Greetings from the Northwest!
Those familiar words have been a hallmark of our quarterly newsletters for many years and are likely to remain our first words for years to come, gently easing our readers into whatever more serious topic that is bound to follow. Working shoulder to shoulder with Jim Parr over the better part of two decades, I’ve learned that people enjoy, and get comfort from, the familiar.
When Jim and I founded Cairn “way back” in 2007 we made a sincere effort to create a place where our investors, our people, could feel at home; a place where they were known, valued and thought about on a regular basis. It’s my desire to continue on this same path, putting you above all other goals, and you should expect no less than this. Inevitably there will be change, but change intended only to improve our service, improve our investing and improve our overall effectiveness. If we can do this and have you, our investor, feel like nothing has changed, only improved, then we will have succeeded.
We have a great team today, I think the strongest in our 12 years here. As Jim mentioned in a prior note, Patrick Mason will be joining the ownership this year, adding a comforting layer of assurance that our methods and our mission can continue seamlessly in support of your goals. Read his message that follows, take it to heart, understand the choices that we are faced with in this complex economic and political environment, and know that you are being well served. Jesyca and Patricia put a smile on my face every day when I observe and hear the way they deal with our investors’ needs, simple and complex. Of course, Lara continues to provide a solid backstop to everyone’s efforts, and Jim cheers us on from his new and slightly different perspective. In the next few weeks I’ll be announcing another exciting addition to our team, but more on that later!
I’ll leave the serious stuff to Patrick this time around, but I do want to sincerely thank all of you for being a part of the Cairn family, and in particular those of you who give us honest feedback on your experience, as it only serves to make us better. It’s my goal to revitalize our communications in 2020 to see and talk with as many of you as I can. Between the changes here, the upcoming election, and inevitable twists of the economic cycle, we should have plenty to talk about.
Equities finished the year in a celebratory mood, with U.S. large cap and small cap stocks posting fourth quarter gains of over 9%. Developed international stocks and emerging market stocks also fared quite well, with gains of 7% and 12% respectively. Fixed income, which had been a strong performer earlier in the year, posted flat returns as interest rates moved higher on longer dated bonds. Global markets were strong in 2019 after coming under pressure the year before. Concerns about trade and economic growth were pushed aside as investors cheered the Federal Reserve’s change in interest rate policy last January. As you can see by the Fear & Greed Index chart below, the majority of investors have now embraced equity market risk with little thought of the actual risk being taken.
In fact, the 2019 S&P 500 performance can be attributed to roughly 4% earnings growth, 2% dividend yield, with the remaining 25% attributed to multiple expansion (P/E ratio moving higher). In other words, over 80% of the S&P 500 Index return was generated by investors’ willingness to pay more for many years of future earnings, in the present. I think that fits the definition of greed pretty well. When valuations are already stretched, paying an even higher premium for future earnings can open investors up to experience larger losses or underwhelming gains in the future. Even with the strong performance of 2019, it would only take an 11% drop in the S&P 500 to get prices back to where they were in January of 2018. As we noted last quarter, we continue to observe softness in the current economic expansion, combined with generally high equity valuations. However, the data does not point to imminent recession and there are still opportunities for us to invest wisely. We continue to look for fundamentally sound investments selling at attractive prices, while balancing both risk and reward. As famed investor and writer Howard Marks likes to say, “Move forward with caution.” We think that is pretty sound thinking in the later stages of this cycle.
Another topic of discussion this year revolves around the Secure Act and IRA distribution changes that passed into law recently. There are some major changes taking place, and we find the following two will impact the greatest number of our investors. The first involves the age at which a person must start taking their required minimum distribution. The second discusses the new parameters for beneficiaries that inherit a retirement account.
Estate planning issues may arise from these changes. The primary one we see is the naming of a trust as a beneficiary of an IRA. Attorneys will occasionally recommend this so that the assets are still under control of a trust while allowing the stretch provision for the RMD. Under the new law, all assets in the inherited IRA have to be distributed by the 10th year. Since there is no annual withdrawal required, the new provision could cause a large taxable distribution to the beneficiaries of the trust in the 10th year. As we meet with you over the coming year, reviewing IRA beneficiary designations will be an action item.
My last topic involves cash management within your portfolios. As interest rates have done a U-turn over the last 12 months, interest paid on cash and money market funds has continued to fall. To make sure we are earning the highest interest on your cash while we either construct a portfolio, or wait for a new opportunity, we have implemented new cash management tools. To efficiently manage your cash, we are using liquid and safe securities consisting of CDs, T-Bills, position traded money markets, and short-term Treasury Bond ETFs that earn a higher interest rate than cash. We don’t want a lot of idle dollars earning very little in this challenging environment, and feel it is our job to manage your cash as effectively as possible.
Thank you for your continued trust and please drop me a line if you have any questions or additional topics you wish to discuss.
As always, our doors are open, the coffee is hot, and the parking is free, so please make a point to visit when you can.
Happy New Year,
Tim Mosier, Principal
Cairn Investment Group, Inc.
There is no Frigate like a Book :: To take us Lands away
Nor any Coursers like a Page :: Of prancing Poetry
Greetings from the Northwest.
During past market cycles I had a chance to read company reports, newspapers, and periodicals. Visit with company executives and their business to business trading partners. Reflect on business and industry segments and then pin it all up on my “wall of worry” and look at it. The process was a little like adding a new chapter to an ongoing story each quarter. Everything must continue to evolve. Well, welcome to the crazy-fast times. It is not as common as it once was to read a book. The tales of far-off lands now arrive as fast as the next news cycle, which is terrifying. It’s hard to find time to reflect on the good or the generous and the joy of a poem. And why would we when we can be entertained and amazed at the silly, greedy, and stupid behavior of so many prancing world leaders?
Let’s take a moment of our precious time and focus on the real monster in the room. Uncertainty. It has often been said that the “market” likes good news, dislikes bad news and absolutely hates uncertainty. We should add that investors don’t like volatility. Uncertainty creates volatility, which causes investors to become restless. Restless about what? Patrick has been doing some thought-provoking work looking into the comings and goings of recessions. Yes, I’ve said it. Recession. We will have them. Patrick’s work is helping shed light on the recession monster and what we should be doing now… or not.
Equity returns during the quarter were mixed, with large-cap U.S. stocks posting a slight gain of 1.7%, while small-cap U.S. stocks, international developed stocks, and emerging market stocks posted slight losses of -2.3%, -0.79%, -4.75% respectively. Volatility has started to pick back up again, as markets grapple with a combination of trade tensions, changes in monetary policy, and slowing global growth.
During the year we spend a lot of time with our clients discussing what is going on in their lives, the ongoing management of their wealth, and how we view this ever-changing market environment. We learn a great deal from these discussions. Though the economy has been strong over the last few years, in recent months we have observed recessionary fears rising amongst the public and the folks we talk with. It’s easy to see why, as the news chatters regularly about when the next recession will happen. This has largely been driven by the consistent yield curve inversion. As of August 31, 2019, the New York Federal Reserve Bank’s Recession Probability Indicator, based on the yield curve, has moved to a 37% chance of recession within the next 12 months, up from 14.5% a year ago.
In April, I wrote about the lag times after the yield curve inverts and the inconsistent message that an inversion sends (read about it here). However, there are more data points in recent months revealing that the economic recovery is showing signs of stalling. We take evidence as it comes and do not attempt to predict the likelihood of when the next recession will start. At this time, the data we analyze does not point to immediate recession. Where we have been focusing our efforts is in analyzing what the most likely market experience would be if we entered a recession in the near term. Our conclusions are as follows:
On a positive note, as Cairn searches the investment landscape for opportunities, we have continued to find quality companies to invest in that are trading at appropriate prices.
As our reliance on technology continues to advance, cybersecurity is of the utmost importance. We are always keeping an eye out for suspicious activity in your accounts and will call to verify as soon as we see any changes made. Cairn has your back. If you access your accounts online through Schwab Alliance, here are a few helpful tips to improve the security of your accounts:
Thank you, Patrick and Jesyca.
Come on by and let’s review your equity exposure and/or two-factor authorization. We’ll make sure the coffee is fresh.
Jim Parr, Principal
Cairn Investment Group, Inc.
Greetings from the Northwest.
Our second quarter report is always a little chaotic to produce, since the Fourth of July holiday generally jumps right into the middle of the progress. The distraction of summer, and all that this Fourth brings with it, can cause your diligent advisors to be found yearning for the sizzling BBQ burger or the thirst-quenching relief of an ice-cold beer. This Fourth of July holiday was marked by distinctly cool weather that made the 32nd Waterfront Blues Festival, held along the bank of the Willamette River, quite tolerable in the warming afternoons all 4 days. If the afternoons were filled with blues, the morning of Sunday was exploding with excitement as the U.S. women’s national team took the soccer World Cup for the fourth time!!
Being distracted from the business world for a bit was a nice relief from the growing number of global economic woes filling the airwaves recently. The most significant topic of today may be the announcement that Deutsche Bank is retreating from its global expansion and laying off 18,000 people. Oops.
Closer to home, in the American oil patch, things are slowing down as well. “Hoping for a gusher, driller came up short.” It’s a common refrain heard in so many words about many business ventures these days. There are so many situations in business now that are good, but not quite great:
I’m sounding like a deflated firework and Patrick is itching to report on the current economic trends, so over to Patrick while I go squeeze our lemons into lemonade.
The second quarter witnessed investors tossing tariff risks and economic growth concerns aside to focus on the possibility of the Federal Reserve cutting interest rates in the coming months. After bouts of volatility during the 4th quarter of 2018 and again in May, large company U.S. stocks closed near an all-time high. During this time, investors have experienced quite a change in economic growth expectations and monetary policy implementation. Just one year ago, the U.S. Fed was forecasting 2019 GDP growth to be 2.4% and 2020 growth to be 2.4%. When they released their most recent projections on June 19, those figures dropped to 2.1% and 2.0%, respectively. Looking at corresponding interest rate projections, previous forecasts were calling for a rise in the fed funds rate (short term interest rates) to 3.4% in 2020. The current forecast is predicting that interest rates will fall to 2.1%. What a difference a year makes. This flip-flop in policy has been a large component of falling interest rates across the bond market (prices rise) and the tailwind we have witnessed for U.S. stocks in the short term. As Danielle DiMartino Booth, former Federal Reserve Bank of Dallas Advisor and founder of Quill Intelligence, recently said, “We are having a recession party” when describing how positively the stock market is reacting to much slower growth that could result in easier monetary policy.
As the S&P 500 index (large company stocks) trades close to an all-time high, while small cap and international stocks do not, we like to check underneath the hood to see what is really driving these recent returns. One question I looked at recently was, “Are all stocks carrying their weight and rising together or are just a few winners saving the day?” Examining this allows us to determine the overall health of the equity market. The breadth of participation signals how broad or shallow a market rally can be, which we find useful during the late innings of a cycle. One of the ways we analyze this is to look at the return contribution of the top names of the S&P 500. Recently, I ran comparison of the return contribution of the top 4 (largest) companies during 2013 and the contribution of the top 4 companies over the last 12 months. For the majority of 2013, we witnessed a broad based contribution and participation from U.S. stocks across the board. Which makes it a good comparison point. Here is the story the data tells:
Last 12 months:
In essence, 2013 was a year where there was broad participation with many names of the index carrying the weight. Over the last 12 months you cannot say the same thing. A little more than 10% of the index is making up almost a quarter of the return. This indicates that the largest, and most popular, names have been carrying the load and the majority of companies have not been keeping up. I will leave it to you what you draw from this observation, but just a hint: It’s not sustainable in the long run.
Cairn’s approach is not just following the crowd by investing more and more dollars into overly expensive companies. Our process of uncovering suitable investments is disciplined and consistent. As we stated in our September 2018 letter:
“Through our quarterly letters and individual meetings we have discussed our process for uncovering successful investments, our current view of U.S. stocks, and how we are managing assets concurrent with that view. First, we are always on the lookout for industry leading companies that generate significant cash flows, with balance sheets that can provide financial flexibility. The final, and what we believe is the most important, piece is paying a price for a company that is significantly lower than what our analysis says the business is worth. We use a combination of cash flow analysis and the historical operating performance of the business to identify suitable investments, avoiding ones for which we would be paying too high a price, therefore limiting appreciation potential.”
As the chart below illustrates, your portfolios trade at a significant discount to the S&P 500 by many different valuation metrics.
Lastly, here is just a small subset of the companies we own across portfolios we manage. We thought it would be of interest.
As we head toward the second half of the year, we will continue to look for opportunities, realizing that risk management remains paramount as we reach the late stage of both this economic and market cycle.
If you’re interested in reading more about individual companies that we’ve researched, check out the Company Spotlights or give us a call and Jim, Tim or I will be happy to provide more information.
Thank you, Patrick.
As I’m fond of saying at the close of our quarterly letters, swing on by for a cup-o-joe. The coffee pot is always on.
I’d like to add a personal note to all, about how thrilling it is to see our children grow. This event found me walking daughter Lindsey down the outdoor aisle in Wyoming as she accepted Aaron’s hand.
Jim Parr, Principal
Cairn Investment Group, Inc.
Greetings from the Northwest.
My golly, what a crazy twelve weeks of news it has been. The first quarter of 2019 showed that the economy still had strength as investors bid prices up again after the 2018 fourth quarter deflate.
How to absorb all of this noise, and move on? I like a bit of quiet time with the Wall Street Journal and a cup of coffee on the weekends. This particular end-of-the-first-quarter newspaper even had a few pink cherry blossoms stuck to it as I pulled it out of our paper box. How beautiful, the scents of spring blossoms, fresh pressed coffee, and printer’s ink not quite dry on the sunrise edition.
And then the crazy stuff begins. Parliament rejected… The FBI has embarked… Trump again threatened… The Justice Department… Emails in a lawsuit… U.S. and Chinese trade… The Red Cross said… The Vatican issued… Lyft shares jumped… and then the clincher… U.S. stocks notched their biggest quarterly gains in nearly a decade, lifted by bets that central banks would hold interest rates at low levels as global growth slows.
Patrick, what does it all mean?
With the markets regularly acting like a kid bouncing on a pogo stick, you are forgiven if you are wondering what will happen next. In the third quarter of 2018, U.S. stocks (measured by the S&P 500) rose 7.71%, followed by the fourth quarter decline of -13.52%. And just when pundits were calling for continued declines, the S&P 500 rebounded 13.65% during the first quarter. Predicting short-term market movements is usually an exercise in futility, which is why we spend our time looking at long-term valuations on which we base our expectations. While the decline that happened during the fourth quarter made the broad market “cheaper,” it did not move the needle very much, from a long-term perspective. So while we were able to invest in some new companies, at cheaper prices, we still view the broad market as rather expensive.
The topic du jour over the last few weeks has been the Treasury yield curve and the inversion of the 3-month/10-year U.S. Treasury yield. On March 22 the shorter yield was higher than the longer yield, thus inverted. Inversion of the yield curve has predicted the previous nine U.S. recessions with few false signals, so you can see why this news has become so prevalent. News articles and TV pundits will confidently make predictions about the timing of the next downturn, but, like many events in both finance and economics, inversion of the yield curve is not always a direct cause and effect relationship regarding stock market returns, or an accurate predictor of when a recession will emerge. The chart below graphs the yield spread versus the one-year future return of the S&P 500 Index.
When we examine the data, a few things become clear. First, taking a look at the previous three recessions, the average time from yield curve inversion to recession was twelve months, with the longest being twenty-two months in 2007. Second, future one-year market returns were inconsistent with no discernable pattern. When the yield curve inverted in 1989, rolling one-year returns post-inversion were positive and continued that trend through the recession that followed. In 1998, there was a false signal during the Asian Currency Crisis. No recession followed and market returns were positive as the tech bubble took hold. After the inversion in 2000, market returns were negative approximately 16-20% and would continue that trend through the recession. Most recently, in 2006, rolling one-year returns were positive for almost a year before turning decidedly negative as the housing bubble burst. A hard look at the data is always needed to see what historical outcomes have unfolded. Does it signal that caution should be warranted? Yes, especially when combined with other market data points. We have been in that camp for some time now as market valuations remain elevated. Does it signal that the twelve-year economic expansion is getting long in the tooth? Yes, but that is what should be expected after a twelve-year economic recovery. To quote famed value investor Howard Marks when discussing cycles, “We may never know where we’re going, but we’d better have a good idea where we are… and act accordingly.”
We will not try to guess when the next recession or bear market will start, but we do have a good idea of where we are in this cycle and our research has us acting conservatively.
Please feel free to email or call with any questions regarding these topics and how we are managing through them. Thank you!
Thank you, Patrick.
These are exciting times, made more comfortable by having a plan and sticking to it. Maybe we will change Patrick’s name to “Col. John Hannibal Smith” the leader of the renegade commando squad “A-Team”… or not?
Please take me up on my standing offer of swinging in for coffee. The pot is always on.
Jim Parr, Principal
Cairn Investment Group, Inc.