January 23, 2019

Market Summary – 4th Quarter, 2018

Of all the liars in the world, sometimes the worst are our own fears.

                                        ~Rudyard Kipling

Investor frustration after a month like December 2018 is understandable. In a period when the stock market resembled a casino more than the foundation of our free market economy, stocks were prone to wild price swings in both directions. On no less than 13 occasions during the fourth quarter, the Dow Jones Industrial Average experienced daily gyrations of 500 points or more. Of course, it was the downturns that were most significant and painful for everyone involved. Investing would be much easier if such times could be avoided. But no one ever said investing was easy.

The closing month of 2018 will go down in history as the worst December since 1931 (during the Great Depression). The stock market suffered its steepest monthly percentage decline since February 2009 (during the Great Recession and financial crisis). Noticeably absent, however, was an actual recession or financial crisis.

This likely puzzled investors and only exacerbated the pain. We believe that the selloff was unjustified and without mercy. It came at a time when the economy is strong, the jobs environment is the best in years, consumer confidence is high, and inflation is under control. It was a classic case of fear, rather than reality, gripping the markets. The significant disconnect between the recent downturn in the market and the reality of today’s economy is reflected in the market’s valuation. On the night before Christmas, when stocks reached their low point for the year, the forward-looking price-earnings multiple on the S&P 500 dropped to 13.5, its lowest level in five-and-a-half years¹.

Another telling measure of the market’s rediscovered value is the dramatic change in the equity risk premium (ERP). The ERP measures the reward an investor is positioned to earn by taking the risk of investing in stocks rather than choosing a “risk-free” option such as 30-year government bonds. On Christmas Eve, the ERP on the S&P 500 reached its highest point since the days of the financial crisis (2007-2009).¹ By most measures, stocks of quality companies offer a tremendous level of value and upside potential that hasn’t existed in a decade.

The finger of blame for the market’s heightened volatility can, in large part, be pointed at the growing domination of trading driven by machines and passive investors focused on investing in indexes. These are market participants who don’t base buy-and-sell decisions on fundamental valuation methods. Objective judgment grounded in an understanding of the underlying environment does not apply. Instead, headline-driven algorithms primarily drive their decisions. Short-term developments move them in a specific direction, and they gain momentum as these machines feed on each other’s activity, intensifying the market’s volatility. According to The Wall Street Journal, roughly 85% of all trading “is on autopilot – controlled by machines, models or passive investing formulas.” As the Journal says, this creates “an unprecedented trading herd that moves in unison and is blazingly fast.”²

While computer programs were making major “sell” decisions that drove stocks into bear market territory for the first time in a decade, average investors were left wondering how to deal with the volatility created, in large part, by these machines. Many are left wondering, “Has algorithmic-based, short-term trading and the resulting increase in volatility changed the rules for successful investing?”

The simple answer is no. It is true that increased volatility in the markets has led to more dramatic daily price changes in stock prices. This has altered the dynamics of the market, to be sure. Unchanged, however, are the basic tenets of successful investing. The stock market, for all of its short-term volatility and unpredictability, remains the greatest wealth creation vehicle of all time, offering numerous opportunities for individual investors to flourish.

The market may, at times, feel like a casino as prices change rapidly, but being invested in stocks is still key to long-term financial success. Rather than viewing the greater speed of price movements triggered by an avalanche of algorithmic trading as an impediment to wealth creation, investors must realize the increased importance of “knowing what you own.” Knowing how the machines are impacting the market allows investors to put new money to work and be patient with existing positions, rather than be distracted with fear and assuming that something sinister is around the corner. Investors must accept that the machines are part of our market, and act accordingly in order to protect and grow their wealth.

Investing in strong businesses at bargain prices has proven to be the greatest defense against market gyrations. When overdone growth story stocks (i.e., the FAANG stocks of the past several years – Facebook, Amazon, Apple, Netflix and Google) start to fall in price, those drops can be far more precipitous than many investors anticipate. Quite often, companies that have become “hot” based primarily on future expectations (as reflected in high price-to-earnings multiples) lack the backstop of fair valuations to halt the impact of a market slide. By carrying astronomical valuations into a bear market, the potential for a significant downside is amplified. Our experience shows that the best way to put the brakes on a stock downturn is to acquire good businesses at the right price with strong balance sheets and differentiated products or services that generate prodigious amounts of cash flow. Stocks that fit this profile may still get wet during the proverbial hurricane, such as what we experienced in December. However, our experience shows us that these quality, value-style investments will dry off faster than their counterparts, and resume climbing higher and creating wealth for their owners.

Making money the old fashioned way

It’s important to acknowledge the widespread damage investors felt in 2018. We think a fair measure of the broad market may be the NYSE Composite Index. It includes all common stock listed on the New York Stock Exchange, including foreign stocks, American Depositary Receipts, real estate investment trusts and tracking stocks. In 2018, this index declined 11.2%, reflective of the actual damage experienced in the broader market.

Even value investing sustained losses in 2018. Yet history has proven that owning businesses at cheap prices is the best defense against challenging market environments. What’s more, stocks owned at the right price will recover from downturns much more quickly than those that are hard hit due to their overvaluation.

A real-life example of the risk of owning overvalued stocks is the so-called “Nifty Fifty,” a group of companies that became the “one-decision, must-own” stocks of the 1960s. The over-popularity of these stocks became evident when their combined price-to-earnings ratio reached 42, more than twice that of the broader stock market. Beginning with the bear market of 1973, the Nifty Fifty portfolio of stocks lost more than two-thirds of its value, and didn’t fully recover until a decade-and-a-half later, in 1988³. By comparison, the S&P 500 Index peaked in January 1973 at 120.24, and by the end of 1988, actually more than doubled in value, far outpacing the tepid results of the Nifty Fifty.

A more recent example is the dot-com bubble of the late 1990s that finally burst in 2000. At that time, much attention was focused on the meteoric rise of the technology-heavy NASDAQ Composite Index. It topped out at more than 5,000 in March of 2000. The Index proceeded to lose more than 75% of its value over the next two-and-a-half years. It also required 15 years to again pass the 5,000 mark. At that point, when the NASDAQ had simply broken even, the Dow Jones Industrial Average was up by more than 80% and the S&P 500 Index had risen 51%.

In 2018 and previous years, the growth-focused S&P 500 Index (that is highly concentrated in about 20 positions) appears to have become as loved as the Nifty Fifty in the 1960s and the dot-coms in the 1990s. The proliferation of index funds and exchange-traded funds (ETFs) allows investors and traders to move in-and-out of the market on a whim, often based on the latest headlines. This level of popularity and accessibility has, in our opinion, exacerbated the bubble characteristics of the S&P 500.

December reminds us that no stock investor can avoid the impact of a serious market downturn. The key is to blunt its force and be in a strong position for recovery. MPMG’s All Cap Value Composite portfolio, following a discipline of selecting what we believe to be quality stocks at bargain prices, demonstrates the benefits of this approach. We aren’t immune to down years, but we take a lot of pride in the fact that the longest that it has ever taken for the MPMG All Cap Value Composite portfolio to recover from a year-over-year loss was less than two years, and that was following the Great Recession of 2008⁴.

This is particularly crucial to consider in today’s market environment. Until October 2018, investment success seemed to require little effort. The past decade was an era of easy money policies by the Federal Reserve and a solid recovery for most American businesses. However, investors no longer have the luxury of pursuing a “lazy” approach to investing. Simply choosing to automatically allocate equity assets to an S&P 500 Index and thinking it represents “the market” is a strategy that will be tested as we cope with a changing investment environment.

Investing is hard work. To capture the true upside potential of the market through a select group of stocks, investors need to understand financials, income statements, balance sheets, cash flow generation, debt, business fundamentals, product lines, industries and their competitive environments, disruptive technologies and pricing power, among many other factors.

©Tom Cheney / The New Yorker Collection/The Cartoon Bank

Once that homework is done, the next step is even harder – creating a hypothesis that states the case to buy a specific stock which is contrary to majority opinion. This is the essence of effective value investing.

Even if you comprehend the objective and the tasks involved, this is a sophisticated process that requires years of experience. In today’s headline-driven environment, it also requires an extra degree of discipline and patience. Anyone can read a headline and have an immediate, visceral reaction to it. Computers can be programmed to react to specific events and trade accordingly. But that is not how one succeeds over time to reach specific goals. To quote a once famous TV commercial, in the markets you make money the old fashioned way – you earn it.

The tale of two bear markets

The broad stock market as measured by the NYSE Composite Index tripped into bear market territory (defined as a decline of 20% or more from a peak) on Christmas Eve. Stocks proceeded to experience a mini-rally in the days following Christmas to come back from the brink.

For much of the rest of the stock market, the bear already arrived. The NASDAQ Composite, Russell 2000 (small-cap stocks) and MSCI EAFE (international stocks) all moved well into bear market territory by mid-December. 68% of stocks in the S&P 500 were down for the year⁵.

The real concern for investors is what happens from here. Is this just the start of an extended downward spiral for stocks, or are markets poised for recovery? History shows us that there are two types of down markets – those driven by deteriorating fundamentals, and those that are driven by fear.

In the first case, where real economic issues exist, market downturns have proven to be dramatic and warranted. The most recent example was the 57% loss in the S&P 500 around the 2008 financial crisis.

But there are literally dozens of other corrections/bear markets dating back to the 1950s that range from 10% to 25% that typically lasted only a matter of months. These often are driven by emotions rather than reasoned judgment about underlying economic realities. These typically prove to be speed bumps along the path to greater wealth creation.

As previously stated in this letter, we believe that the strength in the underlying economic fundamentals puts the December 2018 decline into the second type of market correction, one that should recover more quickly.

If you can keep your head when all about you are losing theirs…

It is important to accept the things we can’t control, and that includes the machinations of today’s headline-driven trading mentality. Machines, coupled with the passive investing crowd, have taken investors on an undeserved roller-coaster ride. But it is important to recognize that serious wealth creation requires investment in the stock market. The best way to make that work in today’s environment is to keep a realistic perspective on the true state of the economy AND pay particular attention to value. Volatile times call for clear-headed investment judgment. Yet it is clear headed judgement grounded in facts that has, astonishingly, been out of favor over the past ten years. During this time, easy monetary policy, an economic recovery from one of the worst recessions in history, and (until recently) relatively mild market volatility created an investment environment that rewarded crowd-following complacency. As we have seen throughout history, successful investing comes down to judgement and economics, not fads and trends. Over a short period of time the market may swing wildly based on factors outside of our control, and these trends can persist longer than many investors can tolerate. However, it is exactly during these times of doubt, fear, and pessimism that judgement is most needed. Those that remain level headed while others are losing theirs (either by succumbing to fear or to the passive investing craze of today) will see that value investing, along with patience, continues to be the surest way to wealth creation and preservation.

~MPMG

<sup>1. Luskin, Donald, Trend Macro, “2019 Outlook: Confidence Rots from the Head Down,” Dec. 31, 2018.
2. Zuckerman, Gregory; Levy, Rachael; Timiraos, Nick; and Banerji, Gunjan, The Wall Street Journal, “Behind the Market Swoon: The Herdlike Behavior of Computerized Trading,” Dec. 25, 2018.
3. Schlossberg, Boris, “Are FAANG stocks the new Nifty Fifty?,” cnbc.com, Aug. 7, 2017. (https://www.cnbc.com/2017/08/07/are-faang-stocks-the-new-nifty-fifty.html)
4. This is since the inception of the MPMG All Cap Value Composite portfolio, is net of fees, and assumes investment in such portfolio on January 1 and calculating gain or loss as of December 31 of the same year.  See also the disclaimer at the end of this newsletter.</sup>

^{5. van Doorn, Philip, “The best and worst stocks of 2018,” marketwatch.com, Dec. 31, 2018.}

Established in 1995, Minneapolis Portfolio Management Group, LLC actively manages separate accounts for individuals, families, trusts, retirement funds, and institutions. Our proven value-oriented investment philosophy has created long-term wealth for our clients.

Visit our website at: www.MPMGLLC.com

Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted. Market returns discussed in this letter are total returns (including reinvestment of dividends) unless otherwise noted.

The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.