Hind Sight is Twenty Nineteen

Published at Dec 28, 2019, 12:00 AM in finance by Buğra Bakan

*“You are in pretty good shape for the shape you are in.” Dr. Seuss

“It isn’t the mountains ahead to climb that wear you out, it is the pebble in our shoe.” Muhammad Ali*

In this last newsletter of the year, I think it is suitable to start with a story involving Dionysus, the god of wine, ritual ecstasy and theater, as most of us will likely be engaged in a related activity in one shape or form, joining the spirit of the season.

According to Greek mythology, Dionysus’ foster father Silenus gets lost in the woods and brought to the Phrygian King Midas by peasants who found him. Midas recognizes Silenus, takes good care of him and delivers him to Dionysus after a few days of his stay. Dionysus, delighted with the kindness Midas had shown, offers him a reward for whatever he wished for. As a result, Midas was given the gift of turning everything he touched into gold, hence the expression “the Midas’ touch”. Although this gift does turn out to be problematic as Midas inadvertently turns his daughter into gold, that is not the part we will be focusing on today.

I thought of Midas because in 2019, almost all investments turned into gold, including gold, which is odd (further explained) especially given the fears of a recession and a strong bear sentiment seen in the beginning of the year.

We closed 2018 with a 20% loss in major US stock indexes and many questioned, as markets being a forward-looking indicator, whether or not we were headed for a 2008 like period. (I have to add a side bar here, because of this loss in 2018, 2019 returns look inflated. If you look at 2-year returns, you will get a better picture of your investment performance). To see strong market performance in investments that usually move in opposite directions, is unusual to say the least. In the case of gold for instance, which usually zigs when stocks zag, it had a decent year as many investors flocked to safety and turned to an inflation hedge at a time of low interest rates.

The usual worries that tend to weigh on markets didn’t matter much. Low cash, high stock allocations, high valuations, low economic growth, low unemployment and high political uncertainty was more than balanced with company buybacks and FED rate cuts. According to Goldman Sachs, in 2019 companies invested almost a trillion dollars (with a T) in their common shares. Where did this money come from? Two sources: tax breaks and repatriation from overseas funds. How much longer can this go on? May be not forever and not at this rate, but at least for another year albeit at a lower rate. As for the FED, we will most likely see a wait and see mode with very limited moves in either direction. With low inflation rates and strong political pressure, a dovish stand wouldn’t surprise anyone, but even so, a pause in rate cuts is more likely.

What to expect from 2020?

After turning his beloved daughter into gold, heartbroken Midas will most likely stay away from markets in 2020, but even so, a volatile and yet profitable year in the capital markets is expected. This is not painting a rosy picture by any means as I will discuss in more detail later but in short, as global economy recovers and yields move higher, stocks are poised for a year with single digit returns on major indices where as bonds may struggle with their negative correlation to yields (bond values go down when yields rise).

Those who have been holding their breaths for a recession will turn blue if they haven’t already done so, as the U.S. Gross Domestic Product (GDP) growth is expected to be around 2%. Not great, but not a recession either, which seems to be the story of the last decade; sluggish growth. Economies in Europe and Emerging markets may play some catch up as a result of pent up demand and central banks all across the world stimulating growth. So, even though valuations are still elevated, earnings growth is expected to continue. This can also be seen in the steady uptrend in the Purchasing Managers Index (and other leading indicators) pointing to improving production in the U.S. On the valuation front, those focused on absolute ratios like price to earnings, price to sales etc…have been blindsided by reasonable relative valuations compared with bond yields coupled with low unemployment.

Inflation expectations are muted across the globe, 2% range in the U.S. This will continue to pressure yields but with global economy improving, wage growth in the U.S. and low unemployment rates, yields may rise modestly. This move in yields may prove to be significant in bond and bond proxy prices as we have seen a bubble-like activity in this section of the market. So those who have been playing safe with bonds and bond proxies and have been handsomely rewarded on a risk/reward basis, may see their fortunes reverse. So, what to do then? Dividend stocks may be the refuge for income and especially in a total return (growth + income) basis. If not for an entire portfolio, but for diversification purposes.

International stocks may have an edge in 2020 not only because of (past due) catching up and better valuations, but also a weakening dollar against major currencies, especially in the Emerging Market space. Given the (now certain) Brexit process in Europe and UK, not knowing how amicable this divorce will be, it is hard to gauge currency moves, but purely on valuations, Europe is more attractive than the U.S. In the UK, depending on how different scenarios play out such as Scotland leaving the union or not, hard versus soft landing, the market performances are less predictable.

China and Russia, along with other Emerging Markets may see improvements in economic growth and GDP, especially Russia with rising (or stabilizing) oil and natural gas prices.

On US sectors, potential tailwinds exist for energy, healthcare, financials, consumer and tech sectors. This is due to rising oil prices for energy, discounted valuations due to political risks for healthcare, flat yield curve for financials, rising incomes for the consumer and a mega bull trend for tech sectors are set to play out in 2020.

If you haven’t heard already, we will have presidential elections in the U.S. The third impeached president in the history of the U.S. will face a Democrat challenger. Historically, in the years when the incumbent president loses, markets tend to be weaker, sluggish, even negative. Election years in general tend to be volatile and weak in the first half of the year, and recover in the second half and after elections as uncertainty dissipates. As seen in Brexit, markets prefer bad news over the unknown.

So, if you add this all up, a trading strategy may be to get your shopping list together and start getting in during February-September period. OR, as some strategist suggest, buy on Jan 1 and forget about it until Dec 31, depending on your taste of risk, and how much time you have for speculation.

CEOs’ Balancing Act

You may see this as the pebble in your investment shoe, but CEO confidence is one reliable indicator of recessions and down markets. Currently it is down at levels last seen in 1980, 1991, 2001 and 2008, ALL coinciding or followed by a recession. This is not a new development either as CEO confidence has been dropping for the last 2 years. So, while improving global economy is an underlying waive supporting stocks, this one pebble is one hell of a pain hard to ignore. With other late cycle jitters in the U.S. economy and markets, it tells me not to lose sight of risk in allocations, even though a more risk on sentiment is in the air. One way you can do this is by overweighting large stocks as opposed to mid and small, as they tend to experience bigger losses if a downtrend resume.

One last positive note before we part ways: US is in a unique spot with favorable demographic trends, mainly among the highest spending ages of 35 to 49. This is now the fastest growing segment of the population and will support sectors that are in this group’s focus for the foreseeable future. So, even if we get a bad year or two in the next few years, we have valid reasons to hope for a recovery after. That’s for the long-term investors with a secular view.

Happy Holidays

I wish you all a great time with your families while finishing up 2019, and a prosperous 2020.

Thank you for reading my newsletter. I hope you’ve found it a fun read and informative. Please feel free to reach me with questions and comments on bbakan@shieldwm.com.


The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy. The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.