Since the S&P 500 stock market index bottomed in early 2009, stock markets have averaged total returns of nearly 20% per year. At the apex of market panic, where the last holdouts finally capitulated and sold their investments on March 9th 2009, stocks were priced to deliver some of the best returns in a generation. This, at the precise moment investors had the smallest amount allocated to stocks and the highest level of cash in many decades.
The stock market is funny like that. When it’s the worst time to own stocks, after substantial gains, at high valuations, and at the peak of the economic cycle, like March 2000 and October 2007, the stock market draws more and more investors in. When the economy is terrible and investors have already experienced substantial investment losses, when things literally can’t get any worse (and prices represent great long-term value), it’s just the opposite: the stock market drives investors into the “safety” of bonds and cash at the worst possible moment.
Today, we’re eight years into an economic expansion that shows no signs of letting up. Employment is at all-time highs, wage growth is adequate, housing continues to expand, and confidence is widespread. By our estimates, the U.S. economy should continue to expand for at least the next couple of years. And if President Trump and the Republican-led Congress can cut taxes on corporations and the middle class, reduce regulation where excessive and punitive, and deliver a well-needed infrastructure package, the good times should continue for some time beyond that. And that’s obviously positive for the stock market.
One of the world’s great investors, Charlie Munger, Warren Buffett’s long-time investing partner, notes that constructing a “latticework of models” from various fields like art, science, and philosophy is the best approach to problem solving. And by building this latticework, one develops a mental structure of wisdom that can be applied throughout life, and in our case, to investing.
In his 1994 lecture at USC Business School, Munger said:
“What are the models? Well, the first rule is that you’ve got to have multiple models—because if you just have one or two that you’re using, the nature of human psychology is such that you’ll torture reality so that it fits your models, or at least you’ll think it does… It’s like the old saying, ‘To the man with only a hammer, every problem looks like a nail.’ … But that’s a perfectly disastrous way to think and a perfectly disastrous way to operate in the world… So you have got to have multiple models across an array of disciplines.”
In past letters, we’ve detailed one of our models, which is the application of Newton’s First Law of Motion to the U.S. stock market. One part of Newton’s Law states that an object in motion will stay in motion at the same speed and in the same direction unless it is acted upon by an opposing force. We think the same can be said for stocks. And we see four important drivers, or forces, on the stock market and its trajectory: fiscal policy, monetary policy, leading economic activity, and stock valuations.
Below is an updated visual of the Law as applied to the U.S. stock market. Our intention with the graphic is to illustrate that there are still many factors offering positive “force” (in green) to U.S. stock markets. The items in red represent opposing forces, ones that could cause a change in direction. As more items turn up red, the opposing forces start to offset existing momentum and place stocks at risk of a material, persistent change in direction (note that we aren’t concerned with short-term volatility, only sustained market direction changes). At least, that’s how shifts have occurred in the past and how we envision the model will work in the future. The opposite occurs as markets bottom (red shifts to green).
We think it is best to manage risk with a medium-term (2 to 5 year) outlook. And Newton’s Law as applied to the stock market serves that purpose in two key ways. First, it helps us look beyond the short-term noise to the forces that impact sustainable investment performance. And second, it offers insight into potential turning points in stock markets. Both are necessary for properly managing risk.
A myopic focus on the overly positive/negative short-term situation is the cause of the most pronounced investment mistakes. Investors tend to focus on what’s right in front of them, instead of on the shifting counterforces that have durable market impact, but take time to influence markets.
Of course, an overly-long-term focus can also lead one astray, as the overly bearish investors touting an expensive equity market since 2010 might (secretly) confess to, after having missed out on much of the current bull market’s gains waiting on the stock market to crash. A medium-term outlook, then, in our opinion, provides superior risk management.
Application of Newton’s First Law of Motion
Our application of Newton’s First Law is just one model in our latticework. It explains how a market’s existing momentum can continue to carry it in one direction, even when some or all of the four forces offer counterforce. However, like an object in motion, eventually those forces will slow existing momentum and cause a change in direction.
Our usage of Newton’s Law applies to the entire U.S. stock market, but it is worth noting that we do not own the S&P 500. We are instead invested in a small collection of carefully researched individual companies, which we believe in aggregate offer better valuations, returns on capital, and return expectations than the S&P 500. Despite our differentiated positioning, stock market moves do bear on our portfolio, which is why we utilize Newton’s Law to help manage risk. For now, we are comfortable in our selections and confident in the medium-term outlook, but we remain cognizant that much good news is already reflected in broad market stock indices.
The Specifics of the Four Forces
Below are the details of the four forces and their current impact on stock markets.
The Federal Government has two levers to impact economic growth: fiscal policy and monetary policy. Fiscal policy is its use of taxation and spending to influence the economy. Since recovering from the 2008/2009 recession, Congress has added new taxes and prioritized entitlement spending over long-lived asset investment such as roads and bridges. President Trump intends to change that. He wants to cut taxes on U.S. corporations and individuals and to lower the tax rate on cash repatriation from overseas corporate holdings. The President also wants a public-private partnership for a massive infrastructure project. Tax cuts and infrastructure spending, if enacted in substantial size, should grow the economy, create jobs, and increase wages and corporate profits. The silver lining is that even if these White House proposals fall flat, fiscal policy is becoming a more positive contributor of growth.
The government’s second lever of economic influence is monetary policy, which is the control of the supply of money in an economy, primarily by means of a central bank (i.e. Federal Reserve) targeting interest rates. Until recently, it has been the government’s only driver of economic activity. While President Obama and