Client Investment Letter January 2020

“Gravity is a habit that is hard to shake off.” -Terry Pratchett


2019 came in like a lion and went out like a lamb. This time last January, investors were worrying about a significant market swoon driven by fears of higher interest rates, the impact of quantitative tightening as the Fed began unwinding its bloated balance sheet, and a trade war with China. The Fear & Greed Index, a quantitative measure of investor emotion, was pointing to extreme fear. Twelve months later, the Fed has cut interest rates three times and seems poised to hold rates steady for the foreseeable future. Not only has it ended its balance-sheet normalization process, possibly forever, but it has embarked on some version of quantitative easing. Donald Trump claims a “phase one” trade deal with China will be signed within weeks. Meanwhile, the yield curve, which inverted in mid-2019, has since returned to normal. The Fear & Greed Index is now pointing towards max greed. All of these factors, along with a continued healthy job market, have led to a strong rally in the equity markets after nearly two years of treading water.


The question, as always, is will the good times last? Further, are the positives already priced in to a historically expensive market? While the Fed rate cuts could have a lasting effect, they come with a cost. If the economy slows, the Fed will already be starting from a very accommodative position without much flexibility. It will quickly be wrestling with the “zero bound” of 0% interest rates if it is forced to cut again. And the economy has already slowed. Growth has returned to around 2%, the same slow and steady rate we saw before the tax cuts gave us a few quarters of extra vigor. Earnings for the S&P 500 are most likely going to end up being down for 2019, with the entirety of the strong stock market advance driven by multiple expansion. So then, it seems to us that the recent leg of the long bull market has been driven more by “animal spirits” conjured by the Fed, rather than by fundamentals.


It should also be noted that there is another unusual force exerting influence on markets, negative yielding debt. Globally, there are over $11 trillion in bonds trading with negative yields. It is truly a strange situation when people are willing to pay governments or corporations to hold their money for them. In general, finance is built around positive interest rates. A core premise of finance is that the present value of something is equal to the future cash flows discounted back at a certain required return or discount rate. Or, put more simply, “A bird in hand is worth two in the bush.” If interest rates are negative, this principle is turned on its head, as future cash flows are more valuable than present ones. The discount rate is often equal to the risk-free rate (usually a 10-year government bond) plus some additional risk premium. As the discount rate approaches zero the value of all kinds of projects approaches infinity. Basically, the risk-free rate acts like gravity exerting its force on every project or investment opportunity. In the absence of gravity, all kinds of strange things happen and valuations can float to stratospheric highs. In addition, negative interest rates in one part of the world impact rates in other parts of the world as investors in negative-rate countries seek positive rates in other places. The result is that negative interest rates permeate from one country to another across the entire world like ripples spreading out across a pond and can cause a gross misallocation of capital.


So, we are faced with a conundrum. Fundamentals are tepid and weakening while easy money is plentiful but limited by the zero bound. Multiples are high, but could go higher.  But, if fundamentals worsen, then earnings and cash flows and the multiples investors are willing to pay for them could decline in tandem. Rather than making absolute bets, we have continued to choose a barbell approach to managing risk and opportunity. We continue to keep a healthy percentage of your portfolio in ultra-safe short duration Treasuries while keeping the bulk of your portfolio in high-quality companies trading at reasonable prices.


Furthermore, we are always on the lookout for pockets of opportunity. 2019 brought us a few, including United Healthcare selling at a multi-year low multiple thanks to worries about an unlikely Medicare-For-All program, Activision selling off due to a lull in its game release cycle, and Sprouts Farmer’s Market declining due to changes in management and worries about Amazon’s intentions in the natural and organic food space. We like when high-quality growth businesses drop due to what we believe is a short-lived issue or hiccup, and are happy to establish positions and wait for the clouds to part.


As has become commonplace in recent years, others also found value in what you owned. In particular, Celgene was acquired last year by Bristol-Meyers Squibb, and a number of our holdings were later bought by activist investors seeking to make shareholder-friendly changes. We expect 2020, with an election coming and numerous trade and geopolitical uncertainties, to provide us with plenty of new opportunities and we have positioned your portfolio to be ready to take advantage of them when they arise.


The core holdings in your portfolio continued to do what they do best: Grow, invest in their businesses, and return excess cash to you. Our general philosophy is to continue to let good companies do good work for you. We may trim some things if they get too expensive in a Fed-induced low-gravity environment, but for the most part we expect the high-quality companies in your portfolio to keep compounding value for you, just like they did this past year. We appreciate the trust you place in us and look forward to navigating whatever opportunities 2020 brings.


Penn Davis McFarland, Inc.
January 2020