February 2020
Major League Baseball (MLB) has had quite a buzz about it for the past two weeks. This is rather extraordinary, given that we are in the offseason of the sport, and the nation increasingly ignores baseball – even during the World Series – as depicted below in Exhibit 1.
EXHIBIT 1: Average Number of World Series Viewers (Mil)
There is vigorous debate regarding why this precipitous drop in popularity has occurred, with typically some combination of the following being offered:
- The games are too long;
- The games are boring;
- The regular season is too long and boring.
Whatever the reasons, I would summarize that they point to a failure to adapt. The NFL is the king of adaptation. Rules change every offseason. For the most part, rule changes have been implemented to increase scoring (which fans like) and decrease injuries. Likewise, the NBA has implemented a variety of rules over the past 20 years to increase offense, and the hard fouls of the 70s, 80s, and 90s would warrant multi-game suspensions now. The powers that be in the NBA have no interest in seeing their stars sidelined either.
MLB, on the other hand, is highly resistant to change. The purists want their game played just as it was 100 years ago. The historians would like statistics to be comparable across generations, an exercise that is now much harder to do in basketball and football because the games have changed so much over time.
So, it is ironic that MLB is now making national headlines for the “scandalous” introduction of technology. Several weeks ago, there was a mild uproar about the Houston Astros stealing pitching signs to aid in their success over the past few seasons (including their 2017 World Series Championship). But sign stealing – done the old-fashioned way with the human eye – is as old as the sport, so initial uproar was minimal. However, we are now learning that the Astros used technology (at a minimum, cameras, and potentially buzzers taped to the bodies of batters) to relay which pitch was coming.
Based on recent conversations, I think the investing public could benefit from one such buzzer. Instead of signaling a change-up though, perhaps it could alert us to a 10% dip in equities? On that point, outside of the Financial Crisis, I do not think I have ever spoken to so many investors worried about the market’s next move. The relentless upward ascent in stock prices has surprised most, and depending on who you talk to, you typically hear some version of the following:
- I am fearful – because what goes up 30% that quickly, must be ready to come back down even more swiftly;
- I am angry – because how could this be happening with all the negative events transpiring in the world?! (And, it may be true that I missed the rally due to my fear in preceding years, but that is beside the point);
- I am appreciative but anxious – because I have stayed invested, yet these rising account balances seem too good to be true.
Of course, there are more extreme reactions. At last week’s World Economic Forum in Davos, Guggenheim Partners’ CIO compared the market to a Ponzi scheme and said it was headed toward collapse. That seems a bit over the top to me, but as the saying goes, financial media favors the bold. Famed hedge fund investor Jack Ablin of Cresset Capital called for a pullback of at least 15% this year. Watch CNBC for 15 minutes and you are bound to hear the word bubble. Yes, the gains are similar to those of the late 90s, but anxiety and carbon footprint have replaced the jubilation and sock puppets of the tech bubble.
I understand anxiety related to 2019’s performance. The gains in most stock indices last year were almost entirely driven by an expansion in multiples as opposed to earnings. More specifically, as shown in Exhibit 2, 2019’s gain in the S&P 500 (represented in white) is almost identical to the expansion in the index’s forward P/E ratio (represented in green). Put another way, the S&P 500 rallied 30% last year while its earnings increased approximately 2%.
EXHIBIT 2: 2019 S&P 500 Returns vs. Forward P/E Ratio
Now trading at 19x forward earnings, stocks must be extraordinarily rich, right?
Pulling back the chart to 1990, we have graphed the range for forward P/E multiples against the S&P 500 in Exhibit 3. 19x is toward the top of the range, but it is by no means an absolute sell signal.
EXHIBIT 3: 30 Years of S&P 500 Returns vs. Forward P/E Ratio
In fact, Exhibit 4 shows how long it took to reach the beginning of the next bear market from the last four times the S&P 500’s forward P/E breached current levels, as well as the total returns of the index (assuming dividends are reinvested) in between.
EXHIBIT 4: Time to Next Bear Market
| Date | Next Bear Market | Time (years) | % Gain to Next Bear |
| 12/31/91 | 8/31/00 | 8.7 | 312% |
| 6/30/97 | 8/31/00 | 3.2 | 69% |
| 12/31/03 | 10/31/07 | 3.8 | 49% |
| 8/31/17 | ? | 2.4+ | 37% |
Source: Bloomberg, Hamilton Point
Now, you may be a patient soul who does not mind bowing out of the market for several years (or a decade, give or take). You may not be bothered by missing the next 50% up move (or a couple hundred %, give or take). However, if that does not sound like you, then I will attempt to ease your anxiety.
Since you are regularly bombarded with reasons why this market sits in perilous territory, I thought it may be nice to hear the opposite. This is not to say that the markets do not make us squeamish. You can count us as plenty squeamish. Yet, at the same time, we recognize that there are plenty of reasons for 2019’s strong performance and continued bullish backdrop for 2020. Without further ado, here are a few of the reasons – in our view — we find ourselves here:
1. Don’t Fight the Fed – It is an old axiom but still highly relevant to today’s market. I would argue the direction of monetary policy is the most important variable to consider in a developed economy. (Actually, we made the same argument in our December 2019 commentary.) In 2019, U.S. monetary policy shifted from restrictive to accommodative. That is a big deal. Following three rate cuts in 2019, Fed Chairman Jerome Powell further upped the ante and said that inflation would need to persistently run above the Fed’s 2% target before rates went higher. The Fed may shift course again in 2020, but given the coronavirus’s likely drag on global growth, we doubt we will see any rate hikes this year. Moreover, this “hold” is unlike prior ones because the Fed continues to intervene in the repo markets on a daily basis, meaning that banks can access billions in cash from the Fed at low interest rates in exchange for securities like Treasury and Agency bonds. In other words, banks have access to an extremely reliable, low-cost lender. Who would not like that?
2. The Market Loves a Low Volatility Environment – Observe Exhibit 5. Note the large gains attained during periods of calm in the market (as indicated by low levels on the VIX Index – yellow line, left axis). Animal spirits, for both investors and corporate executives, are higher when there is calm in the world. Risk models for fund managers allow them to be more aggressive when volatility is low. Borrowing costs for countries, corporations, and individuals are lower when volatility is low. Right now, volatility is low, and that is a positive for the markets.
EXHIBIT 5: Market Volatility
3. The Threat of a Trade War Has Dissipated – I never really bought into trade war anxiety, but I do recognize that it existed for some. I have always believed that the likelihood of anything substantial materializing from the China trade deal is low. I think it is far more likely that China agrees to buy more soybeans, we lower tariffs on some of their imports and they promise to steal less of our technology. In the end, there is probably low to no compliance with whatever is agreed to, which only further diminishes its importance. All of that said, anyone with business experience would tell you that a full-blown trade war between the world’s two biggest economies would be bad for global growth. Whatever the probability of that outcome was a year ago, it is lower now. The market trades on probabilities, so that is another positive.
4. There Likely Will Be Growth – Monetary policy takes some time to work – historically about 1 to 2 years. Monetary policy did not just get easier in the U.S. last year. Globally, central banks eased to stimulate growth, which means we should see global gains in earnings this year. Ed Yardeni estimates that S&P 500 earnings will grow ~5% each of the next two years. A 19x P/E multiple does not seem lofty when you consider 5% earnings growth and a 10-year Treasury yield below 1.60%.
In conclusion, these are odd times. But we have seen odd times before and they do not always spell disaster. So, keep at it. Stay studious. Watch for changes in global monetary policy, volatility regimes, and global growth. Also, please contact me if you come across any bear market body buzzers.
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