We finished a strong year, but perhaps not as strong as the numbers appear. Remember, we started from a low point after the market tanked in the 4th quarter of 2018 when the market decided the Fed was tightening too fast. The Fed reversed course, and after a few zig-zags rallied to finish strong.
I look for the stock market to return around 10% per year ON AVERAGE. Rarely does it go up 10% in any given year. It seems to be either +20% or more or -10% to flat. Furthermore, on average it goes up about 2 out of 3 years. That means it goes DOWN about 1 in every 3 years. We emphasize planning for liquidity to reduce the need to sell when the market is down. Financial planning helps define when, and how much you expect to need from your portfolio, at least for major events you can plan for.
A good year in the market does not change affect the probability that the next year will be up or down. Much like flipping a coin, the market has no memory. The market reflects what is known and expected at any given time. You can’t time the market and go to cash after years the market goes up by more than average and expect to improve the odds. That’s the gambler’s fallacy.
I view the current rally as a high risk, risk-on market. The rally is high risk because it occurred while 3 significant geopolitical events were happening: impeachment, trade war, and Brexit. A negative outcome from the market’s perspective in any one of these events could have precipitated a market correction. The trade war and Brexit appear to be moving toward a positive direction. Although pro-business Trump has been impeached by the House, the market appears to discount the possibility of conviction in the Senate.
Where do we go from here? The key variables include interest rates, valuation, and earnings. Economic indicators point to continued slow expansion rather than recession. Generous valuation is a function of low interest rates. Low interest rates coupled with continuing slow expansion can sustain current valuations. The wild card seems to be inflation. Although there is little indication that it will accelerate, it is notoriously hard to predict. The Fed wants higher inflation, and inflation could erase some Government debt (they pay it off with cheaper dollars). The Government would benefit from higher inflation. Inflation drives long-term interest rates and that would challenge valuations. Fortunately, as the last 10 years indicate, it is hard to generate inflation without stronger growth, but faster growth would help offset the effect of higher interest rates.
This starts to look like a circular argument, and that’s good news. Much like Newton’s Third Law, for every force there is an equal and opposite force, the economic forces driving markets tend to revert to long term averages. However, caveats include non-economic events such as wars, plagues, systemic failure, and meteor strikes. Sleep well!
Cross-Currents
The cross-currents of economic data are all over the place. The good news is that there is no clear indication of a recession. More specifically, indications are that the economy will continue in slow-growth mode of around 2%.
Personal consumption is about 70% of GDP and is currently the strongest component. Business investment and labor force growth are the keys to productivity, and this is the more worrisome factor. Political uncertainty discourages capital investment. Workers need better tools if they are to increase output. Labor supply, on the other hand, is constrained by birth rates, demographics, and immigration policy.
Trade war issues are contributing to weakness in manufacturing. While that could spill over into other areas, the weakness appears to be within the bounds of normal volatility. The best news on the trade front is that the pain does not discriminate. There are no winners. Consequently, trade wars are generally short-lived. The bad news is that neither China nor the U.S. has much incentive to compromise before the next Presidential election.
Finally, the Fed has worked itself into a position that raising interest rates appears to cause the stock market to decline. That’s logical since interest rates factor into stock valuation. However, the real issue is whether higher rates would dampen economic activity. I believe higher rates would be healthy and lead to a stronger economy. Any economic activity that would cease due to a 4 or 5% interest rate is probably an inefficient or unwise use of resources anyway. Getting to higher rates will cause market tantrums, but the end is nothing to fear.
Quarterly Update – 1Q19
The market peaked in early October, 2018, and came very close to the official 20% decline that defines an official “bear market.” The real issue is not the depth of the decline, but how long it takes to recover. After the market roared back (+13.06%) in the first quarter, we are nearly there.
Last quarter I shared a chart I use, that indicated the market was valued at 88% of fair value. Today, that reading is about 98%. There is a natural regression to fair value. We’re about where we are supposed to be, not cheap but not too expensive.
There has been a lot of talk in the media about the “yield curve” and what that means about recession risk. I wrote a blog post on the issue the day the curve inverted on March 22. Link here: https://www.daltonfin.com/2019/03/22/what-volatility-looks-like/. Sure enough, the inversion was transient, with the 3-month T-Bill currently at 2.4% and the 10-year Treasury Note at 2.41%, virtually flat.
(Caution – the next 2 paragraphs are on the wonky side)
The main problem with conventional yield curve analysis is that current conditions are a lot different from past circumstances, after 10 years of central bank intervention. The absolute level of interest rates has not been this low in any prior inversion analysis. To illustrate why this is important, consider an economy with no inflation. If the interest rate is the price of money, how much would you need to be paid to lend your money to the U.S. Federal Government? Now, add that rate to the expected inflation rate to get the level that the 3-month T-Bill should yield today in a normalized environment. Anything short of that is like a morphine drip to the economy. The Fed is trying to wean us, but that requires balancing the market’s tantrums (see December) which can become a self-fulfilling prophecy if a stock market decline causes a slow-down.
The Fed only controls the short end of the curve. The market controls the long end. When bond traders bet the Fed will cut rates, they buy the long end because interest rate changes compound and prices move inversely to rates. Increased demand on the long end causes long rates to fall. The greater concern is when the Fed starts cutting short rates. That signals trouble because they have more information than anyone else. What does the Fed do when they see trouble? They cut short rates to juice the economy. The problem is, there’s usually trouble on the horizon when that happens. The good news? That’s not the case today.
Volatility is the price of equity returns. We can manage risk if we understand your liquidity requirements. If we can anticipate distributions, we can reduce or eliminate the possibility of being forced to sell when the market is cheap. That’s what converts a temporary loss of capital a permanent loss.
What Volatility Looks Like
It is hard to fathom the sway in sentiment from yesterday to today. Yesterday markets soared despite Biogen’s dismal news about a failed clinical trial that caused it to drop about 29%. Markets closed up strongly (S&P 500 +1.09%). Market analysts attributed the broad market strength to investors getting more comfortable with the Fed’s dovish stance.
Today, alarm bells went off because the yield curve inverted. This shouldn’t surprise anyone. The curve has been flattening for a while. The gap between the 3-month and 10-years yields is viewed as a leading indicator. It will be important to see if the inversion persists. The indicator’s success rate as a recession predictor increases when the inversion lasts more than 10 days. This is day 1. That was enough to send the S&P 500 back down -1.9%.
At the end of the day, there is no material, fundamental change. Sentiment changed, and that creates volatility.
Investing involves risk, including possible loss of principal. Past performance is not a guarantee of future returns.
And Now a Word from Our Sponsor
I was watching CNBC with the sound muted when I noticed an interview. I saw a woman and the graphic, 30 Years of Industry Experience. Wow! That’s all CNBC can say about their distinguished guest? While experience is necessary, it is hardly sufficient. One might expect something more substantive. It’s true that I only have 25 years of industry experience, so what do I know?
I know that the length of time I’ve been a financial advisor says very little about me. In my case, I think the 13 years as a financial analyst, before the last 25 years in financial services, was far more influential in my professional development. The role of a financial analyst is that of a paid devil’s advocate.
A corporate financial analyst is a gatekeeper. Any advocate in a company promoting a project or strategy that requires investment needs to demonstrate the financial effects of the idea to management. That requires a financial analysis of the project to determine the net present value and internal rate of return based on projected investment and the resulting cash flows. The financial analyst must be sold on the assumptions that will drive his models. Garbage-in, garbage-out.
The analyst must drill into the underlying data to verify everything. The marketing, engineering, and new product folks become emotionally invested in their ideas. The analyst must vet the projects as the gatekeeper to funding and balance the interests of zealous advocates against the numbers.
I view investing like project analysis. They both need to pass the expected return on investment hurdles and scrutiny of the underlying assumptions.
Many financial advisors, in fact, the most successful ones in my experience, are successful because they are well-connected and are great relationship managers. They impress, like any good salesman.
Who’s watching your wallet?
An autobiographical perspective from Robert Higgins
Spooked
Sometimes the herd gets spooked, but sooner or later things settle down. Sometimes there’s real cause for concern and other times it is mostly rumor blown out of proportion. But whether it’s a world war or a banking crisis, it usually gets resolved in less than 5 years. Then everybody gets back to business building the earnings of companies that drive markets higher.
In last quarter’s note, I referred to my blog post from September 26, Recession Strategy,
“The real issue is not how deep the correction will be. The real concern is the duration of the decline. How long will it take to get back to even? The problem is not that the stock market will go down. The real problem is if you need to sell stock when valuations are low to fund current living expenses. That converts a temporary loss of capital into a permanent loss of capital.”
The good news is, we’re not in
I often refer to a Morningstar Market Valuation Analysis that tracks a ratio that represents the average
According to the ratio, the market has gone from about 4% overvalued to a 12% discount. That’s a swing of 16% in terms of market price to fair value, and potentially more in absolute terms if analysts have reduced fair value estimates because of weaker economic data. Despite that, these types of corrections are more common than you might think if you focus on the last 10 years. A 10% decline represents a “correction” and a 20% decline counts as a “bear market”. Whatever you call it today, it doesn’t feel good, but it will pass. The main question is how long will it last?
Zoom Out
Time brings perspective, and now might be a good time to reflect on that. This month has been exhausting for investors. The damage is relative. If you invested last month and need to sell now, you might have a problem. But if you are a prudent investor with a 3 to 5-year time horizon, I think you’ll be just fine. This is normal volatility. For perspective, consider the following views of the S&P 500.
First, consider how you feel. The chart below shows a 5-day view. Pretty lousy, huh?
Next, we’ll zoom out to a 3-month view. Not much better.
Now let’s see how the index has done over the past 12 months.
As the above chart shows, it has been like a roller coaster, but it is still positive. Now let’s zoom out to the 2-year view. I think most investors would be pleased with the 29% gain they would have received from the SPY, an ETF that tracks the total return of the S&P 500 including dividends. These charts show just the index, excluding dividends.
Finally, here’s the 5-year view that shows the accumulation of retained earnings created by millions of people going to work every day. This is more like it. Now our scary stock market looks more like a not so uncommon speed bump along the way to greater prosperity.
Exhale and have a nice day!
Charts from Yahoo Finance. Past results are not guaranteed. Investing involves risk, including loss of principal.
Risks to the Market
Two risks to your financial future include inflation and market declines triggered by asset price bubbles.
Inflation has not been a problem in the U.S. for over 30 years. Three of the biggest market declines in the last 100 years included in the Great Depression, the tech bubble and the more recent Financial Crisis. Each of these events was related to price bubbles. High stock valuations preceded the 1929 and 2000 corrections, and real estate speculation precipitated the 2008 crisis.
The fuel for asset bubbles is cheap credit that encourages risky behavior through leverage. Why does this matter? There is widespread concern, not unfounded, about the effect of rising interest rates on stock prices. But presently, short-term rates are still less than inflation. We need a positive real interest rate to support healthy economic incentives and to discourage speculation. Normalization requires more interest rate increases, contrary to President Trump’s tweets. The improving economy supports current market valuations.
The real risk of higher interest rates occurs when it begins to limit investment in otherwise productive projects. The problem with low rates is it encourages bad investment.
Recession Strategy
I am seeing a lot of ink about how to prepare for the next recession. Clients want to know what we’re doing to prepare. Investment companies are asking me which funds I think are best for the next downturn.
The real issue is not how deep the correction will be. The real concern is the duration of the decline. How long will it take to get back to even? The problem is not that the stock market will go down. The real problem is if you need to sell stock when valuations are low to fund current living expenses. That converts a temporary loss of capital into a permanent loss of capital.
I’ve been investing since the 1970’s. My education and career have focused on economics and finance. What have I learned? In my view, valuation risk is easy to observe, but timing a correction is still difficult. I recognized that the S&P 500 was overvalued in 1998, but it doubled again before getting cut in half in 2000. I observed in 1999 that the market would either go down by 50% or trade sideways for 10 years while earnings caught up. I had no idea I would be right on both counts. Despite that, a diversified portfolio including small cap, international and bonds fared much better.
Systemic risk is harder to recognize. I didn’t see the 2008 crisis coming. But it really wasn’t a stretch to see what asset class was overvalued, i.e. real estate. But then you needed to understand that banks and credit agencies were operating in a corrupt system underwritten by government agencies, that mortgage defaults would create a downward spiral as underwater homeowners defaulted, forcing prices ever lower.
We accept the unpredictable nature of corrections, and that unique circumstances precipitate them. Today, credit seems to be the most mispriced asset class, driven by government intervention. But bonds are math, and the effects of normalization should be more moderate than a speculative equity correction unless there are forces involving leverage that are not on my radar – like the mortgage security market. Still, the recovery of the past 10 years made staying invested worthwhile. We just needed to hedge for liquidity needs over the next 3 to 5 years to emerge unscathed.
What does all this mean? I believe that a heightened level of concern about the next recession or correction is healthy. As investors de-risk portfolios, valuations will be earnings driven, and that’s a good thing for fundamental investors. Certainly war, policy mistakes, and scandal can impact markets, but these events have nothing to do with the duration of a market expansion. They can happen at any time, so why should the risk seem greater now?
My favored strategy continues to be the bucket approach. One of the key benefits of a financial plan is that it identifies anticipated liquidity needs. Given that most market downturns are resolved in less than 3 to 5 years, it is prudent to establish reserves equal to your liquidity needs in something with less risk than the stock market. Accepting risk in the short-term is gambling, and gambling with what you can’t afford to lose is a bad idea. Investors have time on their side as companies continue building wealth even while the market doesn’t always correlate with that. Be prepared, be vigilant, and stay the course until fundamentals indicate otherwise.
“WE’RE BUYING STOCKS THIS MORNING, AND I’D RATHER BUY THEM CHEAPER, BUT I’VE BEEN BUYING STOCKS SINCE MARCH 11th, 1942, AND I REALLY, I BOUGHT THEM UNDER EVERY PRESIDENT, SEVEN REPUBLICANS, SEVEN DEMOCRATS I’VE BOUGHT THEM QUARTER AFTER QUARTER. SOME OF THE BUYS WERE TERRIFIC, SOME OF THEM WEREN’T AT SUCH GOOD TIMES AND I DON’T KNOW WHEN TO BUY STOCKS, BUT I KNOW WHETHER TO BUY STOCKS, AND ASSUMING YOU’RE GOING TO HOLD THEM, WOULDN’T YOU RATHER OWN AN INTEREST IN A VARIETY OF GREAT BUSINESSES THAN HAVE A PIECE OF PAPER THAT’S GOING TO PAY YOU 3% IN 30 YEARS OR SHORT TERM DEPOSIT THAT PAYS YOU 2% OF THE SORT.” WARREN BUFFETT, August 30, 2018
Investing involves risk, including loss of principal. Past results do not guarantee future results.
Evidence of Growth
As of mid-year, my single variable economic indicator is still going strong. According to the 
American Association of Railroads, “North American rail volume for the week ending July 14, 2018, on 12 reporting U.S., Canadian and Mexican railroads totaled 374,909 carloads, up 4.6 percent compared with the same week last year, and 374,090 intermodal units, up 4.7 percent compared with last year. Total combined weekly rail traffic in North America was 748,999 carloads and intermodal units, up 4.7 percent. North American rail volume for the first 28 weeks of 2018 was 20,148,123 carloads and intermodal units, up 3.5 percent compared with 2017.” America is on the move. Will tariffs crash the party?