October Update, 2019: Volatility Is The Only Certainty

Recent reports have called into question the strength of the U.S. economy. As we wrote in our September update, we still put low odds on a recession over the next year. Most forecasters agree that healthy consumer spending, high savings rates, what appears to be full employment, and strong corporate profits support the U.S. domestic economy.

That said, there are some areas of concern as highlighted in our last update. Global trade tensions continue to hamper the confidence of businesses when it comes to making long-term investments. This has hit the global manufacturing system hard, which is likely experiencing a mild recession. Changing regulations and consumer preferences have had an enormous impact on the global automotive supply chain. This greatly affects Germany’s economic growth, which has been the engine of strength in Europe. Brexit craziness continues to mire all of Europe and Great Britain in a slow-motion traffic accident. The coming U.S. election is becoming a close call. Trump seems destined to provoke anyone and everyone while Joe Biden appears to be running an increasingly tight race with Elizabeth Warren. Warren terrifies Wall Street. There are lots of things to worry about and yet investors seem to allow equities to levitate at reasonable levels because “there is no alternative” (TINA).

When it comes to your portfolio, we focus on businesses that generate profit because that is what drives returns over the long run. It is telling that generally speaking, stocks have made no progress from one year ago. The S&P 500 Index has returned 4.24% over the past twelve months while corporate profits have fallen by about 3%. The relationship holds; stocks return what profits provide. Dividends are the cash return you earn, and the capital return is the multiple that investors pay for expected profits in the future. Basically, investors value forward profits at the same multiple they did a year ago (about 17.4X) and that is the long-run average. Returns have been low this past year because profit growth has been non-existent.

Here is where it gets tricky. As a group, analysts are an optimistic bunch and their forecast for profits one year forward is always too high. Despite slowing global growth and already record-high profit margins, this gang of analysts expects profits to increase 8.7% next year. It would seem reasonable to expect a moderation of those forecasts over the coming months, but this will likely act as a headwind for stocks to make great advances.

So, given the above, what is reasonable to expect for your portfolio return? Most of the companies in your portfolio can be expected to produce earnings growth of 7.49% (the weighted average of names in our fund). If you add the present dividend yield of your portfolio and assume that the market multiple of earnings assigned to your portfolio stays the same as today, your expected return is 9.29%. Simple, huh?

But here’s the thing, the market rarely moves in a linear manner and volatility is the only certainty (along with death and taxes). The following observations of the stock market over the past 70 years are illuminating:

From 1946-2014 we had:

126 declines of 5% or more
12 declines of 10% or more
2 declines of 15% or more
2 declines of 20% or more

Since 2014 we have had:

8 declines of 5% or more
1 decline of 10% or more
0 declines of 15% or more
0 declines of 20% or more

With all the craziness of the past five years, we’ve only had a small number of significant corrections. This serves as an important reminder that volatility is nothing new and always something to be expected.

So, what do we expect over the short term? More of the same volatility hence our conservative stance and large cash position. We just don’t think the risk versus reward favors bold bets with valuations being slightly on the high side, earnings growth expectations likely on the high side given the facts of slowing growth, and a global political climate that seems intent on undoing global trade and calling corporations criminals. We own a portfolio of great companies that will perform well despite this mess. And if the short term brings downside adjustment, we have lots of cash to put to work.

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