What a year 2019 was!

Quarterly Letter

Amid the continuing threat of a full-blown US-China trade war, the unpredictable tweets of a US president on any political, economic or social issues and the impeachment saga of the same US President, the S&P 500 climbed a wall of worries to post the best annual return since 2013.

However, statistics can be misleading: let’s not forget that the last quarter of 2018 witnessed a gutwrenching correction, taking the S&P 500 down by 14%. All in all, from the end of September 2018 to the end of 2019, the US benchmark price index was up an annualized 10.75%, not too shabby by any means.

Financial markets tend to be more sensitive to monetary policies from central banks than to any other variables. After raising interest rates 4 times in 2018, the US Fed spooked the market into a nasty correction. It then reversed course by lowering rates 3 times in 2019 and pumped over US$ 200 billion into the system to stabilize short term markets. As the saying goes in the industry, “don’t fight the Fed”. In simpler terms, more and cheaper money makes markets go up. Whether it is healthy for the overall economy is another question.

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It is always instructive to look at history in order to gain some perspective. Although it may not repeat, it usually rhymes. On that, below are some interesting observations regarding the 2010s:

• From January 2010 to December 2019, there was no meaningful correction (20% or more) based on monthly data. For comparison purposes, the prior decade (2000-2009) witnessed 2 major corrections: one of 46% and the other of 52%;

• As unlikely as it might have appeared in 2010 (amidst the worst recession since the Great Depression of the early 30s), the U.S. economy completed an entire decade without a recession for the first time in history;

• Here is a compilation of annual returns per decade (returns are in local currency):

Annual Returns per DecadeS&P 500 S&P/TSX
1930s-3.36%-5.28%
1940s9.55%4.97%
1950s19.34%9.72%
1960s7.81%6.27%
1970s5.88%5.92%
1980s17.55%8.15%
1990s18.18%9.27%
2000s-0.95%5.57%
2010s13.55%6.89%
2020s??????

 

It should be noted that the US market seems to outperform the Canadian market most of the time, except for the 1970s and the 2000s where oil and other commodities prices were strong.

• We can identify four fundamental factors that largely explained last decade’s performance: inflation, economic growth, demographics, technological change and the interactions among them:

o Low Inflation thus low interest rates: Without a doubt, low inflation, fading price expectations, and central banks’ inability to generate inflation had profound effects that were felt throughout the economic, political, and investing worlds. Central bankers had to keep policies accommodative, including experimenting with negative interest rates. That led to record low bond yields in many countries, driving asset prices higher. The lack of price pressures and low interest rates helped growth stocks outperform value stocks. It also allowed companies to borrow cheaply to buy back stocks and pay dividends.

Low inflation and accommodative monetary policies helped contribute to the longevity of the expansion. The low interest rate environment has created a dilemma for pension funds worldwide: most pension funds need to earn above 6% in order to meet their future liabilities, i.e. what they promise to pay their pensioners. With long-term bonds yielding less than 3% in North America and mainly zero or negative in Europe and Japan, the paradox is that the lower the return achieved, the more money employees and employers will have to contribute to their pension funds in order to meet future liabilities and consequently, the bigger the quantity of money is available to be invested. Unfortunately, more money will force bond yields even lower.

Pension funds are then pushed into the stock market in search of higher returns. Because of their size, they must invest in the biggest and the most liquid companies, thereby contributing to the momentum effect throughout the decade. Not to be left out, central banks worldwide also join the stock market game. The Official Monetary and Financial Institutions Forum estimates that 30 to 40 central banks have a portion of their assets in equity. For example, the Swiss Central Bank, the 8th largest public investor in the world, has more than US$ 90 billion in American equity. Microsoft, Apple, Amazon and Facebook are among its biggest holdings. In 2010, equity comprised less than 10% of the bank’s invested assets. Today, it represents 19%. In contrast, government bonds are only 68% of assets versus 83% ten years ago.

With hindsight, the above factors contributed to the outperformance of passive investing over active investing by a good margin. Since more and more money is flowing into index funds, passive investing is tantamount to momentum investing, which means the stock prices of the largest companies have been chased up, the bigger the company, the higher its price goes. For example, the top 15 companies in the S&P 500 accounted for 40% of the return: Apple, Microsoft, Facebook, Amazon, JP Morgan, AT&T, Visa, Alphabet, Johnson & Johnson, Bank of America, Procter and Gamble, MasterCard, Disney, Citigroup & Intel.

The concentration is even more acute in the tech-oriented Nasdaq index where the top 15 companies account for 60% of the return whereas in Canada, the top 15 also account for 60% of the return.

o Economic growth. Albeit modest, economic growth has been persistent and helped drive cash flows and propel asset prices higher. Moreover, the lack of economic imbalances helped sustain the expansion and pushed the unemployment rate from over 10% to 3.5% -- the lowest level in 50 years.

o Demographics. Aging populations and a delayed start by Millennials led to a greater demand for services at the expense of goods. Services spending is less volatile than goods consumption, thereby contributing to the durability of the expansion and subdued inflation.

Aging Baby Boomers also led the hunt for yield and income, keeping bond yields low and fueling the demand for dividend stocks.

o Technological change. Technology changed the way we shopped, interacted with each other, how we were entertained, and led to the rise of the sharing economy. These disruptions lowered costs, which kept inflation down. As a result, Technology winners were rewarded with huge market capitalizations, which contributed to growth outperforming value and the U.S. outperforming the rest of the world’s stock markets and most economies.

In summary, a congruence of factors led to low inflation and low interest rates, which in turn allowed for modest economic growth without imbalances. Since asset prices are generally inversely related to interest rates, low rates have provided an environment for increasing stock prices.

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As you should know by now, we, at Claret, spend an enormous amount of time studying history (financial or otherwise) in the hope of gaining some insight as to where we are in different cycles. We have avoided making forecasts because it is very difficult to predict events when the numbers of variables are so numerous and interrelated. We can certainly assign some probability to certain events happening, but it would be like forecasting the weather: 60% probability of rain, with periods of cloud and sun. We can never be wrong, but it is quite useless as a forecast. We would rather spend time analyzing companies and their management in order to determine whether there is something worth buying for the long term. We recently came across a very interesting article on prediction. If any of you are interested, let us know and we will send you a copy. For those of you who love summaries and power points, here is it:

• The distinction between “wrong” vs. “early” has less to do with analytics than the social ability to prevent listeners from giving up on you.

• Credibility is not impartial: Your willingness to believe a prediction is influenced by how much you need that prediction to be true.

• History is the study of surprising events. Prediction is using historical data to forecast what events will happen next (do you see the irony?)

• Predictions are easiest to make when patterns are strong and have been around for a long time – which is often when those patterns are about to expire.

• Prediction is about probability and putting the odds of success in your favor, but observers mostly judge you in binary terms - right or wrong.

• Past predictions that end up on the unfortunate side of probabilistic odds might cause hesitancy to make more predictions in the future.

• Predictions are often calibrated to promote or preserve one’s reputation and career goals.

• Enough effort goes into an initial forecast that updating one’s views when new information becomes available can trigger the sunk-cost fallacy and cause one to be right or wrong for the wrong reason.

• Predicting the behavior of other people relies on understanding their motivations, incentives, social norms and how all those things change. That can be difficult if one is not a member of that group and have a different set of life experiences.

• Effort put into a prediction may increase confidence more than accuracy.

• Last word from Daniel Kahneman, the 2002 Nobel Memorial Prize in Economic Sciences:

“It is hard to think of the history of the twentieth century, including its large social movements, without bringing in the role of Hitler, Stalin, and Mao Zedong. But there was a moment in time, just before an egg was fertilized, when there was a fifty-fifty chance that the embryo that became Hitler could have been a female. Compounding the three events, there was a probability of one-eighth of a twentieth century without any of the three great villains and it is impossible to argue that history would have been roughly the same in their absence. The fertilization of these three eggs had momentous consequences, and it makes a joke of the idea that long-term developments are predictable.”

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In conclusion, for the next decade, and this is not a forecast, we believe that:

• If interest rates remain low and money remains plentiful, corrections will likely be shallow and returns reasonable. However, with so many actors leaving the fixed income world and chasing equity returns, there is a risk of bubbles forming along the way.

And if so, asset allocation and stock selection will be the most important factors in determining returns and will outperform passive investing.

Happy reading and Happy New Year.

The Claret Team