Fundamentals not headlines ultimately drive financial markets. Although it is always tempting to listen to the news, successful investing depends (perhaps more than ever) on a dispassionate review of fundamentals. We’ve attempted to sift through the current noise to highlight what we think is important and not, and summarized them as “The Three Ps” of politics, profits, and probabilities.
Politics: ignore it.
Politics is about what should be. Investing is about what is. At RBA, we invest based on what “is.” Our sole goal is to invest successfully for our clients, and not to advocate a particular political position.
One might have liked President Obama or not, but there was a major bull market during his two terms. One may like President Trump or not, but the bull market is continuing. If one structured portfolios based on one’s views of what should be, one has missed all or part of the 8+ year bull market. Period. End of story.
We pointed out last month that the recent performance of the South Korean stock market is glaring evidence of how listening to politicians can obscure potentially exciting investment opportunities. Although politicians have focused on the geopolitical risks associated with North Korea, the stock markets have focused on the fundamentals of South Korea. The South Korean stock market is up more than 25% year-to-date (in USD terms) and roughly tripled the return of the US stock market! (see Chart 1)
There may indeed be geopolitical risks associated with North Korea, but investors need to remember that fundamentals and not politicians’ desires to alter geopolitics ultimately drive stock markets.
Source: Bloomberg L.P. For Index descriptors, see “Index Descriptions” at end of document.
Profits: crucially important
Perhaps the primary distinction between RBA’s investment process and those of other firms is that RBA focuses on profit cycles and not economic cycles. That is a subtle, but extraordinarily important, difference because history shows the financial markets watch profit cycles whereas most investors follow economic cycles.
Profit cycles are more important than economic cycles because profits, and not GDP, are the heart of equity investing. When one is a partial owner of a company, as one would be when holding the stock of a company, then one’s sole concern is the profitability of their company and not the economic output of the entire country.
Our groundbreaking research in the early 1990s1 demonstrated that profit cycles were the essential factor behind size, style, sector, country, and asset rotation. RBA’s investment process today combines profits, liquidity, and sentiment based partly on this time- tested research.
Most investors focus on economic cycles and, as a result, can miss significant investment opportunities. There have been two dramatic examples just in the last five years or so:
1. It has been popular to suggest that the Fed’s immense liquidity injection into the US economy is the only reason the US stock market has appreciated. Investors see a strong bull market with US tepid real GDP growth of roughly 2% and conclude that the bull market must be highly speculative. However, these observers are missing that corporate profits became the largest portion of US GDP in history during the bull market (see Chart 2).
The bull market can more easily be explained if one examines profit cycles. The combination of record central bank liquidity and profits becoming the largest proportion of GDP better explains the bull market, and suggests the market is not as speculative as many believed.
2. It was consensus after the last recession that emerging markets were “growth” stock markets. Investors saw GDP growth that was 2-4 times the growth rate of the US economy. Yet, emerging market stocks underperformed US stocks for the next 5 years. That underperformance is easily explained if one considers profit cycles instead of economic cycles. The emerging markets’ profits growth was among the worst in the world (see chart 3).
When it comes to macro fundamentals, it may be critically important to ignore economic cycles and strongly concentrate on profit cycles.
Source: Richard Bernstein Advisors LLC, BEA.
Source: Richard Bernstein Advisors LLC, Bloomberg L.P., MSCI.