Annual Letters

Yearning for Order

Download PDF

On this first business day of the new year, I’m pleased to attach our 2018 annual letter. A few key thoughts:

  • Global growth is slowing, but high-quality companies in specific areas of the market still offer opportunity
  • The need for a US alternate source of revenue is driving tariff and trade wars – though the likelihood of a deal with China is high
  • The battle between Trump-driven growth and Fed restrictive monetary policy will create a lot of noise and hand-wringing ..and opportunity

I hope you enjoy these random thoughts.

“Human nature yearns to see order and hierarchy in the world. It will invent it where it cannot find it.”

– Benoit Mandelbrot, Mathematician

As we penned our 2017 letter, the opening paragraph spoke of escalating risk ‐ North Korea sabre rattling, Donald Trump’s tweeting, Catalan separatism, the UK’s muddled Brexit negotiations, and the stock market continuing to set new highs despite everyone knowing it’s “too expensive”. And here we are, twelve months later ‐ the political issues remain the much same but the market risk is certainly in full correction.

Let’s begin this year’s letter by addressing a response to the current market conditions.

At times like these, it seems tired to echo Buffett’s words to “be greedy when others are fearful”. Now that downside volatility is back with a vengeance, market commentaries are full of fear stories, since markets are driven by narratives much more than they are driven by data. As Morgan Housel has cautioned: “The business model of the majority of financial services companies relies on exploiting the fears, emotions, and lack of intelligence of customers. The worst part is that the majority of customers will never realize this.”

Dan Gardner, author of The Science of Fear said it perfectly: “Fear sells. Fear makes money. The countless companies and consultants in the business of protecting the fearful from whatever they may fear know it only too well. The more fear, the better the sales.” We respond emotionally to stories. Moreover, fear is the most motivating of emotions, at least in the short‐term. To quote Jason Zweig paraphrasing Mike Tyson, “investors always have a plan until the market punches them in the face.”

The human desire for predictability and order will result in people sometimes seeing patterns that they believe will deliver certain outcomes. This human desire is often encouraged by promoters who know how to turn dysfunctional thinking into cash – their cash. Unfortunately, our brains can conspire against us when it comes to successful investing. Much of the work a successful investor must do is related to avoiding emotional or psychological mistakes. Even a random number generator will spit out results that a human brain will see as a pattern.

Outspoken money manager, economist, and perma‐bear John Hussman is once again calling for a severe market crash that would send major U.S. stock market indices plummeting by 60 percent or more, resulting in losses of roughly $20 trillion, and he has positioned his firm accordingly. The details may have changed, but this is a tired and familiar story. He has been warning that stock valuations have been extreme for more than a decade.

Accordingly, over the decade, Hussman’s flagship Strategic Growth Fund has provided his investors with a ten‐year return almost 20% below the US S&P500 index, compounded annually. That is a differential of roughly 620% over 120 months, or an average of 5% monthly! And his business reflects the inaccuracy, with assets of approximately $6.7 billion in 2010 to barely $300 million today. Radical positions are bad for business.

Since my beginning as a fledgling investor over forty years ago, the US market has experienced four “bears” (defined as prices falling greater than 20%): 1980‐82 (‐27.8%), 1987 (‐33.5%), 2000‐02 (‐49.1%), and 2007‐09 (‐56.4%). In addition, there have been eleven “corrections” (prices falling more than 10%) including the past three months.

Despite all these severe moves, the market has provided long‐term investors with a considerable return. On January 1, 1980 the index value of the SP500 index was 107.94 while, at the close of 2018, despite the considerable pull‐back, the index value stood at 2506.85, providing an annualized return 8.4% per year (plus dividends). Notwithstanding, this spectacular return is impractical as the investment return would be either increased or decreased by additional deposits or withdrawals to the market over time, and assumes an investor could maintain the long‐term view without emotion during bears or corrections.

The facts simply prove the atypical investor manages his account based on fear. Even the famed Harry Markowitz (Nobel Prize winner for exploring the mathematical tradeoff between risk and return) made an interesting comment when asked how he positioned his own portfolio ‐ “I visualized my grief if the stock market went way up and I wasn’t in it – or if it went way down and I was completely in it. My intention was to minimize my future regret so I split my contributions 50/50 between bonds and equities.” Clearly his thinking was more fear‐based than analytical.

In short, while dramatic market volatility makes the investor fearful, it truly is the appropriate response to avoid attempting to time the market (statistics show this approach actually results in weaker long‐term returns), and wait for equity prices to respond in the longer term. And, if you have cash, take the opportunity to purchase your holdings at lower prices.

Gradually working our way through the current market clutter, there are certainly a number of key themes to play out over the coming year. The US and China seem to be settling in to protracted negotiation on trade tariffs. Like him or not, President Trump has been focused on re‐establishing the US trade dominance that has suffered over the past decade or so. The aggressive stance taken by the US in trade negotiations with not only China but every other nation focused on trading with the US (e.g. the renegotiation of NAFTA) seems confusing to some, unless you understand the need.

From the 1944 completion of the Bretton Woods negotiations, the US trade imbalance has fallen from a positive 4.5% of US GDP (granted, a high from WWII production) to its current position of a negative 4.5% of GDP (data 2015). In his book, The Accidental Superpower, author Peter Zeihan notes, “the Bretton Woods agreements are the single most important factor behind the Japanese and Korean miracles, the European Economic Community and its successor the European Union, the rise of China…and the statistical monster that is the US trade deficit.” In short, the US opened its doors to foreign goods following the war, allowing battered economies access to the buying power of the US consumer thereby providing needed economic growth.

Why is this important to understand? First, consider the World Bank compares countries based on their total debt‐to‐gross domestic product ratio. It considers a country to be in trouble if that ratio is greater than 77 percent. The U.S. ratio is already 101 percent (meaning total debt exceeds GDP). So far, that ratio hasn’t discouraged investors. America is the safest economy in the world with the largest free market economy and its currency is the world’s reserve currency. One of the primary reasons interest rates plunged to 200‐year lows after the financial crisis was the US economic strength. Those falling interest rates meant America’s debt could increase, but interest payments could remain stable.

Second, more recently interest rates began rising as the global economy improved. As interest rates rise, the debt interest payments will also rise ‐ though presently there are sufficient funds in the federal budget to fund these payments. Since 1970 (1998‐2001 being the exception), each successive White House has been addicted to deficit spending to prop up economic growth. To do so, interest‐free borrowing has been provided by the Social Security Trust Fund which has been taking in more revenue from payroll taxes on the boomer generation than needed to fund retirees. But as the population ages, that revenue source is drying up – it’s predicted that the Trust Fund will have insufficient assets to fund baby boomer retirement benefits.

So, assuming politicians don’t want to raise personal and corporate tax rates, other sources of revenue needs to be found. Hence the current import tariff discussions which, as Forbes so acerbically states, “is simply a tax on consumers and businesses. Not in the exporting country, but the importing one.” In effect, the US government has found another source of revenue, though the input costs will rise for impacted businesses and result in additional inflationary pressure to the consumer.

The famous 19th century Russian gloom merchant, Anton Chekov, observed: “Any fool can cope with crisis. The difficult thing is to cope with everyday life.” Everyday life in late 2018 presents investors with a confusing array of signals pointing in multiple directions: we could be anywhere.

Globalization has generated net gains around the world, but that has masked winners and losers in different sectors and regions, such as low‐tech/low‐skilled workers in developed countries exposed to international competition from cheaper emerging markets labour forces.

At the same time, technology has turbo‐charged globalization with innovation transcending borders and cultures. In this respect, the so‐called Fourth Industrial Revolution has the potential to provide a much‐ needed boost to productivity, but could also trigger a mass displacement of labour, thereby exacerbating the three economic mega‐trends;

  • Over the past quarter century, labour’s share of US national income has trended downward. US data shows the general decline of income share for workers has accelerated sharply since the start of this century – plateauing somewhat following the global financial crisis of 2008‐09;
  • According to the 2018 World Inequality Report, income inequality has been rising in the developed west, but declining globally. In 2016, 12% of national income was received by the top 1% in Western Europe versus 10% in 1980. In the US, the top 1% has risen to 20% of national income compared to 11% in 1980; and,
  • There has been a secular decline in productivity growth across the western world. Data from the 2016 report by the Organisation for Economic Co‐operation and Development, shows the five‐ year average growth in worker productivity across developed markets has fallen from a high of 4‐ 5% in 1975 to 0‐1.5% in 2016 (differences depending on market).

The ever‐expanding domain of technology firms is causing both excitement and unease in equal measure. Arguably, technology firms are mainly responsible for sustaining the record bull‐run in equities; but they face backlash from regulators and workers who may feel, not unreasonably, that the tech giants are further squeezing their already shrinking share of income.

Trump, tariffs, trade wars, and tech: this is where we are today.

The rising tide of central bank liquidity that has lifted all boats since the financial crisis is on the turn. As we’ve written previously, the decade‐long trend of convergent global growth and correlated positive returns across almost all asset classes is finally petering out. The US Federal Reserve seems to envisage its ability to engineer a “soft landing” by turning monetary policy slightly restrictive to maintain normalized growth rates in the economy. This is counter to the Trump desire to stimulate growth at home – whether the Fed can hold out against intense political pressure remains to be seen. Historically, the Fed has typically over‐reacted to the conservative, setting the stage for a recession.

Many would argue that the Fed has already taken its restrictive policy too far. Work by Barry Bannister at Stifel indicates the Fed has already reached “maximum tightness” versus the neutral rate. This concern has been echoed by many who follow the Atlanta Shadow Feds Fund Rate.

This “push‐me, pull‐you” battle should continue through the coming year with a cacophony of fear‐ mongering and hand wringing. These are the times that truly test an investors mettle. Clearly global growth is slowing but, assuming the Fed stops tightening, that shouldn’t result in a recession any time soon. And with China still slowing, both they and the US have incentives to do a trade deal.

Despite all the noise, growth assets have already experienced a markdown coming out of the fourth quarter. With some reasonable profit growth by lower‐levered companies, there are gains to be expected in specific areas of the equity market over the coming quarters.

Having just finished reading Howard Marks newest book Mastering the Market Cycle, I’ll close this off with one of my favourite comments: “while they may not know what lies ahead, investors can enhance their likelihood of success if they base their actions on a sense for where the market stands in its cycle….there is no single reliable gauge that one can look to for an indication of whether market participants’ behavior at a point in time is prudent or imprudent. All we can do is assemble anecdotal evidence and try to draw the correct inferences from it.”

I’ve brushed lightly over some very detailed concepts, including Bretton Woods, shadow and neutral rates, and the funding mechanism of the US deficit‐spending approach. I’ll leave it with our readers to explore details further but, as always, am happy to provide further context.

The past year has, once again, been terrific for our firm with strong asset growth despite the poor markets at home and abroad. Based on the preliminary year‐end numbers, it appears our capable investment team has performed admirably in this difficult market environment, comparing quite favourably to our peers across all products. I remain confident that the concentrated portfolios managed by our team will continue to provide our clients with prudent growth over the next number of years, regardless of what Mr. Market throws at us.
On behalf of my partners, we would like to thank our extraordinary clients and their advisors for the confidence you’ve continued to show Laurus.

As I’ve said in prior notes, every year end also marks a new beginning. All of us wish you the courage, faith, and strength of spirit to walk the difficult road ahead ‐ along with the tenacity and patience to achieve everything you desire.