Markets & Economy

The Federal Reserve is sounding more aggressive about hiking rates even though its inflation expectations are still muted, and that sets up some interesting dynamics in the markets. Stocks are reacting to news of a possible trade war breaking out as the White House continues to announce tariffs, most recently on China. Bonds are also reacting. Though the Fed hiked rates a quarter-point on Wednesday, bond yields fell on the same trade war fears. The Dow Jones industrial average plunged more than 700 points on Thursday afternoon after the China tariffs were announced, closing down 2.9%. It is now down 3% for the year. The S&P 500 is now down 1.1% year to date, led by weakness in telecommunications, consumer staples and real estate.

Some positive numbers:

1. Home sales surged in the U.S. last month, but a chronic shortage of available homes on the market will still be an obstacle during the spring selling season.

2. Net worth is $98.75 trillion, nearly seven times the disposable income for households, according to the Fed. That means American wallets have gotten bigger from investments rather than from gains in home values or other assets.

3. Consumer sentiment rose in March to its highest level since 2004. Consumers appeared to be focused on positive economic news, the University of Michigan survey said.

4. Industrial production jumped 1.1 percent in February, the largest increase in four months, due to a weather-related rebound in construction and a rise in output from the nation's oil and gas fields and mines.

Some not-so-positive numbers:

1. The benchmark 10-year Treasury dropped the most in six months, to a yield below 2.8%, over anxieties about a global trade war.
2. S. import prices rose more than expected in February as the largest increase in the cost of capital goods since 2008 offset a drop in oil prices. That supports the view that inflation will pick up.

Recommended reading

Investors who have heavily bet on the indexes are probably not feeling very positive this week, given the sell-off in stocks following the announcement of tariffs on goods from China. Of the interesting articles recently was one by Morningstar, which examined how well active funds have done in tough times over the last 20 years. Its analysis found that 60% of active funds beat their benchmarks during the downturn in January and February. The article is highlighted here, as are some other blog posts and articles, in case you missed them:

Dollar Drop Jeff Gundlach says there don't appear to be disastrous warning signals ahead but the market will probably be down at year end. He says the dollar will move down and rates will move higher. Read more

Bonds Rival Stocks Bonds are a legitimate competitor to stocks for the first time in years, an article in Bloomberg points out. Yields on the 10-year are now more than 100 basis points higher than the dividend yield on the S&P 500. Read more

Downturn Coming An economic contraction could be coming as soon as next year, according to a recent Bloomberg article that cites the Fed, interest rates, corporate borrowing and tariffs. Read more

Understanding Luck Risk and luck are different sides of the same coin when it comes to investing but you need to understand one to appreciate the other, Morgan Housel says in an article for the Collaborative Fund. Read more

CEO Pay MSCI found in a 2016 study that the best paid CEOS tend to run some of the worst-performing companies, and the reverse is also true, even when pay and performance are measured over time. Read more

Historical Bias Using historical returns to forecast the future is one of the most common shortcuts in financial planning, but such bias can be unhelpful or even dangerous. Read more

Active Wins Morningstar looked at active funds over the last 20 years to see if they can insulate investors during a market downturn. It found that 60% of unique active U.S. stock funds beat their indexes during the downturn in late January to early February. Read more

Equity influence London Business School's Alex Edmans did a study of CEOs and short-term decision making and found that the more equity a CEO has vesting in a given quarter, the more they cut investment. Read more

Rotten Tomatoes Harvard's endowment lost $1.1 billion on tomatoes and sugar, leading it to write down the value of its natural resources portfolio last year and make the decision to move to outside money managers. Read more

Negative Hedge AQR's Cliff Asness says the negativity about hedge funds these days has gone too far. Hedge funds are supposed to lag the market in good times and blunt the downside during bad times. And they've been doing that. Read more

Borrowing Risk The increase in borrowing to buy stocks could lead to more market volatility, according to a Wall Street Journal article that cited data from the Financial Industry regulatory Authority. Read more

Passive Line Blurred Is there really such a thing as passive investing? Researchers at Sanford Bernstein tell Bloomberg the divide between active and passive investing is blurring. Read more

News on Hot List Stocks

Micron Technologies beat quarterly profit expectations on soaring demand for the chips it makes for smartphones and computers. It raised its third quarter revenue forecast to $7.20 to $7.60 billion.

Toll Brothers said Wendell Pritchett, the provost of the University of Pennsylvania, was elected to its board of directors.

Since our last newsletter, the S&P 500 returned -3.5%, while the Hot List returned -0.7%. So far in 2018, the portfolio has returned -10.1% vs. -1.1% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 227.0% vs. the S&P's 164.3% gain.

Quarter in Review: Trump, Taxes and Tech

January started out with positive undertones and a favorable view of macroeconomic trends. Globally, economies were growing in synch, and markets had continued their steady climb from 2017, led again by technology stocks.

President Donald Trump's tax cuts, enacted in late 2017, came in time for several companies to announce plans for buybacks and employee bonuses. The optimism stoked by tax cuts supported the view that they will lead to real growth in gross domestic product as companies increase capital spending. Consumers were also seen reacting positively to economic expansion, though low unemployment numbers still haven't translated into big growth in wages.

The animal spirits awakened by President Donald Trump's pledge to cut taxes and regulation helped fuel the rally forward. The government stimulus coincided with the Federal Reserve's plan to raise interest rates as part of its effort to return markets to normal following a decade of extreme monetary easing in response to the financial crisis. In March, the Fed raised rates a quarter point and signaled it might be more aggressive with its rate raising timetable, though it was still muted on its inflation outlook.

Starting out the year, traders across Wall Street had bet heavily that volatility would continue to stay low as stocks climbed. Selling volatility while buying stocks was the hot trade. Momentum traders were also continuing to bet on big technology companies and semiconductors.

But something went awry in early February, and the low-volatility trade blew up. Markets swooned and had their worst few days in years after peaking in January. It all seemed to point to an increase in inflation, even though the Fed's planned rate increases had been well-telegraphed to the market for months.

The stock market would regain much of its declines in the weeks that followed, and then the cart would come off the rails.

The first sign of trouble came in the second week of March, when President Trump announced broad tariffs on steel and aluminum, igniting fears of a global trade war erupting as members of the EU and other nations threatened to retaliate. The stance on steel and aluminum would soften with exemptions for major trading allies, like Canada and Mexico. But then President Trump launched tariffs against China and promised more to come. The U.S. stock market had its worse day since February on Thursday in response.

Technology stocks also lost their luster as the quarter wore on. President Trump blocked Broadcom's hostile takeover of Qualcomm (citing national security), sending semiconductor stocks down 3% for this week. Facebook - one of the FANG stocks that had dominated the index over the last year - slumped 10% this week after scrutiny of a data leak. The S&P's technology sector is down 5.3% for the week. Bank stocks, the natural beneficiary of rising interest rates, have not stepped into the void.

After initially reacting negatively, markets appeared more willing as the quarter went on to accept rising interest rates, especially if they signal continued economic expansion with job creation and strong corporate profits. But the government risks diluting the positive effects of reduced regulations and tax cuts with trade policies that are raising tensions and drawing threats of retaliation from abroad.

Become an Equity Compounder like Buffett

It's a simple concept but, over time, it accomplishes extraordinary things.

That's how legendary investor and stock market guru Warren Buffett has described compound interest, a concept that Albert Einstein called the "eighth wonder of the world." The idea is simple: If you invest even modest amounts of money at modest rates of interest and leave it invested over long periods of time, it can grow exponentially-since the interest you earn each year is added to your principal, the money grows at an increasing rate.

Compounding can also apply to equity investment, although in a slightly different context. Since share prices fluctuate, you don't have the same assurances that your investment will grow consistently and compound the same way dollars invested in a bank account can. However, you can increase your chances of generating consistent returns and building wealth by focusing on fundamentally sound companies with strong underlying characteristics.

This is consistent with Buffett's philosophy, which he described in a Forbes article last year as one that aims to "find a good business--and one that I can understand why it's good--with a durable, competitive advantage, run by able and honest people, and available at a price that makes sense. Because we're not going to sell the business, we don't need something with earnings that go up the next month or the next quarter; we need something that will earn more money 10 and 20 and 30 years from now."

It's easy to see why at Validea we refer to Buffett as the Patient Investor , and created a stock screening model inspired by his investment methodology. This market legend has earned billions by using a strict, conservative philosophy that targets well-established, conservatively financed firms that have decade-long track records of success. You won't find him jumping to the next big thing, the next "hot" stock. Instead, he invests in simple, well-run businesses and holds onto them for years and years.

A similar approach was highlighted by Morgan Stanley in a 2015 paper titled, "The Equity 'Compounders': The Value of Compounding in an Uncertain World." The paper outlines the firm's research that showed how "compounders" -- companies that possess "strong franchise durability, high cash flow generation, low capital intensity, and minimal financial leverage" - have generated "superior risk-adjusted returns across the economic cycle." The paper goes on to argue that, even in a climate of strong equity performance, compounders still offer attractive valuations relative to their long-term intrinsic value. Further, it asserts that investors in such an environment would be wise to adopt a "back to basics" approach to portfolio management to increase their chances of earning high risk-adjusted returns throughout market ups and downs.

Buffett would no doubt agree, particularly since many of the metrics outlined in the Morgan Stanley paper are reminiscent of the characteristics Buffett looks for when evaluating companies for purchase.

Here are some qualitative criteria that Buffett focuses on (as outlined in the 1997 book Buffettology):

Strong brand recognition (think Coca-Cola);

A company should have the ability to pass on costs--if it can adjust prices to inflation and still sell as many products or services, it can probably withstand any negative shifts in the economic climate;

Product complexity--Buffett likes companies that are easy to understand and that make products everyone needs and uses.

Quantitative measures (which we also use in our Buffett-inspired model) include:

• Predictable earnings-per-share that have been continually expanding over the last 10 years;
• Conservative financing structure--Buffett likes to see that a company can pay off its long-term debt with earnings in under two years;
• Return-on-equity of over 15% in each of the past ten years;
• Positive free cash flow;
• Management's use of retained earnings (total amount of retained earnings for a specified period divided by any gain in earnings-per-share over the same period) reflecting a return of at least 12% and preferably 15%.

Whether you're talking about compounding with respect to interest or equity returns, patience is a key common denominator - and one that can be elusive for investors, particularly in this age of endless headlines, financial news casts, alerts and banners.

For Buffett, the trick is in knowing what you know, and knowing what you don't. Throughout the countless sound bites, interviews, articles and quotes attributed to the billionaire, a common theme is his ability to remain steadfast in his, well, steadfastness. A staunch believer in level-headed, well-informed investing, Buffett argues, "There's a temptation for people to act far too frequently in stocks, simply because they're so liquid." He says, "If you're emotional about investing, you're not going to do well. You may have all these feelings about a stock, but the stock has no feelings about you."

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