Monday, January 1, 2018

HLTC Market Commentary - January 2018

Andy Means, CFA®
Author position
Director of Investments - Hilliard Lyons Trust Company

Risk Appetite is on the Rise

The financial collapse and recession that occurred a decade ago left significant carnage in its wake. Long lasting collateral damage included the effect it had on investor attitudes toward risk. The 2007-2009 collapse was the second time in less than ten years that markets declined by more than 50%, inflicting devastating losses just as investors were recovering from the 2000-2002 decline. As a result, in the years immediately following that last painful downturn, many investors went out of their way to avoid any risk. In fact, investor risk aversion was the strongest I have seen in my 36 years in the industry.
Fast forward to today, and the pendulum has swung the other way in investor attitudes concerning risk. It has taken nine long years to journey from maximum risk aversion to the embrace of risk-taking that we see today. This increasing appetite for risk is not necessarily a bad development, unless it becomes insatiable in the years ahead. As for today, many valid reasons support investors’ rising optimism and explain their willingness to add more risk to their investment portfolios.

Coordinated worldwide growth

One of the most positive developments in 2017 was the blossoming of a synchronized global economic recovery for the first time in decades. The United States, Europe, Asia, and emerging market economies have all been growing in tandem. As a result, corporate earnings are growing at a healthy rate. Coinciding with this pickup in growth is a continuation of the benign inflation environment that has existed throughout the recovery. Interest rates across the globe remain astoundingly low. This combination of factors is a salutary environment for global stock markets, fueling a robust 21.8% return for the S&P 500® in 2017. Returns in many international markets were even higher.

In the United States, economic momentum seems to be building, with GDP growth accelerating from a sub-2% average over the past several years to over 3% in the last nine months of 2017. In addition, the lower U.S. corporate tax rate recently passed into law will boost 2018 corporate earnings. The official unemployment rate is near all-time lows at 4.1%, and consumer and business confidence measures are soaring. These are just a few of the reasons for the pervasive sense of optimism in the investment markets.

Paradoxes and conundrums

At times of rising optimism, investors should keep in mind one of the great conundrums that they face. Simply stated, when investors are cautious and risk averse (2009), valuations tend to be lower because of modest expectations for future returns. When prices are low due to investor pessimism, there is a greater margin of safety built in and the likelihood for strong future returns is high.
Conversely, when investors willingly embrace risk and valuations are higher (as they are now), the margin of safety is smaller and future returns are likely to be lower. Stated another way, if prices of investments reflect particularly rosy expectations and disappointment follows, prices have further to decline. This is the paradox of the stock market: Risk tends to be higher when investors are their most bullish and lower when investors are most fearful. Warren Buffett has alerted investors of this phenomenon by stating that investors are wise to be “fearful when others are greedy and greedy when others are fearful.”

Are we seeing irrational exuberance?

This is a time of rising optimism, and investment valuations are on the higher end of the historical range. Does that mean we are in a risky investment environment? Not necessarily. As stated in our last newsletter, we think the pricing structure of the stock market today is rational. Valuations appropriately reflect growing corporate profits combined with very low interest rates. But the margin of safety has narrowed. And if the optimism about today’s economic picture turns out to be unjustified, prices could suffer a decline.

So should you invest in Bitcoin?

BitcoinWhile we do believe that overall investment market valuations are justifiable, we also see pockets of speculation that prudent investors should avoid. One obvious example is the trading activity occurring in Bitcoin and other cryptocurrencies.

Bitcoin is a new type of digital “currency” with no government or central bank backing it. We think the mania surrounding cryptocurrencies has all the hallmarks of an investment bubble. As was the case with some prior bubbles, there is an exciting development that underlies the speculative trading. The blockchain technology that makes cryptocurrencies possible is real and may have significant applications in the future. That said, we don’t know exactly how those uses of this new technology will unfold.

The problem with Bitcoin as an investment is it has no intrinsic value. An investment’s intrinsic value can be estimated based on its expected cash flows and earnings. Bitcoin has neither. Since Bitcoin has no intrinsic value underlying its price, the trading of it is nothing more than speculation in its purest form. It has turned into a speculative trading chip. Because our approach to investing is founded on the concept of intrinsic value, we believe any investing disconnected from underlying value is nothing more than speculation. Warren Buffett has opined many times that for any investment, “Price is what you pay; value is what you get.” Investors should be very careful paying anything for something that doesn’t have a reasonable estimate of underlying value.
If you can keep your head when all about you are losing theirs …

As we enter the New Year, optimism in the investment markets is on the rise. Economic growth appears to be accelerating, and while valuations are on the high side, they are justifiable. It is an exciting time, with consumer and business confidence reaching their highest levels in many years. It is also a world with many challenges and risks that investors must face. Our approach in this environment can be summed up in a quote from Charlie Munger, Vice Chairman of Berkshire Hathaway at last year’s annual meeting: “A lot of other people are trying to be brilliant. We are just trying to remain rational. Trying to be brilliant can be dangerous.”

Remaining rational will help us avoid getting caught up in the excitement of the day. Our focus will always be on investing your assets in a highly disciplined, responsible manner. We try to reduce risk in our clients’ portfolios by investing primarily in high-quality stocks and bonds at prices we deem reasonable in relation to our estimate of intrinsic value. With risk appetite on the rise in markets today, we are keeping a tight lid on the risk levels in your portfolios.

Thank you for choosing Hilliard Lyons Trust Company. We sincerely appreciate the confidence that you place in us. We are fully committed to providing you with excellent wealth management services delivered with a high level of professionalism and service. We look forward to building on the long-term relationships that we have with you.

Past performance is not a predictor of future success. All investing involves the risk of loss.