Quarterly Investment Update: 2018 Quarter 4

by
Ursa Major, Urania’s Mirror by Sidney Hall

Abstraction

The human mind is both unlimited in its creativity AND very easily influenced by the ideas and attitudes of others.  It’s an interesting combination because it results in perhaps fewer ideas than there might otherwise be, but a shockingly high degree of overlap and agreement on all sorts of abstract topics.  This ability to have a shared perception about something beyond any of its tangible qualities is uniquely human. 

In prehistoric times, ancient people assigned meaning to groups of stars, such as the constellation Ursa Major that includes the Big Dipper.  The myths about these characters in the sky became powerful tools for helping people connect with each other and for creating cultural norms.  Additionally, telling stories about the stars and grouping them into constellations helped people feel like they understood their world more deeply.  However, the truth is they had little or no understanding of the stars in the Big Dipper or any other constellation.  While these stars are in roughly the same direction from Earth, they are literally light years away from each other.  More often than not, what feels like knowledge about abstract things like constellations, is actually just a shared set of feelings with little or no hard data to support it.  For example, why is a $100 bill worth so much more than a $10 bill?  Because we all feel the same way about how the US government will treat those two pieces of paper.

As civilization has advanced the abstractions we use to describe our world have grown in both number and complexity.  We love creating abstractions that help us communicate and interact with each other more efficiently.  Our financial system is full of abstractions.  For instance, corporations are legal entities, designed to be separate and distinct from any of the people associated with them.  While we can talk to their employees and touch some of their assets, corporations themselves are not actually tangible.  The shares we own of these companies are thus an abstraction of an abstraction.

Interestingly, it seems that the more abstract, or devoid of intrinsic characteristics, a “thing” is, the more we look to other people in order to support or shape our attitudes around them.  In other words, the harder it is for us to observe the essential nature of something, the more powerful the influence of the herd mentality becomes.  

Increasingly we see evidence of money rushing into and out of various funds that invest in abstract concepts like sector funds and ETFs that focus on investing in “factors” like momentum, value or size.  Much like the stars in a constellation, these tools group securities together in convenient and interesting ways that make us feel like we understand the way they work.  But the reality is that investors in these products have very little hard data to rely on when times get tough because many of the companies in these funds react in completely different ways to any given variable.  The only thing that the companies in these products really have in common is the way we feel about that particular constellation at any given time.  As a result, when fear or greed captures the mind of the herd, we believe investors in these products are even more likely to make emotional decisions that they will regret.  We are looking forward to capitalizing on some of the opportunities that will be created.

Executive Summary

  • The Quarter in Review
  • Sentiment & Value Update
  • Mood Swings
  • What Is It About Houses?
  • Your Personal Investment Compass

The Quarter in Review

            It was a wild quarter with a peak-to-trough swing in the S&P 500 of -19.3%, just shy of an official bear market.  Several trading sessions saw the S&P 500 swing by more than 5% in either direction.  The price of oil collapsed by 40% and international stocks continued to suffer losses.  The one bright spot was a rally in the bond market that helped to dampen the volatility a little.  It was a rude awakening for investors who had become used to the muted volatility of the past two years.

Relevant Index Performance

Total Returns as of 12/31/18

           Index                               Qtr. to Date                Year to Date

            S&P 500                                  -13.52%                       -4.38%

            MSCI World ex-US                -12.78%                      -14.09%

            MSCI Emerging Mkts.           -7.74%                       -14.58%

            S&P Municipal Index             1.52%                          1.36%

            10-Year Treasury                    3.47%                          1.29%

Sentiment & Value

The chart above shows our opinion on where various markets are as of December 31st 2018.  Many of the best purchase decisions are made when prices are cheap and sentiment is bearish or depressed (bottom left quadrant).  Conversely, many of the best sell decisions are made when prices are expensive and sentiment is bullish or euphoric (top right quadrant).  This chart and the comments below are intended as a behavioral guide, not as a timing tool.

US stocks have at least partially “caught down” to international stocks.  Despite this development, US stocks are still optimistically priced.   Professional equity analysts are expecting nearly 8% earnings growth for the S&P 500 in 2019, which is just slightly below the average of the last 8 years.  Meanwhile, the bond market, which tends to be the “smarter” money, is beginning to price in the possibility of a recession starting in 2019.  Additionally, evidence is mounting that the threat of tariffs may have caused a brief flurry of economic activity in order to maximize purchases before higher tariffs go into effect.  On balance, we expect that economic growth and earnings growth will undershoot expectations this year.

There was one other interesting development in the fourth quarter of 2018.  It appears that in the race to sell equities, investors were desperate for any tax losses they could take to offset their gains from the nearly 10-year-old bull market in US stocks.  As a result, the constellation of “losers” lost even more.  Thus, selling begat even more selling in these stocks.  We believe that this selling has created a pocket of opportunities in some of the badly beaten down US stocks.  That said, with the likelihood of slower growth and the rising possibility of a recession we still think it is best to invest cautiously.  Short-term T-bills (a proxy for cash) now yield more than inflation.  Cautious investors are finally being paid to wait again.  All things being equal, if the S&P 500 were to trade below 2,400, we would be interested in buying US stocks and if the 10-year treasury yielded more than 3.25% we would begin adding to long-term bond positions.

Mood Swings

When it comes to corporations, our collective mood can change very rapidly.  There is no better (or more timely) example of this than Facebook.  Prior to the election in 2016, Facebook was quite possibly the ultimate feel good company.  Everyone wanted to share details about themselves with hundreds if not thousands of their “friends.”  Profits and revenue were exploding higher.  And the noble mission of the company, “to give people the power to build community and bring the world closer together” was impossible for anyone other than the most resolute grouch to dislike. 

Fast-forward to today and Facebook is the media’s favorite scapegoat for shamelessly sharing its users data.  Some go so far as to say that Facebook is intentionally deceptive and question the moral character of management.  In a very short period of time the public mood around Facebook swung from almost universal admiration to almost unanimous derision.

For investors, the lesson here is that an extremely positive, especially an irrationally positive, perception of a company is a risk.  When the mood is extremely positive, by definition the herd will be encouraging you to buy.  However, as the recent example of Facebook teaches us, massive swings in public sentiment can happen for unpredictable reasons.  Extreme sentiment never lasts forever; it is best to tread lightly when it looks like the sky is the limit.  Conversely, there is usually opportunity when everyone agrees that something is awful.

What Is It About Houses?

For some reason when it comes to stocks and bonds, most investors want to buy what has been going up and sell what has been going down.  They actually seek out opportunities to pay a higher price today than they could have paid last week.  Sometimes they feel an urgent need to sell a stock today for less than they could have yesterday.  In our opinion, this is completely irrational. Additionally, it highlights that most investors have a very poor idea of how to evaluate the stocks they buy and sell.  There is however, one asset class that even complete amateurs tend to have a rational opinion about – houses.  We believe there are three main characteristics of real estate that help to make it less abstract thereby reducing the impact of the herd mentality.

  Tangibility: because our homes are tangible it is much easier for the average person to appreciate one house’s value relative to other houses.  Observing the key aspects of a house such as location, size and amenities is pretty straightforward.  These are the metrics that are relevant to any real estate valuation.  Conversely, identifying the relevant facts for valuing a stock requires training, time and effort.

  Illiquidity: because it takes weeks if not months and considerable effort to sell a house the average person is more likely to thoroughly consider the reasoning for such a decision.  Similarly, if everyone had to wait at least two weeks and spend at least two hours thoroughly evaluating the rationale for selling a stock there would be a lot less trading and far fewer of those trades would be influenced by the prevailing mood of investors on any given day.

  Obvious value: because we all need shelter it is impossible to ignore the fact that selling your primary residence requires that you find another place to live.  In other words, the value of your home is impossible to ignore when you are faced with the possibility of having to replace it. 

The point we are trying to make is that with enough effort and enough evidence, people are able to use their critical thinking ability to overcome the influence of the herd.  Our efforts with regard to individual stock investments are centered around gaining insight and knowledge about the business in order to make it feel more tangible, force ourselves to think more thoroughly before making a decision and most importantly to be able to appreciate the intrinsic value of those businesses.  With a clearer view of what is actually happening at the individual business level investors can gain the confidence and resolve necessary to break away from the herd at the most important times.

Your Personal Investment Compass

You may recognize that the graphic above resembles our gauge of sentiment and value.  They are essentially the same thing.  Your gut feeling is an excellent tool for measuring sentiment.  While your brain, when it is thoroughly evaluating information, is good at identifying relative value.

Using your gut is pretty easy.  Most people can pretty accurately get a sense of what the general sentiment is for investing in a particular asset class or industry, particularly at the extremes.  Another great sign is when people who have no business sounding like experts on an investment start talking like they do.  The classic example is the proverbial “taxi cab driver” that hands out investment advice.  When regular people love or hate an investment so much that they feel compelled to tell you about it, take notice.

Using your brain is much trickier.  First, because it’s not always easy to separate your feelings about an investment from your thoughts about an investment’s value.  Second, because it is very difficult to distinguish between the actual facts and data and the pseudo facts and data.  At any given time there is always a lot of misinformation swirling around.  Don’t worry, because we are very happy to have you lean on us to do most of this for you.  However, if the current selloff turns into an Ursa Major (a big bear market), then it is likely to test your sea legs as well as ours.  By understanding that the best money making opportunities come when your gut says “no” but your brain, based on a rational assessment of the facts, says “yes,” you will be better prepared to persevere through the volatility and fear that often peaks during recessions and market crashes.

If you have questions about these topics or any other financial needs, please contact

FC Advisors at:

415-528-2826

hello@fcadvisors.us

www.fcadvisors.us

Following Claire Advisors, LLC DBA FC Advisors is a Registered Investment Adviser. This brochure is solely for informational purposes and is not intended to provide investment advice. Advisory services are only offered to clients or prospective clients where FC Advisors and its representatives are properly licensed or exempt from licensure.  Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by FC Advisors unless a client service agreement is in place.