May 2014 Investor Letter

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Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

The S&P 500 continues to tread water in 2014. The index was up 1.92% at the end of April, but so far 2014 has been a stalemate between bulls and bears. The index crossed back and forth between positive and negative territory throughout last month, and the S&P 500 has actually spent slightly more time below breakeven than above it this year.

Although the S&P 500 is mostly flat, there are some important segments of the market have been deteriorating. Since mid-March, many popular momentum stocks are down more than 20%+ from their peaks. The Nasdaq and Russell 2000, which are indexes that contain a higher proportion of aggressive momentum names, are both down for the year. At the same time, defensive asset classes are faring best. Interest rates have fallen as bond prices have rallied and utilities stocks are among this year’s top performers. When defensive assets are leading and aggressive assets are lagging, it is typically not a positive signal.

Markets are sending weak signals, but investors seem ready to write-off the warnings signs. In April, we found out that first quarter earnings growth was uninspiring and that GDP only grew by 0.1%. The numbers were weak, but most investors readily accepted that the economic weakness was wholly due to weather. Counterintuitively, weak data has led to higher expectations because investors are expecting a big bounce back. Many analysts are now speculating that we will get 4% GDP growth in the second quarter. The higher bar will be harder to clear.

Meanwhile, we’re seeing textbook late cycle behavior in the economy. Leading economic indicators like securities prices and the housing sector are showing weakness, while lagging economic indicators like unemployment, energy, and commercial real estate are showing strength. Additionally, inflation is starting to percolate and the Fed is tightening monetary policy by tapering asset purchases. To top it off, retail investors are more heavily invested in their brokerage accounts than at any time since September 2007.

Furthermore, the conditions are ripe for a decline. This economic expansion is now the 6th longest in history, this bull market is the 4th longest in history, and equity valuations remain higher than at any point outside of the dotcom bubble. We all know that markets periodically become volatile, but today hardly anyone truly believes that the economy or markets could see a material fall.

This willingness to overlook negative data is typical when the economic cycle is cresting. Bull markets are often compared to parties, and we appear to have entered the “beer goggles” phase of this one. There are plenty of reasons to be concerned, but investors are too intoxicated by the effects of a prolonged bull market to maintain clear vision.

Bull market beliefs have become deeply ingrained by relentless reinforcement over time. Investors have been well trained to accept that: 1) interest rates will stay low forever 2) PE ratios will stay high forever 3) it’s not unreasonable to value a growth company based on 2019 revenues and 4) the Federal Reserve has absolute authority to control the economy. Sadly, these beliefs are probably held most deeply by the people who have argued most passionately against them. The former bears have been painfully disproven for years. As a result, long time bears’ confidence is shattered and most have likely already found new investment strategies. After 17 months without a meaningful decline, bears are all but extinct.

All of this evidence is pointing to the fact that we are through the inflection point where we go from climbing the wall of worry to descending the cliff of confidence. Our orientation has likely flipped. On the way up, bears turn into bulls; on the way down bulls turn into bears. The weakness in momentum stocks is especially telling, because it shows that selloffs are not being driven by bears who are having brief moments of influence, but instead by bulls jumping off the top of the pile.

As the cycle inflects, many stocks will fall enough that they will start to look attractive, but we have to be careful to make sure that we are not judging them with our new-found beer goggles. The realities that we have come to accept during our bull market party are not necessarily ones that will remain when we wake up sober.

Scott Krisiloff, CFA