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  • KPB & Co Research

There is no question that some of the issues that defined the 2018 investor terrain will likely carry over into 2019. While these issues are not entirely prohibitive to profits, they will likely make your path to profit somewhat challenging. These issues are as follows: tighter monetary policy, greater uncertainty around fiscal policy, and the approach of peak stock market valuation.

Tighter Monetary Policy

Federal Reserve chairman Jerome Powell has overseen several rate hikes in the last couple of months. He has also communicated that the US Federal Reserve is a good deal away from what is deemed to be the neural rate. The neutral rate is the level of interest rates that is seen as neither accommodative - low rate environment nor tight - high rate environment. This communique has roiled up markets for the simple reason that it implies further rate hikes down the road. All assets on planet earth is priced as a discount to future cash flows, and so as rates rise the discount gets bigger, and the value of all assets decline, except in the instances where future cashflows are growing quickly. There have been calls for slower hikes to interest rates going forward from not only president Trump, but also many key investors. There is no telling what the US Federal Reserve will do, but given the negative reaction of the stock market to their policy thus far, they are incentivized to slow down. In any event, investors should be prepared for further rate hikes whether at high pace or slow pace. In making this preparation investors should seek out investments that have strong growth in free Free cash flow (8% or higher). The growth in Free cash flow in a sense provides a cushion to a higher discount rate thereby protecting your capital.

US Fed Rate Changes (2015 to 2018)

Fiscal Policy Uncertainty

The year 2019 is getting ready to serve investors a political cocktail of uncertainty, that comprises of a touch of policy implementation difficulties, trade wars, bigger government deficits, tensions in the middle east. All of these issues will likely keep a lid on investor excitement. By the end of January, control of the house will have passed to the democrats who for sure are very excited at the opportunity to block and tackle Trump policies. The house of congress kicked off 2019 with a government shutdown, and there will likely be more political drama unfolding over coming months. Impeachment of the president is possibly on the list of things to do, as well as ramping up the Russia probe, sexual assault investigations, and maybe just maybe the economy. There is also the infrastructure program that has been apparently sidelined. I suspect that this will become a bigger political issue by mid 2019, as people begin to position for presidential elections in 2020. In preparing for these uncertainties, none of which are good for business, and many of which can go in any direction, investors should stick to the stocks of businesses with visible growing Free cash flow. Starting in the second half of 2018, the big Index funds have moved into defensive stocks in preparation of a recession. This provides the opportunity to pick up "those babies that have been tossed out with the bath water".



Approach of Peak Stock Market Valuation

Over the last decade, the stock market has been bullish, with the S&P 500 Index increasing at an annual average of 8.7%. Today, many investors believe that we are at the beginning of a bear market, with the possibility that there will be a more aggressive move to the downside during 2019. Top investors such a Jeffery Gundlach of Double Line Capital, and Stanley Druckenmiller of Duquesne Capital are echoing similar sentiments. Other investors such as Gary Shilling are holding wads of cash to pick up good investments on the cheap later in the year. On the other hand, some of the best investors in history such as Carl Icahn, and Warren Buffett would tell you that no one knows where the market will go in the short term. So where does this leave you? The bearish investors may be right, or they may be wrong and the bull market goes on for another 2 or 3 innings. Our approach, and the approach we recommend is to focus on individual companies if you know these companies well. If you don't know these companies well stick to an Index fund. In all cases (whether individual stocks or an Index fund) buy cheap or don't buy anything. Always maintain a margin of safety, because anything can happen, and finally stick to businesses with solid fundamentals.

In the coming months or years, expected returns on stocks on average will tend to be low as the bull market runs its course. The issue of low returns will likely be compounded with uncertainty around fiscal policy, and monetary policy. Monetary policy will likely get less accommodative as the US federal reserve inevitably slim down its balance sheet, and raise interest rates simultaneously. Given the huge debt levels among households, government, and businesses, tighter monetary conditions will lead to bouts of intermittent stress periods that will create opportunities to pick up good assets on the cheap. On the hand, there is always the possibility of a recession and so we would encourage caution.


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