In July 2007, Citi’s Chuck Prince, infamously quipped when referring to the firm’s leveraged lending practices: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing you’ve got to get up and dance. We’re still dancing.” That offhand comment has haunted the former Citigroup chief executive, and he has since tried to explain that he was referring to not wanting to lose top bankers who worked on private equity deals. One of the consequences of “not dancing” was that Citi could lose private equity firms as clients and lose the bankers who have those relationships. He compared running a firm like Citi to managing a baseball team where none of the players have contracts. Just months after the dancing comment, Citi took a $1.5bn write-down tied to its leverage loan portfolio, and most of the bankers who did those deals are no longer employed by the firm. Early into March of 2018, the music is still playing. The economy is red-hot, but some investors are starting to get the sense that this might be as good as it gets. Even though almost everyone insists a recession is at least 12-18 months away, it all could reverse at any moment. A key advantage that individual investors have versus large institutions and hedge funds is that we don’t have to dance until the music stops–we’re not evaluated on the basis of the quarterly (sometimes monthly) performance of a benchmark, and we can take our chips off the table whenever we feel like it.
2017 was too easy. The graph of the S&P 500 last year was pretty much just up and to the right, and everybody made an effortless 20%. Euphoria continued into January, but trees don’t grow to the sky, and I think that the days of easy money are over. The S&P 500 peaked at 2,873 on January 26th—the day of President Trump’s Davos address. Many expected the speech to be a clash of civilizations with an overall theme of “America first.” However, the speech was actually crafted for a kind of virtual togetherness, a merging of “America first” with everybody else as partners. The key development was that President Trump’s radical anti-globalization and anti-free-trade rhetoric became real. A key snippet: “We cannot have free and open trade if some countries exploit the system at the expense of others. We support free trade, but it needs to be fair and reciprocal … The United States will no longer turn a blind eye to unfair economic practices, including massive intellectual property theft, industrial subsidies, and pervasive state-led economic planning … we will enforce our trade laws and restore integrity to the trading system.” The following Monday, the S&P was down ~70 bps. Not a huge move, and who knows, maybe it would’ve bounced back to reach new highs in the coming weeks. However, President Trump emphasized the tough trade rhetoric again in his State of the Union Address on January 30th. The S&P closed at 2,822 (1.1% lower than the prior day and 1.8% below its peak). The rotten February that ensued probably had more to do with interest rates, inflation, systematic outflows and low liquidity, but fears over belligerent trade policy have remained.
We have recovered from the 2,581 low of February 8th and now stand at 2,752 at Friday’s close. Tamer US inflation was one precondition for risk to resume its uptrend. It’s also crucial that both macro (global synchronized growth) and corporate fundamentals (tax reform and record earnings) remain intact. Moreover, trade rhetoric was less belligerent this week. There’s no reason that stocks can’t reach new highs and maybe even the common 3,000 S&P 500 price target. In fact, (if I had to), I’d bet that they do move higher from here over the next month or two. But fortunately I don’t have to. There are few things I’d like to note as a significant number of investors remain overweight US Equities.
The current US expansion is almost the second-oldest of the post-war era, and asset class performance varies considerably over the business cycle. Also, most equity and fixed income markets are expensive based on historical valuation metrics. High valuations offer little protection or risk-premium for a possible slowdown as rates rise over the next two years—much less a more extreme outcome like a recession. And now, President Trump is talking about imposing $60bn of intellectual property tariffs on Chinese goods (2.6% of total imports). Not only does this risk the possibility of tit-for-tat tariffs, but it (combined with a $10bn steel and aluminum tariff and a gas tax) would also cancel out a significant chunk of the $200bn tax cut ($80bn to corporations and $160bn to individuals) that is supposed to be a key driver economic growth over the next 1-2 years. As mentioned previously, you also have interest rates that are being driven up by strong growth, a hiking fed, a large federal deficit, the reversing of global QE, and inflation (perhaps not on the most recent data point, but the trend is definitely upward). Lastly, you have midterm elections this year. On average, the S&P 500 has an 18% correction in a midterm election year.
So the question I’m asking myself right now is whether it’s worth it to try and ride the S&P 500 up another ~9% to 3,000 or take some chips off the table in case we get some sort of 10%+ correction. First of all, I feel like everybody’s waiting for S&P 3,000, which probably means we won’t get there. Nonetheless, I think it makes sense to reduce US stock exposure if you’re overweight—especially when the 1Y US Treasury is now offering a pretty attractive yield above 2%. I love Warren Buffet’s famous mantra: “Rule No. 1: never lose money. Rule No. 2: don’t forget rule No. 1.” It highlights the power of compounding. To use a very elementary example, let’s say you have $100 invested in the S&P 500. If it falls 50%, the value of your investment drops to $50. To get back to $100, you now have to make 100%, which can be a mountainous task. This is obvious but it bears repeating. Investing has to be thought of in terms of risk and reward. The fact of the matter is nobody can predict the future. The price of any asset should be a probability-weighted expected value. If there’s a 50% chance of stock going to $100 and a 50% chance of it going to zero, that stock should be priced at $50. When the odds are skewed against you, you’re supposed to take some chips off of the table. When the odds are in your favor, you increase the size of your bet. Nobody has a crystal ball and the sooner an investor acknowledges this, the better. Right now, I think there’s more downside than upside in US equity and fixed income markets for the remainder of 2018. The music may not have stopped yet, but fortunately, we don’t have to dance until it does.
My Top 10 Reads of the Week:
- Bloomberg: Not a Single Japanese 10-Year Bond Traded Tuesday
- WSJ: Who’s Afraid of Higher Wages?
- FT: Rex Tillerson: Tough Texan Who Failed to Connect with Washington
- Wired: Stephen Hawking, A Physicist Transcending Space and Time, Passes Away at 76
- MIT Technology Review: A Startup is Pitching a Mind-Uploading Service That is “100 Percent Fatal”
- WSJ: What’s the Biggest Trade on the New York Stock Exchange? The Last One
- HBR: Are Buybacks Really Shortchanging Investment?
- Wired: The Dangers of Big City Subsidies
- The Economist: The Battle for Digital Supremacy
- The Economist: Britain’s Poisoned Relationship with Russia