December Update, 2018: The Story Remains The Same

Stock markets around the world have entered the final stretches of the year in a foul mood. While fundamentals are the law in the investment business, the short run price action is all about confidence. Economic growth is strong. Corporate profits are at records. Confidence in the future is low. Markets always overreact to good news and bad. To take the direction of the ‘stock market’ for a couple of months and predict the future is a very bad investment strategy. Many investors get caught up in the news flow of what is happening today in the markets and panic. That’s what creates an opportunity for long-term investors.

John Authers, a wise Bloomberg reporter recently wrote:

Markets don’t run on numbers so much as narratives. As humans, we like to think in terms of stories. Investment cases are generally made as stories. And people such as myself are expected to take disparate and complicated market data and turn them into a comprehensible and comforting story.

The problem is that we’re prone to something called narrative fallacy. In other words, we have a narrative in mind and we adjust our perception of the facts to fit that narrative. Only when a narrative becomes totally untenable do we abandon it, often with sharp effects on the markets. In the interim, markets are affected by the dominant narratives. The stories we tell ourselves to make sense of the world tend to affect real stories in the real world.

The two most important financial measures for most U.S. investors are the S&P 500 Index and the benchmark 10-year U.S. Treasury note’s yield. There was a two-pronged narrative throughout most of last month.

First, the Federal Reserve was tightening monetary policy too fast, that it always tightened until something broke and if it could only step back from its aggressive plan to raise interest rates further the stock market would recover. The second narrative, roughly as important, was that markets were spooked by escalating trade tensions between the U.S. and China. The meeting between U.S. President Donald Trump and his Chinese counterpart Xi Jinping at the Group of 20 summit in Buenos Aires was thought to be all-important. If the two leaders could only engineer a truce and avoid having the U.S. raise tariff rates to 25 percent on Jan. 1, the market would breathe a sigh of relief and life would return to normal.

According to this narrative, everything came up roses for the stock market. Fed Chairman Jerome Powell made a speech saying rates were close to what is deemed neutral, implying that rate hikes might soon be over. And Trump and Xi indeed engineered a sort of truce by agreeing to continue talks for another 90 days.”

Markets continue to be met with selling and negative narratives, so clearly, something else is concerning investors. We think there’s a good reason to believe that markets have perhaps tilted too far to the downside.

Many analysts have pointed out that the economy continues to chug along at a good clip; earnings are rising and expected to continue to do so. This has caused valuations to improve considerably. But what investors need is confidence that the economies will continue to expand; driving profits higher. Here the news is encouraging. The ISM manufacturing and services indexes have always been a very good indicator of future economic activity. These data points were freshly reported, and they continue to flash positive signals.

The sell-off in stocks suggests there’s something wrong with the narrative that economic growth will continue. Clearly some quantum of investors feel compelled to take short-term bounces in stock prices as an opportunity to sell and their vigour to sell outweighs the optimism of bulls willing to buy. What we are seeing is a good old-fashioned correction of expectations. The narrative of trade worries and rising interest rates are outweighing good growth.

The narrative that seems most compelling to explain the correction is highlighted by twenty of the thirty companies in the Dow Jones Industrials Average stating that the rising US dollar is a concern that could hurt profits down the road. Only five companies complained about Trump’s tariffs. The problem is that tariffs and rising interest rates cause the US dollar to rise.

Authers continues:

“For now, ‘tariff war’ concerns are really about the strength of the dollar, and there is every reason to think tariffs could yet have a big effect even without being formally levied. Importers will be reluctant to place orders for March of next year while there is a possibility of a 25 percent tariff, as the U.S. has threatened.” 

Recently, we wrote that a war of sorts was afoot amongst the great powers of the world. It is a war about technological domination. China has been playing an unfair game and “stealing” others technology. Trump may not be liked for his methods, but growing choruses of countries are joining his war against China’s behaviour. We think the likely outcome will be China’s movement toward more fair play. Trade tensions will eventually moderate because China really has no choice if it wants to be a global player. The pressure to change is growing exponentially as more countries are threatening to exclude China’s technologies from the global supply chain. If the Chinese government wants to maintain domestic harmony via employment, they need export markets willing to buy their products. Change is coming. China needs to adjust, and it could be surprisingly soon.

Interest rates are likely not to rise much further anywhere in the world. The U.S. Federal Reserve has just said so. This should begin to alleviate concerns of rising interest rates choking economic activity. The trade war seems to have settled down and negotiations are underway. China likely wants a deal and Trump probably wants to announce a ‘win’.

Encouragingly, few companies in your portfolio have substantial exposure to this battle of wills between the World and China. Their profits are rising and their balance sheets are strong. Unfortunately, this has not spared them from indiscriminate selling and their share prices have experienced significant declines.

We have every confidence that over any reasonable time, the values of our portfolio companies will move to new highs. After all, people will still shop at McDonald’s regardless of trade tensions and slightly higher rates. People will still go to see a Disney movie, continue to shop on Amazon and need to use their bank every day. To our mind, the stories always change, but the fundamentals of the companies you own have only gotten better because they are fundamentally great businesses that people will continue to support regardless of what the market says on any given Monday.

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