Dear Clients and Friends,
If the theme of 2023 was inflation, then for 2024 I will go with regime change. Don’t worry, I have no interest in talking about the 2024 election. As would be true for most people, it exhausts me and I would prefer reading about almost any other topic, ranging from vacuum cleaner reviews to prescription drug disclosure inserts. The regime change I am talking about is multi-faceted – yes, there is a political component – but it is also a reset in market dynamics. Big tech dominance, a resurgent economy, a strong dollar underpinned by high interest rates, and low market volatility are hallmarks of the recent market environment, but may not accurately describe the market 18 months from now. It is a prediction of change, not of the direction in which that change will take place. Or in other words: brace for uncertainty.
Of course, we never know what is going to happen, but continuity is not the most likely outcome in an environment where trends seem long in the tooth. My prediction, if I may be so bold as to wager, is that uncertainty will be dear (as in gold prices could rise), other currencies could rally as places like Europe will be able to lower rates on lower inflation, whereas the US might need to go slow to compensate for the lack of fiscal discipline, and – to the extent markets advance – the rally might broaden to sectors that were left out but are screaming “cheap.” Einstein once defined insanity as doing the same thing over and over and expecting a different result. I think in markets today the inverse might prove to be true: trying the same thing over and over and expecting the same result seems like the choice that might disappoint.
Retail Dystopia
Have you ever heard of Shein? If the answer is “no,” then no shein on you. However, in that case, two things are probably true: you are over the age of 30 and your shopping habits are more sustainable – in terms of environmental impact and labor practices embedded in the supply chain of your products – than those of many Gen Z-ers. The immense popularity of Chinese online shopping platforms like Shein and Temu should lay to rest the narrative that younger people care more about the environment and social issues than older generations do. Of course it is person dependent, not age dependent, but the statistics don’t bode well for the under-30 crowd as a whole, when it comes to shopping.
So what is Shein? It is an online marketplace operated by Chinese e-commerce company PDD Holdings. The products are shipped directly to consumers from China and much of the merchandise can be categorized as ultra-fast fashion at bargain prices. If fashion trends historically followed the four seasons, Zara and H&M broke that mold in the 1990s, coming out with dozens of products on a weekly basis at relatively low prices compared to traditional retailers. But that turned out to be just child’s play. Enter ultra-fast fashion players like Shein.
Shein might churn out 10,000 new designs a day, with the average worker having a daily quota of 500 garments at a compensation of as low as 4 cents per item. The stats vary from source to source, but agree that most Shein items go from production to landfill within one year. So that $3 Shein shirt – cheaper than a cup of coffee – is coming at a pretty high cost to unskilled labor and the planet.
Why am I talking about this? I have been analyzing apparel & footwear companies recently, in light of their depressed share prices. My thinking is that there are some gems that are being unduly punished by the market. The industry is grappling with high levels of debt, wage pressures, high input costs, and anemic sales growth. Apart from some notably distressed retailers, the debt burden and inflation pressures in the industry are subsiding. However, I think the anemic sales growth can at least partially be attributed to the ultra-fast fashion competition, even if traditional retailers don’t seem to single them out on their investor calls. There is a way out of this challenging environment for strong brands, but they have their work cut out for them.
The way out? Emphasizing the direct-to-consumer (DTC) model and creating awareness of the destructive nature of their ultra-fast fashion competitors, which would have to be paired with “we do better.” The arc in retail from what is hot to what is not can be steep and short. Perhaps an apt analogy is the fur industry. The domestic fur market gathered steam after World War II and reached its apex in the 1970s and 1980s, after which it pretty much collapsed. Wearing a mink coat in 2024 is right up there with smoking a cigar in a daycare center, in terms of social acceptance.
The challenge for Nike and the like – and I hope they take it on – is to shine a light on their efforts to clean up their supply chain and to be open to constructive feedback to “do better.” With a little help from the right influencers – and not just athletes – they could make ultra-fast fashion ultra unfashionable. Let me stop there, lest I convey the impression that I know anything about marketing. So what retail stocks do I find interesting? It’s a work in progress and currently includes Nike, E.L.F. HanesBrands, and Amer Sports (parent company of Arc’teryx). Whereas these companies exhibit attractive upside potential, hey are not for the faint-hearted, as I am quite unsure of how this story ends.
Diversification wins only when you need it most
I have been preaching diversification most of my career and intellectually it has always made sense to me and can be summarized as succinctly as “don’t put all your eggs in one basket.” But preaching sounds an awful lot like organized religion and I think it is dangerous to assume that financial markets are described by a universal truth that we have to take on faith or, alternatively, anchored in science. I still believe in it, but I understand it differently now than I did 10 years ago. I don’t think diversification produces better results in most years, or even in most 5 year stretches than say a portfolio that only invests in US stocks and bonds.
What diversification will do, is reduce the downside risk. You will never have all your money in the worst performing asset class, but you also will never capture the full upside of a strong US stock market. So in that sense, diversification is a trade-off, not a free lunch, defined as the same return with lower risk. The theoretical underpinning for diversification being a free lunch, is the notion that a portfolio of 30 stocks, give or take, can likely produce the same results as a portfolio of 10 stocks, but with less risk. However, when the investment industry talks about diversification, they mean a portfolio with a dozen asset classes and hundreds of individual securities. That probably serves them more than their clients: there is pricing power in complexity and the more buckets they have to put your money in, the more assets they can gather. I think that is going overboard with diversification and is sometimes panned as “di-worse-ification.” This bloated approach to diversification is what I have soured on.
However, even if diversification across different asset classes does not provide a free lunch and even if one has to be mindful not to overdo it, diversification is still a strategy worth pursuing. Why? For the simple reason that it saves you from what is my biggest fear as a manager of other people’s money: a Lost Decade – a 10-yr stretch where markets do not make forward progress. From March 1, 2000 to March 1, 2010, the S&P 500’s total return was negative 2.98% and that’s without adjusting for inflation. Over that same period, international stocks returned 29%, as measured by the MSCI All Country World ex-US Index.
Had you had an allocation to international stocks of 30%, you would have been up about 7%, which was surely an anemic, but not a lost decade. An allocation of 45% – more in line with the weight of international stocks in the total global stock market at the time – would have produced a return just shy of 12%. Pair that with the fact that bonds did well during the 2000s and you would have navigated through that period just fine – beating inflation and meeting your investment goals – with a portfolio that was as simple as 1/3 US Stocks, 1/3 International Stocks, and 1/3 Bonds. If I were making the case to Japanese investors I would have them at “diversification.” They had a lost 3.4 decades and just surpassed their 1989 all-time high of the Nikkei Index last year. I imagine few Japanese investors have an all-Japan stock portfolio.
Amidst all the uncertainty, one thing is hard to fathom but undeniably true: the dog days of summer are here, as the calendar rolls to August. It’s a time of year I appreciate more and more, as I get to watch my kids expand their horizons in the water and on land. Whereas before, I had no stake in the future and it was just me and my cats (that’s a joke). Whatever or whomever you hold dear, may they be within reach during these long, warm, and hopefully sometimes lazy summer days.
Kindly,
Jan P. Schalkwijk, CFA
JPS Global Investments