Eric R. George, Portfolio Manager
Until this December, investors had experienced a very prosperous decade following the 2008 Bear Market. As time has a way of healing painful memories, a brief review of that wrenching period may provide some perspective on our new Bear Market. The 2008 Bear was born on June 27th of that year, with the S&P 500 having declined the requisite 20% from its record close during October of 2007. By the fall, it was clear that the U.S. banking system was failing, a victim of the ruptured real estate bubble. Only intervention by the Federal Government prevented a true catastrophe. Still, by March 9th of 2009, the S&P 500 had declined to its final nadir of 676. From peak to trough, it had fallen 56.8%.
The damage defined by that March low was rapidly obscured by the velocity of the recovery. Three weeks later, the Dow had gained 20%, and a new Bull Market was born. The S&P 500 gained 30% by mid-May; by year-end, it had risen a full 60%. Over the next ten years, U.S. markets provided sanguine returns, with no negative years and many excellent ones. Computerized trading systems authorized to provide “Supplemental Liquidity” in 2008 helped keep things moving. Negative events persisted worldwide, but the new Bull continued to climb a wall-of-worry. Even the abrupt decline following the surprise election of President Trump provided yet another buying opportunity with the S&P gaining over 12% in 2016 and another 19+% the following year. The near ten year-old Bull, refreshed by tax-cut fueled corporate earnings, forged ahead through the first three quarters of 2018, marking the longest run in history. Then the sleeping Bear, roused by rapidly increasing interest rates, reappeared at last. It had been a long hibernation, and he was hungry indeed.
Reasons for the current Bear Market are many, but even in combination they pale in comparison to the real estate induced financial crisis of 2008. Let’s examine some of the most widely discussed and then offer a couple of thoughts of our own:
1. The Federal Reserve
The Fed Board of Governors recently began to increase short-term interest rates. While widely expected, their resolute posture toward the possibility of future increases has markets very on edge. We believe this is the single largest negative facing a market recovery. That said, the ten-year US Treasury bond yield has declined from 3.25% to 2.75% over the fourth quarter. That should help dampen interest rate fears somewhat.
2. China and Trade Tariffs
Next to interest rates, tariffs have the potential to be the largest anchor on the economy. However, they are equally problematic for China. We feel it is likely there will be a resolution on major trade issues by early next year. Even a partial resolution would be extremely bullish for stock prices.
3. Slowing International Growth
This issue is highlighted by Fed-Ex in its recent reduced guidance in global shipping revenue. Brexit, and continued political unrest in Europe, suggest this will be a longer-term issue. At current depressed U.S. equity valuations, we feel slower global growth may be effectively “priced-in.”
4. Record Corporate Debt
During the ten-year Bull Market, record low interest rates encouraged many U.S. corporations to leverage their balance sheets and utilize debt to repurchase their own shares. This often worked well, reducing the market capitalization and increasing earnings on a per share basis. Now, however, equity owners have been pushed further down the ladder in terms of access to available cash flows.
5. Shortage of Labor
Perversely, good economic news is often bad news for equity valuations. In this case, the current lack of skilled labor is restricting growth in many industries. The current spike in shipping costs due to lack of qualified commercial drivers is but one example. Many CEO’s consider shortage of skilled labor a bigger problem than tariffs.
We believe the above issues, while negative, are manageable. With each successive day, they are now more fully reflected in current equity prices. Indeed, we are scaled buyers at current levels, and would be more aggressive except for two final issues that give us pause.
1. Quantitative Trading
Quantitative trading, also known as High Frequency Trading (HFT), algorithmic, or plain old Program Trading was legitimized to help provide liquidity in the dark days of 2008. Today, it is estimated that quantitative trading accounts for well over half of the transaction volume on any given trading day. Essentially, sophisticated computer models use complex mathematical formulas (algorithms) to help determine the second by second direction of stock prices, and exploit it. Today’s computers buy and sell in milliseconds, and often amplify volatility in both directions. The algorithms have no greed or fear; they are rather designed to capitalize on these all too human emotions. They don’t know if Intel makes computer chips or nuclear weapons, and they don’t care. Volatility is their friend. We do not fear them, but maintain a healthy respect of the occasional damage they cause. Unfortunately, they are probably here to stay.
2. Tax-loss selling
Our final reservation revolves around good old fashioned tax-loss selling, which is likely to be more pronounced than usual this year. Many taxable investors took substantial gains earlier in the year, and are loathe to pay taxes, while sitting on newly created unrealized losses. Of course, our “Quant” friends above already have a program for that!
In summary, while we do not see a rapid return to this year’s highs, share prices now likely have a good deal more upside than downside through 2019. The art of it all is in minimizing that downside. Fear will help us greatly in that effort; not fear on the part of our clients, but the dire and hand-wringing articles in major media. To date, that has been mostly constrained. It is unlikely to remain so. As always, the greater the fear of the Bear becomes, the closer we are to the next Bull Market.
This commentary is prepared by H.M. Payson for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any security. The information contained herein is neither investment advice nor a legal opinion. The views expressed are those of H.M. Payson as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes. H.M. Payson cannot assure that the type of investments discussed herein will outperform any other investment strategy in the future, nor can it guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. Although information has been obtained from and is based upon sources H.M. Payson believes to be reliable, we do not guarantee its accuracy. There are no assurances that any predicted results will actually occur. Past performance is no guarantee of future results. Registration with the SEC or with any state securities authority does not imply a certain level of skill or training.