“If your friends stay out in the damp, they’re liable to catch a cold, aren’t they?” – Clint Eastwood as “The Good”
My father loves a good classic Western film. One of the first ones we watched together was Shane, but soon thereafter I was introduced to Clint Eastwood in The Good, the Bad, and the Ugly. I happened to watch it again recently and suddenly realized that, when thinking about the past quarter and what may lie ahead, I can’t help but think that, just like the movie, there are some good guys, some bad guys, but also some very ugly characters we might encounter as well.
MARKETS IN REVIEW
There was a substantial reversal in the markets between the end of 2018 and the beginning of 2019. We closed the books at the end of Q4 2018 with the Dow Jones Industrial Average (DJIA) falling -11.83%, the S&P 500 Index losing -13.97%, and the NASDAQ plummeting -17.54%. Indices focused on stocks with strong value characteristics were hit especially hard. Large company value stocks, as represented by the Russell 1000 Value Total Return Index, dropped -11.72% for the quarter. Small and mid-sized company value stocks, as represented by the Russell 2500 Value Total Return Index, fell by -17.12% during the quarter.
However, in stark contrast to the end of last year, equity markets started this year significantly well in the first quarter with the DJIA up 11.15%, the S&P 500 up 13.07%, and the NASDAQ up 16.49%. The Russell Value indices also came back nicely although the Russell 2500 small and mid-sized company index did not recover its full loss from Q4. Fixed income produced some nice gains as well this quarter with the Bloomberg Barclays U.S. Aggregate Index returning 2.94% in Q1.
Power of Downside Capital Protection (the “Good”)
Comparing the Q1 2019 and Q4 2018 returns, or just listening to the news, we notice that some clients might think that the recovery this quarter completely eliminated the impact from declines last quarter. One thing that we often remind our clients is that even when you see reversals like this, don’t forget that if you lose 10% of your money, you are not going to break even with a subsequent 10% gain. In other words, if you start with a $100,000 account and lose 10%, you’re left with $90,000 which will only grow back to $99,000 with a subsequent matching 10% gain. Similarly, in the case of the past six months, if you put that same $100,000 into a passively managed S&P 500 Index product on October 1stlast year and didn’t touch it, you would have only $97,278 at the end of Q1 2019.
This is the reason that we remain so focused on protecting investor capital here at WBI. If we can help protect our clients from experiencing the full market downside exposure, like that which occurred in Q4, then they should have more capital left to put to work when the market recovers as it did during Q1.
Using the first simple example, if you started with $100,000 but were able to avoid just half of the -10% market return (suffering only a -5% decline) due to an active risk management strategy, you would have $95,000 left (vs. $90,000). And then, even if you only participated in half of the subsequent +10% market recovery (earning only +5% vs. the market), you would end up with $99,750.
So, the “Good” character here in our story focuses on protecting against that loss of capital first. Because even if you only experience 50% of the subsequent market recovery – and you might be concerned that your 5% return is not as good as the current 10% market recovery – you still end up with more capital anyway ($99,750 vs. $99,000 in my simplified example) because you avoided the full impact of that initial loss in a prior period.
However, in the best Western movies, the “Good Guys” don’t become the heroes without suffering through some difficult gun battles. And similarly, WBI and others that are trying to actively manage risk and protect investor capital over the past six months were forced to fight through some tough situations due to extremely volatile markets.
As you’ll see in the chart below, the lowest closing price for the S&P 500 Index last year came on Christmas Eve. Between October 1st and December 24th, the S&P 500 Index declined -19.63%, and, it certainly looked like markets were going to continue the same volatile and portfolio crushing downward trend, which had started three months earlier, well into the new year. Subsequently, the “Santa Claus” rally between December 26th and December 31st added back over 6% before the end of the year only to then sell off again in the first week of January suggesting that maybe this was just a temporary pause before the violent declines continued further.
So, it really wasn’t until the second or third week in January when there appeared to be some degree of confirmation that the downward trend had abated for now. And since that time, the S&P 500 Index has returned about 9%. That’s a difficult gun battle for even for the best “Good Guys” out there as their portfolio management process is working to protect investor capital from false positives and further downside losses. Although I doubt that anyone could have perfectly called the December 24th bottom, WBI portfolio management has recently enhanced its process such that our actively managed products are able to get out of the market faster when conditions deteriorate, and similarly get back invested in the market faster when conditions improve.
S&P 500 Index (9/30/18 – 3/31/19)
Who is Really Buying Stocks Right Now? (the “Bad”)
Listening to the news or looking at the charts, one would likely come to the conclusion that everyone is piling back into the market this quarter. The worst is behind us and the best is yet to come according to some pundits, so make sure to invest all your capital back in those passive index funds they advise (after suffering that 20% decline that justifiably scared most investors onto the sidelines last fall).
The hidden secret is that retail investors are being much more cautious than it would seem and the current market rally appears to be supported more by company buybacks than anything else. One easy way to see this is by looking at the amount of retail investor capital that is sitting on the sidelines in money market funds these days.
During the Q4 correction last year, there was a significant spike in retail money market fund levels. The increase in retail money market funds was similar to what happened in 2007-2009 and would suggest a degree of panic selling of stock portfolios with the proceeds going into these short-term cash equivalents. Data provided by the Investment Company Institute showed that retail money market fund investments went from around $1 trillion in the beginning of 2018 to $1.17 trillion by the end of the year. Furthermore, even as this market rally has continued, flows keep coming in and retail money markets ended up Q1 2019 around $1.21 trillion, a level that hasn’t been seen since 2009!
According to overall money market fund data provided by iMoneyNet (including both institutional and retail), “money market funds recorded $21.38 billion in inflows to $3.04 trillion in the week ended February 12th [which was] the highest level since the week of March 9, 2010.”2
So, if retail investors, and to some degree institutional investors as well, keep taking money out of the stock market and putting it into money market funds, who exactly is supporting the market rally right now? And furthermore, isn’t it surprising that we have seen such a strong bounce off December lows with so little evidence of retail participation?
One of the primary culprits here is what appears to be the ever-increasing amount of company stock buybacks that are occurring. Stock buybacks refer to the repurchasing of shares of stock by the company that originally issued them. According to some, stock buybacks are beneficial and help companies consolidate ownership, provide a way to pay off investors and reduce their overall cost of capital. However, companies can also use buybacks to “artificially” increase the value of their stock and improve financial ratios, especially in periods of market pessimism.
In 2018, “share repurchases [experienced] four straight quarters of increases and hit a record $806 billion — beating a previous watermark set before the financial crisis, according to S&P Dow Jones Indices.”3 But it didn’t end there. According to FactSet, we’ve seen yet another 59% increase this quarter (vs. Q1 of 2018) as companies in the S&P 500 repurchased $227 billion of their outstanding shares.4
In short, we must continue to monitor the stock buyback potential “Bad Guy” who seems to be one of the primary sources of support for the current market rally as both the retail and even institutional investor appear to remain largely on the sidelines.
Any Good News Left? (the “Ugly”)
The first quarter of 2019 marked the strongest quarterly advance in a decade for the S&P 500 Index. This came as investors gleefully listened to the Fed rotate 180 degrees from its hawkish stance to the message that it does not plan to raise rates any more this year and that it looks to end quantitative tightening as well. Furthermore, the uncertainty regarding a U.S. – China trade deal has all but disappeared as well, eliminating two primary causes of trepidation in the markets. Although there are still signs of slowing global growth, recent manufacturing data from both the U.S. and China helped ease investor fears for the moment. Further, companies aggressively lowered earnings expectations already, so I don’t expect this earnings season to significantly affect the market in one direction or the other. The job market is not displaying material indications of wage inflation and core inflation seems within the Fed target range as well suggesting that, if anything, the Fed’s next move might be to lower rates in 2020 rather than increase them.
However, all that news is already priced into the market, so, is there really anything else that is going to help keep this record-breaking bull market going? Maybe, but I’m not sure what it is at this point, and I’m not the only one who has doubts.
Following the recent inversion in the 3-month vs. 10-year yield curve, which hasn’t happened since 2007, is one of the most closely watched indicators by economists and has preceded every recession since 1960, one hedge fund manager told MarketWatch in an interview “I think people are going to be surprised where the S&P 500 is trading at the end of the year. We’re going at least for a 40% decline from the S&P’s top.”5
After U.S. homebuilding data disappointed in February as construction of single-family homes dropped to a two-year low offering alternative evidence of a sharp slowdown in economic activity, a chief economist told Reuters, “The sugar high is just about over… the risks are more toward the downside than the upside.”
Finally, we note that a record number of Americans are more than 90 days delinquent on their car payments according to the New York Fed.7 That equates to 7 million people and is higher than the prior record from 2010 following the last financial crisis. Although people typically think that you pay your mortgage first, there are also those who believe you pay your car payment first because you can’t get to work without a car. Either way, this statistic led Fed economists to note that “the number of distressed borrowers suggests that not all Americans have benefited from the strong labor market and warrants continued monitoring and analysis of this sector.”1
At one point during The Good, The Bad and the Ugly, Clint Eastwood’s character says, “If your friends stay out in the damp, they’re liable to catch a cold, aren’t they… or a bullet?” Although not a brilliant revelation, it stands to reason that if you hang around long enough in a dangerous environment, eventually, you’re going to suffer the consequences.
Right now, the economy and the markets are feeling a little damp to me. It’s not pouring rain yet, and we might be able to still enjoy a period of positive market returns for some time. But signs of deterioration abound and the likelihood of a recession at some point continues to increase with many economic reports we see, although probably not until 2020 at least.
Here at WBI, we have managed risk to capital for institutions and private investors for over 30 years. Our time-tested active portfolio management process has no mandate to be fully invested. For us, cash is a tactical weapon that can help protect investor capital during market corrections. However, WBI also uses its high-quality security selection process as another weapon in both our actively managed and passively managed strategies with the goal of participating in market rallies as much as possible when conditions are right. So, whether the next character in this movie is good, bad or even ugly, WBI works hard to help you win the investing battle.
-Steven Van Solkema
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