To Our Clients and Friends of Parthenon LLC
“Prediction is very difficult, especially if it’s about the future.”
~Neils Bohr, Nobel Physicist
The economic expansion that began in 2009 moved into historic and uncharted territory as it exceeded 10 years. The stock market rally roared along and is now the longest bull market in history. Neils Bohr was right, and we are hesitant to take issue with one of the most preeminent physicists of the 20th Century. Nevertheless, if asked when the market run will end, we venture way out on a limb and make a daring prediction – we say “yes.” Undoubtedly, there will be another recession and another market decline – someday. A 10-year economic expansion can grow to 11, 12, or longer. There is no immutable economic law that prevents it. An 11-year bull market, though already the longest in history, can go on longer, perhaps much longer. The end of this economic expansion has been predicted nearly since its inception, and a crowd of financial soothsayers have said, every year, that the stock market is doomed to fall “next year.” We will not risk adding another erroneous prediction to that long list. While we believe the economy and the market are closer to the end than the beginning of the upswing, that “bold” declaration leaves of lot of wiggle room.
The S&P 500, including dividends, returned 31.5% in 2019, the strongest equity results since 2013. It was only the second year with a total return over 30% since 1997. We have grown more cautious and wary as the market has risen. But consider this fact: the last three years the S&P 500 was up over 30%, the market jumped more than 10% the following year. What goes up may have to go down – but perhaps not immediately. Bond yields remained low, with the 10-year Treasury bond yield ending the year at 1.92%, down from 2.68% last year. We will present a more detailed discussion on the bond market and yields later in this letter.
In last year’s letter, we discussed our “balance sheet” on the market and the economy, which included a short list of some of the most important economic and stock variables. It was our assessment of the stock market’s “assets and liabilities.” At least one item, current valuation, has obviously changed dramatically. In our opinion, this metric has shifted from an asset to a liability. We felt that equity valuations were a positive coming into 2019, and as such considered it an “asset” for investors. After the robust market advance, which was well-above even our most optimistic estimate of underlying business value growth, we think valuation has shifted to at least a moderate liability. To be clear, this is not 1999, when valuations were historically and dangerously high for much of the S&P 500. Using consensus earnings estimates for 2020 S&P 500 earnings, the market’s price to earnings ratio is about 10% to 15% above historical averages. Low bond yields provide some logical justification for above average equity valuations. Nevertheless, the market has significantly less margin for error (economic, policy, geopolitical or otherwise). We have dialed down our expectations meaningfully, and are planning accordingly.
Readers of past letters may wonder why we seem to have a love/hate relationship with an exuberant, robust stock market. We enjoy, as much as the next investor, seeing our stocks move higher as value is recognized and rewarded. A strong rally out of a very depressed market (such as 2009) is enjoyable with very few caveats, as stocks recover from extreme undervaluation. However, a rally as strong as 2019, in a market that began only moderately undervalued, is more problematic for inherently risk-averse value investors like us. Not only does it become much more challenging to find attractive and promising investment opportunities, preservation of capital moves more to the forefront of our thoughts and strategic planning. The need to be positioned appropriately to withstand a sustained market decline is a permanent goal we have for all our portfolios, and that goal is of even greater importance now.
“The question that he frames in all but words is what to make of a diminished thing.” ~Robert Frost, The Oven Bird
One should not underestimate the contribution made to the strong equity performance by the extremely low cost of capital. In fact, as shown in the table below, interest rates have trended downward, with only brief disruptions, for the last 38 years.
Historic US Treasury Interest Rates
|Maturity||9/30/1981 12/31/1989 12/31/1999 12/31/2009||12/31/2019|
|2-Year||12.14% 7.84% 6.21% 1.14%||1.57%|
|5-Year||16.27 7.83 6.34 2.68||1.69|
|10-Year||15.84 7.94 6.44 3.84||1.92|
|30-Year||15.19 7.98 6.48 4.64||2.39|
In the early 1980s, some highly regarded economists were predicting that long-term interest rates would move into the 20-30% range. What would they have predicted if they had known that annual budget deficits would explode to around a trillion dollars a few decades later? Our personal observation is that the consensus forecast for future interest rate levels is every bit as bad, if not worse, than equity return predictions. The bulk of the dramatic drop from near 16% on the 10-year Treasury rate to under 2% can be attributed to a decline in inflation from double digit levels in the late 1970s and early 1980s to an average level below 2% in the last decade. However, in recent years, interest rates have been driven lower by aggressive intervention by central banks throughout the world to stimulate their economies. As a result, US Treasury investors are now receiving a pretax return on a 10-year security about equal to the current inflation rate.
At least rates are still positive in this country. Negative interest rates are common in Japan and many European countries as a result of weak economies and financial stimulation by central banks. At its peak, the worldwide amount of negative yielding securities exceeded $17 trillion and included some corporate bonds as well as government bond issues. The amount of negative yielding bonds had declined to about $11 trillion by year end. Surprisingly, some investors are paying to have a borrower use their money. For example, the cost to buy a $100,000 par 0% coupon German 10-year bond was recently about $103,000, for an effective yield of -0.30%. Thus, buy and hold investors would pay $103,000, receive no interest payments, and then at the end of ten years get $100,000 back. If the German 10-year yield fell to -0.50% shortly after the purchase, the investor could then sell the bond for around $105,000 for a nice, quick profit. However, if the rate spiked to 1.00%, the $100,000 bond would be worth less than $91,000. We are not looking to be participants in this game.
Given the current interest rate environment, we anticipate quite modest returns on average for fixed income for the next several years. However, fixed income will continue to be an important component in risk management and income generation in portfolios. We will continue to buy high quality fixed income securities specific to each client’s situation in an effort to maximize after-tax returns.
“Life can only be understood backwards; but it must be lived forwards.”
Although these are the words of an existentialist philosopher, they also encapsulate our conundrum as investors. In our investing careers, we have seen a variety of market conditions. Irrational exuberance and unbridled pessimism. Unwarranted skittishness and unchecked confidence. Although the current environment doesn’t seem to squarely fit in any of these categories, another year has passed, this time with strong equity returns and low interest rates. We are reminded that what really matters is how we move forward – despite the emotionality of the market.
Ironically, one of the best ways to move forward is to look back – not necessarily at history (although it is certainly important) – but at principles. Legendary investors such as Benjamin Graham and Warren Buffett have proven that sticking to a disciplined investment philosophy over long periods of time and despite market conditions reaps rewards. As Parthenon celebrates more than 20 years in 2020, we start the year looking for the same kind of investments that we have used to build portfolios over our history: companies that we believe have the best prospects for the long term, with financial characteristics such as high returns on capital, excess cash flow, and balance sheet strength. With the uncertainty that the coming year holds, it is comforting to be able to “live forward” on the certainty of our principles.