Trend Management, Inc. Year End Letter 2018
In the fourth quarter the stock market had its worst December decline in 90 years. It also had its worst ever percentage decline on Christmas Eve. Two days later the Dow had its largest up move point-wise in history. The markets are a volatile mess right now. We will get into the details below on how we plan to handle it.
We have been saying for about two years now that the stock market is 10% to 20% overvalued. That has now changed with this decline. With the S&P 500 at 2400 we now view the market at fair value. We believe interest rates are still overvalued by about 50%. In our view stocks are still the best investment long- term versus cash or bonds. The fourth quarter decline in stocks has not changed our view.
We have a model account whose performance we have audited from 1998 to the present. We think the performance of that account fairly represents how our average client’s returns have been during that time frame. The account is a retirement account where no money goes in or out. During the 21 years that account has been active we have had six losing years. We are averaging a losing year about every 3.5 years. The losing years were 1999, 2007, 2008, 2011, 2015 and now 2018. We have had only one back-to-back period when we lost money two years in a row. That was the Great Recession of 2007-08. During this 21-year time frame we beat the return of the S&P 500 by almost 100%.
What we find interesting about this history is there were two bad recessions during this 21-year period, 2001 and 2008. In 2008 the decline was horrific for virtually all financial assets except cash. There was no place to hide. Everything went down. There were no stocks that survived that meltdown. In the 2001 recession there were stocks that went up despite the dot-com bubble burst. We think the 2018 equity market resembles 2001 and not 2008. We think our accounts are set up for a good two-year run of positive returns. Why?
In 1999 most value stocks did very poorly before the dot-com bubble burst (see chart above). Berkshire Hathaway’s stock dropped over 50% during this time frame. At the time, Warren Buffett’s investing approach was considered out of touch with how to make money in the new world. There were reports that investors in Omaha were stopping him at dinner and asking when he was going to change his “old way” of investing. He was viewed as past his prime (he was in his60’s). They were wrong. He gave a very public speech in August of 1999 telling the investment community why what he was doing was still going to work. He missed the bottom in his stock by eight months.
The only thing investors wanted to do in 1999 was chase momentum stocks in technology and telecom. Those stocks did amazing compared to value stocks. The more tech went up, the more investors bought them and sold value stocks. At the peak of the mania in 2000, tech and telecom represented 33% of the valuation of the S&P 500 even though they made very little money.
Some of the metrics investors used to price the tech stocks were how many visits a web page got and how many eyeballs were looking at those pages. Whetherthose companies made money didn’t matter. The mantra was just keep growing page hits and eyeballs. If you do that, Wall Street will drive your stock higher. That all ended on March 10, 2000. On that day, the dot-com momentum stocks headed south and proceeded to lose over 56% of their value in the next nine months. As investors sold the tech stocks they freed up money that needed to be invested in something else. That something else turned out to be value stocks. After Trend Management lost 19% in 1999, we made 47% in 2000 even as the Nasdaq crashed from 5132 to 2288. But, before we made that 47% in 2000, we lost another 15% going into the March top in the dot-com bubble. It was a very painful and miserable time for our investors and Mark personally. Starting on March 11 our bear market was over and the rest of the worlds bear market started.
Will it play out the same way this time? No one knows for sure. If you look at the chart above, it shows what has happened to value stocks versus momentum stocks the last 5 years. We think that chart is very similar to the one above of tech stocks versus value stocks in the .com bubble. In 2000 you just needed to buy any stock with “.com” in its name and you made money. This year, until October, you just needed to buy Facebook, Amazon, Netflix, Google or any stock that does business with them. Large-cap tech dominated the indexes for the last five years. We don’t see that domination continuing. Just as money in 2000 fledthe dot-coms it will flee this sector. We hope to profit from it.
If I was a client, I would argue that IF there is a recession it will be like 2008 and not like 2001. OK let’s go down that path. In 2008 we had an over-leveraged banking system stuffed full of bad real estate loans. In 2001 we had a lot of fraud on Wall Street led by Enron and WorldCom. The difference in the recessions of 2001 and 2008 is that the bad dot-com investments weren’t a big part of the loans banks made. Those investments were funded by Wall Street and sold to the public through stock offerings. If you wanted to borrow from an Ozarks bank, the losses in Enron, WorldCom or the dot-com stocks had no effect on whether the bank COULD lend you money. In 2008 the decline in real estate loans in the U.S. affected all bank lending immensely. Credit stopped flowing. Banks not onlywouldn’t lend to you, but some called in their loans (BankSouth, Citizens National). In 2001 the losses from the dot-com fraud were felt by investors BUT NOT the banks or their borrowers. In 2008 everyone felt it. That’s the differencewe see and we think it’s big. We don’t see any asset class sitting in the banking system today that can cause the same reaction it did in 2008.
Assuming we are correct on this, the stock market’s decline is discounting aslowing of economic growth — not a collapse in economic growth. When that happens, you get 10% to 25% corrections but not 50% to 60% corrections like we did in 2008. So far this year the S&P 500 has declined 20% from its highs. The Russell 2000 is down 27.3% from its highs while the Value Line composite is down 25%. The markets have taken a pretty big hit this quarter.
To give you some insight into how bad things have been in the stock market this year versus the economy, look at the chart above. In this example we define a correction as a 20% decline from the price of the stock market a year ago. This is different than how much the market has declined from its absolute top. Since 1963 there have only been two corrections in the S&P 500 of 20% or more when there was not a recession. Those two years were 1966 and the crash of 1987. In other words, those two stock markets declined more than 20% year-over-year even though the economy was doing well. We point this out to say that no one ispredicting a recession in 2019. We aren’t either. Assuming the economists are right on their no-recession call in 2019, by January, if the S&P 500 is trading at 2300 (6% from todays close) the index will be down 20% year over year. This would be only the third time in 56 years that has happened. Based on the past history of what happens when you have a 20% market decline when there is not a recession, we think there is a very good chance the market rallies from 2300.
If you are curious how many corrections there have been of 10% or more this decade, there have been seven since the Great Recession bear market of 2009. In each case those declines did not predict a recession. None of them felt good and this one is no different.
Where is the economic growth going to come from if the U.S. isn’t going into arecession like 2008? We currently believe there is a shortage of single-family housing in the U.S. In 2008 we think the U.S. overbuilt single-family homes by 3.2 million. Today we see a shortage of 2 million homes that need to be built. That matters when projecting where economic growth will come from. It doesn’t tellyou when it happens but that it should.
In 2008 there was no investment idea worldwide that would generate economic growth. Today we see the implementation of 5G as a major growth story for the world over the next three years. Every major country views 5G as crucial to its economic future. Implementation of 5G is viewed as a crucial precursor for the future success of a country’s economy. The world will spend on 5G no matter what. The U.S. will be no different. We think the activity in those two areas will keep the economy out of a recession.
We have structured our investments into three main groups of money to try and profit from whatever market we have coming next. They are dividend producers for cash flow, stock buyback companies and inflation hedges. We want toelaborate on how they will “work” together. Two of the groups should help us handle a bear market should we be in a recession. The other one is set up for an inflationary bear market where owning cash won’t be great.
Twenty five percent of our managed accounts are invested in income-producing stocks. Those are BGC Partners, CenturyLink and Newmark Group. The average dividend yield for these three investments at today’s prices is 10%. On average these three stocks will pay the portfolio a yield of 2.5% (25% of the portfolio times 10%=2.5%) in 2019. If you count the other dividends we get from our investments, we would have a total yield of around 3.6% for the entire portfolio. We plan to use the cash flow from these stocks to help fund the cash-flow needs of our clients. Should they not need any cash at this time, we will reinvest this cash flow in other areas beside the income group.
The second group is stocks that can and will buy back their stock should the market go down a lot. They will be dollar-cost averaging their stock purchases if the market declines. This group includes Apple, Banco Macro, Berkshire Hathaway, Data IO, Goldman Sachs, PNC and Wells Fargo. The percentage of assets in this group is between 30% and 35% of our accounts.
The last group is our inflation hedges. We have been building this group up over the last two years. This group includes Barclays commodity index (DJP), Exxon, Colombia ETFs, Ishares Latin America, Ishares Mexico, Nucor, Profire and Royal Gold. This group represents around 25% of our accounts.
We will use the cash flow from group one to buy other investments. Group two will be buying back their stocks, which will help their performance. Group three will lag the performance of the first two until the dollar goes down and inflation threats emerge. Once those fears occur (and they will), this group will lead our accounts performance.
The market decline in the fourth quarter was ugly. It really hit our accounts hard and we hate that. We think the decline is more about the fear of a recession than an actual one occurring. Wall Street is famous for predicting seven of the last tworecessions. We don’t see any changes that we want to make to the portfolios currently. We like what we own even if the world appears not to. We think our patience will be rewarded in 2019 with a profitable year.
Mark Brueggemann IAR
Kelly Smith IAR
Brandon Robinson IAR