Quarterly Letter

“PERSONS attempting to find a motive in this narrative will be prosecuted; persons attempting to find a moral in it will be banished; persons attempting to find a plot in it will be shot.”

- Mark Twain’s “notice” to readers of Huckleberry Finn

Dear Client,

On Friday, December 29, the S&P 500 index closed the year 2017 at 2,674 within a few points of the all-time high it reached just days earlier. In January, the index proceeded to rally further – almost 6%, supposedly (but who really knows) in reaction to the tax legislation signed by President Trump on December 22. The end of 2016 through the beginning of 2018 had been one of the least volatile periods in recorded stock market history. It was THE least volatile by one measure – for the 404 trading days through the beginning of February, the market never had a five percent correction – the longest streak on record.1

The streak has ended. From the end of January through Friday, February 9, the S&P 500 lost just over 7%. (From the January high through the low on Friday, the correction was more than 10%.) Given the length of the proceeding period of calm, the modest move lower felt violent to many. In reality, the index closed February 9 at 2,620, just 54 points (2%) below its 2017 year-end close.

Why the sudden increase in volatility and correction in equity prices? Barron’s summed up the consensus in their February 10 cover story, “Seat Belts Fastened: Volatility Ahead:”

A fast and vertiginous drop in February points to a material change in investor psychology, to cautious from enthusiastic. Where previously rising interest rates were acceptable because of strong global growth, now investors are focused on the potential inflationary threat from such growth.

The underlying concern is that rising prices could cause the Federal Reserve to tighten monetary policy faster than the market is anticipating. There is also a new unknown factor: Fed chair Jerome Powell, who was sworn in Feb. 5.2

Layer on concerns about risk-parity, machine trading, and all of the short-volatility funds that have developed over the past few years and a satisfying narrative emerges. Humans hate uncertainty and are thus excellent at developing explanations. Yet, even though the narrative seems credible, recall Mark Twain’s notice – do not try too hard to find a motive, moral, or plot. Rather than concocting a story that explains recent market action, it is better to look at the setting (prices and fundamentals) where our story unfolds.

Remember, as we have pointed out numerous times in past letters, this is one of the most expensive stock markets in recorded history. As of December 31, 2017 (with the S&P 500 within a few percent of its current price), GMO forecast -4.7% annual real return for large capitalization US stocks for the next seven years.3 Unfortunately, there are few places to hide. From a valuation perspective, only emerging market equities and debt offer the likelihood of (modest) positive real returns. At the end of the day, THAT (valuation) will be the primary driver of any meaningful correction. Like the Mississippi river for Twain’s Huck Finn, valuations are carved deep into the environmental backdrop for today’s investors.