PWA 2024 Year-End Letter, Part 1: Rules, Risks, US Equities, and Stuff That Truly Counts

The Essential Rules of Investing:

1. Risk Control First: Focus on managing downside over chasing upside. 

2. Value Over Price: Buy for less than something’s worth. Quality means nothing if you overpay. 

3. Long-Term Patience: Success doesn’t happen on a schedule. 

--Howard Marks

Or, simply:

Rule #1. Never lose money.

Rule #2. Never forget rule number #1.

--Warren Buffett 

And the question we (at PWA) must answer yes to every single day: 

"Can you observe without any prejudice, without taking any sides, without protecting your own personal conclusions, your beliefs, your dogmas, your experience and knowledge? And therefore be totally free to observe clearly?"

--J. Krishnamurti

Incredible how fast time flies these days... Yeah, I know, the older we get!

As I read through last year's year-end letters (seems like I wrote them yesterday) I find myself in many respects pounding the same table; as, indeed, the economy continues to meander through its late-cycle phase (yes, there's still a cycle), with all the late-cycle risk/reward setups that come with it.

So, it might seem like it's taking forever this go-round -- in fact lately I've been hearing "it's different this time" (or words to that effect) -- from pros* and amateurs alike -- like I haven't since early 2000 (the peak of the dotcom bubble), or since 2006/07 (just ahead of the Great Financial Crisis)... 

*Note, there is indeed a plausible scenario that would have the present cycle extend even beyond 2025, which we'll explore in the coming days.

The fact that I can cite two events in relatively recent history where certain market dynamics defied conventional logic, until they didn't, for an extended period of time, should, at a minimum, have us exhibiting a decent dose of caution -- when it comes to stocks -- while the present setup persists.

But then, of course, being that we're late-cycle, we also need to be giving serious thought to how best to allocate our clients' hard-earned wealth into the next/new cycle to ultimately come... Which we'll explore over the next few weeks.

One analysis that we deem compulsory is the matching of current conditions to those they most resemble among past cycles.

For us, with regard to equity markets, one such analog is the late-cycle stage of the 1990s... And the easiest parallel to draw -- aside from another world-changing new technology (this time AI) -- is valuation.

Let's take a look.

Here (top panel) is the 30-year history of the SP500's trailing price-to-earnings (P/E) ratio... The shaded areas highlight P/E levels where the index (bottom panel) itself typically, at some point along the way, experiences double-digit drawdowns:

And how about the harder-to-manipulate price to sales (P/S) ratio?  Uh Oh!!

And price-to-book value (P/B):  "  " !!

And then there's the Nobel Prize winning work of Robert Shiller -- his Cyclically Adjusted Price/Earnings Ratio (CAPE)... This chart going back to 1880 (present levels are just off 1999's high, and notably above 1929's):

Last (there are others, but you get the point) but not least, the so-called Buffet indicator -- the total market cap to GDP ratio... This chart going back to 1950 (never higher than now):   UH OH!!

Our firm's Co-Chief Investment Officer, Nick Mazorra (yes, same last name, i.e., he's lived his life in and around markets), is these days fond of quoting whoever once said "stocks are the only things people want to buy when they're super expensive."  

Well, indeed, this chart -- amid the valuations illustrated above -- proves his point (h/t Bob Elliott).

Yep, even more so than during the 1999 peak, do folks hold stocks!! 

Of course I could go on and on -- and talk about record concentration in a few names like we haven't seen since, you guessed it, 1999, yada yada -- but suffice to say that US stocks are (still) historically-expensive by virtually any metric... And, while, indeed, they can remain that way for a very long-time, make no mistake, they absolutely will not remain that way forever.

Question is, will they come down to historically-reasonable or cheap valuations by way of falling share prices, or by way of rapidly rising earnings?  Of course Wall Street says the latter, while history says, well, um, be careful with that!

Now, before I copy and paste from past letters those qualities of the investment firms we deem to be great, I want to be abundantly clear that just because we're starting this year's final note with an outright warning about the present (valuation) state of US equities, we are in no way suggesting that there aren't places to comfortably invest in the here and now, and, frankly, as I'll illustrate in the coming days, I can't exaggerate how opportune the setup(s) look for the next cycle -- once it finally gets underway, that is.

As for the here and now, allow me to offer up an example of what we view as the epitome of an all-weather portfolio (a reflection of current global macro realities)... I.e., our current core allocation:

Stock sectors:

Stock styles:

Stock regions:

Bonds:

Commodities (gold, ag, silver, and palladium, currently): 

Now, before any of you non-clients who might've stumbled upon this blog, and are looking to establish your own all-weather portfolio, go replicating the above with your own money, be aware that this is simply our snapshot on this day in late-November 2024... I.e., while we've maintained a low/moderate risk theme throughout this year, you need to know that we've made no fewer than 29 adjustments to our asset mix since January alone.

For example here's from our internal notes just the other day:

11/12/2024

Selling all SPTS, upping IWM, XLB and XLF targets in the A model

If anything, for the time being, there’ll be less pressure on the Fed to cut rates, which makes SPTS no longer attractive… However, beyond the time being, in the event that, let’s say, a global protectionist push results in a weakening economy, the Fed will be back in easing mode, which will once again make SPTS a viable core option at that time.

In the meantime, unloved (till recently) small caps should benefit from a stronger dollar (although higher rates are indeed a headwind), and a nationalist agenda… Materials look attractive right here, as they’ve been underperformers and there’ll be more infrastructure spending (already legislated in, and more promised) likely to come (notwithstanding the still-there recession risk in our analysis)... Financials stand to gain from de-regulation policies as well as higher rates (as long as they prevail).

The above allocation changes are not aggressive shifts by any stretch… They’re marginal moves to reflect the improved data of the past few months, and the potential positive ramifications of the US election outcome… The potential negative ramifications of the election results will be felt if/when they embark on stricter trade restrictions – their extent, and timing, will determine the downside risk.

You see, flexibility, nimbleness and, above all, open-mindedness are absolute musts, particularly at market extremes, and at the extreme ends (very early/very late) of the economic cycle... And, make no mistake, when factors fundamentally align, we'll be absolutely increasing our core risk profile, which, ironically, will likely occur as others are running for the hills.

Yes, we appreciate Warren Buffett's style in that regard, as, we "get fearful when others are greedy, and greedy when others are fearful."  That said, on an individual client basis, we'll of course compensate for factors such as age and personal risk tolerance.

One last point regarding stock market risk: While our general shift to a hedged, moderate-risk profile beginning in the fall 2019 resulted, as planned, in minor drawdowns in client portfolios amid the two notable stock market selloffs since (Covid and 2022), we'd love nothing more than to get back to the kind of growthy allocation we managed, say, from early '09 to fall '19... But, as we've illustrated ad nauseam ever since, general conditions simply haven't -- in our fundamentally (and fiduciarily)-driven view -- allowed for the kind of risk-tolerance we exhibit when underlying fundamentals allow. 

Our justification for such patience lies in those historic comedowns experienced by virtually all bear markets past -- let alone those characterized by today's extreme valuation levels... I.e., they have, virtually without exception, wiped away literally years of past performance.

Recent examples:

The 2000-2002 bear market took back 5.5 years of gains:

The bear market of 2008 erased an entire decade:

The brief Covid affair sucked 3.25 years right out of the market:

The 2022 bear market kissed 2 years of market gains goodbye:

Ah, the echoes of my youth are suddenly ringing in my years: Those early days back in the 80s when my mentors, and for a while me, would preach the ills of market timing, and espouse the notion/mantra that success was all about time in the market, not timing the market, yada yada...

Well.... okay, so history shows that if you just hold on, stocks always come back! 

Yes, but.... well... not so fast... 

I mean, how would you like to have been the 70-year old neverseller in 1968, with all of your money in the US stock market? 

Not counting the dividends you would've received along the way (the knowledge of which may or may not have averted your panicking and selling everything at the market low, or your heart attack), you would've arrived back at your 70 y/o starting point somewhere around your 82nd birthday... Holding "forever" was, let's say, not so good during that stretch.

And what about that 2008 experience I illustrated above? What I left out was how long it took to get back to square one... I.e., the unfortunate 70 year old of that stretch would've had to make it to age 85 -- after living through two utterly hellacious drawdowns along the way -- to get back to square one!

So, no! I object, strenuously, to the notion that investors should simply set it and forget it when it comes to their portfolios. 

Especially these days! I mean there's a reason for the plethora of analyses that have been released of late showing an estimated near-zero (or worse) real return for US equities over the coming decade... They're simply derived from the market's history of periods where we begin from these valuation levels.

Bottom line: While, again, despite our concerns over the present valuation state of US equities, and, thus, their presumably dismal longer-term prospects from here, there are literally a world of macro opportunities (across asset classes) to explore as the next few years unfold... We'll make that case herein over the next three weeks. 

We'll close Part 1 with the following stuff (perspective) that, frankly, matters most:

As you (clients) know, I enjoy using analogies to explain our view of market and economic general conditions... In the past I've associated our macro analysis with the flight path of an eagle affixed with electrodes, etc., that allow us to monitor its vital functions as it glides across blue skies, sores to high altitudes, and flaps its way through the storms that occasionally cross its path.

Fishing, basketball and ice skating have also inspired some storytelling that has helped me drive home how we approach the task of preserving, protecting and growing our clients' wealth in a manner that has them satisfying their objectives while, ideally, feeling comfortable amid the inevitable ups and downs delivered by world markets.

I stumbled onto the latest during a discussion with a client who loves to go hiking... I explained to her that our approach to taking on risk (and, thus, the potential for higher returns) could be thought of as deciding whether or not it’s safe to head for those vaunted higher elevations -- those levels, while beautifully breathtaking when the weather's beautiful -- where an unanticipated storm could do some serious, long-term, damage to one's physical and emotional wellbeing.

Truly, the more beautiful, or greater, the reward, the greater the risk one must take in reaching it.

Here's me paraphrasing the analogy in a June 2023 blogpost:

"When, for example, there's a 50% chance of a blizzard over a given time period, and at a certain altitude, you simply don't go hiking up there until the forecast clears... Whether the blizzard* occurs in the meantime means absolutely nothing... Even if it doesn't snow, not hiking up there (given the risk in the forecast) was 100% the right decision."

In an investing context:

"...if one stays consistent and always makes such thoughtful decisions, the odds of one ever going broke are greatly reduced... As, make no mistake, there will be financial blizzards that will materialize in our future; whether or not one occurs in the coming months remains to be seen, but, as we continue to point out, odds are such that prudence is presently warranted."

In the ideal scenario, we remain in the foothills (diversified and hedged) as long as the storm risk looms... If indeed the storm hits, our goal then will be to strap on our snow shoes and slowly begin our ascent when our models signal that it's beginning to abate.

Along the trail we'll encounter those who either didn't see the signs, or ignored them altogether, and who will be desperate to offload their equipment (for far less than they paid for it), and get themselves out of that freezing mess they got themselves into... Of course we'll be more than happy to purchase quality equipment (stocks, etc.), on the dirt cheap, when we're comfortable traversing those ever-desirable higher elevations.

If, on the other hand, the blizzard doesn't hit, that's perfectly okay, for, as our forecast clears, we'll then gladly begin our ascent to higher elevations -- with zero desire to catch up to those who, unwittingly or otherwise, chose to accept what was in fact cripplingly high risk.

I.e., we here at PWA are steadfastly committed to the principle that investing is in no way, shape or form, a race... Our responsibility is to invest our clients' hard-earned wealth in a manner consistent with their time horizon, their risk tolerance, and with our overall view of the present global macro risk/reward setup -- with utter disregard for what other asset managers are up to... Except, that is, when we're considering the prevailing market sentiment, the degree of crowding, etc.

The following is our list of what we believe to be the essential characteristics of the world’s best portfolio managers -- traits we everyday strive to embody -- that we've featured in the past few year-end letters Part 1:

1. A passion for macro economics and market history.

2. A firm understanding of intermarket relationships.

3. A firm grasp of global macro and geopolitical developments.

4. An obsessively strong work ethic.

5. The ability to transcend his/her ego and political preferences.

6. A willingness to buck prevailing market trends (diverge from the crowd) when the risk/reward setup inspires it.

7. An understanding of and appreciation for the uncertainty of markets.

8. A flexible and open mind.

9. Utter humility.

We'll finish up Part 1 with an apropos-for-these-times quote-fest from one hugely successful, seasoned investor who I believe embodies those characteristics; Howard Marks:

"...you’re unlikely to succeed for long if you haven’t dealt explicitly with risk. The first step consists of understanding it. The second step is recognizing when it’s high. The critical final step is controlling it."

"Investors with no knowledge of (or concern for) profits, dividends, valuation or the conduct of business simply cannot possess the resolve needed to do the right thing at the right time. With everyone around them buying and making money, they can’t know when a stock is too high and therefore resist joining in. And with a market in freefall, they can’t possibly have the confidence needed to hold or buy at severely reduced prices."

"You must be aware of what’s taking place in the world and of what results those events lead to. Only in this way can you put the lessons to work when similar circumstances materialize again. Failing to do this—more than anything else—is what dooms most investors to being victimized repeatedly by cycles of boom and bust."

"Understanding uncertainty: The possibility of a variety of outcomes means we mustn’t think of the future in terms of a single result but rather as a range of possibilities. The best we can do is fashion a probability distribution that summarizes the possibilities and describes their relative likelihood. We must think about the full range, not just the ones that are most likely to materialize. Some of the greatest losses arise when investors ignore the improbable possibilities."

"In the tech bubble, buyers didn’t worry about whether a stock was priced too high because they were sure someone else would be willing to pay them more for it. Unfortunately, the greater fool theory works only until it doesn’t. Valuation eventually comes into play, and those who are holding the bag when it does have to face the music.

• The positives behind stocks can be genuine and still produce losses if you overpay for them.

• Those positives—and the massive profits that seemingly everyone else is enjoying—can eventually cause those who have resisted participating to capitulate and buy.

• A “top” in a stock, group or market occurs when the last holdout who will become a buyer does so. The timing is often unrelated to fundamental developments.

• “Prices are too high” is far from synonymous with “the next move will be downward.” Things can be overpriced and stay that way for a long time … or become far more so.

• Eventually, though, valuation has to matter."

"When markets are booming, the best results often go to those who take the most risk. Were they smart to anticipate good times and bulk up on beta, or just congenitally aggressive types who were bailed out by events? Most simply put, how often in our business are people right for the wrong reason? These are the people Nassim Nicholas Taleb calls “lucky idiots,” and in the short run it’s certainly hard to tell them from skilled investors."

"...since many of the best investors stick most strongly to their approach—and since no approach will work all the time—the best investors can have some of the greatest periods of underperformance. Specifically, in crazy times, disciplined investors willingly accept the risk of not taking enough risk to keep up. (See Warren Buffett and Julian Robertson in 1999. That year, underperformance was a badge of courage because it denoted a refusal to participate in the tech bubble.)"

"The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up." 

"...everything in the investing environment conspires to make investors do the wrong thing at the wrong time."

"...when you consider investment results, the return means only so much by itself; the risk taken has to be assessed as well."

"Surely investors who get their statements and find that their accounts made 10 percent for the year don’t know whether their money managers did a good job or a bad one. In order to reach a conclusion, they have to have some idea about how much risk their managers took. In other words, they have to have a feeling for “risk-adjusted return.”"