Markets

Lyn Alden's Positioning For 2020: A Diversified Global Focus

By Lyn Alden Schwartzer:

This is part of Seeking Alpha's "Portfolio Positioning 2020" series.

What do you expect to be the key driver of stock market performance over the course of 2020?

In most years, changes in valuation are the biggest swing factor for equity markets.

The full year 2019 was about major valuation expansion on top of flat earnings, which along with low interest rates has led to historically high equity valuations.

The question going into 2020 is whether earnings will start to catch up to stock prices, or if earnings will disappoint, potentially leading stock prices to fall back down or stagnate sideways for a time.

Josh Brown, the CEO of Ritholtz Wealth Management and CNBC contributor, once compared the relationship between the economy and the stock market to a person walking a dog on a leash.

The person walks in a relatively straight line, with periods of faster walking, slower walking, stops, and maybe some brief backwards movement if she drops something and go back to pick it up. Mostly, it's an orderly walk from point A to point B. That is the economy over the long term.

The dog, on the other hand, goes all over the place. Sometimes it is tugging ahead on the leash, trying to go faster. Other times it is distracted by something behind, trying to tug backwards. It is always zigging and zagging around the person within the limit of the leash length. Over the course of the full walk from point A and point B, the dog winds up in the same place as the person, but its path to get there is a lot more erratic than the person's more orderly path.

To capture that in image form, we can look at stock market capitalization (red line below, the dog) relative to U.S. GDP (blue line below, the human).

Chart Source: St. Louis Fed

The economy in that chart mostly marches up and to the right at various levels of speed with occasional bumps, while the stock market zigs and zags all over it throughout various stages in the business cycle and secular changes in interest rate levels. Corporate earnings have operational leverage relative to the economy, and valuations are an additional layer of volatility on top of those earnings.

If we put those same charts in year-over-year percent change terms, we need to put them on different vertical axes because stock market volatility is far higher than GDP volatility within any given year:

Chart Source: St. Louis Fed

As the chart shows, year-over-year nominal GDP growth has ranged between about -2.5% and +7.5% since 1990, while the partially-correlated year-over-year stock market growth has been roughly between -40% and +40%.

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As we begin 2020, are you bullish or bearish on U.S. stocks?

I don't have a strong opinion on single-year stock performance, because I focus primarily on fundamentals, and fundamentals say a lot about multi-year performance and relatively little about single-year performance.

For example, this chart by J.P. Morgan shows that the P/E ratio of the S&P 500 is decently correlated with 5-year returns, but not at all correlated with 1-year returns:

Chart Source: J.P. Morgan Guide to the Markets

Over the next decade, I am relatively bearish on U.S. stocks in inflation-adjusted terms, and relatively neutral on them in nominal terms. That's not to say that they will end the decade lower, but simply that I don't expect the 2020's decade to be nearly as good as the 2010s decade, and likely below the S&P 500's historical annualized rate of inflation-adjusted returns.

For the nearer term, I am watching business cycle indicators. If unemployment ticks up and earnings disappoint, which has a moderately high probability this year, stocks are likely to be in for a rough time this year or next, from current price levels. The optimistic view is that this would likely create a decent buying opportunity in high-quality stocks for contrarian and value-minded investors. Volatility is what gives investors opportunities to rebalance portfolios into cheaper assets.

It's important for investors to define their strategy ahead of time. Are you a buy-and-hold investor that ignores market conditions, or are you a tactical allocator that changes risk levels based on valuations, sentiment, and market conditions? Rather than try to figure that question out in real time, try to plan ahead and know what you will do or not do. Define your process and stay the course.

Which domestic/global issue is most likely to adversely affect U.S. markets in the coming year?

Investors that care about the macro backdrop should keep an eye on jobless claims and unemployment. These indicators are showing early signs of beginning a bottoming process, but it is not yet confirmed.

Here are initial and continuing claims, which have run into a 2-year consolidation after nearly a decade of continuous declines, along with a recent uptick:

Jobless Claims
Chart Source: St. Louis Fed

Job openings have declined recently and haven't bounced back up yet. This chart shows the year-over-year percent change in job openings over the past couple of decades:

Job Openings
Chart Source: St. Louis Fed

Companies are already leveraged with record amounts of corporate debt relative to GDP, thanks to low interest rates that have allowed them to service that high level of debt. Money spent on buybacks peaked in 2018, declined in 2019, and is likely in my view to decline again in 2020.

Labor costs are rising; 2019 saw the highest level of year-over-year hourly wage increases during this business cycle. This is classic late-cycle stuff, and the way that companies usually respond to this is by trimming their labor force, trying to squeeze extra profits out of the situation by boosting productivity. However, as that labor force is trimmed, there are fewer people with money able to buy things from those companies. What works well on the micro scale for individual companies eventually gives most of them trouble on the macro scale.

We haven't gotten to that point quite yet. The job market appears to be bottoming, but is not yet turning bad, and could still potentially bounce back to strength. I'm watching it weekly.

For investors that don't care about the economic cycle or other macro aspects, I would say to just be prudent with forward return expectations, and to take analyst earnings forecasts with a grain of salt. If your fair value estimate for a stock relies on companies doing as well as they have for the past 5 years (during a time of greatly increasing corporate leverage along with tax cuts), that's setting up quite a bit of downside risk.

Instead, plan for a rougher period of earnings, and look for companies that are attractively valued even without very bullish assumptions baked into the model.

How does the political climate affect the risks and opportunities for next year?

My investment process is apolitical; I have conservative and liberal readers, and because I take a global view, I have many readers from around the world that fall into very different political camps.

I primarily care about numbers rather than narratives. Emotions are mostly a detriment to good investment performance; how they "feel" about a certain environment can often lead them to be too bullish or too bearish at the wrong times simply because they like or dislike the president, for example.

However, investors would still do well to be mindful of the potential impact of various fiscal and monetary policies on equity performance, bond performance, commodity performance, currency performance, and so forth, from a mathematical perspective.

I view the stock market today as an orange that has had most of the juice squeezed out of it, which makes it harder and harder to find more juice. Companies have had over a decade to build up leverage and boost earnings as much as possible with leverage. Then, the government cut corporate tax rates without cutting government spending, which adds to the annual federal deficit and gives corporations another boost to the bottom line, and is a form of economic stimulus.

Tax from corporate income is now very low both in absolute dollar terms (red line below), and as a percentage of corporate income (blue line below):

Chart Source: St. Louis Fed

As the red line shows, absolute corporate tax revenue is back down to where it was during the 2009 and 2002 recession troughs, despite a large advancement in GDP, corporate earnings, and compounded inflation since those periods, and despite the fact that we're currently in a market expansion rather than a recession.

And as the blue line shows, corporate tax payments are less than 10% of total corporate income compared to being 15-20% during the peak of the previous cycle and over 30-40% several decades ago.

Meanwhile, the annual federal deficit as a percentage of GDP is the second highest it has been since World War II, and the highest it has been outside of a recession:

U.S. Deficits and Unemployment

Chart Source: Goldman Sachs, Retrieved from CNBC

As we move forward, we need to be cautious about reversion to the mean. Right now, the pendulum is very far on the favorable side for corporations. The 2020 presidential and congressional election could of course affect this in myriad ways.

Rather than try to predict the 2020 election outcome, however, I just keep a margin of safety within my fair value models. I assume slower growth, and possible corporate tax increases, rather than basing my investment plans on the idea that this very friendly corporate tax environment during a time of record deficits will persist indefinitely.

In addition, I diversify the jurisdictions of my investments. Many investors believe that if they own the S&P 500, which gets over 40% of its revenue from abroad, that they are automatically globally diversified.

However, all 500 of those companies have the same legal and tax jurisdiction. The U.S. government can raise all of their taxes simultaneously, or regulate them in a way that would affect shareholders. It is jurisdictional concentration, in other words.

For that reason, I prefer to also have exposure to companies in other jurisdictions, so that political outcomes or tax changes of individual countries, including the United States, only have moderate impact on my portfolio.

What do you expect out of the yield curve in 2020, and what impacts will that have on the equity market and the economy in general?

The Fed may very well trim rates on the front end of the curve in 2020, if the economy does weaken. I have some short-term treasury exposure as a bit of a defensive placeholder. The probability of a rate hike this year is virtually zero in my view.

Rates on the long end depend on a variety of factors, including inflation expectations. I don't have a strong conviction about long-term rates, other than that the Fed will likely cap them if they go too high (which is what the Fed did back in the 1940s, the last time federal debt got out of control), and inflation expectations may prevent rates from going as low as some people predict.

Developed markets including the United States are in partially uncharted territory for monetary policy. Lowering rates from 5% to 3%; like they did in the past, can be a big stimulus for consumers and businesses, but lowering rates from already low levels to zero or negative may have diminishing or even counterintuitive impact. Japan and Europe have arguably demonstrated, over the past several years, the limits of what low interest rates can accomplish.

In terms of asset allocation, how are you positioned as we begin the New Year?

I have a diverse mix of U.S. stocks, foreign stocks, short-term bonds, precious metals, and high-quality producers of various precious metals and other commodities.

My portfolio is primarily positioned for multi-year outcomes rather than 2020 specifically. The short-term bonds and precious metals are a defensive hedge, which should be useful if we get a sell-off and buying opportunity in equities more broadly.

As I explained in this article about relative valuations, I currently rank expected asset class performance over the next decade roughly as follows:

Top tier: Commodities and foreign stock indices

Middle tier: U.S. broad stock indices

Lower tier: U.S. treasuries and other low-yielding bonds

However, if we include individual stocks, I am finding examples of companies in the United States and internationally that are undervalued or overvalued relative to their expected level of growth and financial strength. I add to dips in stocks that I think are of high quality, and sell some stocks that go well above the upper threshold of my fair value range, but my annual turnover is rather low.

What 'surprise' do you see in the market that isn't currently getting sufficient investor attention?

I think a weaker dollar is likely in the cards over the next few years. It is already down a bit since I expressed my initial view on it back in early October, but I think there's more to go. There will be ups and downs for the dollar along the way, but all of my analysis points to a high probability of dollar weakness in the years ahead.

The path for dollar weakness is based on long-term factors like the U.S. balance of payments deficit along with a new catalyst in the form of a giant monetary policy shift that occurred this past autumn after the spike in overnight lending rates, so it's not getting much media attention in my opinion. The case for a weakening dollar is more of a secular change with a multi-year outlook, and that kind of thing doesn't often grab headlines.

Rather than interpreting expected forward dollar weakness as bearish, I consider it to be the biggest potential release value for global markets, while also being helpful for several U.S. industries (and harmful to a minority of others).

What role will the Fed play in the coming year?

Since August, the Federal Reserve has been aggressively buying U.S. treasuries while continuing to sell mortgage-backed securities:

Fed UST and MBS Holdings
Chart Source: St. Louis Fed

Based on the evidence I've seen, the Fed's buying of treasuries is likely to continue for longer than consensus currently expects. It may slow down or even stop briefly here and there, but with federal deficits as big as they are, and not enough buyers for all of those treasuries, it looks like the Fed will be on the hook as the buyer of last resort for quite some time.

I don't have a strong conviction on what that means for stocks, but it is a big variable in my expectations for a decline in dollar strength compared to a basket of global currencies. Shifting from a tighter monetary policy towards a looser monetary policy with large twin deficits in place is a recipe for a weaker currency.

Due to this view, when analyzing different asset classes and return expectations for the decade ahead, I think it will be important for investors to separate nominal return expectations from real (inflation-adjusted and/or currency-adjusted) return expectations, and invest accordingly.

What issue is receiving too much investor attention and/or is already priced in?

Tensions between the United States and Iran are grabbing investor attention latterly, but it's hard for most investors to really have an "edge" on geopolitical situations. It heated up, then it cooled down. Will it heat up again?

More broadly, investment strategies based on headlines, like trade tensions, political outcomes, and military conflict don't have much testability, repeatability, or reliability. That's not to say those events are not important for equity prices; the question is whether they can be planned for with any sort of edge.

When markets are expensive, deficits are large, and leverage is high, there is more fragility in the system than usual. A sudden spike in oil, or an unexpected military conflict, or an unexpected election outcome, can have a big impact on the economy in that sort of tight financial situation.

That's why investing with a margin of safety, using conservative forward estimates, and maintaining diversification among asset classes and corporate jurisdictions, is of particular importance during times like this in my opinion.

When one asset class seems to be consistently outperforming most others, and when you start to question whether you even need those other asset classes at all, that's exactly when they tend to become useful. Markets are very momentum-driven. When one thing starts to work for a while due to fundamental reasons, investors naturally pile into it, and they squeeze every bit of juice out of it until there's simply not much more it can do. However, that behavior is what leaves juice elsewhere to be found by investors that are willing to look more than one year ahead.

My process involves value investing with a macro overlay, meaning that I focus on buying attractively-valued or reasonably-valued companies and other asset classes, while maintaining awareness of the global macro setting in rate-of-change terms to determine the aggressiveness/defensiveness of my asset allocation.

See also Axonics Modulation Technologies, Inc. (AXNX) CEO Raymond Cohen on Q4 2019 Results - Earnings Call Transcript on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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