Riding out the storm

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It’s very easy to spot someone who views themselves as the smartest guy in the room.  When their perception is accurate, listening to them can be fascinating.  However, in cases when their preconceived notions are misplaced, they can be frustrating to be around, even dangerous when in positions of power.

I am under no illusions that I’ll ever be the smartest guy in the room.  What I strive to be is the guy in the room with the slowest pulse.  In a nutshell, our investment team strives to make rational, analytical decisions while removing emotional extremes from the process.  In my view, so far this year, emotional extremes are dominating daily discourse and decision making.

To try to better understand the root cause of this heightened anxiety, I’ve been working my way through two very interesting books.  The first, “Time to Start Thinking – America in the Age of Descent” by Edward Luce, basically paints a rather negative picture of our nation’s future.  The second book, “It’s Better Than It Looks – Reasons for Optimism in an Age of Fear” by Gregg Easterbrook, essentially argues the exact opposite viewpoint.  Today, it seems that compelling arguments can be made on opposite sides of virtually every topic worth debating or thinking about.  While this might be confusing to some, when it comes to the stock market, it is really a very good thing.  Let me try to explain.

With conflicting information in news articles, posts and tweets, emotions are once again driving the stock market in the short term.  The increased volatility essentially creates opportunities as two omnipresent, powerful emotions – fear and greed, drive stock prices far apart from valuations supported by company-specific or economy-wide fundamentals.

For example, Trump’s controversial trade strategy has caused all kinds of gyrations in several industries and sectors.  Fears that a trade war could lead to a global recession has, from time to time, put intense pressure on stocks.  Meanwhile, the potential for a more level playing field with China, regarding trade and intellectual property rights could lead to more economic growth over the long term, which would be positive for stocks.  In my experience, reality usually lies somewhere in between the positive and negative extreme forecasts.  However, the ramifications for the economy and stock market from a potential negative outcome is downright daunting, while the potential upside in a positive scenario puts pressure on investors to stay in the game.  Again, there is plenty of evidence in support of both extremes.

Our goal, and the goal of prudent portfolio management, is not to determine which extreme to bet on, but to take advantage of the emotional gyrations in a disciplined way.   In a word, we call this strategy – incrementalism.  We are not looking for the magic moment to be overly bullish or bearish.  We are concentrating on making incremental changes across all of our portfolio strategies, to take advantage of mis-priced securities that result from emotionally-driven volatility.  It may sound like a simple strategy, but it is anything but.

Over the remainder of this year there will undoubtedly be emotional moments related to the following issues:

  • Trade negotiations with China
  • Trump’s potential visit with the North Korean dictator
  • Ever-expanding federal debt
  • Interim election and the potential change in control of Congress
  • Geopolitical tensions in the Middle East and with Russia
  • President Trump’s rather unique management style (to be kind)

What is the point of this list?  Think about the worst-case scenario related to each issue (whatever your political perspective).  It keeps one on edge doesn’t it?

At the same time, there are several positives to consider, namely:

  • Strong corporate profit growth approaching 15% for 2018
  • Lower taxes and repatriation of cash that should help the economy over time
  • Lower regulation benefiting small businesses which create most of the jobs
  • Benign inflation and historically low interest rates

There really is no way to avoid it.  We are in unchartered, potentially dangerous waters due to polarization and political dysfunction in Washington.  But, the outlook is not all doom and gloom.  Discipline, patience, and an investment process based on incrementalism, can be the best way to ride out the storm.

 

Michael Kayes, CFA

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