Maintaining Investment Discipline

Gabe Lembeck
February 13, 2020
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This excerpt, taken from Balentine’s 2020 Capital Markets Forecast, argues that an investment process can keep investors grounded as worries become structurally more excessive than appropriate. Want to learn more? Don’t miss Balentine’s full 2020 Capital Markets Forecast, our signature research piece that serves as the foundation of our investment process.

In some ways, we live and invest in atypical times, at least from a financial markets’ perspective. Take the rate on the 10-year Treasury note. In 2019, the rate briefly fell below 1.5%. Almost 40 years ago, in the 1980s, the 10-year Treasury note yielded more than ten times that amount. To earn $150,000 in interest last year, an investor needed $10 million in principal—versus less than $1 million in 1981. Believe it or not, despite the scorn directed at current rates, buying a 10-year Treasury bond may be reasonable when you compare it to the $14 trillion changing hands in negative-yielding global debt. Think about this for a minute: investors are paying governments to loan to them, not vice versa.1

Despite the unusual environment, 2019 was a phenomenal year for capital markets with equities returning 27.3%.2 In fact, aside from 2017, which may go down as one of the best years in stock market history given the tremendously low volatility on top of a robust return, 2019 was the best year for global equities that this historic bull market3 has seen (Figures 1 and 2).

Figure 1. Best year of this bull market? 2019's total return exceeded 2017's...

Nevertheless, sentiment remains tepid at best. Despite solid fundamentals, some surveys show bearish outlooks are more pervasive than they have been in two decades. Domestically, although economic growth has slowed, the trajectory remains positive, buoyed by a robust consumer resulting from historically low unemployment and wage gains. Globally, growth remains lukewarm, but signs of improvement have made their way into global equity prices. In prior eras, these conditions would have infused optimism.

Figure 2. ...but low volatility within equities may make the case for 2017.

Adding to what should be more bullish sentiment is the possibility of improved growth due to thawing trade tensions. More importantly, the Federal Reserve has pivoted from its hawkish tendencies to favor rate cuts and more data dependency, helping the yield curve regain a positive slope. Following are promising developments we observed toward the end of 2019.

  • Equity markets experienced a sustainable breakout following 21 months of little progress. From the peak in January 2018 until the October 2019 breakout, we saw many subtle bear markets. Entire cyclical sectors (e.g., semiconductors, autos, banks) were down 30%–40%, and leaders turned into laggards. For example, prior market leader Apple fell 40% before regaining its footing and going on to exceed prior highs.
  • Yields came off their lows, and the yield curve steepened out of an inversion. The bond market, which is traditionally a better predictor of economic weakness than the stock market, backed off its doomsday stance. The 10-Year Treasury looked ready to break the all-time low of 1.39% before its reversal.4 FAANG5 stocks reasserted themselves. Facebook, Apple, Netflix, and Google pushed higher despite consistent concerns about regulation (Facebook and Google) and potential growth erosion from competition (Apple and Netflix). While Amazon has yet to get its mojo back, investors have taken a liking to companies poised to compete—including Walmart, Target, Costco, Home Depot, and Lowe’s.
  • There was movement toward cyclicality across sectors, regions, and the cap scale. This is vastly different from the peak in 2018, when investing in U.S. large-cap technology stocks was the only game in town. Breadth is widening tremendously both domestically and globally. In the U.S., industrial and financial stocks are breaking out, while consumer discretionary stocks remain strong, shaking off concerns about the economy, global trade wars, and idiosyncrasies about their largest respective securities, Boeing and Amazon. Except for energy (which is still languishing), all other sectors continue to trade strongly. Even utilities and consumer staples are performing decently despite the move toward riskier assets.
  • Almost half of global markets broke out to new 52-week highs toward the end of the year. Notably, this included a swath of European nations which were recently lagging (e.g., Germany, France, Italy, and even Greece). Keep in mind that capital markets historically tend to lead economies. In other words, by the time the economic data changes, the market has already detected the likely shift and has repositioned accordingly. In this case, we believe the market is telling us next year’s growth will be better than people think, thus removing another brick from the “wall of worry.”
  • High-yield spreads remained low. Although energy high-yield spreads began to tick up as the relative woes of the energy sector continue five years after the great oil price collapse, the remaining sectors are not indicating any abnormal stress. This is a crucial point, as bond market anxiety has typically preceded equity market tension in cases of structural concern.

Given this broad participation, a short-term risk in 2020 is investors finding themselves offsides, yet again, by being under-allocated to stocks. We have identified potential challenges in the private market, but we believe those concerns are being addressed. As a result, we remain optimistic overall on private equity (which we touch upon later in this publication). However, the WeWork debacle, in tandem with weakness in recent public offerings (e.g., Uber, Lyft, Peloton, Slack), reinforces our belief that current sentiment is far from the euphoria and irrationality typically associated with market tops. While not guaranteed, the continued lack of bullish sentiment and positioning should serve as a tailwind for public markets.

As Worries Become Structurally More Excessive than Appropriate, an Investment Process Should Keep Investors Grounded

Why are investors so anxious and concerned? We believe the answer is twofold: 1) residual scarring from the Global Financial Crisis (GFC), and 2) information overload which tilts investors’ biases toward fear and greed more than ever before. We believe the latter is a more serious concern because it indicates a structural change to the investment landscape which will likely never disappear. Although it has been almost 11 years since the end of the GFC, the former will inevitably prove to be transitory; it took decades after the Great Depression for animal spirits6 to return, but return they did. The information age, for better or for worse, is here to stay.

It is no secret that the media’s quest for clicks and eyeballs have led them to bias their financial stories toward sensationalism and fear rather than conveying true, useful financial news—but that is not the only problem. Extreme market responses to monetary policy and a highly partisan political culture also play a role. Social concerns such as wealth inequality run rampant; even CEOs who have created tremendous shareholder value are not immune from criticism. Populism is raging against the upper class and, in many cases, against capitalism in general. Corporate tax rates and stock repurchases have become fodder for populist torches and pitchforks. Similar to negative bond yields, did we ever foresee a time when the capitalist system in the U.S. would be questioned to such a degree that political candidates would suggest socialism as a viable alternative?

How does an investor confidently invest their wealth under such conditions? The key is to have an investment process that works through thick and thin, allowing the client to cut through the noise and focus on what matters. Portfolio shifts and reallocations are often integral to this process, but wholesale buying and selling on respective feelings of greed and fear in response to market noise is not. This leads us to two questions:

  1. What makes up an investment process?
  2. How does an investment process determine what is simply noise?

First, there are two axioms which give an investment process its foundation:

  1. Investing must come with some level of uncertainty.
  2. Having a defined investment process increases the chances of success amid uncertainty by sticking to a discipline which works more often than not, preventing emotions from taking over decision-making.

There is a level of uncertainty inherent in investing; without it, there would be no risk premium and prices would already be high to reflect the lack of need to discount for risk. Thus, there would be no opportunity to make money. But why does it always seem as if uncertainty is more elevated than usual? Our hindsight biases cause us to forget there were concerns during previous up phases of bull markets. Instead, we focus on the results and assume everything was copacetic during those periods. But make no mistake, the stresses were there. Figure 3 shows a sampling of fears during the 1982–2000 bull market.

Figure 3. The Wall of Worry During the 1982-2000 Bull Market

There will always be concerns in the markets, which is why there are always some investors who position themselves more defensively than offensively. To date, none of these worries have resulted in permanent ruin, as the broader market has always regained its footing. In his noteworthy “Buy American. I Am.” op-ed, published in The New York Times during the heart of the Great Financial Crisis, Warren Buffett wrote:

...bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price. Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

Market guru Peter Lynch, who ran the Fidelity Magellan Fund from 1977–1990, took a different tack. Not only are such market episodes inevitable, but their timing is the ultimate in uncertainty:

Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves...If you’re in the market, you have to know there’s going to be declines. And they’re going to cap and every couple of years you’re going to get a 10% correction. That’s a euphemism for losing a lot of money rapidly...And a bear market is a 20–25–30 percent decline…If you’re not ready for that, you shouldn’t be in the stock market.

Uncertainty is a given in investing. In fact, outside of a risk-free investment, which begets the lowest guaranteed rate of return, the only certainty is that there will be uncertainty. Furthermore, the timing and magnitude of such episodes is anyone’s guess. If these anxieties did not exist there would be no compensation for taking equity risk; consequently, there would be far fewer opportunities for investors to generate reasonable returns from their investments. To take this argument a step further, investor anxiety prevents investors and traders from overweighting their portfolios with equities. This, in turn, prevents the stock market from getting too far ahead of itself.

What about the wall of worry during this bull run? Let us count the ways...

Figure 4. The Wall of Worry During the Current Bull Market

This chart is analogous to the prior bull market shown (Figure 3). Reiterating our earlier point, following a defined process allows investors to tune out the noise in the market and focus on what matters. People often make the mistake of assuming good outcomes necessarily stem from good processes and vice versa. This is colloquially known as “resulting.” Perhaps no space embodies this more than the investing world. Resulting leads to a focus on short-term outcomes and assuming those outcomes can be extrapolated into the future with little or no regard for the process which generated the original decisions. The reality is that process and outcome are, unfortunately, not perfectly correlated; while a good (or bad) outcome is likely a product of a good (or bad) process, this is not always the case. Figure 5 demonstrates a matrix of different process/outcome combinations.

Figure 5. Process and Outcome Are Not Perfectly Correlated

When it comes to much of decision-making in life and, specifically, investing, often the only given is there is no given. In contrast with the deterministic (i.e., not random in the long run) risk assumed by entities like casinos, the uncertainty in investing has an undefined outcome distribution. In other words, when a casino takes risk, it knows statistically how many times a certain outcome will come up for all its games. As a result, the casino can price the games such that even though it may lose in the short run, it is statistically improbable to lose in the long run. Investing rarely, if ever, features such a dynamic. The distribution of possible outcomes is essentially infinite and relatively random, ranging from the “realistic” outcomes to the highly unlikely “black swan”7 outcomes. Such results make decision-making challenging not only because of the uncertainty of what may happen, but also because people are biased to believe the possible outcomes will fall only in their perceived ranges, which are often too narrow.

This is where the investment process comes into play. A successful process is not about guaranteeing results in any specific instance; rather, it is focused on maximizing overall chances across the life of the process.

An investment methodology should be dually focused on generating returns and managing risk.

What makes a good process? For starters, it is comprised of three steps:

  1. Investor analysis
  2. Portfolio construction
  3. Evaluation

All three are critically important, but the focus of this piece is on portfolio construction.

Balentine’s investment process follows this paradigm, weighing probabilities and the risk/ reward trade-off to determine the optimal decision. Although this publication assembles asset class forecasts to best determine the appropriate strategic allocations in each strategy, projections have an infinite number of possibilities and paths as capital markets progress over seven years. As a result, it is easy to get overly concerned about the level of precision imputed on these forecasts rather than looking at the bigger picture of what they are saying about markets directionally. We know even if we hit our forecasts, the path to get there will likely be lumpy. In fact, while the current bull market has come with little volatility, the ten years preceding it featured two bear markets. And, in our opinion, the next ten years are more likely to look like the latter. As a result, our process employs a tactical approach to allow us to take advantage of different portions of the cycle, both in the bullish and bearish phases.

Our process allows us to navigate various market conditions by sticking to a discipline predicated on two important points:
  1. Momentum in an asset class is subject to Newton’s First Law in that it stays in motion until acted upon by an external force.
  2. Investors will typically not sell one asset class in favor of another until it gets sufficiently expensive.

This philosophy has served us well; in the case of assets with lower correlation (e.g., stocks and bonds), momentum begets momentum and reveals where the market is putting its money, and relative value signals when the money flow is poised to change. The combination allows us not only to take advantage of excessively depressed prices when the environment is too fearful, but also to sidestep problems when the environment is too greedy; our model positioned us appropriately during both traumatic bear markets during the decade from 2000–2009. Although the discipline has not been able to demonstrate its full prowess this decade without a bear market, it has been, in general, on the right side of the stocks versus bonds asset allocation decision. Assuming investors do not inappropriately extrapolate the success of the last decade to the next decade (i.e., assuming the next decade looks less like relatively smooth 2010–2019 and, rather, more like the volatile 2000–2009 period), we would be well served to stick with the discipline our process affords us.

Additionally, within our allocations, momentum allows us to emphasize areas in which the market is applying capital while under-allocating to areas the market is avoiding. As an example, as growth stocks complete 13 consecutive years of relative outperformance, many investors today have never seen a market in which value stocks were the superior market driver. Similar to the stocks versus bonds decision, some may extrapolate that growth’s run will continue indefinitely. Sticking with a process will allow us to overcome these temptations and will put us in a position to select the equities viewed most favorably by the market at a given time. Again, there are no guarantees over any specific time-frame with this methodology, but it does shift the odds in our favor in what is an inherently uncertain environment.

When it comes to the evaluation part of investing, many investors unfortunately place too high a premium on results over process. This is not to suggest results are not important in the long run. However, evaluating any decision based solely on the short-term results with no contemplation of the process which went into the decision can lead to a falsely high level of confidence in the repeatability of the result. This will inevitably lead to investors either forgoing appropriate calculated risks for fear of “bad breaks” or taking on inappropriate risk to repeat “dumb luck,” neither of which is part of a suitable process for generating investment success.

The market has repeatedly proven that substantive bear markets do not occur until equities become sufficiently expensive relative to bonds. To get from where we are now to this point would require a combination of rising bond yields and an adequately large equity market multiple. Rising rates would not only drive bond prices down, but they would also make the risk-free rate compelling enough to offer an alternative to equities. Higher equity market multiples would result from growth in earnings lagging growth in equity market prices. Furthermore, in the absence of sharply rising bond yields (a scenario which could play out given low inflation and vigorous central bank policy), it would take an even larger increase in equity prices relative to earnings. In either scenario, the bull market should still have room to run.

This said, it is only a matter of time until this historic bull market comes to an end, the current unknowns being when and why. As noted in Balentine’s 2018 Capital Markets Forecast, virtually every bear market of the past 75 years has involved either a military element or a domestic economic event. We saw signs of this in late 2017 and early 2018, but it became self-limiting as fear reemerged. If history is a guidepost, fear will need to decrease for an extended period while animal spirits assert themselves before this market tops out.

Being bearish on stocks simply because of their valuations reminds us of the saying about the stopped clock being right twice a day. Valuations, in and of themselves, are terrible timing indicators. As a classic example, recall former Federal Reserve Chairman Alan Greenspan’s famous “irrational exuberance”8 speech in which he warned the market had gone too high, too fast and investor zeal was not warranted. Ultimately, the internet bubble burst four years later, proving his point. However, the best returns of the market often occur at the end of a growth cycle, and even the smartest person in the room can miss it by a few years.

Uncertainty, both in time and in magnitude, is something with which all investors must live. Following an investment process maximizes investors’ probability of success by maintaining discipline and reducing (if not eliminating) the likelihood of biases and emotions driving investment decision-making.

1 Governments are not paying coupons; instead, these are zero-coupon bonds in which the bondholder will receive less money back than originally loaned.
2 As measured by the MSCI All Country World Index (ACWI)
3 This bull market, the longest running in history, will turn 11 in March 2020.
4 The 10-Year Treasury sank to 1.43% on September 2, 2019.
5 FAANG is the acronym for five of the market’s most widely held technology and communications stocks: Facebook, Apple, Amazon, Netflix, and Google (now Alphabet).
6 British economist John Maynard Keynes coined the term “animal spirits” to refer to emotional (versus rational) mindsets that influence and guide human behavior.
7 The term, popularized by investor and statistician Nassim Nicholas Taleb, refers to events characterized by their extreme rarity, their severe impact, and the practice of explaining widespread failure to predict them as simple folly in hindsight.
8 This term is used to describe a heightened state of speculative fervor.

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