Category Archives: Quarterly

Every Time it Gets Cloudy This Bull Market Finds a Way to Shine Until Tomorrow

2nd Quarter 2019 Letter

Let It BeThe Beatles

And when the night is cloudy there is still a light that shines on me
Shine until tomorrow, let it be
I wake up to the sound of music, Mother Mary comes to me
Speaking words of wisdom, let it be

Let it be, let it be, let it be, yeah, let it be
There will be an answer, let it be
Let it be, let it be, let it be, yeah, let it be
There will be an answer, let it be
Let it be, let it be, let it be, yeah, let it be
Whisper words of wisdom, let it be

Source: LyricFind
Songwriters: John Lennon / Paul McCartney
Let It Be lyrics © Sony/ATV Music Publishing LLC


It’s official. July 1st marked the date of the longest economic expansion in U.S. history. As the Beatles sang in their iconic anthem, “Let It Be,” every time the night gets cloudy for this bull market there is still a light that manages to shine through. Will this record-setting expansion shine until tomorrow?  Should you just sit by patiently and let it be?  These are questions that have been vexing economists and financial advisors for quite some time, so let’s try to bring some clarity.

Yes, the U.S. economy is in the midst of its longest expansion on record—121 months and counting–but some other milestones are being surpassed that could change the dynamic of this market. Take interest rates. As mentioned in my letter to you last quarter, the U.S. yield curve has inverted for the first time since 2007. True, the curve initially corrected itself after inverting earlier this year, but it quickly inverted again and has remained that way for over 30 days. Again, an inverted yield curve means investors are being paid more for holding very short term debt than they are for holding long-term debt. It’s counter-intuitive and usually means investors are very nervous about the future.

Longest Economic Expansion Since WWII.

Another eye-catching statistic is that the performance spread between growth stocks and value stocks is at its fourth highest level in a century.

As BlackRock’s Andrew Angle noted, “The value drawdown that started at the beginning of 2017 is one of the worst investors have faced.” 

Yield curve update and global interest rates

As mentioned in last quarter’s letter, the yield curve inversion is not a timing mechanism, since the market historically performs pretty well another 12 to 18 months post-inversion. We also saw yields on the 10-year Treasury bond break below 2 percent in Q2 of this year—a time when $12 trillion of international bonds are trading at negative interest rates in the midst of a global move downward. That could be a massive amount of money essentially being parked in shoeboxes under investors’ beds!

Source : Torsten Sløk, Ph.D.Chief Economist Managing Director Deutsche Bank Securities

Everyone is talking about the end of the long-running bull market in U.S. equities, but in the second quarter of 2019, the most crowded trade in the world became U.S. Treasuries. Even though rates are abnormally low, the Fed Funds futures market is now signaling a 100 percent chance that the central bank coule ease its monetary policy next month. Incredible!

Here are some excerpts of the notes coming across my radar recently:

For the first time ever, being long US Treasuries was considered the most-crowded trade according to the June global fund manager survey conducted by Bank of America Merrill Lynch.

The bet on government bonds beat out popular crowded trades such as tech, high-quality and emerging markets, each of which has occupied the list’s top spot since 2013.

The study was released Tuesday during a week in which traders were watching multiple events that could set the course for global growth going forward: the Federal Reserve meeting Wednesday, and the G20 summit later in the month.

Historically, when equity bull markets end money pours almost exclusively into stocks. But today, we have seen government bonds beat tech stocks as the most crowed trade in the market and bond ETF assets have doubled over the past year alone.  I don’t know anyone who is bulled up on stocks–, it’s the single biggest anomaly I have witnessed in my 20-plus year career in finance. As mentioned in previous letters, the Great Recession of 2008-09 caused the massive equities risk hangover we haven’t seen since the Great Depression of 1929.

Bond ETFs double assets in one year

As shown above, bond ETFs are booming. According to Dave Lutz (Jones Trading), essentially every category has recorded double-digit growth in average weekly volumes between last year and 2019.

With the inverted yield curve being in place as the first serious sign of a recession in the near future, could the American investing public be right?  After hundreds of years of market flows proving the American public and professional investors as horrific market timers, could this time be different?

As I discussed in my Q1 letter, it’s important to be sure that an inverted yield curve is not just a temporary anomaly:

“First, it’s important to remember that not everyone uses the same definition of ’inversion.’ Like the San Francisco Fed, I consider an inversion to be a situation in which the yield on 3-month Treasuries is higher than the yield on 10-year Treasuries. According to the Cleveland Fed, inversions of that 3-month/10-year spread have preceded each of the past seven recessions, including the 2007-2009 contraction. The Cleveland Fed acknowledged there have been two ‘false positives’ — an inversion in late 1966 and a ’very flat’ curve in late 1998.

First crack in the bull market, but don’t get fooled again

Refer to last quarter’s letter for details about historical returns post-yield curve inversion. Again, the important piece of new data this quarter is that the inverted yield curve has remained inverted—it’s not a temporary blip.

Why aren’t oil prices spiking—another key recession indicator?

Most finance textbooks and market historians argue that recessions are caused by the Fed raising rates and/or oil prices spiking. As Moody’s chief economist Mark Zandi told CNBC, “Quickly rising oil prices have been a contributing factor to every recession since World War II.”   

The first 17 years of my finance career were spent on a trading desk. If you ever had a situation in which Iran attacked oil tankers in the Strait of Hormuz and shot down a U.S. military drone in the same month, you can bet your butt that oil prices would skyrocket!  But today it’s different. Sure, Iran’s recent actions put us on the brink of a hostile U.S. military response, but the price of oil barely budged. Further, the oil volatility index was rolling over just a few days later. Which is hard to believe!

It’s almost unthinkable that President Trump was within hours of a military response against Iran and oil only moved 2 percent higher. But the next several charts help explain why:  

Crude oil production exploded after the 2008 Great Recession

Ed Yardeni


As domestic oil supply expanded to the point that the U.S. become a net oil exporter, our reliance on Persian Gulf crude evaporated. In late June, President Trump said the U.S. may lessen its role in the Strait of Hormuz as domestic oil and gas output grows and our energy imports from the Middle East decline.
Combine massive oil supply and demand changes with climate change and shifting attitudes toward clean energy technology and you have an impetus for massive economic transformation in the Middle East. United States imports of Persian Gulf crude are down by nearly 70 percent over the 10 years. As a result, a number of Middle Eastern countries will need to adjust their economies substantially.

4 major themes dominating global markets

Theme 1-passive management fund flows continue to crush active management

So far this year, about $39 billion has shifted into passive funds and $90 billion has shifted out of active funds. Many think that 80 percent of the market is now on autopilot. Passive investments control about 60 percent of equity assets, while quantitative funds — those relying on trend-following models instead of on fundamental research — now account for 20 percent of market share, according to estimates from J.P. Morgan.

“The pace of outflows from active is at a cycle high while the pace of passive equity inflows has bottomed and [is] beginning to reaccelerate,” Dubravko Lakos-Bujas, J.P. Morgan’s chief U.S. equity strategist, said in a note on late in June.

Theme 2-Large -cap growth stocks and S&P 500 stocks continues to dominate performance

In past letters I have talked about the widening spread in performance and valuations between large cap U.S. stocks and international markets. Large cap growth stocks now trade at close to 9x price to book (P/B) value compared to 1.5x P/B for emerging market stocks and 2.5x P/B for developed market stocks. 

The entire outperformance of emerging market stocks since 2003 has been erased

This might explain why the sell-off at the end of last year functioned as a correction to drawn-out U.S. outperformance, while this latest moment has seen emerging markets lag behind the S&P 500 even more. At this point, all the outperformance by emerging markets since 2003 has been canceled out – an extraordinary statistic given the speed of growth in much of the emerging world. 

(placeholder Vanguard growth vs. EEM emerging markets 5 year)

Theme 3 -Growth investing is crushing value investing

  1. S&P growth stock vs. value stock rallies above 1999 record spread
  2. I started my trading career in 1997 in the early innings of the Internet bubble. I never thought we would witness such a large spread between growth and value stocks again. I was wrong. Not only are we seeing a spread of historical proportions – but we are hearing many of the same themes that we heard in 1999. Twenty years ago, Goldman Sachs published an ill-timed piece about the death of value stocks and a Forbes article suggested for Warren Buffett should call it quits after 10 years of under-performance.

On December 7th, 1999, Barron’s published the infamous “What’s Wrong,Warren” cover eerily before the Nasdaq crashed 50% and Berkshire recovered years’ worth of underperformance.

The below graph plots the time period 6/30/98 through 2/29/00 for the Nasdaq where many dot-com and technology stocks traded, and the price of Berkshire Hathaway, Warren Buffett’s holding company, which consisted of value stocks:

S&P 500 Growth vs Value gets over the 2000 peak, twits notes.

S&P 500 Growth vs Value gets over the 2000 peak, twits note

20 years later “The Big Guy” is back on the cover of Barron’s as “CEO of the Year.”

Take a minute to review the chart below. How many Millennials are familiar with this chart? In my experience, Amazon means just two things to them–(1) that’s where they order almost everything in their lives and (2) the stock only goes up. 

1999-2000 Nasdaq and Amazon chart.

Theme 4-Demographics is destiny

Speaking of Millennials, we tend to be passionate believers in the power of demographic trends.  Consider these facts:

  • By the year 2020, eight of the top ten demographic cohorts will be under age 40 (Boomers will be fading away).
  • By the year 2030 the top 11 cohorts will be the youngest 11 cohorts.

There will be plenty of “gray hairs” walking around in 2020 and 2030, but the key for the economy is that the number of Americans in their prime working years is now increasing. If nothing else, this should be a positive trend for housing and the economy.

U.S. Demographics: Largest 5-year cohorts, and Ten most Common Ages in 2018

by Calculated Risk on 6/11/2019 11:59:00 AM


As shown above, the U.S. has the largest demographic group in history hitting its prime spending years. That makes me believe the next recession–like all previous economic slowdowns–will present great buying opportunity for stock investors. But make no mistake – I believe we will have a recession before reaping the full benefits of Millennial spending power.  If you doubt this macro trend, just scan some of the charts about student loan growth and urban apartment expansion. The “pig through the python” is coming and it may have a profound impact on our economy over the next two decades. There will be more on this trend in a future letter focused on demographics.

Beyond U.S. demographics, we have global population projections predicting the rise of Africa as Asian hyper-growth rolls over.

Future Population Growth.


After being historically bullish about stock pullbacks–including hosting a webinar at the beginning of this year [LINK] that the end of 2018 was a buying opportunity, not the start of recession, I believe we are now in a more precarious situation. The inverted yield curve should not be ignored, and our economy appears to be running out of qualified workers as the jobless rate settles below 4 percent. Amazingly we have not experienced inflation despite such a historically low unemployment rate, so the stock market continues to rise.

Sure, stocks are on the pricey side, but I don’t believe it means the market is on the brink of crashing. I wouldn’t consider this to be a bubble when you consider how low interest rates and low inflation are. Now is not the time to give up on a diversified portfolio. The S&P is expensive versus other options and we should temper our expectations for equity returns over the next half decade as stocks will likely face new headwinds.

Final thoughts: Prepare for the years ahead

I’d like to reiterate the advice from my Q1 letter:

• Stick to your plan. Investing is a psychology game, not an IQ game. Do not get emotional, have a plan.

• Prepare for lower but acceptable returns.

• Mentally prepare for a recession size drawdown in equities, possibly 30-40%

• Get aggressive when stocks are on sale.

• Ignore the headlines and doomsayers.

 • Ignore politics as elections approach.

• Don’t leverage up now. Opportunities will likely present themselves in the near future to use your debt/margin in a more efficient manner.

First Crack in the Bull Market, but Don’t Get Fooled Again

First Quarter 2019

“Won’t Get Fooled Again”

I’ll tip my hat to the new constitution
Take a bow for the new revolution
And smile and grin at the change all around
Pick up my guitar and play just like yesterday
Then I’ll get on my knees and pray
We don’t get fooled again, don’t get fooled again, no no no no
Meet the new boss
Same as the old boss

Songwriters: Pete Townsend
Produced by: The Who

Key Takeaways

Don’t get fooled again by rising interest rates doomsayers.

  • The yield curve just inverted for the first time since 2007—short term rates are now higher than long term rates.
  • There’s typically a 17-month lag between a yield curve inversion and the start of a recession.
  • The curve did not stay inverted very long further confusing outcomes.
  • Markets tend to perform well during the post-inversion lag period–but stocks eventually draw down when the economy contracts.
  • Stick to your plan. Ignore the media. Buy when things are cheap and take lower but acceptable returns.

 The Yield Curve Inverts

In 2007, I was in China and purchased a statue of a bull for my home office. The statue arrived via FedEx with a crack down the middle. Little did I know that crack would be an eerie warning of the 2008-09 financial crisis—the most punishing global recession we had seen since 1929?   I’m not superstitious, but a more traditional recession indicator flashed negative soon after my damaged shipment arrive from the Far East–the yield curve had “inverted.” In other words, rates on long-term (10-year) Treasury bonds were actually paying investors less than short-term (3-month) notes were. As we’ll see in a minute, this phenomenon has happened at least five other times over the past 40 years, and each time a recession has followed.

A similar inversion just occurred at the end of March 2019 while U.S. stock markets had rebounded nearly 20-percent from a recent bottom and the bond markets were on a win streak as well. Does that mean another recession is looming? Quite likely it is, but there are some important caveats to consider in terms of timing, severity and what you should do with your portfolio. The markets like life are never easy.

First, it’s important to remember that not everyone uses the same definition of “inversion.” Like the San Francisco Fed, I consider it to be when the yield on 3-month Treasuries is higher than the yield on 10-year Treasuries. According to the Cleveland Fed, inversions of that 3-month/10-year spread have preceded each of the past seven recessions, including the 2007-2009 contraction. The Cleveland Fed acknowledged there have been two false positives — an inversion in late 1966 and a “very flat” curve in late 1998.

What does the yield curve really mean?

The 10-year rate is set by market supply and demand as investors determine the equilibrium point of where that 10-year rate should be. But, the 3-month rate is set not by market forces, but by policymakers at the Fed. As the old saying goes, when investors are scared, they run to the 10-year and when the Fed is scared it raises short-term interest rates. These two forces collide to invert the curve. As a result, when short-term rates are higher than longer term rates, investors are indicating that they’re cautious about the future of the economy and they don’t want to tie up their money.

Yield Curve is Not a Timing Mechanism

The problem with using the yield curve blindly as a recession indicator is that there is historically a lag of 10 to 24 months between when the yield curve inverts and when the economy limps into a recession (see below). More importantly, you don’t want to head for the hills immediately because markets tend to perform very well during that initial post-inversion lag period to the tune of PLUS 15 percent on average (see subsequent chart).  Here are the start dates for the five previous inverted yield curves along with the beginning of the ensuing recessions:

Source: Ben Carlson, A Wealth of Common Sense

As you can see, there has been a substantial lag from the time of the inversion until the start of the recession in each of these instances. The average number of months was 17, meaning it took about a year and a half for the economic slowdown to hit after the yield curve inverted. Again, history shows that markets tend to perform very well in the initial year or two following an inversion.

Source: Ben Carlson, A Wealth of Common Sense

As mentioned earlier, the average return during these lag periods was a gain of more than 15 percent. There was just one downturn which occurred after the dot-com bust in the early 2000s. Although the stock market doesn’t need to see a recession for a large correction, it’s a safe bet that an economic contraction will lead to a draw-down in stocks.

What does it All Mean?

I know what you’re thinking: “Thanks Matt. You just hit me with a bunch of financial gibberish that I don’t understand and have thrown out some conflicting signals.” I’ll make it easy: It appears we have our first serious recession signal in over a decade, so we should take this indicator seriously. However, the other Fortis recession signals are not yet flashing red:

  1. Wage growth is still below 4 percent.
  2. Inflation is not accelerating.
  3. Initial jobless claims are not rising, and
  4. Inventories are up, but not at recession levels.
  5. Bonus factor- the yield curve only stayed inverted for a couple days.

Our 4th Quarter Letter encouraged investors to be aggressive and take advantage of the near 20 percent correction in the markets. Over that time, as U.S. market valuations pulled back to median levels, we said the probability of a significant rally following a bad quarter would be quite high (see below grid). We followed that Q4 letter with our first webinar for investors that discussed in greater length the opportunity at hand. As most of you know, the first three months of 2019 ended up being the best quarterly return for the Dow and S&P 500 in a decade.

Source: Ben Carlson, A Wealth of Common Sense

Looking Ahead?

While we can’t avoid a recession forever, we’re not likely to endure a downturn as punishing as we had in 2008. Bank balance sheets are in rock solid shape. American citizens have been cutting debt aggressively, resulting in stronger personal balance sheets than we’ve seen in many years. But we have to be disciplined, because the probability of a cyclical recession is rising and there is a strong likelihood of lower portfolio returns after a decade of euphoria.

At this point, employment numbers can’t get much better–we have more jobs available in the U.S. than eligible unemployed citizens. As is usually the case with markets, unemployment numbers are counter-intuitive: The time to invest is when unemployment is high. When unemployment is high, stock valuations are usually low and no one is buying equities. As Warren Buffet always says: “Stocks are the only thing people don’t buy when they are on sale.”

Interest Rates

I am sure you thought this Quarterly Letter’s theme (“Don’t Get Fooled Again,”) would be a warning about the next 2008.  It’s actually about the probability of interest rates going higher. One of the reasons the yield curve inverted is because the Fed was raising short-term rates at a time when the rates on longer term 10-year Treasuries were falling. As I mentioned earlier, short term rates are driven by Fed policymakers, while long-term rate are driven by market forces.

The chart below shows that estimates for rates under “preferred conditions” have dropped from 3.5 percent in 2018 to 2.5 percent in 2019. Further, there is ample speculation about a rate cut in 2019.

Historical S&P Returns when Unemployment Low

Estimate of Fed Policy Going Forward


Think of Fed Fund Futures as a Betting Line

The line has now moved heavy in favor of a rate cut in 2019.

Global Bond Yields Slide to Fresh Lows Following ECB Comments

As the Wall Street Journal recently reported, yields have slipped as central banks have signaled they are willing to hold rates low for significantly longer than expected.

For 25 years, economists have been predicting doom due to rising interest rates. Here we are again with mortgage rates near historical lows. I am already trying to teach my kids that betting on sports is a loser’s game, but an even biggest loser’s game is making bets with your money based on expert predictions about interest rates. “Don’t get fooled again.

Since 1992, Economists Have Predicted Higher Interest Rates.  How did that work out?


Source:  Blackrock

If you do not believe me, here are Warren Buffet’s comments from his latest Berkshire Hathaway shareholder letter???


Equity investors have enjoyed a historic run over the past decade, and now it appears we have our first serious signal of a downturn.  Again, the inverted yield curve is not a timing mechanism, nor is it a 100-percent reliable recession indicator. We also have a de-levered banking system and a de-levered high-net-worth population in the U.S.

America’s wealthiest households are stashing their cash at record levels. The top 1-percent of households now have three times more money in readily available cash than the bottom 50-percent holds! The 1-percenters have about 20-times more in cash today ($304 billion) than they did before the last recession ($15 billion) according to Federal Reserve data released last week.

 We are blessed to live during a dynamic time in U.S. history. Bull markets are getting longer and bear markets are getting shorter. Most of us endured a once-in-a-lifetime recession in 2008, but came out with a record setting bull market run. When the the next recession arrives, it will most likely follow the same path as shown in the chart below.

For investors who are net savers, over the next decade, you should welcome the recession as an opportunity to buy stocks on sale. I am a firm believer in Warren Buffett’s American Tailwind theory: “Over the next 77 years, however, the major source of our gains will almost certainly be provided by The American Tailwind.  We are lucky-gloriously lucky-to have that force at our back,” quipped Buffet.

History of U.S. Bear & Bull Markets Since 1926

Final thoughts: Prepare for the years ahead

  • Stick to your plan. Investing is a psychology game, not an IQ game. Do not get emotional and have a plan.
  • Prepare for lower but acceptable returns.
  • Mentally prepare for a recession size drawdown in equities 30-40%
  • Get aggressive when stocks are on sale
  • Ignore the headlines and doomsayers.
  • Ignore politics as elections approach.
  • Don’t lever up now. Opportunities will present themselves in the near future to use your debt/margin in a more efficient manner.

As Springsteen Takes Off on Broadway, Investors Got Blinded By the Light

4th Quarter, 2018

 “She Got Down But She Never Got Tight She’s Gonna Make It Through the Night”

 Blinded by the Light

Blinded by the light
Revved up like a deuce
Another runner in the night

She got down but she never got tight
She’s gonna make it through the night


Songwriters: Bruce Springsteen

Blinded by the Light lyrics © Downtown Music Publishing

Springsteen’s off-Broadway

I recently watched Springsteen’s fabulous Broadway performance on Netflix, having seen The Boss over 20 times myself, it still was unreal to hear him tell personal stories around growing up and his career.  As I watched one of the most volatile stock market year ends in history, I couldn’t help but apply investors psyche to a Springsteen song.  Most investors got Blinded by the Light, it was just too easy, buy FANG stocks, buy S&P index, buy anything.  After 2017 being one of the least volatile years in market history including no drawdown of S&P over 3% versus historical annual average drawdown of 14%, the market sent a giant wake-up call that investing is always emotional including an all-time record almost 3% Christmas Eve smack down.  Here’s the good news, it seems she (market) is going to make it through the night as she always does, it’s not 2008 or anything close, we have some wood to chop in the short-term but valuations are reverting to mean.

2018 was a historic year for financial markets in more ways than one-first time in 27 years that stocks and bonds were both negative in the same year, worse stock market December since 1931, over 90% of investable assets were negative in 2018, and no asset class returned over 5% for the first time since 1974.

A Record Share of Asset Classes Posted a Negative Return in 2018

Investors felt pain this year across the board as diversified portfolios were nowhere to hide, in fact some well diversified holdings returned less than the S&P due to exposure to bonds, commodities, international stocks and U.S. small cap stocks.  Three of these groups were down more than the S&P and most bonds were flat to negative.  The tradtional 60/40 model was negative for the year with returns coming in 13% below historic median, if you’re 60/40 was global returns were even lower.  Target Date funds are popular and growing especially in 401k plans, see below as they are posting first negative returns in 10 years.

Diversified Portfolios Big Red Year – Target Dates Down for First Time in Ten Years

In my first quarter 2018 letter I wrote at length about tech facing its Machevellian moment in the next 12 months, mentioning that a small cadre of tech stocks were responsible for most of the markets gains which is unsustainable.   But the bigger problem was the market was due for sector rotation especially since traditional defensive sectors of market hit record low capatalization in the S&P even lower than 1999 or 2008.  This sector rotation back to defensive certainly started in the 4th quarter now the question becomes how long will it last?

Click here for first quarter letter

As popular stocks and sectors started to crumble, retail investors as in the past started to get emotional, including pulling a calendar-month record  $98 billion from U.S. based stock funds in December.  In fact it was almost double the previoius record of $48.8 billion in October of 2008.  As anyone who has read my thoughts in the past knows, investors are terrible market timers.

Investors usually sell in market panic downturns and buy when they are blinded by the light of euporia.  But as you can see from the chart below, selling during bad quarters can cost you, buying during bad quarter has proven profitable on 1yr, 3yr and 5 year periods.

The good news is that markets will most likely, like Springsteen says, “make it thru the night.”  Banks balance sheets are in good shape as are household balance sheets, the debt overhang this time around is corporate debt and private lending, not enough to spark another 2008.  This could leave us looking at a bear market without a recession or a cyclical bear market within a longer-term secular bull.  The good news on these two scenarios is that the pain will be short-lived.  For anyone who is a net saver for the next 5-10 years or more, buying opportunities will present themselves as some are already coming to fruition.

See chart below the length of bull markets versus bear markets, especially some of the shorter corrections or cyclical bears.

History of U.S. Bear and Bull Markets Since 1926

How about returns for the market after bad quarters and months like December?  The market actually has impressive returns on a 1 year, 3 year and 5year basis after a 4th quarter like 2018.  If you strip out the American depression years, last quarter was the top 10 worse quarter in stock market history.  So we should run for the hills right, contrary to the natural emotional response, instead we should channel our inner Warren Buffet and stay to a disciplined system for the long-term.

The good news about market sell off is that valuations naturally come down, as you can see in the following chart, S&P price to earnings ratios have pulled back to the mean.  Even though investors and the media love to talk in terms of the S&P, diversified portfolio holders invest internationally, across market caps in U.S., in commodities and real estate.  The even better news is some of these non-S&P asset classes are trading at 25 year lows.  Value stocks are at record discounts to growth stocks in the U.S., International stocks are trading at half the fundamental valuation measures of U.S. growth stocks and commodities are at a 25 year low valuation to the S&P.  The idea that all asset classes are expensive after this 10 year bull market is fake news.

S&P Valuations Trading Below 25 Year Average P/E

Valuation Grid

Value Stocks and International Stocks Trading at Discount to U.S. Growth Stocks.

Global Valuations as of 12/17/18


Diversified portfolios generally work well over the long-term but they are sometimes painful to hold in the short-run.  The last 10 years have been an S&P dominated investment environment, this has left some asset classes behind resulting in cheap valuations.  Investors that are net savers for the next 10 years now have an opportunity to invest more aggressively at more attractive valuations.  As one of our earlier charts indicated most investors are selling, historically this has been the best time to buy and post bad quarters data also puts probabilities in your favor for a 3-5 year horizon.

Investors should expect more volatility in the first quarter as company earnings hit the tape and the market decides whether this is a correction of something bigger.  Valuations in many asset classes have already priced in something bigger but as the song goes “she will make it through the night.”  As I like to remind readers in most letters, the S&P 500 has experienced twelve 20% corrections in the last 70 years and it’s returned 15,000%.  I believe investing is a psychology game not an IQ game, I suggest you keep your emotions in check and stick to your plan.

3rd Quarter 2018 “Looking for Bubbles in all the Wrong Places”

Looking for Bubbles in all the Wrong Places

Eleanor Rigby – The Beatles

“All the lonely people
Where do they all come from?
All the lonely people
Where do they all belong?
Ah look at all the lonely people
Ah look…”

Liquor, ladies and leverage for the retail investor

Legendary investor Warren Buffet likes to say there are three ways to go broke: Liquor, ladies and leverage. “It is crazy in my view to borrow money on securities,” he told CNBC earlier this year. “It’s insane to risk what you have and need for something you don’t really need.”

After a 10 year bull market in equities, private equity (PE) is now looking for all the “lonely people” who haven’t yet joined the alternative investment party. U.S. equities certainly aren’t cheap today, but there are other areas of the economy and investment world that are closer to bubble territory. In its insatiable hunger for more investors, PE is now pitching average retail investors—The Joe Sixpacks—as aggressively as lending companies served up zero down, no doc mortgages to the masses on the eve of the global financial crisis a decade ago. We all know how that story turned out.

Wall Street wants to help out average investors by offering them access to private investments

In a recent Wall Street Journal interview, Securities and Exchange Commission Chairman Jay Clayton, said the SEC wanted to make it easier for individuals to invest in private companies, including some of the world’s hottest startups. These “opportunities” were once reserved for institutional investors and ultra-high-net-worth individuals.

Wall Street wants to help out Mom and Pop investors by offering access to private investments

Dear Average Investor, Run like hell!

Matt Topley

Needless to say that even if the rules overhaul goes through, Joe Six Pack will not be offered the same type of private equity fund or venture capital fund that the Harvard Endowment is offered. I’ll also go out on a limb here and say these offerings may be a little too complicated for most investors to understand. Trust me. I’ve been working in the investment world for over 20 years and I still struggle to grasp the fees and valuations methods of the private world.

This latest development could well signal the top of the current private investment boom in the U.S. There are now 2,700 private market managers in business today, up from number of 502 less than 20 years ago. (Source: Preqin)This reminds me of the boom in hedge funds in the 1990s which saw the market grow to 12,000 managers from 500 in a short span of time. Not surprisingly, alpha disappeared as too many managers were chasing the same ideas. The same scenario could likely play out in the private world today.

As you can see in the chart below, hedge funds generated a lot of alpha during the 1990s when there were relatively few players in the market. But after 2000, the number of new hedge funds exploded and returns predictably went south.

Is private equity getting too big?

According to Cambridge group, PE returns have lagged the Russell 2000 by 1 percent and the S&P 500 by 1.5 percent for the past five years. In 2015, eight executives at the four publicly traded private equity firms (BX, KKR, CG and APO) made a collective $1.9 billion while shareholders in those same private equity firms lost a collective $13.7 billion.

Institutions are adding $200 billion per year to private investments, thus leaving private equity with $1 trillion in excess cash to spend. At, the end of the day, there are simply not enough deals at reasonable valuations to satisfy demand. It reminds me of 2008-09 when institutions piled into hedge funds just as their alpha generation was disappearing.

But, PE funds are not paid to hold cash. They need to pay high valuations with a big bet on future growth. Another big issue is that PE deals are debt dependent. The average PE deal is 65 percent debt-financed in addition to having an opaque valuation system.

How will a bear market in bonds affect private offerings?

As Daniel Rasmussen explained in American Affairs Magazine, PE firms typically double the debt on their balance sheets from 2.5-times EBITA to 5-times EBITA so they are significantly more levered than a typical public company. Rasmussen said studies from the Canadian Pension Plan Investment Board (CPPIB) and the Abu Dhabi Investment Authority (ADIA) found the average ratio of net debt to enterprise value at inception is around 65 percent. By contrast, the typical Russell 2000 small cap stock is levered at about 16 percent and the typical Russell 2000 large cap stock is levered at about 18 percent.

From where I sit, it seems we may finally be entering a rising rate environment as the 10 year U.S. treasury yield breaks out from a 30 year downtrend. If a bond bear market is underway, highly leveraged companies (particularly small companies with volatile cash flow) will be weighed down by the cost of debt. Also, high investment activity in the private world is driven by easy access to credit—something that may be getting harder for PE managers to get in the future.

On top of that, middle market growth companies, previously the most lucrative segment of the private equity world, are seeing the most competition as big PE firms move downstream in search of returns and as family offices increasingly bypass funds so they can invest directly in companies.

This trend has lowered estimates of future returns with longer holding periods.  Investors with recent vintage years now may be held up longer than the average American marriage lasts. Compare that to small cap value funds that often generate higher returns and can be redeemed within one day while costing only 25 basis points.

Two things may happening if we are truly entering a bear market in bonds:

  1. Investors that previously took on more risk in search of higher returns may now be content to park their money in tax fee municipal bonds paying at 5 percent interest, and
  2. Companies that rely on leverage will see their valuations sink.

The real leverage is private lending. 

 The Rise of Private Assets Is Built on a Mountain of New Debt

Credit businesses have helped drive the private-equity industry’s expansion, but things could get awkward when companies hit trouble. As Paul Davies explained in The Wall Street Journal: “In the world of private deal making, the biggest borrower in town is becoming one of the biggest lenders too. With so much money chasing buyout opportunities, big and risky deals seem the likely outcome.”

Davies also said that in recent years, private-equity firms have increasingly got into lending to buyouts, too—often lending to their own deals. As a result, their credit businesses are “adding to the huge growth in specialist private debt funds and retail money that has taken place in loan markets since the crisis. The flood of money into credit has driven down borrowing costs and cleared out traditional lender protections known as covenants on many loans.”

According to Pensions & Investments (P&I) Magazine, total commitments in 2017 to private lending were 617 percent higher than the $4 billion tracked by P&I in 2010.

Private credit funds now run three times as much money as they did in 2007. Although default rates are low, interest rates have been benign. On top of that, we know that most lenders will keep playing until the music stops. It appears the discipline in lending standards has broken down as “covenant lite” leveraged loans hit another record.



A private equity market, already bloated with record inflows, is now being offered to the general American public at a time when interest rates are moving higher and the investing discipline is breaking down. When you see a 600 percent increase in money flows, loan covenants disappearing and valuations hitting record levels, PE is not what the average retail investor needs in his or her 401(k) plan.

I have nothing against private equity. Many PE many firms have admirable track records and private equity is also an awesome space to drive the economy as capital flows to small business. But, everything runs in cycles. Money tends to flow to where it’s treated best–until the music stops. Now is a great time to be a seller to private equity, but I wouldn’t include PE in your 401(k) plan. 

Instead, wait until the headlines trumpet the death of private equity. As Warren Buffet likes to say: “Buy when there is blood in the streets,” not when it’s raining covenant lite loans and 14x EBITA buyouts. For all the lonely people who feel left out of cool private investments, save yourself a lot of money and stress: Go buy a small cap value fund at 25 basis points. You’ll sleep a lot better and have more in your pocket. 

Eleanor Rigby – The Beatles

“All the lonely people
Where do they all come from?
All the lonely people
Where do they all belong?
Ah look at all the lonely people
Ah look…”