Client Investment Letter July 2019

“The heart of man is made to reconcile the most glaring contradictions.” – David Hume


If there is one concept that defines the markets right now it is that of cognitive dissonance. For those who aren’t psychologists, Merriam-Webster aptly describes cognitive dissonance as a “psychological conflict resulting from incongruous beliefs and attitudes held simultaneously.” Incongruous beliefs seem to be on offer all across the markets.  Start with the most basic principle: when you lend someone money, they should pay you interest for the use of your capital. Makes sense, right?  Then explain how $13 trillion in global bonds are presently trading with a negative yield to maturity. France, Germany, Japan, and Switzerland are all able to issue 10-year debt that offers a lender back less than he gives the government in the first place. This kind of incongruity seems like it will surely lead to misallocation of capital in the end.

Other inconsistencies also exist. Perhaps, most prominently, a stock market flirting with all-time highs while bond yields have plummeted and the yield curve has inverted. It should be noted that bonds often rise in value (and yields therefore fall) when people are scared and seeking safety of their principal, often foreshadowing a slowdown in the economy. In the last quarter the 10-year Treasury rose in value significantly as its yield plunged from about 2.5% to under 2.0%. People must have been really scared, right?  Not if you look at the broad equity indices. The S&P 500 started the quarter at 2,834 and ended it at 2,941, a healthy 3.8% rise that turns into 4.3% when you include dividends. People often hold a portfolio of stocks and bonds because they are supposed to move in opposite directions, helping balance each other out. However, lately, they have been moving hand in hand.

Furthermore, the drivers of the equity strength have also been perplexing underneath the surface. Defensive businesses like Utilities and Real Estate Investment Trusts have been leading the gains since last fall. To some extent these are responding to falling interest rates. The cyclical darlings during a strong economic upturn like Industrials and Materials have underperformed. This suggests that below the headline, investors seem to be favoring the defensive stocks that often perform relatively better in a downturn. So perhaps stocks and bonds are sending a similar message after all?

The yield curve continues to get a lot of press as well. Generally speaking, the longer you lend someone money, the more you expect to get paid. So, while a one-year loan may fetch 2%, you might expect 4% for a ten-year loan as compensation for tying your money up longer. Right now, however, the yield curve has “inverted.” As of this writing, a 3-month loan to the government in the form of a T-bill offers a 2.15% annualized yield, while a 10-year loan in the form of a 10-year T-note offers only 2.01% annualized. Historically, the yield curve has inverted before recessions (indeed, it has happened each of the last seven recessions) as people seek to lock up long-term fixed interest rates today before a rate plunge during an economic slowdown. Meanwhile, the economy continues to expand, albeit modestly. However, in recent months there has been some weakening in consumer confidence and also a slowdown in various measures of manufacturing activity across many Federal Reserve Districts. We think some of this softening was driven by increased uncertainty as President Trump used a tariff threat against Mexico as a way to address the immigration situation and also hasn’t quite made peace with China on trade, but even beyond these transitory factors, growth seems to be abating.

The Federal Reserve itself has done a complete 180-degree turn in the last six months. As late as last December, the Fed felt the economy was strong enough to raise interest rates and continue with its quantitative tightening on “autopilot.” The equity market rioted with a substantial decline and the Fed changed its position to remaining “patient” about further rate increases. By June, the Fed estimates of future rates showed that a cut is likely in the near term. Its balance sheet normalization program will soon be terminated— well before the still-bloated balance sheet has returned to anything near normal. Indeed, the belief that the Fed will do “whatever it takes” to extend the expansion seems to be a driving force behind stocks’ ascent.

On balance, the markets are sending a bunch of mixed signals. And just as psychological cognitive dissonance is so uncomfortable that it often causes people to change their behavior or beliefs to resolve the conflict, we expect that eventually markets will have to resolve their conflicts too. Either stocks are correct and yields will rise as people believe the economic expansion will continue for a while longer, or bonds are right and we will head into a contraction with stocks adjusting to reflect less growth ahead. Historically, the bond market has proven more prescient and so we are proceeding with caution.

While the markets may change their views, we remain steadfast in our belief that the best way to make money is to buy quality growth companies at reasonable prices and hold them for the long-term. We found one such company this quarter in Sprouts Farmers Market, a natural and organic grocery with 321 stores throughout the United States. We believe the natural and organic food trend is here to stay and that, one day, Sprouts could reasonably have 600-900 stores. In addition, we expect Sprouts to continue to grow some of its higher margin offerings such as store-branded products and prepared foods. The stock sold off recently due to some management turnover at the top and fears that Amazon’s purchase of Whole Foods will dramatically change the landscape for natural and organic grocers (even though it has been nearly two years since the acquisition and the competitive dynamics remain little-changed), giving us an opportunity to buy this growing company at a fair price. We think earnings will “sprout” for years to come and your portfolio will benefit as a result.

In conclusion, we feel your portfolio is well positioned for the times ahead.  We have a significant cash reserve that will afford us ample opportunity to scoop up bargains if the bond markets prove right and a slowdown is around the corner. Meanwhile, your portfolio of high-quality companies will continue to benefit if the stock market’s rosier view comes to pass. We are working hard to ignore the noise and strike a prudent balance between caution and optimism. Thanks for the trust you put in us and we hope you have safe travels this summer!


Penn Davis McFarland, Inc.
July 2019