Third Quarter 2018 Market Review

Q3 2018 – How Long will the party last?

The stock market has many old sayings, from “buy the rumor and sell the news” to ”as goes January, so goes the year.” And let’s not forget this memorable one: “Bulls make money. Bears make money. Pigs get slaughtered.”

But one old saw from Wall Street that you probably heard recently is “sell in May and go away.” It means that you should sell your stocks in May, and come back to the market in the fall, specifically in November.

According to the folks at the Fiscal Times: “The full quote dates to 1930s London, when stock traders would tell each other to “sell in May and go away, stay away till St. Leger Day.”

St. Leger Day is dedicated to the St. Leger Stakes, the final leg of the British version of the Triple Crown in horse racing that’s held each year in late September.

Basically, English traders wanted to enjoy a long vacation—and ended up altering stock market behavior in the process.

Why? Because stocks have historically underperformed between May through October, compared to returns seen from November through April. Since 1950, the Dow Jones industrial average has returned an average of only 0.3 percent during the May to October period, compared with an average gain of 7.5 percent between November and April, according to the Stock Trader’s Almanac. A less-pronounced “sell in May” effect is present in the Standard & Poor’s 500-stock index as well.”

However, in the past 6 years from 2012 through 2017, following this strategy would have made you miss gains ranging from just 0.27% to 12.99% in the DJIA. And in 2018, while we haven’t yet reached the start of November, the stock market rewarded those who stayed invested with the DJIA returning 10.64% through the end of September. During that same period, the S&P 500 and NASDAQ Composite were up 10.98% and 14.42%, respectively.

It is interesting to note that, in a turn-about from recent history, this past quarter saw the Dow Jones Industrial Average (+9.6%) and S&P 500 (+7.70%) outperform the technology heavy NASDAQ Composite (+7.4%). This was a result of weakness in some of the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google) that have been propelling the markets, especially the NASDAQ, higher for so long,

Bonds returned 0.08% in the quarter as measured by the S&P U.S. Aggregate Bond Index. This index includes U.S. treasuries, quasi-governments, corporates, taxable municipal bonds, foreign agency, supranational, federal agency, and non-U.S. debentures, covered bonds, and residential mortgage pass-throughs. Commodities returned -2.08% based on the Dow Jones Commodity Index.

As we sifted through the news, two themes kept popping up as the major equity indices set new all-time highs

1. How long can the longest running bull market in history continue, and;
2. Which marijuana stocks will create the next generation of millionaires?

We will address these two items first before updating the real issues that concern us.

Welcome to the Longest Bull Market in Wall Street History

That was actually the title of an article posted on MarketWatch on August 22nd, along with the obligatory table of “Bull Markets Since WWII” showing that “Since March 9, 2009, which marked the low of the financial crisis and which many consider the birth date of the current bull market, the S&P 500 SPX…has advanced 320%, the Dow Jones Industrial Average DJIA…has risen 290% and the NASDAQ COMP…has soared 520%.”

But there is a problem with this article: there is no hard and fast definition of what constitutes a bull market or when it begins. As a writer at “The Reformed Broker” points out:

“It’s become likely that we are in a secular bull market for stocks. We do not measure secular bull markets from the bear market low of the prior cycle. The 1982-2000 secular bull market is measured from the day in 1982 when stocks finally took out their 1966 high. It had been a 16 year secular bear market until closing above those highs, and stocks never looked back. We do not date that bull market from the lows of 1973-1974 that were the nadir of the prior bear. Nor should we use 2009 as our starting point for the current bull market. 2009 was merely the cycle low of the prior bear, not the starting point of the current bull.”

So, according to the analysis by The Reformed Broker, the current bull market is actually only three years old, not seven and, if it were to end today, only three other bull markets measured this way would have shorter durations. This viewpoint should be solace for investors who find reason to worry about the age of the current bull market, despite the axiom that bull markets don’t die of old age.

Pot Stocks Continue to Go “Higher”

Just like bitcoin and other cryptocurrencies last fall, “pot stocks” are now skyrocketing as the general public has suddenly become enamored with the possibility of explosive profit potential within this new industry.

On September 19, Tilray (TLRY), a Canadian medical marijuana company, rose more than 50% in a single trading session. At one point, its shares had more than doubled in just a few days. It’s currently valued at roughly 500 times sales, about 300 times book value, and around 800 times its negative earnings before interest, taxes, depreciation, and amortization (“EBITDA”). It has a market cap of roughly $14 billion and sales of less than $21 million. No business anywhere, in our opinion, is worth such valuations.

If you recall, last year there were a dozen companies that reaped rewards by putting “bitcoin” or “blockchain” in their name. Long Island Iced Tea Corp. rocketed 458% after changing their name to Long Blockchain Corp.

The Tilray example is part of the wider bubble in marijuana-related stocks. The number of cannabis news stories recently overtook the number of cryptocurrency news stories, according to data compiled by Bloomberg.

It is apparent that the crypto mania that gripped the investment world last year has now been replaced by a manic demand for marijuana related stocks.

Of course, it goes well beyond crypto and marijuana. From the housing bubble in 2008, to the dot com bubble in 2000, Gold in the 1970’s all the way back to the tulip bubble of the 1700’s, humans have always had a tendency to be gripped by investment manias.

Manias like these don’t end well for most of those involved. Parabolic rallies are typically followed by huge declines of 50%… 80%… or more. That’s exactly what’s happened to bitcoin and other “cryptos” over the past several months. And we expect pot stocks will eventually suffer a similar fate.

The aftermath however, can present buying opportunities for the patient investor who is willing to accept that the fast money has already been made. Amazon, after all, was trading for $40 per share as late as December of 2004, long after the market had started to recover from the “dot-com” bust.

We believe that if we continue to analyze the universe of stocks for those companies with better than average sales, earnings and profit margins, marijuana companies with solid long term potential may eventually make it to our screens. In the meantime, we are happy to watch from the sidelines.

Trade (Wars)

On the trade front, Mexico, Canada, and the U.S. reached a new trade agreement. Most opinion makers seem to think the new accord is better than NAFTA. The market breathed a sigh of relief.

Earlier in July President Trump and Jean-Claude Juncker, the chief of the EU’s executive arm, the European Commission, held a joint press conference in which both leaders promised to work towards zero tariffs on non-auto industrial goods; to reduce barriers and increase trade in services, chemicals, pharmaceuticals, medical products, and soybeans.

They also agreed to reform the WTO and that the European Union will buy more liquefied natural gas from the United States. Perhaps most importantly, they agreed to refrain from imposing new tariffs on one another while they work together on these issues.

While this agreement sounds promising, it should be noted that nothing specific was established or signed and as Goldman Sachs put it:

“The lack of specifics in today’s U.S.-EU announcement raises the possibility that the negotiations could falter at a later stage, as U.S.-China negotiations did earlier this year.”

Hopefully, with an agreement with Mexico and Canada completed (although not approved yet by the congress), momentum will build toward reaching an agreement with the EU which would then put pressure on China to possibly rethink their current strategy.

Each agreement which takes away the implementation or threat of tariffs will be positive for the market and, hopefully, beneficial for US companies most impacted by these agreements.

Currency

Interestingly, the dollar has appreciated sharply this year despite the various “trade wars” referenced above. Coincidentally with the US imposing tariffs on Chinese solar panels and washing machines on January 22nd, the dollar began a sharp run higher.

A rising dollar makes imports cheaper which could, at least for those imports priced in foreign currencies, offset to some degree the inflationary impact of tariffs.

North Korea

Talks with North Korea continue as both sides jockey for a win-win outcome that makes neither side look like they surrendered. This is a situation that has been festering since the 1950’s so a quick solution, like the Mexico and Canadian Trade agreement, would seem highly unlikely. However, it is promising that both the North and South have continued to work towards a de-escalation of border tensions and we haven’t seen a North Korean missile test since November of 2017.

Federal Reserve Policy

In our Q2 letter, regarding the Federal Reserve Bank’s policies on interest rates, we wrote: “We see these Fed moves as the #1 driver of the overall volatility in the market for several reasons:….”

Our opinion has not changed, interest rates not only impact consumer spending decisions about homes, autos and luxury items, but they also impact business investment as well. Businesses typically finance their large capital expenditures with debt so an increase in interest rates will either increase the cost of the expenditure or curtail spending altogether. Either way, neither is good for the continued private sector economic growth that we need for both higher wage growth and a larger workforce.

Since August 20, the yield on the 10 Year Treasury has leapt from 2.83 to 3.22 on October 1st. This is not an insignificant move and signals a dramatic increase in borrowing costs which eventually make their way into the economy. For those of you wondering, the ten-year yield was 3.43 on January 1, 2008.

We have written before that the Fed feels that they need higher interest rates in order for the Fed to “reload” in advance of the next economic downturn. It is our opinion that they should have started this back in 2010 at a much more gradual pace to reach a “neutral stance”. In the Fed’s terms, those are rates that are neither accommodative nor restrictive to economic growth.

We readily admit that we have no idea as to when rates reach a level of neutrality, which is why we will never be nominated to serve at the Fed. We only observe that historically it appears the Fed didn’t know what level neutral was either and only found out when it went too far and sent the economy into a contraction. Motivations driving the Fed aside, the speed and magnitude of further rate increases demand ongoing attention.

One last comment on interest rates is in order. A lot has been made in the press recently of the yield spread between 10 and 2-year maturity Treasury bonds. Over the last 30-40 years, when this spread went negative, meaning that short term (2 year) yields were higher than mid-term yields (10 year), a recession followed in fairly, short order. While this spread is still positive, it is quite close to going negative. If, as it has in the past, this foreshadows an imminent recession, then it’s time to be extra cautious on the stock market as well.

Trade negotiations, geo-politics (short of nuclear war) and even election cycles will continue to create volatility shocks in the market. However, we believe that the biggest threat to the market remains the Fed’s monetary policy. In a recent article posted on MarketWatch, researchers calculated that stocks have suffered around $1.5 trillion in losses following speeches from the Fed’s Chairman Jerome Powell.

Powell has hosted three news conferences this year following meetings of the rate-setting Federal Open Market Committee. which were followed by an average decline of 0.44 percentage points in the S&P 500. Other talks and speeches have resulted in an average fall of 0.40 percentage points, with losses coming in five of the past nine prominent speeches or Congressional testimonies Powell has delivered.

The stock market knows that, over the long term, it is the economy that drives growth in sales and earnings and that sales and earnings growth ultimately drive long term performance in equities.

We believe it is our role to continue to identify those companies who can thrive in different economic conditions and buy them when they are trading t a favorable price. Watching business fundamentals instead of charts, newsletters, or headlines, we expect to be rewarded over the long term with less volatility and better sustainability.