Grateful 2018 Year End (+ charts)
By Julien B. Booth
January 3, 2019
I hope this note finds you well. Happy New Year!
At this close of 2018 trading, the stock market is down: -13.4% for the past 3 months and -4.6% for the year to date.
The post-Christmas “Hail Mary” and “China-Trade” Tweetstorm (+6.1% total bounce) saved an otherwise gruesome year.
While we do not carry this level of investment risk (pure stock), all asset prices (except cash) have declined substantially for 2018. 2019 has not started well either.
At the end of Q3 2018, we published a manifesto on valuation and an expectation of the moderation of growth (See that note here). It came in spades and even faster than I expected.
The three best indicators of economic health – internal stock sector performance, yield spreads, and credit availability – are definitely sending a signal. Net, net, only Healthcare, Consumer Discretionary, and Utilities had positive returns.
When the economy is growing, money is lent at a cheaper price (lower interest rate) because the probability of lenders being paid back is higher when the economy is on the up-and-up than when it is not. This chart essentially shows the interest rate at which a company with a BB credit rating (high-yield/higher risk) can borrow money. Notice that the cost of borrowing money for a somewhat “risky” company almost doubles in the three months between October – December of 2018. The price of borrowing money increased because lenders believe growth is slowing, making lending money more risky. In fact, US lenders practically halted the issuance of new debt in the last 2 months of 2018 as a result of the perceived increase in risk.
Additionally, the crash in 10 year US Treasury interest rates, from 3.24% to 2.60% is telling. As late as October, we were still being scolded for owning bonds; interest rates are CLEARLY signaling slowing growth.
This downward move in rates (upward move in bond prices) is truly historic. Seems as though we are always one tweet away from a changed world. Apple cutting sales guidance (January 2nd) is empirical evidence confirming the trend.
Liquidity and durable cash flow become the primary determinants of capital preservation when markets become this turbulent.
Accordingly, we believe that forced sellers (open-end mutual funds and ETF’s) will continue to create market volatility. S&P 500 Index funds are exacerbating the declines. When someone decides to leave the pool, it can get ugly.
We continue to like structural protection: bonds, preferreds, real estate, and stocks with large liquidity positions – like Oaktree Capital and Berkshire Hathaway.
Additionally, closed-end bond/real estate funds trading at multi-year discounts to NAV and yielding north of 7%+ are very attractive.
Net, net, the durability of value and consistent cash flow will prevail.
2018 was difficult for growth (stock) markets – fortunately our positions are much better suited for slower growth and lower inflation.
As usual, thank you for investing with Forest Capital! For additional information on portfolio positioning, please contact Forest Capital directly at jbooth@forestcapital.net.