Third Quarter Market Review
“To prove that Wall Street is an early omen of movements still to come in GNP (gross national product), commentators quote economic studies alleging that market downturns predicted four out of the last five recessions. That is an understatement. Wall Street indexes predicted nine out of the last five recessions! And its mistakes were beauties.” – Dr. Paul Samuelson, “Science and Stocks”, 1966
Dr. Samuelson’s quote is an important reminder of how difficult it is to accurately forecast the future. Moreover, to correctly predict the future with any regularity is nearly impossible. Dr. Samuelson is also credited with a famous quote—an important tenet of investing— “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” Dr. Samuelson was correct in knowing two things: the future—and its impact on financial markets—almost never goes the way one thinks it will, and investing is a marathon, not a sprint, where the riches go to those with patience and a long-term mindset.
While the quotes above reflect how we think about investing at Madison, we’d be remiss if we didn’t point out that economists are also famous for perfecting the “on the other hand” response to questions. This quarter, you could use that response to justify almost any headline. As an example, concerns about U.S.-China trade tensions continued to add uncertainty to the markets, with no real progress being made on tariffs, intellectual property protections, enforcement, or state subsidies. These tariff and trade concerns could have the effect of slowing global growth. “On the other hand”, central banks the world over have lowered interest rates to try to thwart the effects that trade uncertainties have had on global growth. As of this writing, the net effects have resulted in the market being volatile but overall remaining fairly neutral.
Casual observers would look at the year-to-date returns for the markets and be pleased with global equities, whose returns are up double digits; however, these same markets are up only low single digits over the past twelve months. The fourth quarter of last year was the main culprit. Despite the sideways market, a Goldman Sachs report pointed out that 90% of the 18% rally in the stock market over the first half of 2019 was attributable to multiple expansion, with the earnings multiple increasing from 14x to 17x. When market multiples expand without material earnings growth, it signals a positive change in investor psychology towards equities. “On one hand” global growth is slowing, and earnings revisions and earnings growth are trending south. “On the other hand”, investors are willing to pay more for those earnings. We do indeed live in interesting times.
Fixed income returns over the past year have been the standout; in fact, fixed income returns have bested equities over the past year by a large margin. It’s rare to see fixed income returns look like stock returns. The main reason bonds have continued their upward trajectory is that central bankers across the world have continued to reduce interest rates to combat slowing global growth and modest inflation. Bonds in the U.S. followed suit as the U.S. Fed cut rates 0.25% twice, in July and September. In the face of uncertainty, investors flocked to safe-haven Treasuries, driving the 10-year treasury yield down to a low of 1.43%. In fact, the most-talked-about topic this quarter centered on fears of what a yield curve inversion might signal for the market. “Curve inversions” are when the spread between the two-year treasury (short-term rates) and 10-year Treasury (longer-term rates) go negative. The last time we saw inversion was in August of 2007; we know what happened a year later. “On one hand”, we could be headed for the inevitable market correction everyone fears. “On the other hand”, a Credit Suisse report noted that the yield curve would need to be inverted for 11 months to have any predictive power as a signal of a recession. In the 2019 case, it was inverted for less than two weeks while “on the other hand” Credit Suisse also found that even after the spread between these two benchmarks goes negative, equity markets historically rose over the corresponding six months by almost 7%. We’re quickly running out of hands!
What’s an investor to do, given the seemingly conflicting messages in the economic data, financial markets, or commentary from industry pundits? “On the one hand” manufacturing data has contracted for the second month in a row, falling to its lowest level since 2009. “On the other hand”, the economy has been supported by a resilient labor market with unemployment rates at 50-year lows (currently 3.5%) and consumer confidence is high. On the geopolitical front, we are one tweet away from a new market high. “On the other hand”, we could be one tweet away from a market correction.
Dr. Paul Samuelson’s quotes remind us of the tried and true wisdom we need when times feel uncertain. On the one hand, times are indeed uncertain and investing seems difficult. On the other hand, the future is always uncertain and investing has always been difficult; there’s never any certainty. As such, we believe a diversified and balanced approach to portfolio management is of utmost importance in any market environment. A steady and long-term perspective can handsomely reward those that realize the markets are nuanced and who are able to avoid overreacting to the positives or the negatives.
As always, we appreciate your trust in Madison as we help you navigate through these choppy waters.