Bourgeon Capital's Market Insights: Winter 2018

“Was Valuation our Cindy Lou Who?

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Fourth quarter 2018 stock market action felt eerily like “The Grinch who Stole Christmas” by Dr. Seuss. The Grinch initially ruins Christmas for the happy citizens of Whoville by stealing their Christmas decorations and presents. But then The Grinch encounters Cindy Lou Who, an innocent young girl who lives in Whoville, who serves as a trigger to the Grinch’s change of heart. Shortly thereafter the Grinch’s heart grows three sizes, and he returns the presents and participates in the Whoville Christmas feast. The financial markets ended September just like the happy citizens of Whoville, with the S&P 500 up 10.5%. But The Grinch (i.e. trade risks, fed tightening, high valuation, slowing global economies, credit spreads widening, oil prices plunging, yield curve flattening, General Mattis resigning as Secretary of Defense, government shutdown, Brexit risks, etc.) showed up for the fourth quarter, and the S&P 500 fell 20% from October 3rd through December 24th. At the lows, stock market valuations were 27% lower than a year earlier, creating a Cindy Lou Who moment. Subsequently, the stock market rallied and is up 10% through January 11, 2019. As we look to 2019, we will be watching for catalysts to grow investors’ hearts even larger. A more dovish Fed? Trade Progress? China Stimulus? During the first nine months of 2018, because of high valuations in the face of growing risks, we sold stock while increasing cash and Treasuries to 10-20% of portfolios. While we will always be data dependent, we are currently inclined to begin reinvesting some of that cash in 2019.  


“Santa Claus, why, Why are you taking our Christmas tree? WHY?”

There were so many Grinch-like issues in Q4. Initially the major investor concerns were faster tightening from the Federal Reserve, growing trade risks with China, and historically high valuations. But many additional negatives were added as the quarter progressed such as: slowing global economies, credit spreads widening, oil prices plunging, yield curve flattening, General Mattis resigning as Secretary of Defense, government shutdown, Brexit, etc. As the list of negatives grew, so did market anxiety. Selling begot selling. Program selling, now representing about 80% of trading volume, likely exacerbated the problem. In December 2018 the S&P 500 was down 9% the worst December since 1931 which was down 14%. During the fourth quarter alone the S&P 500 was down 13.5%, at one point approaching a bear market (down 20%). For 2018 the S&P 500 total return was down 4.4%, its first negative year since 2008.

Was Valuation our Cindy Lou Who? 

The stock market decline in Q4 created compelling valuations. While valuations are a great starting point, valuation + positive catalyst (i.e. reduction of Grinch-like issues) is even better.

Valuation Was More Compelling

Were valuations our Cindy Lou Who?  As we have said before, financial tightening (i.e. Fed raising rates or reducing balance sheets) leads to multiple contraction. Over the past quarter, valuations became the most interesting since 2013.  For example, on a forward price-to-earnings basis the S&P 500 multiple declined by 18% in the fourth quarter and 27% in 12 months.  At 15.4x for 2019, the PE multiple is now below average. One year forward EV/EBITDA multiples have also contracted, but are only down 14% from 12x to 10x. Finally, dividend yields have increased – with many good quality low debt companies yielding more than 5%.  While we don’t know if the recent turbulence is over, if one has confidence in the level of projected earnings, and has a long-term time horizon, then we believe it makes sense to start slowly putting money to work.

Table 1

S&P 500 Valuations Have Contracted by 18% in 3 Months, and 27% in 12 months

One Year Forward Bloomberg Consensus Price-to-Earnings Multiples

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Source:  Bloomberg

What Factors Could Make Investors' Hearts Grow Even Larger? 

Fed Could Reverse its Tightening Trifecta 

During 2018 the Fed significantly tightened financial conditions.  We called it a Tightening Trifecta.  First, they raised rates.  Second, they reduced the balance sheet through quantitative tightening.  Third, in October they talked about raising rates at a faster pace.  The Fed was “all-in” tightening by Q3 2018 as tax cuts helped move unemployment lower. In December 2018 the Fed started to pull back on some of their tightening – first with words, and second with lower forecasts.  They still have several more levers to pull going forward – pausing on rate hikes or reducing interest rates and pausing on federal balance sheet reduction or increasing the levels.  Current low inflation makes this possible.  The stock market would applaud these moves.

 

Trade Tensions with China Could Ease

US negotiations with China have taken many twists and turns, and we believe encompasses more than just tariffs – including intellectual property rights and cessation of government sponsored cyber espionage.  This is the area where we can see many different outcomes and thus our ability to forecast is low.  Our hoped-for solution would be for China and the US to remove/reduce tariffs and then the US would join the global community to force China’s compliance.  Either way, this is not an easy fix and will likely be an overhang for at least the upcoming 6-12 months.

More Fiscal Stimulus from China, Less from the US

Global economic growth rates are slowing.  In its October 2018 report the IMF stated that “downside risks to global growth have risen in the past six months and the potential for upside surprises has receded.” A large part of the slowing growth has come from China.  In response, China started stimulus about 6 months ago, by lowering tax rates.  Since then they have consistently increased fiscal and monetary stimulus.  We believe that China stimulus will continue to build and eventually begin improving their economic growth in the upcoming months.  For the US we still have a significant benefit from tax cuts going into Q1 of approximately $70 billion.  But thereafter the benefit recedes, and we are less optimistic of fiscal stimulus. There is continued demand for infrastructure spending.  However, we believe that large fiscal stimulus in the US is unlikely given high government debt levels.

What Unresolved Issues Make us Tread with Caution?

Recession Risk, Leveraged Loans, and Central Bank Balance Sheets are Top of Mind. 

Current economic conditions in the US are very strong, with unemployment under 4% for the past 9 months. But the financial markets are forward looking, and they are starting to warn about recessions and credit risks as the benefit of tax cuts fade and the negative impact of rate hikes begins to take hold. Has the stock market discounted the upcoming risks?  We are not completely sure, but it’s well on its way.  

Recession Risk:  First, with the recent inversion in part of the yield curve, recession risk has been a headline discussion.  The most accurate yield curve inversion to forecast a recession is the spread between the 3-month Treasury and the 10-year Treasury.  The spread is currently 28 basis points, the lowest since 2007.  Second, a recent Duke Fuqua CFO study discovered that nearly 50% of US CFOs believe the nation’s economy will enter a recession by the end of 2019, and 82% believe that a recession will have begun by the end of 2020.  While we are confident that the US economic growth rate slows in 2019, in our minds recession is not a foregone conclusion, especially if the Fed begins to ease.

Credit Risk:  When credit markets freeze, major problems can follow.  The credit markets are often where trouble lurks for the financial markets. Thus, it is important to be mindful of increasing credit risks.  In general, US financial institutions are strong, many with fortress balance sheets. However, outside of the major banks a potential risk lies in the leveraged loan market. There was no high-yield issuance in the month of December.  Junk bond spreads swiftly rose from a low of 300 basis points to 500 bps, right in line with historical averages.  Several large leveraged loan deals went unpriced.  While we anticipate that deals could be successfully repriced lower in January, the ripple effects of this have yet to be fully seen in our view. 

Central Bank Balance Sheet Risk:We continue to be mindful of unintended consequences of the reduction in central bank balance sheets.  The US Federal Reserve has reduced its balance sheet by 9% this year and has plans to further reduce in 2019.  From a global perspective central bank balance sheets are down 5%, the largest contraction since the great experiment began in 2008.

Our Reinvestment Will be a Process, Not an Event.  

In this environment, with many stocks down 20-30% in the most recent quarter, but with risks remaining, it is a time to review what we own and to gradually start reinvesting the 10-20% cash that we have built up over the past year.  While we never will be able to exactly predict the bottom, we can seek out opportunities to invest in great companies that are currently ‘on sale’ and should reward us in the long run.  We view this as a process, not an event.

Why do we own the Companies we do in this Environment? 

When markets get volatile it is helpful to not only review why we own our companies, but to reconfirm why they are in the portfolio. 

Value stocks with a catalyst:  As we previously discussed, low valuation + positive catalyst is a winning combination. We own several stocks in this category. 

Companies with limited exposure to China: With the uncertainty about tariff negotiations with China, this seems a good area to focus additional investment.  

Fortress balance sheets:  Given the uncertainty in the credit markets, we like financial companies with incredibly strong balance sheets.  

Significant stock buyback programs:  With the ability in 2018 to repatriate cash held overseas, many companies announced large buyback programs.  These large programs are helpful in providing some downside support. Some of the companies we currently own have recently announced share repurchase programs that represent over 5% of their current equity market value.

Secular growth companies:  Irrespective of what happens in the economy, we believe that there are several growth trends that will continue such as the Cloud, digital payments, and cyber security.  

Defensive Sectors:  Staples and Healthcare typically fare better during economic downturns. As recession risks have been increasing throughout the year, so has your exposure to these defensive sectors. 

High dividend companies:  As stock prices declined, dividend yields went up.  Several companies we currently own have yields greater than 5%.

During the Fourth Quarter we raised more cash, took an initial investment in a healthcare stock, and did tax-loss selling. 

During the fourth quarter we continued to reduce stock exposure, using the money to take an initial investment in a healthcare stock and buy more Treasuries.  Although we don’t enjoy selling stocks at a loss, with the stock market decline in the fourth quarter we did tax-loss selling where we felt appropriate to reduce capital gain taxes.

Bond Yields Showed Significant Volatility and Signs of Credit Risk Emerged.

We are buying Corporate Bonds Again.

The volatility around bond yields continued. Yields dropped throughout the quarter, starting with the 10-year yield at 3.2%, and ending closer to 2.6%. Investors are now expecting that the Fed will have to pause/reduce interest rates, a full 180°vs. expectations 3 month ago.  In addition, investment grade corporate spreads vs. Treasuries widened significantly, moving from historic lows, back up to normal levels.  The inversion of part of the yield curve (where longer dated yields drop below shorter dated yields) has led investors to recognize the increased probability for a recession in the upcoming year or so. After primarily buying Treasuries for clients this year, the increased spreads are welcome for buy and hold bond investors, and we have started buying corporates again. We have maintained a short-term position on our already short-term portfolio, and we will reevaluate this strategy as the yield curve changes.

Mutual Fund Portfolios were Cautiously Positioned ahead of Q4

We maintained our cautious stance within our mutual fund portfolios during the fourth quarter. In Q3 we increased our cash holdings and purchased a money market fund. With rising rates, the yield on this fund is up 20 basis points since last quarter to 2.35%. This is quite significant when compared to the current 0.33% yield on a bank sweep. By focusing on managing risk in both our fund selection process and by utilizing cash management vehicles, we were able to limit our downside risk throughout the volatile end to 2018. Similar to our equity portfolios, we are inclined to add to risk in 2019, but will be data dependent.

Over the past several years we have increased the financial planning capabilities at Bourgeon. We currently utilize goal-based financial planning discussions and software as well as personal financial websites to assist our clients in navigating their unique financial journey. If you haven’t already taken us up on the offer of these services, please do so. We find them to be incredibly helpful, insightful, and fun. “Those who plan often fare better than those who don’t.” 

As always, we welcome the opportunity to discuss your portfolio and our current thinking with you at any time. While we have only spoken generically about asset allocation in this letter, we believe that it is a very individual decision. We do our best work for you when we are up-to-date on changes that may be occurring in your lives. We enjoy speaking with you and sharing ideas on a consistent basis; if your situation changes at any time between our regular discussions, please reach out to us and let us know. 

 

We look forward to speaking with you soon and thank you for entrusting us with the management of your money.

 

 Sincerely,

John A. Zaro III

CFA®, CIC 
Managing Partner

Laura K. Drynan

CFA®,CFP®,CIC
Partner

Important Disclosure:

This letter should not be relied upon as investment advice.  Any mention of particular stocks or companies does not constitute and should not be considered an investment recommendation by Bourgeon Capital Management, LLC.  Any forward-looking statement is inherently uncertain.  Due to changing market conditions and other factors, the content in this letter may no longer reflect our current opinions.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this letter will be profitable or suitable for your individual portfolio.  In addition, past performance is no indication of future results.  Please contact us if you have any questions regarding the applicability of any matter discussed in this letter to your individual situation.  Please contact us if your financial situation or investment objectives change or if you wish to impose new restrictions or modify existing restrictions on your accounts.  Our current firm brochure and brochure supplement is available on the website maintained by the Securities and Exchange Commission or from us upon request.  You should be receiving, at least quarterly, statements from your account custodian or custodians showing transactions in your accounts.  We urge you to compare your custodial statements with any reports that you receive from us.

Bourgeon Capital's Market Insights


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