2019: The Year of Everything

I like the division of last year’s review newsletter and this year’s is laid out the same way: three parts – 1) 2019 in review; 2) Where do we go from here? and 3) What guides us.

2019 in review

2019 was the mirror opposite of 2018. In 2018 nothing worked – cash was king. In 2019 everything worked. Stocks went up across the board, and interest rates fell which produced positive returns in the bond markets too.

2018 ended with a bear market (the S&P 500 fell 20% in the last four months of the year, bottoming on Christmas Eve). 2019 ended with a strong rally – the S&P 500 was up 8.5% in the fourth quarter of the year. Over the year the total return (including dividends) of the S&P 500 was 31.5%. Emerging Markets and Europe didn’t fare quite as well as the US, but the MSCI AC World ex-US index still clocked up total returns of 22.1%.

This strong return makes 2019 sound like an easy year, but investing is never easy. If we break the year down (for the S&P 500) it went something like this:

· The first four months of 2019 made back all of the 2018 drawdown.

· May then saw a fast correction before the uptrend resumed in June and July.

· There was a sharp but small fall at the end of July and beginning of August and the market then rallied from the beginning of October until the end of the year.

Since 1980 the US market has fallen on average around 14% from the peak to the trough during the year, despite ending the year positive 75% of the time (30 out of 40 years have been positive). We call that the ‘intra-year decline’. The intra-year decline in 2019 was 7% during the month of May. So, the intra-year decline in 2019 was half that of the average.

A 7% fall is not even officially described as a ‘correction’. A correction is a 10% or more fall, whilst a bear market is defined as a fall of 20% or more.

What is interesting is how investors responded to the May fall, and also to the even shallower fall in July and August.

Pay attention here.

During the 7% (please note again, this is half of the average intra-year fall) ‘non-correction’ in May investors went into a full-blown panic attack. Net liquidations of US equity mutual funds and ETFs reached levels not seen since the Great Financial Crisis in 2008.

This is a crazy reaction. Once again - it was a 7% fall! Fear has defined the market over the past decade and continues to do so. We must not underestimate the scars that the Financial Crisis left on investor psyche.

Although the figures are not complete for the year, 2019 almost certainly saw the greatest outflows of US equities since 1992. This is after the S&P 500 went from 1,115 ten years ago to 3,230 at the end of 2019.

This is a very strong and positive contrarian indicator (more on this below).

Where do we go from here?

I am not making any predictions – that’s not my job – BUT, I take great comfort, and so should you, from the fear that grips our fellow investors, even after a decade of great returns in the US.

The stock market is driven by the earnings growth of the underlying companies over the long-term and by human psychology over the shorter-term. At the top we have euphoria. Everyone is piling in, dinner parties are characterized by stock market conversation and your taxi driver starts telling you what stock he owns. I will worry when we get to that.

Howard Marks, founder of Oaktree Capital, wisely said “while we never know where we’re going, we ought to know where we are.” The valuation of the market, i.e. how cheap or expensive it is in relation to history, is a useful yardstick for where we are today.

This time last year I wrote:

“The P/E ratio of the market is now less than 16 which is below the 25-year average. This is a very positive thing for market going into this year. Valuation is a terrible timing tool in that it doesn’t tell us anything about what markets are going to do in the short-term. However, over the longer-term when market are cheap future returns tend to be higher, and when markets are expensive future returns tend to be lower.”

The chart below is taken from JP Morgan’s indispensable “Guide to the Markets”. It shows the steep fall in valuations that occurred in 2018 and the rise that we have seen in 2019. The US market is now a little bit more expensive than it has been on average over the past 25 years, but it certainly gives me no cause for major concern.

I talk about the US because we are on this side of the pond and because it makes up 56% of the global stock market. Emerging markets account for 12% of the global stock market, and Europe (including the UK) is around 20%. However, as a client of Liberty Wealth you own a globally diversified portfolio which has exposure not just to the US but to Europe and emerging markets too.

European and emerging markets stocks are currently cheaper than US stocks, which gives me confidence in the return we will see from these markets going forward. European stocks currently trade pretty much bang on their 25-year average and emerging markets are cheaper (on a price to book basis) than their 25-year average.

I want to end this section with one of my favourite quotes from Nick Murray – “if you think the equity market is “too high” now, wait ‘til you see it 20 years from now.”

Look up the price of the S&P 500 on the day you were born (every investor should know this figure- click here and then on ‘historical data’ and change the time period). On the day my parents took me home for the first time, the S&P 500 stood at 118. It closed out 2019 at 3,230.

What guides us

The beginning of a year is a good time for me to restate my overall philosophy of investment advice and for you, as a client, to confirm that this aligns with what you expect from me and our relationship.

The advice I give you, and all my clients, is goal-focused and planning-driven. It’s not market-focused and current-events-driven. The reason for this is that long-term real-life investment success comes from continuously acting on a plan. Investment failure on the other hand comes from continually reacting to current events in the economy and in the markets (look at the long-term performance of hedge funds if you need convincing on this matter).

We are long-term equity investors and our edge is patience and discipline. As I wrote last year, “we are not in a hurry. All good things take time.” Warren Buffett once said, “people who want to get rich quickly will not get rich at all.”

I can’t forecast or time the equity markets (neither can anyone – some people get lucky and get in or out at the right time, but it can’t consistently be repeated). That is, I don’t know when they will turn up or when they will turn down. The only way therefore to capture the remarkable long-term return of the markets is to get in, and stay in. The down-turns are always temporary and always give rise to the resumption of the permanent up-trend. Our motto is ‘this too shall pass’.

Here is a chart of all the bear markets (defined as a 20% fall) since the end of the second world war.

There have been 15, which is an average of one every five years. The average decline during these bear markets was around 30%. At the end of 1945 the S&P 500 stood around 17. Today it is over 3000. The advance is permanent, the declines are temporary.

Goal-focused investment management acknowledges the following:

(1) The performance of a portfolio relative to some arbitrary benchmark is not what matters.

(2) The only benchmark we should care about is the one that indicates whether you are on track to achieve your financial goals (for most of you, this is to retire and maintain your lifestyle, dignity and freedom).

(3) We measure risk as the probability that you won’t achieve your goals.

(4) Your portfolio should be invested in the asset class(es) that minimizes that risk.

Dear clients, thank you for the trust and faith you place in me to help you and to look after your hard-earned money. 2019 was Liberty Wealth’s first full year in business. We got through our first inspections by the regulator and our first financial audit. We have a stable and growing asset base and a group of clients whom I love spending time with.

I started Liberty Wealth with the goal of serving a finite number of affluent clients/families with a high level of personalized advice. We are still growing and looking for others like you that we can service. If, and only if, Liberty is serving you as you had hoped and as you had expected, I would love to ask that you share this letter with a friend, colleague or family member who you think would benefit from what we do.

I would also love to hear your comments or suggestions that come from this letter, or from anything else that has happened over the past year.

Here’s to the next decade.

Best

Georgie