It is human nature to want to know the future, and the turn of the calendar to a new year overwhelmingly tempts investors to make forecasts about the year ahead. Gallons of ink are spilled in an attempt to make sense of the current economic and market situation and discern therefrom how the future is likely to unfold. Yet only the bravest forecasters spend any time reviewing the historical accuracy of their predictions. It is an exercise both humbling and instructive in equal measure.
As befits a firm a few years into its third century of operation, we retain a reverential respect for the lessons of history, and therefore, approach the future with a glance towards the past. In a keen observation, usually credited to Mark Twain, “history does not repeat itself, but it often rhymes.” Understanding how the future is likely to rhyme with the past may give us some indication of what environment investors may face as 2020 unfolds and how to invest accordingly.
A Brief History of Economic Cycles
This third decade of the 21st century begins on a record note. The economic recovery that rose from the ashes of the global financial crisis in 2008-2009 continues apace, making this the longest expansion in American history. For the first time in the economic record, the U.S. economy experienced an entire decade (the 2010s) without a recession or bear market. The pace of this expansion, however, leaves much to be desired. This may be the longest cycle in our history, but it is also the weakest. Gross Domestic Product (GDP) growth over the past decade has averaged a mere 2.3%, half the average-growth rate of previous post-war expansions.
Yet therein lies the secret of this cycle’s success. As the nearby graph of historical economic expansions shows, slower growth is correlated with more durable growth. That the dots on this graph run roughly from the upper left-hand corner down to the lower right demonstrates the inverse correlation between the path and pace of an economic cycle. Economies that grow rapidly tend to burn out quickly, as bubbles inflate, provoking the Federal Reserve to raise interest rates and bringing the party to an end. Conversely, slow growth prevents – or at least postpones – the excesses that lead to tighter monetary policy and a recession.
Just as dieticians prescribe a low-calorie diet to slow down the body’s metabolism and stave off the effects of aging, so too a low-calorie economic diet of modest growth helps to prevent the economic inflammations that lead to recessions. This economic cycle is in ketosis.
A Not-so-Brief History of Economic Cycles
There are bigger trends at work here as well. A secular shift in the shape of the domestic economy further underpins the cyclical support outlined above. The U.S. Census Bureau has conducted a decennial survey of Americans since 1790, and the changing composition of the labor market reveals three economic paradigms in our history, each with meaningfully different economic drivers.
In the early years of the republic, the U.S. economy was driven predominately by agriculture. Throughout most of the 19th century, over half the labor force spent its time “growing things,” and economic cycles, therefore, depended on the weather. When there was too much or too little rain, crops failed, families lost farms, loans went unpaid and the economy slipped into recession. John Steinbeck’s “The Grapes of Wrath,” published in 1939, viscerally distills this economic volatility into the experience of one family living near the end of this era. The Joad family, having lost their family farm in Oklahoma to dust storms and bank foreclosures, traveled west in search of work, only to discover that job opportunities in California were not much better than what they had left behind. Between 1857 and 1939, the average length of an economic expansion was a short 26 months, and the story of the Joad family was played out again and again and again.
The loss of agriculture jobs that Steinbeck chronicled was largely due to automation and the rise of the industrial and manufacturing sector. Industrial jobs surpassed agricultural jobs by the end of the 19th century and continued rising throughout the first half of the 20th century. Weather ceased to be the primary driver of the economy and was replaced by the inventory cycle. The Federal Reserve Act of 1913 granted the newly-formed central bank the responsibility of supporting the economy through managing interest rates, adding another variable into the economic equation. The Federal Reserve could stimulate growth by lowering interest rates and making it easier to finance factories, inventories and employment, but when too much inventory was met with too little demand, goods went unsold, factories closed, jobs were lost and recession followed.
Economic cycles still happened in the industrial era, but they became more durable. From 1940 through 1980, industry and manufacturing led the economy, and as the Federal Reserve got better at analyzing and responding to economic trends through monetary policy, the average expansion lasted 49 months – more than double the average of the agricultural era.
We are currently undergoing another evolution in the economic paradigm, and this one is happening far more rapidly than previous shifts. Forty years ago, the Fortune 500 list of America’s largest corporations was topped by energy companies (Exxon, Mobil, Texaco, Chevron, Gulf Oil and Amoco) and capital goods manufacturers (General Motors, Ford Motors, General Electric and IBM). The merged ExxonMobil is the sole survivor of this list today. The league table is now dominated by technology, consumer and health-services companies, underscoring the radical change in economic leadership.
This 1980 list of leading companies relied heavily on interest rates to finance inventory and capital spending on plant and equipment. But what does inventory mean to UnitedHealth Group or AT&T? How much does Apple or CVS Health spend on plant and equipment compared to the General Motors or General Electric of an earlier era? In a world of global supply chains, inventory on demand and just-in-time deliveries, inventory and interest rate cycles do not have as big an economic impact as they did just a few decades ago. As the composition of the economy has shifted more towards services and technology, the length of economic expansions has doubled once again, to 103 months on average.
This is not to say that the business cycle is dead: what John Maynard Keynes referred to as the “animal spirits” of human nature will always lead to bouts of greed and excess that inflate economic bubbles, to be followed inevitably by the fear and despair that drive and define recessions. The difference this time around is that these innate human emotions are not magnified as much by inventories, interest rates and the weather as they have been in previous economic eras.
The New Paradigm
Economists endlessly debate the cause of recessions, disagreeing even when the hindsight of history offers clear evidence. Economic cause and effect has become even cloudier as the economy shifts away from a reliance on the traditional business cycle; and furthermore, we do not have many cycles in this new paradigm on which to base an analysis. As cycles get longer, recessions become rarer, to the point that we have only had three economic contractions in the United States in the past 30 years. The common distinction of these three recent recessions is that, arguably, economic distress in each case originated in the financial markets rather than the real economy. The traditional causality of earlier economic eras has been reversed.
The groundwork for the short recession of 1990-1991 was laid by the deregulation of the savings and loan industry in the late 1980s, which led to aggressive lending, a bubble in residential real estate and the eventual failure of one third of all S&Ls, at a cost of $160 billion to U.S. taxpayers. As if this economic debacle did not weigh on the sentiment of consumers and depositors enough, in August 1990, Iraq invaded Kuwait, tripling crude oil prices in a matter of three months. As a result, consumer sentiment plummeted, personal spending followed and the economy slipped into recession.
The 1990s were defined by a long economic expansion fueled primarily by the commercialization of the internet and the rise of associated technologies. The Mosaic web browser was released in 1993, Netscape went public in 1995, and by December 1996, Fed chairman Alan Greenspan warned that cautious optimism had yielded to “irrational exuberance.” The bubble continued to inflate. The 2000 Super Bowl featured ads from no less than 14 dot-com companies, which paid record rates to air ads for (then) iconic brands such as Computer.com and Pets.com. The Nasdaq, where many technology companies chose to list their shares, provided a daily measure of investor exuberance. From 1990 through 2000, the Nasdaq rose 1024% (27% annualized), leading many investors to conclude that it was riskier to be out of the market than to be in it. The fear of missing out loomed large.
The bubble peaked in March 2000, and receding prices revealed shocking corporate malfeasance. Headlines in late 2000 and early 2001 were dominated by reports of accounting anomalies and outright financial crimes at Enron, WorldCom, Arthur Andersen, Adelphia, Global Crossing and others. Market declines combined with a general loss in confidence in corporate America led to a drop in consumer sentiment and spending and a recession from March to November 2001. In retrospect, it is surprising that this recession was as mild and short as it was, given the magnitude of the financial bubble and the breadth of corporate misconduct that accompanied it.
Of more recent vintage, the global financial crisis of 2008-2009 clearly took root on Wall Street. Assigning blame for the crisis is a target-rich environment and beyond the scope of this article, but included a toxic combination of lowered lending standards, cheap money, the demand for mortgage assets to feed securitization, over reliance on rating agencies, misplaced trust in government sponsored entities such as Fannie Mae and Freddie Mac, a near-religious belief that housing prices only ever went up and misaligned interests between the owners and managers of capital of Wall Street banks.
This is by now a familiar story, although the details differ from cycle to cycle. In each of these cycles, excesses in financial markets, often exacerbated by pro-cyclical government policies, fueled perverse investment incentives and inflated asset bubbles, which eventually became unsustainable, leading to losses and damage to consumer sentiment and spending, and therefore recession. Inventory cycles and interest rates played a minor role, other than in response to economic developments.
Causality is reversed in this new economic paradigm. As the last three cycles have demonstrated, what happens on Wall Street affects Main Street rather than the other way around.
The Health of the American Consumer
The common thread throughout this economic walk down memory lane is the overarching importance of personal consumption. At 68% of GDP, the spending decisions that 330 million Americans make on a daily basis is the ultimate driver of the U.S. economy. This is not to dismiss the importance of other economic engines, such as business investment, government spending or trade, but instead to note that all of these other economic drivers combined add up to 32% of GDP and cannot possibly be robust enough to overcome weakness in the personal sector. As goes the consumer, so goes the economy.
The fundamental support for personal consumption remains healthy. People spend money out of a sense of financial well-being. Every spending decision we make – whether large or small – results from the (usually subconscious) questions “Am I rich enough to afford this?” or “Do I make enough money to afford this?” In turn, the wealth effect is primarily a function of the housing market, the most valuable asset on the balance sheet of most American households, while the labor market is the primary source of income for most Americans. The fundamental health of the housing and labor market are therefore crucial to personal consumption and economic activity.
The good news is that both housing and the labor markets are healthy. Housing prices nationwide accelerated into the end of 2019, closing the year with a 7.8% year-over-year gain. Mortgage rates are the lowest they have been since late 2016, offering a further tailwind to housing prices as we enter 2020. The labor market is similarly strong: the U.S. economy has added two million jobs over the past year, bringing the unemployment rate down to a 50-year low. Wages have risen at 3% or faster for a year and a half now, modestly ahead of inflation. This means that there are more people with more jobs and more money in their pockets (even after inflation). As important as the reality of these statistics are, the psychological implications are even more important. A rising real estate market makes people feel and act wealthier, even if they have no intent of refinancing or selling their home. Similarly, the job security that accompanies a low unemployment rate encourages spending as well. It is easier to remodel the house, buy the new car or take the long vacation when you are not worried about your job or paycheck.
One of the most remarkable developments in the labor market lately is captured in the nearby graph: the labor market has become so tight that since early 2018 there have been more job openings in the United States than there are workers available to fill them. This implies that employment will remain robust as companies seek to fill these positions and that wages are likely to continue rising in response to a scarcity of labor. As long as this remains the case, household cash flow should continue to support spending, and therefore economic growth.
Household balance sheets are in good shape as well, at least compared to recent history. Whereas it is true that overall debt levels have risen across this cycle, household income and assets have risen more rapidly. In other words, households have not spent as much of their incremental income and wealth as in previous economic expansions, and household balance sheets have deleveraged as a result. This explains why the current economic cycle has been so subdued. The difference between the peak of 134% debt-to-income and the current level of 97%, shown in the nearby graph, represents over $6 trillion of foregone spending. If household debt had simply remained steady at 134% of income for the past ten years, the economy would be 28% larger than it currently is. In the short run, this deleveraging has exerted an unprecedented drag on economic growth. In the long run, however, this restoration of the financial health of household balance sheets is a welcome development, as it means that the household sector will be in better financial shape when the next economic downturn occurs.
Similarly, although debt levels have risen in absolute terms, delinquencies remain well under control, with no category experiencing delinquency rates anywhere near the crisis of 2008-2009. Student loans are the single exception to this broad claim, but even here delinquency levels have not worsened over the past eight years. Mortgages and home equity loans represent over 70% of all household debt, and only around 1% of these loans are more than 90 days overdue. We keep a wary eye on the rise in automotive delinquencies, as this is often a leading indicator of consumer stress, but this sector accounts for only 9% of total loans, and delinquent loans remain well below the 2010 peak. Delinquency rates across all categories of debt stood at 3%, well below the 9% peak of 2010.
In sum, American households enter 2020 in decent shape, supported by a healthy housing market and job environment, rising wages, stronger balance sheets and improving consumer confidence. This sentiment will no doubt be tested over the course of the year, as has been the case throughout this cycle. We believe that it will take more than election-year political uncertainty or the novel coronavirus to derail these fundamental drivers of a continued, albeit modest, economic expansion.
Financial markets have not reflected the modesty of this economic cycle. Nominal GDP is now 51% larger than when the recovery began in 2009, while S&P 500 earnings per share are 295% higher over the same time period, and equity prices (as measured by the S&P 500 index) are up 377%. What alchemy is this? How can corporate earnings grow at six times the pace of the economy, while equity prices have risen even more than that? The answer lies in how corporate profitability turns revenues into profits and how the market values those earnings. These two additional cycles – operating margins and valuations – amplify underlying economic activity.
Operating margins rise and fall with economic cycles. During the short and shallow recession of 2001, margins dropped from 8% to a low of 5%, and then rebounded within just a few years to a more historically normal range of 8-10%. The financial crisis of 2008-2009 was more pronounced. Indeed, in the fourth quarter of 2008, the S&P 500 in aggregate posted a loss, largely due to massive write-offs of impaired assets in the banking sector, which pushed operating margins to zero. As the recovery took hold in 2009, operating profits and margins snapped back to a more normal range, then continued to expand. From 8% as recently as 2015, margins rose to a high of 12% in third quarter 2018 before settling back to finish 2019 at 11%.
A few percentage points of margin may not seem that meaningful, but two or three extra cents of profit on every dollar of revenue for every company in the index adds up to a great deal of earnings and explains how modest economic growth can translate into robust corporate earnings growth.
Shifts in index composition help to explain this margin expansion. Information, services and technology businesses generally enjoy higher margins than industrial and manufacturing companies, and index averages reflect the increasing influence of these sectors. Furthermore, technology is a broad benefit even beyond the information sector, as companies across the economy find new ways to incorporate technology into their operating models, thereby increasing efficiencies, lowering costs and boosting margins. The nearby graph of operating profit margins captures the broad benefit of the technology revolution. Parenthetically, company share buybacks do not affect the calculation of S&P 500 earnings at the index level. The methodology aggregates total profits (not per share) to arrive at index earnings.
The tailwind of earnings growth has been fanned even further in this cycle by expanding valuations. From a low of 12 times price-to-earnings (PE ratio) in the early days of the market recovery, the S&P 500 Index ended January at 20 times trailing earnings, almost exactly one standard deviation above the long run historical average of 15.6 times. This is, as the nearby valuation graph illustrates, rarified territory.
This lofty valuation is tempered somewhat when interest rates are taken into account. Financial markets are discounting mechanisms. The current value of any asset – a stock, a bond or real estate – is the net present value of all future cash flows discounted back at an appropriate interest rate. Lower discount (or interest) rates are therefore correlated with higher present values (or PE ratios), and vice versa. This mitigates the apparent overvaluation of stocks to a degree but does not make it disappear completely. When the above data is adjusted for interest rates, equity valuations appear much more reasonable, but still not cheap.
A careful consideration of the history of market PEs shows that valuation is a poor timing tool. High PE multiples do not mean that something bad is going to happen, but they do imply that if something bad happens, the market reaction is likely to be magnified. Cheap valuations act as shock absorbers for bad news, but expensive valuations leave little room for error.
To make matters worse, markets do not require a reason to correct, although our innate desire to link cause and effect inspires us to assign one, if only in retrospect. Volatility is an innate characteristic of financial markets. Over the course of this bull market, the S&P 500 has fallen by 5% or more on 22 occasions, averaging a drawdown of 9.9% and a duration of two months. Investors and financial journalists easily and eagerly blamed each of these corrections on some combination of the trade war between the U.S. and China, concern that interest rates were too low or too high, Brexit, political uncertainty, ill-timed White House tweets, fear of an economic slowdown and so forth. And yet, no correction accompanied the recent political showdown over President Trump’s impeachment trial or rising tensions in the Middle East, following the assassination of an Iranian general, or the proliferation of the novel coronavirus. As much as we like our effects to have causes, markets often do not work that way. Volatility is often endogenous.
An old story tells of a young investor approaching a seasoned Wall Street veteran to ask him what, in all of his years of experience and wisdom, he thought stocks would do. “They will fluctuate, young man,” came the thoughtful reply. That this witty response is variously attributed to J. P. Morgan, John D. Rockefeller and Henry Poor (the founder of the eponymous index) speaks to the universality and inevitability of volatility.
How to invest in such an environment?
So, then, what is an investor to do? There are essentially only two investment approaches, although there are practically infinite variations of each. The most common investment approach is price anticipation: an investor tries to figure out what is going to happen in the future and invests based on the anticipated market response to a particular outcome. This is, of course, hard, as the future is always and forever an unknowable place. Knowing this, the investor applies a probability analysis to future events, but usually only takes into account a limited range of possible outcomes. We naturally think of future probabilities in the same terms as flipping a coin or rolling a die, where the range of outcomes is preordained and known. But, inconveniently, the range of outcomes in the real world is not preordained, and it is not known. Roll a die, and the result will be a number between one and six, never a purple unicorn. Life, on the other hand, comes up with purple unicorns far more frequently than one might anticipate. The die of life has infinite sides.
But wait, it gets harder. Not only does a price anticipation approach require an investor to know what is going to happen, she also must know when, as being too early is indistinguishable from being wrong. Finally, even if a forecast and timing are correct, one must furthermore assess how the market will respond to a particular outcome. An investor may accurately predict a strong product launch at a certain company and even anticipate when the benefit of new sales will show up on the bottom line, but if the news is already priced into the market, or if other investors were expecting even stronger sales, the stock price may fall. To successfully employ a price anticipation strategy, you have to be right, at the right time and correctly judge how the price of the asset will respond. Get only two of the three right, and you lose.
Rather than engage in this unsustainable and unrepeatable guessing game, we would rather spend our time and energy learning how to invest in a world of perpetual uncertainty. After all, this is the only environment in which we ever invest. In doing so, we are focused on value recognition rather than price anticipation. This is a far less common type of investment strategy, but more readily repeatable, and, we believe, a better way to pursue the ultimate objective of wealth preservation and growth. If we can successfully identify assets that are trading at less than their fundamental value, then future developments pose less of a risk to portfolios. Of course, no portfolio is immune from macroeconomic or market risk, but investing with a margin of safety helps to mitigate these uncontrollable risks.1
Relying on value is important at any point in the market or economic cycle and is even more important in a market characterized by heightened valuations and volatility. This investment approach is easier said than done, but the key elements of a value recognition approach are as follows:
Invest Actively. Index averages can be misleading, in no small part because company weights in most indices are determined by capitalization. The larger a company is (number of shares outstanding times the market price of those shares), the bigger it is in the index and the more influence it has on the averages. For example, Apple, with a current market capitalization of about $1.4 trillion, has over four times the influence on the index as Walmart, with a market capitalization of only $330 billion. Active investing allows an investor to escape the risk posed by an index that may become heavily exposed to certain companies or sectors over time.
Active investing is not frequent investing. In fact, when done well, it should be the opposite. Studies show that the real benefit of passive investing lies in low turnover: allowing the miracle of compounding to work for your benefit over time without incurring the trading costs, frictional drag and capital gains taxes that accompany a strategy reliant on frequent trading. An active approach combined with low turnover can provide investors with the best of both worlds.
Focus on durability of value, instead of being distracted by the volatility of price. Price is a wonderful concept: it is readily available, constantly updated and consistently agreed upon. The dark lining in this otherwise silver cloud of goodness is that price is volatile, as illustrated earlier in this commentary. Value has the opposite set of characteristics. It is not readily available and requires a great deal of work to obtain. Investors frequently disagree on value. Different analysts can arrive at widely differing opinions on the intrinsic value of an asset, even when they start with the same set of data. On the other hand, value, unlike price, is durable. This one benefit, in our opinion, outweighs all the other, more ephemeral, benefits of price.
Manage risk through concentration rather than diversification. Institutional managers define risk as deviation from a benchmark and manage that risk by diversifying, often to the point that their portfolios look very much like the index. Conversely, managers who define risk in more absolute terms manage this risk through concentration in order to develop and maintain a firm grasp on value. The time and resources required to understand the intrinsic drivers of a company’s value prohibits doing this across a whole index but grants the investor the patience and temperament to invest with conviction throughout a market cycle.
A firm understanding of value allows an investor to invest with a margin of safety. Safety in investing is always and forever a function of price. An investor can lose a lot of money buying a great company at too high a price. Conversely, underpaying allows room for error if fundamental analysis missed something or if unanticipated negative developments arise.
A patient and disciplined focus on value allows an investor to exploit market volatility rather than be victimized by it. The old cliché that one should “buy low and sell high” only focuses on price. Instead, one should buy when market volatility pushes asset prices down to a substantial discount to intrinsic value and sell when upside volatility pushes prices to a premium to intrinsic value. This is a great way to invest over the long term. It just does not fit well on a bumper sticker or t-shirt.
Economic fundamentals remain healthy, despite the historic longevity of this cycle. The consumer, in particular, is proving resilient in the face of sustained assault on confidence, seemingly daily. In these early few weeks of 2020 investors have confronted rising tensions in the Middle East, a rare impeachment trial of a U. S. president and the spread of the novel coronavirus. To echo an earlier sentiment, the future will likely continue to fluctuate. Despite this, the economy continues to grow, admittedly at a modest pace, and financial markets remain resilient. Credit a robust labor market and ongoing strength in housing, which allows for a rise in consumer spending while also allowing for the restoration of household balance sheets.
Just because the economic tide is coming in does not mean that waves won’t keep crashing on the shore. Volatility is a feature of financial markets, not a bug. It is human nature to read meaning into each and every zig and zag in the market, when in reality most headlines are little more than noise. Retaining a firm grasp on the durability of value fosters the temperament to stay the course, invest with conviction through inevitable volatility and corrections and allow compounding to assist in the pursuit of wealth preservation and growth.
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1 Margin of safety: when a security meets our investment criteria and is trading at meaningful discount between its market price and our estimate of its intrinsic value.