Review of Markets, Valuations, Process:
As we write this, markets continue to march higher, reaching all-time highs and are on pace to notch another year of double digit returns. The yields on investment grade bonds continue to bump along near their all-time lows (low yields equate to high prices). Relative yields on non-investment grade bonds, such as high yield, mortgage backed securities and emerging market bonds, are also at or near their all-time lows, or what we call “tights” as they are measured relative to Treasury bonds.
In layperson’s terms, “everything is expensive”.
For the U.S. and global markets, forward looking measures of valuation, such as the Price to Earnings (P/E) ratio, is within a hair of its all-time high. Only emerging and select European markets would seem to present much relative value.
The great economist Robert Shiller regularly takes this “P/E” ratio and smooths it out to quiet what can be noisy earnings data. This measure, the “Shiller P/E” is currently at a level only seen in 1929 and 2000. See chart below.
The translation of this incredibly technical presentation: interest rates are exceedingly low and the valuation of markets, primarily the U.S. stock market, is quite high on a relative basis.
We like to joke that we broke, lost or were never issued our crystal ball. It’s true though, and we have also gone so far as to tell clients and others that anyone who claims to know with certainty what is going to happen in financial markets (perhaps in life) is at best a naïf, at worst a charlatan. This much we do know, or at least seems safe to posit: financial markets are wildly unpredictable, though they do tend to move in trends, with interspersed corrections. They have tended to be, over time, mean-reverting series, which is to say if valuations are very high or very low, over time they will tend back toward an average. But one is compelled to ask, when? And there is no way to answer that question with accuracy.
Elsewhere in this newsletter we review the books we read this summer, and a favorite was a biography of billionaire Charlie Munger, who has been Warren Buffett’s business partner at Berkshire Hathaway for more than 50 years. An eccentric and brilliant man, Munger is known for saying, “The only thing I want to know is where I’m going to die, so that I never go there.” We believe this is the sort of bemusement and wisdom with which one must approach capital markets.
Early in life, or on any sort of intellectual journey, one knows very little. But over time one acquires the sense that they know so much, they must know all there is to know. This is where many so-called experts get stuck. It seems a durable notion that true wisdom is the next step, that is, knowing what you know, but then also knowing what you don’t know. Exploring the limits of one’s own ignorance is not for the puffed up. It is humbling, of course. Who wants to hang out in the zone of ignorance and feel dumb? Well, that’s a fork in the road. For some that is uncomfortable – it’s easy to stay where you know what you know.
As portfolio managers, stewards of our clients’ savings and partners in their financial lives, we confront the knowable vs. the unknowable regularly. We think this is a wise, patient and rewarding approach. The best minds in finance, indeed, the best minds, recommend this way. But it’s not for the newbie, the beginner. I have heard it said that there are two kinds of investors – the humble and the not-yet humble.
We believe that markets and economic data are mean-reverting, they are cyclical and that they will correct. Stock prices will fall, economic growth will slow, unemployment will rise and perhaps even inflation will turn upward. We do not know when; however, and we are thus in the position of thinking about the world in terms of continuous risk assessment.
One risk we face is being complacent in light of current valuations, what could be slowing economic growth, or even increasing geopolitical uncertainty. Complacency means ignoring a change in the risk landscape. Our equity portfolios, Global Growth and Global Value, have higher levels of cash than at any time in our firm’s history, and indeed, as markets continue to march higher performance has lagged modestly.
On the other hand, we face the risk of being overly conservative. Perhaps we become convinced of an impending correction or war or the like, and we protect portfolio values at the expense of continued gains. Neither we nor our clients have the luxury of sitting out many rising periods in markets. We all have a unique set of needs and goals – retirement, health care, travel, philanthropy, etc. Sitting in cash waiting for the correction is a good way to leave lots of money on the table.
So, at risk of playing our record one more time, here goes: We never take our eye off the risk-return contract. To do anything else is to derelict our duty to clients, to ourselves. Unfortunately, the market for financial advice is strewn with practitioners who think this contract, the relationship between risk and return, can be nullified. It cannot. We just read a fun summary of financial history which mentioned that in Ancient Greece more dangerous sailing routes required a contract which compensated the investors for the added risk. It seems obvious, yet it gets lost in a modern era of financial products and distraction.
We build portfolios to do a short list of things, because we know that the more things one tries to do the greater the chance that any one thing will be done poorly. Our objectives are:
Maximize return per unit of risk – Analogous to gas mileage. This keeps us acutely aware of how much return we are earning, because that is ultimately the point. But, we never think we can earn excess return without added risk.
Capture more of an up market than of a down market – Because a market that falls 10% requires 11.1% to regain its prior level, we work very hard to be down less. We acknowledge that markets fall and correct – that part is unavoidable. What we can do is work to participate less, and smooth out the ride.
Maintain liquidity – Liquidity, the ability to turn investments into cash, has a price. Much like risk, it is not directly observable, not until it is too late that is. Lack of liquidity often becomes apparent at the worst possible time. We believe that there is value in some illiquidity, such as a house, or some private investments, but the market and history remind us time and again that liquidity carries a premium of up to 25% over a comparable, yet illiquid, return. That is, one should be compensated for illiquidity risk
Keep costs low – Fees and expenses act like a dead weight anchor on portfolio returns. Because we invest alongside our clients we work to keep portfolio costs low. Because our business grows by referral and our clients can fire us at any moment, we work to keep our fees low and reasonable and offer a high level of attentiveness and services such as financial planning, advisory relationships, and discipline.
Transparency – This one speaks for itself. Clients should always know what they own, where it is located, how to get it, how they are doing and how to reach us. We take transparency very seriously.
We cannot add “predicting the future” to this list because it is impossible. Some things are knowable but uninteresting (see “Amusing Ourselves To Death” in our book review), whereas other things are very interesting but unknowable. That is the realm of investment returns. So, we endeavor to prepare ourselves, our clients and our portfolios for the inevitable uncertainty of the markets.
In the past when writing this survey we’ve gotten bogged down in simply reciting specific asset returns, and even modest prognostication. We don’t find much value in that, and indeed I (Kreighton) have been trying more and more to separate signal and noise, value added information and amusements (Again, refer to our summer reading).
Our focus and time is best spent serving clients, continuing to monitor, test and build portfolios for uncertain outcomes rather than forming opinions on, say, the North Korean peninsula. Even though news and foreign affairs are a hobby, it should not cloud our thinking in terms of what we can be doing for clients.
Markets are lofty, and when they correct – and they will – it is likely to be swift, somewhat painful and unexpected. We think about that every day.
Interest rates are low, and they may rise someday – we have less certainty and less surprise there because a variety of plodding levers work on the path of rates. We believe you should access these rates while you can, if you can.
And on top of that, if you are reading this and you have some health, some wealth, some community and family around you, then those are the most important things. We believe that sunny days and a happy life continue to be as vital as robust investment returns in achieving a life well lived.
We are profoundly grateful for our clients’ trust in our process and our approach, and we look forward to many happy returns ahead.