2019 Mid-Year Update - Market commentary

7/10/2019

II. 2019 Mid-Year Update, 7/10/2019 - Market commentary:

The last twelve months demonstrate how rapidly stock market sentiment can change. In September 2018 the S&P 500 stock index reached an all-time high—only to subsequently generate a -14% total return during fourth quarter 2018. Fourth quarter 2018 was the worst single quarter for the S&P 500 since 2011.

In our 2018 letter, we argued that fourth quarter 2018’s decline in stock prices and investor sentiment was primarily due to four factors:

… (1) macroeconomic worry related to China, (2) weaker housing sentiment, due in part to strong home prices and a since-diminished rise in long-term interest rates during the second half of 2018, (3) December 2018 concerns that the Federal Reserve might raise short-term rates too much in 2019, depressing the economy, and (4) a self-reinforcing liquidation of stocks by institutional and retail investors.

As we will discuss, we do think it makes sense to be uneasy about China’s pace of economic growth but we are less concerned about (2), (3), and (4)—factors we regard as real but ephemeral. This means that Long Game Financial (“LGF”) will continue to invest in US assets based on their individual merits and also minimize ownership of China-exposed assets.” (LGF, 2018 Letter)

Of these factors, only China concerned (and concerns…) us due to—in our view—its long-term unsustainable government borrowing-and-spending growth rate, economic reliance on expanding infrastructure development and real estate prices (both of which are already elevated relative to global comparisons), and continued consumption of more than half of the world’s industrial commodities. A hypothetical though impossible to predict Chinese economic contraction could have meaningful ripple effects, including global deflation.

Epilogue: year-to-date, through June 30th, 2019, the S&P 500 generated a +18.5% total return and many 2018 market narratives have fully reversed. Last fall, investors were worried that a 3.25% 10-year treasury yield would become 4%. Today, 10-year treasuries yield 2%. In December, investors worried that an out-of-touch Federal Reserve would raise short-term rates too fast and harm economic growth. Today, the Fed’s tone has grown more accommodative. These and other shifts have helped stabilize investor and homeowner sentiment this year—and consequently the self-reinforcing liquidation of stocks that reached its nadir on December 24, 2018 reversed too.

What a difference a few months can make. As I write this on 7/8/2019 the S&P 500 is at an all-time high of 2,975, which is only 1.5% above its September 2018 high. (Of course, between its highs the index did take us on an unpleasant “V-shaped” roller-coaster...) Meanwhile the forward price-to-earnings ratio of the S&P 500 is 16.8x—which is roughly its average over the past several years—and the collective “Haven’t You Heard? The Sky Is Falling” feeling that was so convincing in December is now a memory. Our collective fear, nevertheless, will return one day…as it always does.

Market fluctuations like that one are the rule rather than the exception when it comes to the stock market and at LGF we manage them by attempting to distinguish the multi-year from the ephemeral before we invest in an asset and position ourselves such that we are able to persevere during inevitable occasions of heightened volatility. When it comes to macro in specific, our two primary multi-year themes—as we outlined in our 2018 letter—are “China is borrowing-and-spending at an unsustainable pace” and “the US in aggregate does not have enough housing relative to demand for housing.” The latter is a set-up that is positive for US employment, home prices, and consumer net worth.