Evergreen Annual Letter - 2019
2019 Year-End Review and 2020 Forward Outlook
What a great year for the markets! The US Stock market, as represented by the Wilshire 5000 price index, ended the year up 28.53%(1). Less risky bonds, as represented by the Barclays Capital Aggregate Bond Index, climbed 8.67% (1).
What a great decade for the markets! The US Stock market, as represented by the Wilshire 5000 price index, ended the DECADE up 189.66%(1) and if you re-invested dividends the index total return was 253% (1). Less risky bonds, as represented by the Barclays Capital Aggregate Bond Index, climbed 42.24% (1).
During our 2019 outlook letter, we highlighted trade policy and federal reserve actions as the dominant forces for 2019. Then, on December 21st, 2018, we addressed the market decline in a special market update and explained how we believed the worst was likely over, and the near term future looked bright. This outlook has proven fully accurate. We also highlighted why stocks continued to look most attractive relative to all other alternatives and the importance of staying the course and taking the long view. 2019 rewarded investors yet again and was the perfect end to an almost perfect decade for investors!
So what does all of this mean?
I suppose you could say our crystal ball was working well and we had good insight, but the simple truth is that markets are designed to go up and we (Evergreen Wealth) are designed to ignore the blips and focus on owning solid investments for the long run. I am much, much more concerned about having you properly diversified relative to your risk and owning great companies that will reward you the next 10-20 years!
Temporary declines (like 2018) followed by major run-ups are a normal and healthy part of the investment process. 2018 was a good reminder about the volatility markets can - and will - experience from time to time, and has probably all but been forgotten by now. However, do not forget the advice we gave to remain invested, and the result. Many managers did make emotional moves or advise clients in a dangerous direction amid the market swoon. Many publications advised changing course and many clients wondered if they should cash in the chips. Amid fear, common-sense decisions like staying the course often do not seem so common sense. We saw these same emotions in 2011, 2015, 2016 and 2018 during some big market dips and yet we keep on preaching long term investing. With a decade behind us and tremendous returns experienced, we wonder what would have happened if you listened to the “talking heads” and so-called "experts" last decade?
In 2009/2010 many money managers seemed stuck in the 2008 recession and predicted doom and gloom. I will use a quote from Bill Gross that summarizes much of the investment community beliefs heading into 2010 (from Morningstar article 5/28/2009, Gross Predicts a New Normal).
"Gross suggested that investors would need to question many long-held beliefs as they adjust to this new normal. Among them is the idea that risky assets such as stocks are always better for the long run. In the subdued economic climate ahead, risk-taking is simply not going to be as rewarding, so investors may want to switch down to a more sedate asset allocation mix with more bonds and stable blue-chip stocks. Another key point of advice from Gross is to raise investments outside the US because the dollar is likely to lose its status as the world's reserve currency amid massive levels of debt."
In 2009/2010 the general consensus was to lower portfolio risk greatly via bonds, diversify away from US markets since they predicted dollar was going to decline and advised healthy cash portions. I heard this rhetoric from academia to professional managers across the board.
In 2010, at a young 30 years of age and surrounded by peers with much more experience, I had a very specific thought. Either I hold much more long-term common sense than most or I am much less qualified than I think to manage money.
Factually I knew this; no one has a crystal ball and variables way beyond the expert's control can change many equations. I also figured the math (profits) behind the sustainable company payouts alone would lead clients to a much higher return in stocks than bonds or cash. Most important I figured equities had to remain locked to all other asset classes and thus still must offer a superior return long term due to capital compounding structures. Lacking a crystal ball, I decided to go against the crowd and simply stick with the long-term focus and a healthy dose of equities or increased equity exposure for clients matched with risk.
10 years later many "expert" predictions have been proven wrong and common sense has proven to not be very common. The dollar is stronger than ever, equities destroyed bond returns and clients who stuck it out had a tremendous decade!
While we have performed very well this decade, perhaps the truest measurement of success should be alternative real choices. That is, what clients would have done if not using or being influenced by us! This includes the action of other managers and so-called experts. It is hard to find a perfect benchmark for such a group or decisions, but our consistent comparisons against other management and alternative decisions have proven laughable at times. While many were busy moving in and out of cash at every little blip, we stay the course and let the money keep compounding. Compared to many client emotions and desires to make plan destroying moves, we convinced many to stay the course and have seen accounts far outpace decisions clients would have made left to there own device.
We don’t know what the next decade holds anymore than I knew what the last one would hold. Maybe this time the talking experts will be more successful at predictions. Regardless, common sense again tells me to make a plan, align the acceptable risk, choose great investments for the long run, and tune out the white noise! Perhaps our greatest value to you will be helping you along this path.
As a general rule, we are not big fans of giving market outlooks. Our view is simple: markets for securities are inherently volatile and capricious. Some days, weeks, months, and years, they go up and in others, down. Over 10, 20, and 30 year periods, the market will reflect the compounded profit and interest in a very effective manner, but the short-run is extremely unpredictable.
This does not mean we should ignore market activity. We aim to capitalize on short-term inefficiency created from the market bouncing around to capture and enhance the long-term effects of compound interest. Our job, in short, is to always keep emotion away and allow compounded interest to work its magic while constantly looking for small enhancements created from short-term volatility. With this opportunity-seeking mindset, we move forward with our 2020 outlook.
Federal Reserve Interest Rate Policy and Repo Market Actions will continue to play a key role
Stocks continue to be the best relative value for long term investing
Near 0 or negative rates would mark serious concern for the upcoming decade
Declining interest rates are a wealth increasing effect. Loans become cheaper, thus homes are often more valuable and businesses can generally gain access to cheaper money. Lower rates also increase asset prices and usually drive market values upward. This is a reversal from the rate disconnects we identified in 2018 and we expect rates to remain low in 2020. Stable rate policy and stable trade removed two of the biggest uncertainties of past years and may serve as a tailwind.
We are also keeping a close eye on the overnight bank lending markets (repo markets). In September we saw a large disruption within the overnight lending markets that spooked the general markets. In short, the federal reserve has needed to start buying treasuries to keep rates stable and fund overnight markets. We will not go crazy in-depth on this topic, but we believe it serves as one more way the federal reserve is keeping the gears turning for now.
Investments are generally valued relative to future earnings potential. You buy an investment for a future earnings/profit stream. Therefore, the valuation equation is comprised of 3 main thoughts. Will the earnings stream grow/shrink? What is the security of the earnings stream long term? What are my alternative choices? For example, if you buy a rental property you will likely consider the earnings produced by rental income relative to price, the security of the renter to keep paying, and the ability for the property to appreciate and drive higher rents or a sale. Stock and Bond valuation is not much different. We must consider the earnings today relative to price levels, earnings in the future and our alternative choices. In aggregate, the S&P 500 earnings yield was estimated at around 4.26% for Q4 2019. Perhaps more important is the operating earnings (actual operational profit), which was near 5.17% at year-end. When compared to alternative choices such as bonds and cash…stocks still appear the most attractive long term. 4.26% - 5.17% is much higher than a 10-year bond at 1.81% or a savings rate of less than 1.50%. Also, companies offer the potential for growing the earnings stream over the next 5-10 years, making stocks the obvious current favorite long term. In short, stocks still seem like the best choice long term, but we do not see them as significantly cheap nor do we feel they are overvalued.(2)
Investment Expectations – Future Rates Remain Key
In 2019 we saw the effects of lower rates on stocks. As rates declined, the valuation and future potential of stocks increased. The combination of growing profits and higher valuations lifted markets to all-time highs. If rates such as the 10-year yield stay below 3%, we believe the long term outlook for stocks is favorable and would not be surprised with a possible 6-8% US equity return over the next 5 years. Currently, the Federal Reserve projections are to hold the federal funds rate steady in 2020. While this gives us a reason for optimism, we are reminded about a quote from Warren Buffet, "Be fearful when others are greedy and greedy when others are fearful." When things are looking this perfect, we start to think about being a bit more fearful!
Our Biggest Concern for the Next Decade
While we remain optimistic about 2020 and always optimistic about long term investing, we see one major issue that could prove very disruptive…..interest rates that approach 0 or turn negative.
Since the Fed was established, they have had the power to essentially buffer recessions and avoid depressions. When recessions hit they take an aggressive stance in lowering rates to increase the wealth effect. When times are good they generally will slowly raise rates to combat inflation. After we removed the gold standard in 1933, the federal reserve was given extreme discretion to alter the interest rate and thus greatly impact business cycles. Since this time we have become accustomed as investors to expect rebounds within 1-3 years after a recession. However, pre federal reserve we would experience many more recessions and depressions. One such depression lasted from 1873 to 1896 and was labeled as the Long Depression. In short, this was caused by a tight monetary policy as a result of the gold standard. About 30 years later we see a similar catastrophe when the gold standard caused extreme tightness again and either caused or exacerbated the great depression.
In both cases, it was the lack of monetary policy control that caused such large issues. While we no longer have a gold standard, the element of monetary control and influence is still the key point. Without a strong federal reserve to “buffer” the economic slowdown and adjust by adding liquidity to the system, you could see normal recessions turn into unhealthy depressions.
If we move interest rates close to 0, we are left wondering what the influence of the Federal Reserve would look like? Without the ability to lower rates, how can the federal reserve "buffer" recessions? Are we going to head back to a pre-Federal Reserve economy and see the possibility of depressions creep back in? Or perhaps we create new levers to stimulate the economy and kick the can down the road. Or maybe, the debt itself means less than we thought in today's ultra-connected world and things go on without a hitch.
Europe, perhaps a few years ahead, has already exhausted its central bank to 0 and negative rates, which seems to leave little room for influential monetary moves when a recession hits. Furthermore, with governments awash in debt, the fiscal stimulus that could be offered is fairly minimal unless major tax increases took effect, which would again place more pressure on the economy. Is the answer deeper negative rates and more debt? It seems for now they will be forced to leave alone and let the markets react for better or worse. Watching this play out in Europe will hopefully give us some clues about how much further we can lower rates domestically. Ideally, we see Europe accelerate in the upcoming years and slowly return to normal, somewhat unscathed from the negative rate experiments.
It seems a day of reckoning is coming with government debt, monetary policy, currency rates, inflation, and taxes all lining up for a period of pain. Thankfully the US economy remains the strongest within the developed world by a long shot. Hopefully, we can use the next decade to become more prudent with debt loads, allow rates to stay positive, and embrace a healthy short term recession rather than kicking the can down the road for more pain. In a perfect scenario, we would see the fiscal government (administration) coordinate more with the Federal Reserve to create a policy that works long term. Ideas such as low-interest rates while we pay down debt, or raising rates while we build out infrastructures. Ideas that allow us to buffer recessions while still strengthening our overall economic balance sheet will take coordination and teamwork rather than blame and finger-pointing. We believe the concepts around negative interest rates, extreme debt loads, faster inflation and the consequences will be some very hot talking points over the next 5-10 years.
Investment Action – Stay the Course
Andrew and I have constantly discussed the investment power of NOT doing something as stronger than the power of doing something. Human emotions seem to always bait us into doing something. When things are bad, humans get emotional to change; when things are good, we get emotional to find improvement; and when things are great we seem to get restless and almost desire change for change's sake. Human emotion has a way of being the number one investment killer.
Jacobi, the great Prussian Mathematician once said, to solve the most complicated problems you must Invert, always Invert! When we invert human emotion we often find waiting as the right answer. Said another way….Patience is the primary virtue and skillset for investing. From this general principle has sprung many of the core principles
Andrew and I hold dear for investing. Andrew and I generally let companies and investments adjust to market conditions over long periods. We favor long-term ownership with investing and are not looking to market time back and forth with cash. We believe it is best to pick a risk you are comfortable with and stick with that general allocation for a long time. It requires no brilliance to take the current events today and predict negative outcomes. Over almost any 3-year period, there is some very negative aspect of the economy or market that would make it easy to sell fear and self justify a movement to cash or lower-risk assets. History and countless studies have shown trying to time the market is a waste of time and hazardous to investment success. The intelligent investors understand this concept and use negative events as an opportunity to simply buy more of wonderful companies if possible.
We don't invest in unpredictable business models/investments or business models/investments we struggle to understand. We want to own companies and investments within our circle of competence. Said another way, we are fine waiting for our pitch to swing. This alone has helped us avoid many hot stocks and fancy investment ideas that failed to stand the test of time.
We do not allow clickbait media, conflict-ridden analysts, and Wall Street group think to influence our decisions. Analysts and commentators who get paid based on short-term results or viewership hold no value to us. We align our client decisions by owning long-term investments. This means we think like a business owner when buying a stock. We base decisions on long term data that aligns with your goals. As such, we partner with like-minded clients and advisors to steward assets and help them make wise decisions for the long term. Sharing a common goal of long term results that align with your financial plan makes for an enduring business "marriage" between our firm and clients we serve.
We do not invest in companies we will need to trade short term. While we occasionally do trade short term because we see a change worthy of this action, our intent is always to own quality businesses and investments that can be held for a very long time. When investing directly in stocks this means looking for great companies that exhibit a certain economic moat or echo system which will allow them to fend off competition and compound capital for a long time.
We do not say yes to many so-called “growth” opportunities for our business. We have said no to many opportunities to manage more money for other advisors and clients. Even so, we have grown from managing $20 million in 2015 to near $100 million today. We continue to say no to honor our commitment to spend the bulk of our time researching, managing and communicating for our clients. Said another way…we get paid to do a job for you and we aim to spend our time doing that job! While this might seem a bit common sense, this is not common in the industry. We do not spend countless hours designing material, networking, doing seminars, or schmoozing the big money. We believe if we do great work for our current client and advisors the referrals and opportunity will be plentiful to provide for our families and us. God will bless us with exactly what he desires. Most importantly, this approach allows us to do what we love! Andrew and I feel retired half the time because we love managing money so much.
Invert, Always Invert! Each of the foundational thoughts and principles is rooted in patience. Patience to grow the right way and avoid traps of greed for our business or hot stocks for clients. Patience to allow investments to compound and patience to ignore the short-term noise and fear created by clickbait media. Patience to stick with investments we fully understand and not force investing decisions. Patience to become the best long-term investors and long-term business we can become!
We remain cautiously optimistic, with an understanding that variables well beyond our control can play a large role in temporary results. Most importantly, we remain confident in the market over the long term and the ability for stocks and bonds to keep producing solid long-term results that can meet planning objectives. 2016 and 2017 offered solid returns in accounts that exceed our planning objectives. 2018 was a bit of a wash after 2 really good years and 2019 was incredible! Markets appear to be optimistic for 2020 thus far and we believe that if interest rates remain stable and trade policy talks continue to be resolved, then we may have reason to continue optimism. We look forward to 2020, ready to take advantage of the opportunity should it arise, but hope to see continued gains and/or income that meet or exceed planning goals.
1. Data reported by Folio Institutional.
2. Data reported by Y-Charts Data, www.ycharts.com
Index results such as the Wilshire 5000 and S&P 500 do not reflect management fees and expenses and you cannot typically invest in an index.
Evergreen Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.