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2018 Year-End Letter

When Tides Don’t Roll

Headed into the NCAA Football Championship game on January 7th, the Alabama Crimson Tide were favored by more than five points over the Clemson Tigers. Just about everyone was picking Alabama. Even those picking the underdog Tigers would have guessed it would be a close game. In the end, it wasn’t. Not only did the Tide not roll, they got rolled. It had been unthinkable because, under Nick Saban’s leadership, Alabama’s decade-long dominance has been largely unapproachable, hardly ever losing and never by much. In 2018 they had looked better than ever... until they didn’t. Sometimes things that aren’t supposed to happen do.

After a good start to the year, the final quarter was a reminder that you can’t plan for every scenario. Specifically, it turned out to be the S&P’s worst December since the Great Depression. It felt a bit like getting rolled over—not because of the declines, but because, as the CEO of another investment manager put it, “Everything that was supposed to work, didn’t.” Aside from US Large Cap (SPX), every equity asset class was down by more than 10 percent on the year. What was supposed to help diversify didn’t. Long-term treasuries, bonds, credit, and commodities were also in the red, while volatility was abnormally subdued.

We had been expecting a larger, more visceral correction in stocks, one lasting at least a few months, which we haven’t really seen since fall 2015 thru early 2016.

What we saw in Q4 looked and felt like that sort of correction. Indeed, it provided some good buying opportunities. However, the declines of December may have been a tremor, a preview of what’s to come. At the lows, the S&P 500 was down more than 19% for the quarter, while the Russell 2000 and Nasdaq-100 were down 25.3% and 22.7%, respectively. All of this without many significant signs of recession. To reiterate what we said in our Q3-18 letter:

The risk is always there. Volatility tends to bring out the talking heads. It generates fear. It’s good for ratings. But it will not govern the successful investor’s analysis and mentality. Volatility is not real risk. It is price risk. What’s the difference? Real risk is the chance of permanent loss. And permanent loss occurs for two reasons:

  1. Emotional buying/selling. Buying too high (e.g. at the top in 1999) when prospective returns are low or negative. Panic selling (e.g. selling at the bottom in early 2009) when prospective returns are attractive.

  2. Deterioration in a company’s fundamentals leading to a greater chance of insolvency and a permanent reduction in value.

Our views are not a prediction. We do not believe we can necessarily time market moves even if we believe them eventually inevitable. We do, however, observe market conditions. From what we can tell, the move in December more than likely encompassed a relatively small number of those who are likely to sell during an extended, multi-month decline. In other words, December was more likely a quick panic attack before the nervous breakdown.

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