Market and Capital Gains Cycles
Generally speaking, everyone loves a bull market and no one loves a bear market. As professional investors who are looking forward, we would refine the statement by shifting our time frame to say that our favorite period starts at the final phase of a bear market- usually the nastiest phase and ends after the middle stage of the bull market. As the final phase of a bear market approaches, portfolios may carry higher than normal cash balances, and when the final phase is underway opportunities abound to get that cash to work. Quite often cocktail party bragging rights go to the person who bought something near the market lows with the cash they had waited patiently to deploy. By the middle stages of a bull market portfolios are fully invested, valuations are a little higher than normal, the investment thesis from purchases made a few years ago still has some room to play out, and even many lagging stocks show a profit. This is where the fun ends for us.
The late stages of a bull market are particularly challenging. In the late stages of a bull market, some holdings are at such high valuations that favorable developments at those companies may not result in favorable returns for those stocks over the coming few years. Even if especially positive developments occur at those companies, the stocks still might go down. The later stages of a bull market are points from which you might not win much and you could lose a good bit. So, the only defensible action to take is to reduce the stake in those holdings. And while this is good medicine, it does have the side effect of creating realized capital gains. The antidote for the side effect is to take losses. However, in the latter stages of a bull market, even the poorly performing stocks tend to have appreciated and there tend to be few losses to take. Indeed, the stars might line up for investors to experience cyclically high levels of capital gains during the year when a bear market is underway.
The world has been changing at faster and faster rates driven by advances in technology and rapid information sharing. As such, it becomes harder for many companies to adapt and maintain their level of relevance or competitive advantage for, say, the next ten years. Our goal is to grow wealth, but in a rapidly changing world, it will be necessary to realize for some of those gains from time to time.
A Tale of Three Stock Markets
The stock market is comprised of extraordinarily diverse subsets such as sectors, industries, high/low PE ratios, fast/slow earnings growth etc. The trends of 2017 have extended into 2018 so far. High PE stocks continue faring much better than low PE stocks. To wit, our analysis shows that through early July, the 60 stocks in the S&P 500 with the highest PEs have appreciated 15.4% on average, the 60 stocks with the lowest PEs were -6.7% on average, and the middle 60 appreciated 2.5% on average (this excludes dividends). So, there is clearly a bull market in high PE stocks and a challenging environment for low to mid PE stocks.
RAM has seven equity strategies: Core Growth, Conservative Growth, Growth at a Reasonable Price (GARP), Equity Income, Small Cap, Concentrated, and Global. It should not be especially surprising that the strategies with the highest cash balances are the ones where high growth high PE stocks are found in greater abundance: Core Growth and Small Cap. As the PEs increased beyond our comfort zone, the high PE stocks have been sold at a faster clip than we can find opportunities to reinvest the proceeds. In Conservative Growth and GARP, where PEs are lower, there are more buyable stocks than there is room in the portfolio to hold them.
Just as high growth, high PE stocks have been bid even higher, investors have shown a strong preference to own dividend oriented stocks of established companies as opposed to the minuscule interest rates on cash and short term bonds. Many stocks of established dividend paying companies have been bid up too far too fast, in our view. So, in Equity Income accounts, stocks have been sold faster than we can find opportunities to invest the proceeds, and cash balances are higher than normal.
It may seem contradictory to have the lowest cash balances in the more conservative strategies- Conservative Growth and Growth at a Reasonable Price (GARP). However, cash in a portfolio is a residual outcome from a lack of investment opportunities according to our investment philosophy and that applies in all of our strategies. The amount of cash is simply a function of the investment process. RAM is not interested in market timing and hence does not use cash tactically. In the environment when the high growth high PE stocks are out of favor, we would expect returns from the more conservative strategies to fare relatively better. When that will happen is anybody’s guess, so for now, as always, we will just stick with the process.
No one likes a bear market and no one likes paying taxes. The final phase of a bull market can last for years, but it can also be ended abruptly by a large event. As stocks, in general, enter the later phase of a bull market, please be sure to sit down with us to talk through how we can balance your specific pain points as it relates to avoiding being fully invested through a bear market and avoiding taxes.
Redmond Asset Management, LLC July 2018
The opinions contained in the preceding commentary reflect those of Redmond Asset Management, LLC. The stated opinions are for general information only and are not meant to be predictions or an offer of individual or personalized investment advice. They also are not intended as an offer or solicitation with respect to the purchase or sale of any security. This information and these opinions are subject to change without notice. Any type of investing involves risk and there are no guarantees. Redmond Asset Management, LLC does not assume liability for any loss which may result from the reliance by any person upon any such information or opinions.
Redmond Asset Management, LLC (RAM) is an independent, SEC registered investment management firm located in Richmond, VA and is not affiliated with any parent organization. RAM was founded in 2005 and registered with the SEC on 22 Dec 2005. The company offers investment management services for equity, balanced and fixed income portfolios to corporate, institutional, and individual investors.