain modest exposure to long-dated US Treasury bonds and gold, as well as, hold some cash as portfolio ballasts. In general, we are relatively neutral – cautious on valuations, but constructive regarding signs of investors’ willingness to continue to take risk in the near-term.
Sincerely,
Grey Owl Capital Management
Grey Owl Capital Management, LLC
[1] The market (or asset class) returns are measured on a total return basis using index exchange traded funds (ETFs): SPY for the S&P 500, GSG for the S&P GSCI Commodity Index, TLT for 20+ Year Treasury Bond index (i.e. “long-dated” US Treasury bonds), and GLD for gold.
[2] The MSCI All Country World Index is represented by the ACWI ETF.
[3] However, we might quibble with the most strident and alarmist commentators on details around profit margins, corporate competitive advantage, and market structure – all of which could argue for slightly higher normalized valuations. In that case, equity valuations are not quite as egregious as they appear relative to historical metrics such as price to sales and price to book.
This newsletter contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves the potential for gains and the risk of losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Any information prepared by any unaffiliated third party, whether linked to this newsletter or incorporated herein, is included for informational purposes only, and no representation is made as to the accuracy, timeliness, suitability, completeness, or relevance of that information.
The stocks we elect to highlight each quarter will not always be the highest performing stocks in the portfolio, but rather will have had some reported news or event of significance or are either new purchases or significant holdings (relative to position size) for which we choose to discuss our investment tactics. They do not necessarily represent all of the securities purchased, sold or recommended by the adviser, and the reader should not assume that investments in the securities identified and discussed were or will be profitable. A complete list of recommendations by Grey Owl Capital Management, LLC may be obtained by contacting the adviser at 1-888-473-9695.
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