Short-term forecasting is a fun, but not often a particularly profitable, exercise. To think one can predict what the next year holds is folly, and to assume you could profit from that prognostication is dubious. In 2016, would you have predicted Donald Trump would be inaugurated in 2017 as the next U.S. president? If so, how would you have expected markets to react? Consider everything we’ve seen in the past year or so:
- Stock prices swelled in the run-up as Hillary Clinton’s victory looked assured, and S&P 500 Index futures plummeted 5% overnight on the news of a Trump presidency, a clear indication that Trump was “bad for markets”
- Yet the S&P 500 Index closed over 1% higher the next day (take note efficient market theorists), the eventual optimism clearly a response to “market-friendly” reforms the new president was expected to usher in with a clean sweep of the legislative bodies
- 12 months later and almost no major reform has been accomplished, Trump’s inner circle is perpetually reconstituting itself, top Republicans are openly taking shots at their leader, and the word “impeach” is being thrown around with the same cavalier tone that “president” was a year earlier
- Despite all this, the bull market roared on for a ninth year
So, as 2017 winds down, my team casts our eyes not on what 2018 holds, but three to five years further along the horizon. As we look out at the future from today’s vantage point, here are a few of the risks and uncertainties we see – and some of the opportunities as well.
- Nationalism/populism. This sort of governance, with its anti-immigration and protectionist policies, can entrench inefficiencies in domestic economies, drive up the cost of goods, and result in a global economy that adds up to far less than the sum of its parts. My team is watching out for lower margins and a decline in purchasing power for consumers.
- Interest rates. The one-year time horizon doesn’t concern us. However, the longer-term outlook raises important questions. If you believe (as we do) that the value of a business is the present value of its future free cash flows, the bulk of a company’s value is based on what it earns five to 20 years from now. Are you willing to discount those cash flows based on today’s interest rates? Similarly, if rates do rise in the years ahead, what does that do to consumer purchasing power as mortgages and other asset-backed lending rates reset? As Wayne Gretzky said, skate to where the puck’s going to be.
A close cousin to risk, here are some of the uncertainties popping up in our meetings more often these days:
- Electric vehicles/autonomous driving. This has far-ranging impacts on the economy from the price of oil to the auto manufacturing ecosystem, gas-tied convenience stores, repair and distribution businesses, and beyond. How long until electric vehicles are economical versus an internal combustion engine? How quickly does the car park turn over when this happens? If some of today’s dominant businesses are melting icebergs, is that already embedded in the stock price, making them attractive investment candidates?
- Amazon. Whenever we look at a retailer or distributor, we almost always ask ourselves if Amazon will kill it. This is another great reminder of how fickle retail can be. (Remember when Wal-Mart was considered to be indestructible?)
- China. It’s almost certain that China will be the biggest driver of the global economy over the next 20 years. But what’s not as certain is the path it will take. Will China be able to transition from a government-controlled, debt-fueled infrastructure economy into a consumer economy led by an emerging middle class? The answer is probably yes, but the trajectory is unlikely to be linear, creating risks and opportunities for investors along the way.
- Automation. As artificial intelligence and machine learning continue to evolve, what does that mean to our economy? Productivity should surely improve, but what about wealth distribution and, consequently, gross consumption? Where do the blue/grey collar workers of today, whose jobs are displaced by machines, find work? Are our universities graduating enough students with science, technology, engineering and math skills to fill the jobs of tomorrow? Will the “rise of the machines” lead to the downfall of society? Where will the money be made and lost in this transition?
In my view, the biggest opportunity today derives from a willingness to make long-term decisions, embrace short-term volatility and look different from the crowd (what I call “time arbitrage”).
Using the U.S. equity market as a case study, approximately 80% of the market is invested in a combination of passive funds and “closet indexers” – funds that don’t look meaningfully different than their passive benchmark.1 This means a significant portion of the market is making no real effort to analyze and determine the value of a business. For those of us in the minority – the truly active investors – the opportunity to distinguish ourselves is increasing as our ranks become thinner. A market that has largely gone straight up and that has seen high stock correlation for much of the run has temporarily obscured the ability to demonstrate value. Should the historical cycle of active/passive outperformance repeat itself (or even rhyme), I expect active investors to see their star rise.
Sources: CRSP, Bloomberg L.P., Robert Shiller data and Instinet research.
Shows the percentage of U.S. active equity mutual funds (purple) and fund assets shown by AUM (pink) outperforming the total return of the S&P 500 Index based on trailing five-year performance after fees. Funds are those in existence for five years or more and belong to U.S. growth, growth and income, and income funds (based on CRSP fund objective code). For percentage of fund outperformance, only funds with more than $10 million total net assets are considered. Percentage of fund assets outperformance is calculated as the ratio of total net assets of active equity funds outperforming the S&P 500 Index over total net assets of all the active equity funds. Period of analysis is from January 1970 through December 2016.
The U.K. is a prime example of how my team employs time arbitrage. Following the surprise of Brexit, a number of our portfolios substantially boosted their U.K. investments and continued to maintain a high exposure throughout 2017. We believe the market priced in a protracted recession while the actual impact is more likely to be less severe. Additionally, the Brexit discount was applied indiscriminately in many cases, allowing us to pluck a few proverbial babies from the bathwater. Looking out, the Brexit headlines may remain ugly, and our decisions might backfire in the short term, but we embrace this risk of looking foolish in the belief that the long-term rewards will be outsized relative to our alternatives.
I see fewer and fewer investors behaving this way today. I believe those who can combine courage and judgment stand to gain the most.
2018 will be full of surprises. In an increasingly myopic investment world, we think this gives us an opportunity to arbitrage the profit between our long-term view and the short-term gyrations of the market.