No Margin for Error
Baseball lovers this year were treated to the best World Series in a long time, with the Los Angeles Dodgers besting the Toronto Blue Jays by the slimmest of margins in extra innings in a game- seven classic. The whole series was electric, with an amazing display by Vladimir Guerrero of the Jays and a Ruthian performance by the Dodgers’ Shohei Ohtani. In the final game, it seemed as though Toronto was about to run away with the championship, but the Dodgers kept hanging around, chipping away at the Jays. A play at home plate would have given the Jays their first title in 32 years, but the runner was called out by a fraction of an inch. In the end, the Dodgers prevailed, and the difference came down to a handful of small base-running mistakes by the Jays. The thing is, in game seven of the World Series, those mistakes matter. Everything matters. There is just no margin for error.
There’s a lesson in there somewhere.
Financial markets were strong again in October, with tech momentum powering the markets higher. While equity markets posted good performance basically from top to bottom, it was the top that, in a familiar refrain, performed the best. A basket of the Magnificent Seven stocks rose 5.6% in October and is up more than 25% for the year. Globally, including the U.S., stocks rose 2.2% during the month, with the MSCI All Country World Index climbing to a 21.1% return for the year. International equities have returned 28.6% YTD through October, ahead of the S&P 500’s also strong 17.5% return. In essence, what was an either/or question earlier this year—buy pricey U.S. tech giants or buy inexpensive international shares—has been answered the way Billy Ray Valentine, Louis Winthorp and Coleman the butler decided after striking it rich in Trading Places: Why not have both the cracked crab and the lobster?
So here we are, in early November, looking at the third consecutive year of equity returns that are well-above average. Of course, we are pleased when the market goes up, and we are pleased that client portfolios are generally doing well. However, it is also true that high valuations make us nervous. The margin for error for the broader markets just doesn’t seem that high.
Errors happen all the time, including right now. Two recent high-profile bankruptcies, First Brands and Tricolor Holdings, have raised questions about corporate credit quality and corporate governance. First Brands was an auto parts supplier, and Tricolor was a subprime auto lender, so it is unclear if these two lending mistakes are industry-specific or if they are indicative of a bigger problem, but it is a growing question.
Speaking of potential lending errors, the Federal Reserve itself is faced with a difficult question. Does the Fed lower short-term rates to support what seems to be a weakening labor market, or does it maintain rates to try to choke off tariff-fed inflationary pressures? One more rate cut before year-end seemed a foregone conclusion just a week ago, but Fed Chairman Powell has advised against that assumption.
One might have assumed that, given these risks, stocks would have retreated lately, but you know what happens when you assume.
High prices create higher hurdles for future returns. With stock prices at these above-average levels (the S&P 500 now trades at 23x earnings when the longer-term average is 17x), it’s just mathematically less likely for an asset class to deliver returns that are in line with historical averages. That’s just a fact. That’s the bad news.
The good news is that because of our value discipline, our slight tilt toward small caps, and our commitment to international diversification, we believe that we are optimally positioned for challenges that may lie ahead. We are not predicting problems, and we are not hastily making adjustments ahead of potential problems; we are merely saying that if problems materialize, we believe we are already positioned to outperform, in no small part because of our significant margin of error provided by our commitment to valuation discipline. To illustrate, using the old-school metric of price-to-book (market price vs. a company’s book value), our model portfolios have a P/B ratio of about 2.0x. That compares to the current P/B ratio (trailing-12 months) of the S&P 500 of 5.6x. That is an enormous difference and constitutes what Warren Buffett and Benjamin Graham would call a margin of safety.
The Dodgers won the World Series with persistent hitting, great defensive plays and because Toronto made a handful of mistakes on a very large stage that proved costly.
There’s a lesson in there somewhere.
For more information, please reach out to:
M. Burke Koonce III
Investment Strategist
bkoonce@trustcompanyofthesouth.com
Daniel L. Tolomay, CFA
Chief Investment Officer
dtolomay@trustcompanyofthesouth.com
DISCLOSURES
This communication is for informational purposes only and should not be used for any other purpose, as it does not constitute a recommendation or solicitation of the purchase or sale of any security or of any investment services. Some information referenced in this memo is generated by independent, third parties that are believed but not guaranteed to be reliable. Opinions expressed herein are subject to change without notice. These materials are not intended to be tax or legal advice, and readers are encouraged to consult with their own legal, tax, and investment advisors before implementing any financial strategy.
