Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
f the market calm of 2017 was like retreating to a beach on a serene desert island, 2018 represented a return to the stresses, strains, and unpredictability of the real world. A statistical analysis reported by Bloomberg confirmed that last year was one of average market volatility, but the increase in the range of fluctuations when compared with the previous year was one of the biggest on record. Statistical studies, however, were hardly necessary to gauge the difference; newspaper articles said it all. “Worst December for stocks since the Great Depression,” “Biggest weekly drop since 2011,” “Biggest recorded crash for a Christmas Eve,” “Funds suffer record outflows.” Then, as often happens when such overwhelmingly negative sentiment grips the markets, the Dow Jones Industrial Average leaped 1000 points on Boxing Day, its biggest point jump ever, and at 5%, the largest percentage gain since March 2009. A year that began with stocks racing to new highs — following the enactment of big tax cuts at the end of 2017 — ended with the worst annual results in a decade. At its low point in December, the S&P 500 was briefly down 20% from its high in September, which is the common definition of a bear market. “Volatility" — that bugbear of Wall Street — was back with a vengeance.
While the numbers for 2018 were decidedly negative, they were not overwhelmingly so. Yes, the S&P 500 average suffered that big December loss (9.2%), and finished the year about 15% below its high, but for the year it lost a more modest 4.4%, including dividends. (Europe, by contrast, was down 13% for the year.) Declines were widespread, however. Only a couple of industrial sectors escaped unscathed; healthcare, for one, gained about 4%. Energy lost 20% after oil prices — up 30% year-to-date in early October (amidst renewed talk of $100 per barrel oil) — rapidly declined by 25% thereafter. The big technology companies, having led the markets higher in recent years, continued that record of leadership in late 2018, but this time in the opposite direction.
On the surface, the popular averages portrayed a modestly negative year, but beneath the surface, “market internals” reflected a far weaker market dynamic. As of December 21, according to the Financial Times, fully 44% of the S&P 500’s component stocks had suffered year-to-date declines of at least 20%. When measured from their closing high prices, the change was even greater; another report from mid-October indicated that 239 (48%) of the S&P components were down at least 20% from their highs, and this was before the rout two months later. 159 (32%) of the S&P stocks had declined at least 30% from their respective highs, and 107 (21%) 40% or more. Six stocks were off at least 50%. From an historical perspective, these internal market dynamics are reminiscent of what happened in 1998 and 1999, during another “adjustment” that followed years of rising prices; at that time the indexes indicated market strength, while most stocks were actually declining in price. (Note: something similar also occurred in the months leading up to the final quarter of 1929.)
The implications of these facts and figures should be obvious, yet investors and the media largely ignore them. With the exception of the Dow Jones, the popular market indexes are constructed as weighted averages, meaning that the largest components by market value have the biggest impact on changes in the index value. When those large components also happen to be companies that are currently favored — or shunned — by the market, the indexes can give a distorted picture of what is really happening in the universe of stocks. Focusing on these market barometers too much on a short-term basis can result in poor investment decision-making, as it tends to create anxiety about the direction of prices. This is why we maintain that investing should be viewed over a long arc of time. From such a perspective, 2018’s year-end “rout” pales in significance to the history of growth in business values and becomes a rare moment of opportunity for long-term investment. At such times, when an investor’s acumen and experience can yield the greatest benefit, fear and wasting time trying to divine the market’s future are inevitably very costly distractions.
What was behind 2018’s about-face in the markets? Extrapolation probably played a role; reinforced by the tax cut goodies at year-end, a calm and profitable 2017 likely fed hopes for more of the same. Indeed, in the strongest January since the financial crisis, security valuations, already at extreme levels by some measures, rose even more. However, these inflated prices made markets extremely vulnerable. As many observers had noted, big tax cuts on top of an already strong economy risked increasing inflation, which would bring higher interest rates. A rate scare did indeed occur in February in response to inflation fears, and stock markets promptly fell 10%. Stocks recovered, however, and rose to new highs in September. The U.S. seemed impervious to problems felt elsewhere, such as in the U.K. and Italy, but interest rates continued their rise and fears of a more aggressive Federal Reserve helped to bring on a more severe market crack beginning in October, led by falling technology and energy issues. At year-end it was, paradoxically, falling interest rates that spooked the markets into a further, steeper sell-off. Even as the Federal Reserve lifted short-term rates, long-term rates declined, causing market participants to fear that the lower borrowing costs were in fact an omen of a recession, which could mean lower corporate earnings going forward.
As 2019 begins, we notice many of the same issues that challenged our economy and the financial world a year ago — trade wars, political instability, and inflation pressures, to name a few — but for investors there is a key difference: we are now downwind from a market downturn, and nervousness still pervades the investment scene. Valuations in general remain too high to really be attractive, but are at least more reasonable, and pockets of significant value have appeared here and there in the stock list. Such conditions are often precursors of a more positive market environment. We’ll see as the year unfolds.
While the stock market drama drew much of the attention, developments in the debt markets were also of moment. To understand this, a quick review of financial history as it relates to interest rates is needed. Rates were on a downward trajectory since the early 1980s, a time when even credit-risk-free sovereign bonds sported yields in the 14-15% range. The bottom of the downward slope was reached over the last few years when yields on some government paper turned negative (in the U.S., treasury bill yields fell to about 0%).
Why this happened is a story in itself, but here we are more interested in market reactions and potential consequences. As bond market returns fell lower and lower, investors seeking income became ever more desperate in their “search for yield,” to the point where fixed-income became a “sellers’ market.” So immense was the demand for income that lending standards were compromised and borrowers with poor credit ratings were able to access the bond markets at exceptionally low cost. Even borrowers that had never before been able to raise funds in the capital markets due to their high risk were able to get money at relatively low cost. Higher quality issuers did even better, selling an avalanche of debt at historically low interest rates.
The end result of this long-term trend has been an astounding increase in the world’s debt burden. Between 2007 and mid-2018 global corporate debt grew by 2.7 times, to about $11.7 trillion. About $10 trillion of those obligations are due to be repaid (or refinanced) over the next five years. “High Yield,” or — “junk,” — was popular, growing from $700 billion to about $1.2 trillion over the same time period. Indicating the decline in credit standards, about half of U.S. “investment grade” debt issuance was rated one notch above junk. Riskier paper, such as “leveraged loans” (obligations arranged by banks, incurred by borrowers of poor credit standing and often used for buyouts and such), also found ready buyers. For companies in the S&P 500, among the largest of businesses, debt levels relative to cash flows reached records.
What can happen in such a situation? Well, as a Financial Times headline put it: “Record outflow from U.S. junk bond funds in 2018.” With world debts, public and private, now standing at a record $164 trillion, buyers need to beware. This could be a source of considerable financial market turmoil down the road, more so than we experienced this past year.
As recent events have demonstrated, investing demands decision-making in the face of great uncertainty. In developing the capacity to make these judgments we find that history is a useful teacher in that the perspective it affords permits us to contemplate the rush of world affairs with detachment, having seen much the same forces at work in the past. History doesn’t repeat, but it does “rhyme.”
We like to think of investing and the markets as sort of a microcosm of the broad sweep of history, but with events happening in a shorter time frame, and the rhyming more often doggerel than poetry. Here, also, an historical sense brings an ability to view the proceedings calmly, even with anticipation. In the rush of potentially calamitous events, intense emotions, and the fruitless clamoring for direction and stability, the ebb and flow of investment values continues as before. When all seems lost, never to recover, history teaches us that it always has. “This too shall pass.”. ________________________________
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 33 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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Revised: January 10, 2019 TAF
© Copyright 2019 Dennis C. Butler, All Rights Reserved