Fourth Quarter, 2019

A Good Year — 2019 was a good year for almost all asset classes. The S&P 500 total return of 31.5% was the second best in the last 20 years. U.S. bonds performed well, with 10-year Treasuries returning 8.8% for the year. Non-U.S. equities, gold and oil, all had positive returns.

But stepping back, the S&P return looks less impressive and the outlook less than inspiring. The 2019 rise followed a sharp 2018 drop from a peak in January 2018. The S&P 500 has averaged a more modest 8.4% annual return over the nearly two years. Calendar returns are noteworthy but other periods, some longer and some shorter, can be more meaningful.


Financial Conditions: “As Good As It Gets”

U.S. equity returns were poor in 2018 when the market was digesting four Federal Reserve rate hikes and expecting two or three more in 2019. The yield curve flattened as short-term rates rose and credit spreads widened on fears of a recession. Consumer net worth declined 13% as asset values fell. Global manufacturing slowed.

What changed in 2019? Central banks massively increased liquidity. The Fed pivoted from tightening to easing, cutting the Fed Funds rate three times, and returning to balance-sheet expansion in October. The European Central Bank resumed open- ended quantitative easing in November. Because Japan’s central bank never stopped quantitative easing, the three largest central banks in the developed world were printing money in unison, the first time since 2010.

With 85% of central banks easing at year-end, the highest level since 2010, and up from just 35% in early 2019, global short rates fell to near record lows, foreign exchange reserves grew, and money aggregates grew faster than credit across major advanced economies. Conditions have rarely been this easy, particularly in the absence of a recession.

Easy financial conditions are generally bullish for equity markets. But, as the display below shows, it will be hard for financial conditions to get much better from here.

Financial Conditions Have Only Been Better Than Today’s Levels Twice:

2000 Tech Bubble and 2017 U.S. Corporate Tax Cuts

Markets tend to do well when financial conditions are easing for three related reasons. First, investors expect falling interest rates to stimulate spending and investing, fueling economic and earnings growth. Second, lower rates reduce the discount rate applied to future earnings, increasing their present value. Third, falling rates make bonds and cash less attractive alternatives to stocks.

In the past year, the Fed and other central bank policies drove the S&P 500 price/earnings multiple from 15.5x to 20x. With component earnings only 1% above their 2018 level, more than 95% of the Index price gain in 2019 was from P/E expansion, not earnings growth.

Short rates have little room to fall from current low levels. Level matters, but change matters more. With interest rates near historic lows and liquidity near historic highs, there’s also little room for further P/E expansion. The Fed’s commitment to maintaining easy financial conditions should support stocks and risk assets generally, but multiples are unlikely to rise significantly.


Recession Spotting and Timing Turns

Economists and investment strategists have a dismal record predicting recessions and market turns. Many who claim to have predicted the 2008 global financial crisis were either bearish long before the collapse or remained bearish long after the recession ended. The difficulty in anticipating recessions stems from two factors. First, economic data is only known after the fact and is not predictive. Second, precipitous market declines generally coincide with falling outputs, leaving little time to exit risk assets.

Making predictions is easy. Making accurate predictions is hard. Acting on predictions can be costly. Keynes famously quipped, “Markets can stay irrational longer than you can stay solvent.” Below are some noteworthy investor warnings that proved too early or wrong.


“There are some parts of the global economy that are now at the risk of a double-dip recession. From here I see things getting worse.” Nouriel Roubini; May 20, 2010

“Another recession is coming, and soon… [I am] 99% sure we will have another recession by the end of next year.” David Rosenberg; June 4, 2011

“I think we could have a global recession in Q4 or early 2013. That’s a distinct possibility.” Marc Faber; May 25, 2012

“I see real tremendous problems ahead and I don’t think we are handling it right and nobody really wants to talk [it] out… We are headed toward strong correction and possibly a complete meltdown but not systematic like 2008. It won’t threaten the system, it’s just going to threaten your livelihood and net worth… I do think you are in a very massive bubble and when it bursts it isn’t going to be pretty, it could be a bloodbath.” Carl Icahn; September 29, 2015

“Global markets are facing a crisis and investors need to be very cautious… China has a major adjustment problem. I would say it amounts to a crisis. When I look at the financial markets there is a serious challenge which reminds me of the crisis we had in 2008.” George Soros; January 7, 2016


Investors who sold equities based on these warnings would have missed much of a great bull market. The display below shows the opportunity cost for a dollar shifted from equities to a diversified bond portfolio after each warning. For example, after Rosenberg’s mega-bearish commentary in June 2011, bonds underperformed the S&P 500 by almost 60%.

The Consequences of Listening to the Armageddonists

Trouble Spotting

If there are trouble spots or even bubbles that could precede a downturn, where could they be? Three possibilities are FAANG stocks, private equity, and the U.S. relative to the rest of the world.

  • FAANG stocks (Facebook, Apple, Amazon, Netflix and Google) have dominated market returns for the past decade. As we showed in last quarter’s commentary, no group of market leaders has dominated for two consecutive decades (though a few individual stocks have). And for each of the past five decades, underweighting the prior decade’s leaders added alpha over the subsequent decade. While it is too early to say FAANG stocks have peaked, we do not believe the group will lead the coming decade.
  • Private equity was one of the best performing asset classes over the past 20 years. As a result, many investors, particularly institutional investors, have significantly increased allocations to this asset class. Private equity assets soared from $500 billion in 2000 to almost $6 trillion in 2018, while the number of listed stocks on U.S. exchanges plunged from about 8,500 to 5,500. One result is that public equities have lost their comparative liquidity premium. Today, private equity valuations are significantly higher than public equity valuations in many sectors.

Money has also poured into venture capital. WeWork is an example of how such investments can go wrong when investors become too bullish. Public funds invested alongside private capital in WeWork’s last rounds of financing, ahead of its anticipated initial public offering and before WeWork’s valuation collapse.

WeWork Valuation

  • Finally, U.S. equities have outperformed non-U.S. equities by an unprecedented margin since 2008. About half of the gap is due to higher growth in sales per share in the U.S.; another third, to more growth in U.S. profit margins; the balance due to greater U.S. P/E expansion. As a result, equity markets now appear more reasonably priced outside the U.S. than inside.

The Divergence Between US & Ex-US Equities

We think non-U.S. markets may soon be performance leaders. The MSCI World Index, excluding the U.S., has been essentially flat since 2006. Reaccelerating global growth, a weaker U.S. dollar, favorable valuations and generally improving corporate governance should provide support for many foreign markets in 2020 and beyond.


Portfolio Positioning

Our current view is neutral to slightly defensive. In our view, the U.S. stock market was expensive at its January 2018 peak and it is expensive now. While stock markets could continue to rise in the near-term, primarily from global stimulus and low recession odds, long-term returns are likely to be low. A downturn will inevitably come, even if it doesn’t come soon.

The adage that valuations are usually useless as a short-term timing tool has truth. Valuations by themselves offer little guidance on where the stock market is going in the short run. But if there’s a catalyst for change, valuations can have a big impact on subsequent returns. When stocks are inexpensive, unexpected good news can cause prices to surge. When stocks are expensive, as now, unexpected bad news can be the catalyst for sharp declines.

Heading into 2020, we expect to increase allocation to non-U.S. stocks and decrease allocation to U.S. stocks. We are favorably inclined toward Europe. Net profit margins among companies in the STOXX Europe 600 Index are about three percentage points below S&P 500 margins. This gives many European companies opportunities to grow earnings.

We will continue to trim FAANG stocks and FAANG-related holdings, which populate our Heterogeneous Computing, Cultural Convergence and Wealth Concentration themes. We are finding attractive opportunities in Molecular Medicine in both the U.S. and Europe. We believe the broader healthcare sector is well-positioned to outperform in 2020, after underperforming in 2019. We are also researching new opportunities in our Automation theme in the U.S., Europe and Japan.


Thematic Investing

More and more investment firms are using “thematic” to describe their investment approach. In many ways it is becoming a buzzword with little definition and few commonalities. Most common are single theme exchange-traded funds; there are now more than 120 U.S. listed funds and the number is growing. Almost equally common are actively managed products that refer to favored industries or geographies as investment themes.

Here is our foundational definition:

Thematic investing seeks investable ideas that stem from economic or technological changes powerful enough to influence corporate performance across multiple industries.

To amplify this definition, we expand on three key terms.

  • “investable ideas” – We seek themes that are investable, which includes two traits. First, there must be enough public companies that are beneficiaries of the theme, with sufficient liquidity for us to invest at least 5% of our portfolios in the theme. Water as a scarce resource, nanotechnology and space travel may be fascinating trends that could have major impacts on the world, but they are not investment themes because we haven’t found sufficient or appropriate investment candidates. Second, we must believe that other investors will begin to discount the change or disruption in their valuation models within a reasonable time frame, which for us is three to five years. We don’t have to expect the change or disruption to mature within that time frame, just that other investors begin to expect it.
  • “corporate performance” – Our approach focuses on changes most likely to have a profound influence on corporate performance, seeking companies that will be beneficiaries of thematic tailwinds and avoiding companies that will be casualties of creative disruption. We think some thematic investors fail to distinguish between a trend and a potentially profitable investment theme. There are many significant changes occurring across the globe.But, most of these changes are simply trends and not investment themes because they are not likely to create economic advantages that will result in sustainable profits.
  • “multiple industries” – Today, most Wall Street research on both the sell-side and buy-side is organized by industry, with each analyst tasked with being an expert in his or her niche. The result? Few researchers look at the big picture – or even know how to. This creates an inefficiency. We organize research analysts by theme, not industry. Each analyst is tasked with thinking about his or her themes holistically and uncovering relevant investment opportunities regardless of industry or geography.

This framework for thematic investing is then executed using a four-step process.

1) Identifying Long-term Secular Themes – The research team focuses on disruptive changes that span multiple industries. Special attention is paid to new technologies or business models, industry leaders, disruptors and high barriers to entry. The evolution of a theme is as important as the development of a new theme.

2) Individual Company Research – The thematic research process identifies companies that are participating directly or indirectly in thematic change. We seek companies positioned to capitalize on the change or disruption over a multiyear timeframe. Fundamental company research considers thematic exposure, financials, management and valuation.

3) Macroeconomic Overlay – The investment team constructs a macro view of the global economy including tax, trade, fiscal, monetary and governmental policies. While our themes unfold over the longer-term, cyclical factors can have shorter-term but important impacts on market weightings.

4) Portfolio Construction and Risk Management – Thematic portfolios consist of 40 to 50 stocks across five to seven themes. Individual holdings and the overall portfolio are continuously analyzed for portfolio characteristics, including beta, price/earnings multiples, factor exposures, and company, sector and geographic concentrations and diversification.

We adhere to our structured thematic investment process. It’s the constant we carry into 2020.


Fixed Income

Bond yields have been particularly volatile the last few years. The 10-year Treasury yield rose to 3.24% in November 2018 and then fell to a low of 1.46% in September of 2019, for a 55% decline in just ten months. The yield subsequently rebounded to end the year at 1.92%, still well below its 2.9% average for 2018.

While central bank easing is succeeding in stimulating economic growth, it is also prompting a borrowing boom. Total global debt topped $250 trillion in 2019, as debt in the U.S. and China ballooned to levels never seen before. Global debt is now three times as large as global GDP and about three times the value of world equity markets.

We find the U.S. government’s trillion-dollar deficit in the eleventh year of an expansion worrisome. We’re also concerned the U.S. business sector, forced to deleverage after the credit crisis, is again taking on high debt loads. Recent corporate bond issues have generally been covenant light, suggesting that corporate borrowers, not lenders, are getting the better deals.

With yields low, we fear that many investors are chasing incremental yield. We think it likely that capital is being misallocated and money will be lost. We expect bond yields to be range-bound to modestly higher in the short to medium term. In this setting, our portfolios continue to be dominated by relatively short duration, high-quality debt instruments.