What Will Shape the Markets in 2019: A Game of 20 Questions, Part IV
To the extent one can ask the right questions, the best available answer is often something other than a concrete "yes" or "no." Rather, one has to use ones best judgment based on an assessment of the probabilities. It is in that vein that my posts this month are modeled after 20 Questions, with my best sense of the relevant probabilities provided for the 20 issues I believe are likely to prove the most germane over the course of 2019.
16) Will the investing public collectively "rage against the machine" in 2019? 25% probability.
As the Wall Street Journal recently highlighted, approximately 85% of trading is now automated in nature. That includes quantitative-oriented hedge funds, passive funds, and high frequency traders. This comes at a time when Obama-era regulations have made traditional banks and brokers less active in the trading markets. To be sure, the rise of quant- and passive-oriented investing has helped to fill some of that liquidity void. Moreover, it is not as if these trends were not already well-established as recently as 2017—a year of remarkably low volatility. Still, there is little question that quants and electronic traders can exacerbate the speed and magnitude of market movements via their largely momentum-driven algorithms. The issue may be more acute in the fixed income markets, where many bonds held by passive funds are difficult to trade. This all has elements of the "known unknown" risks we alluded to in part three, as evidenced by past flash crashes and leveraged quant-driven turmoil such as what befell Long Term Capital in 1998. The increased prominence of so-called risk parity funds may be a source of particular danger if traditional equity/debt correlations breakdown. Either way, any bout of machine-driven downward volatility could well trigger a tweet storm from Pennsylvania Avenue and unleash a sustained backlash against this relatively new market backdrop.
17) Will President Trump still be in office at year-end 2019? 85% probability.
Special counsel Mueller’s final report is rumored to be nearing completion. Whether the findings rise to a level that would cause two thirds of the GOP-led Senate to support a potential House Impeachment seems unlikely. Of course, there are other reasons President Trump could leave office, but our guess is that it would take clear evidence of collusion with Russia for conviction in the Senate. In any event, while a House-led impeachment effort and related drama may help sell a lot of newspapers (clicks included), a “smooth” potential transition to current Vice President Pence would be unlikely to rattle the markets. Alternatively, while the sample size is extremely small, a full-fledged constitutional crisis could prove highly disruptive, with the market turmoil that coincided with Watergate as a worrisome data point.
18) Will Japan outperform the MSCI All Country World Index? 60% probability.
Having highlighted key risks associated with the world’s second largest economy in questions four and five, it seems fair to assess the world’s third largest economy. Suffice it to say that the near-term momentum is not encouraging given the negative GDP posted in 3Q18 (in part due to natural disasters) and the threats posed by a slowing China and trade protectionism. Still, the reduction in trade tensions we anticipate over the course of the year, sustained improvement in profitability trends—includingreturn on equity as many companies become more efficient—and undemanding valuations leave us moderately bullish. We have a preference for active management in Japan given our view that long needed improvements in productivity and corporate governance are occurring at many, but by no means all, Japanese companies. Good active managers should be able to separate the proverbial wheat from the chaff.
19) Will the FAANG's outperform the S&P 500 in 2019? 35% probability.
It was no coincidence that the 14% 4Q18 decline in the S&P 500 overlapped with an even steeper 23% average sell-off in the high-profile FAANG's. Although their growth trajectories and valuations differ, the five tech-oriented darlings have been the clear go-to momentum stocks of the post-crisis era. Again, each story is unique, but from an overarching perspective, we are reminded of what famed ex-internet analyst Mary Meeker used to say: be very careful when fast-growing technology companies become caught in the regulatory cross-hairs as it tends to be extremely distracting for the management teams. Regardless of how the FAANG's perform, our view is that after one of the longest and largest stretches of growth outperformance versus value, the pendulum is likely to swing toward the sectors that have underperformed the most dramatically in recent years, including energy and real estate investment trusts. The banks, sizable laggards in 2018, should also outperform, in our view. Along somewhat similar lines, we expect reversion to the mean to help narrow the performance gap in favor of high quality stocks (i.e., those with characteristics such as low debt, stable earnings growth, strong cash flow generation and high returns on equity) over the lower quality stocks that often outperformed during quantitative easing.
20) Will the surge in share buybacks over the last several years reverse course in 2019? 65% probability.
Goldman Sachs recently estimated that S&P 500 companies will repurchase $940 billion in shares in 2019, up from about $770 billion in 2018. That would be a continuation of a powerful seven year trend that has seen US share buybacks of approximately $4 trillion, or roughly a third of the S&P 500’s market cap appreciation during those years. Many corporate management teams have relied upon low interest rates to issue debt to repurchase shares, raising EPS (and often their own compensation given the prevalence of EPS-linked performance incentives). We think Goldman’s forecast is too aggressive. Somewhat higher interest rates than prevailed in recent years and the market’s increased concerns regarding corporate indebtedness should trim some of the buyback demand. Moreover, while logic would dictate that companies should be especially keen to buy repurchase shares after they have declined in value, history suggests the opposite—that managements behave more like the masses in terms of buying more when share prices are rising and the economic outlook appears benign. Over time, management teams have simply not been very good at timing their buybacks. From a broader perspective, we have no particular philosophical aversion to share buybacks when a company’s stock appears inexpensive relative to its intrinsic value. Similarly, double taxation aside, we believe that dividends can provide a helpful check on corporate profligacy. However, all else equal, we believe the most successful companies typically use extra cash to reinvest in their businesses. (Apple’s $120 billion cash horde that has mushroomed in recent years comes to mind as an example of where perhaps additional cash should have been allocated to innovation and capital expenditure). The repatriation provisions of the 2017 tax reform were designed to help provide such an inducement—with seemingly mixed to slightly disappointing results to date.