Tag Archives: Stock Market

Higher Still?

The good news is the stock market had another great year. The S&P 500 was up 26.84% in 2021. That is on top of the 16.26% in 2020 and 28.88% in 2019. That’s quite a run, even if it started on the back of a down year in 2018.

On the other hand, the S&P 500 is overvalued by most standards. By comparison, the Vanguard Total International Stock ETF, was up only 9%. More telling is the price to earnings ratio. The S&P 500 trades for 21.15 times earnings while the non-US Vanguard ETF, VXUS, trades for 13.2 times earnings, a 37.6% relative discount. (based on Morningstar data)

If you have a diversified portfolio, your investor returns have lagged the S&P 500, where performance was driven by large cap tech stocks.

When will things reverse? I cannot say when, but I can imagine how it might happen. In the words of John Maynard Keynes, “The market can stay irrational longer than you can stay solvent,” the timing is unpredictable. The predictable factor is that it will likely require a catalyst to put the market on sounder footing.

Potential catalysts include:

  1. A worsening COVID scenario with new variants and higher case counts
  2. Persistently high inflation
  3. A Fed policy mistake (watching the yield spread between 2- and 10-year Treasuries)
  4. Slowing earnings growth as Fed stimulus recedes.

If one or more of these events occur and earnings expectations decline, I think a 20% correction would be reasonable. The math of a 4% decline in earnings and an 18 P/E multiple fits such a scenario. But things can go right too, so timing a correction is not a sound strategy.

The prudent course is to plan for liquidity needs and maintain a diversified portfolio and perhaps more cash than usual. Think of cash as an option to buy stocks cheaper if they go down. A 20% correction is not fun, but it is to be expected. When it happens, a little cash goes a long way. One more thing… when the market goes down 20%, you only lose 20% if you sell low. The bigger issue is how long it takes to recover. It has always recovered. Whatever you do, don’t sell low

The Pause that Refreshes

The S&P 500 closed the 3rd quarter with a gain of about 14.7% YTD, despite recent volatility that brought it down about 5% off the highs. (International holdings continued to lag, causing diversified portfolios to generally come in a bit lower.) There are several issues creating enough headlines to spook the market, including inflation, the debt ceiling and potential Government shutdown, tax increases, supply chain disruptions, Fed tapering and the yield curve, and the continuing Covid pandemic. What could go wrong?

I could analyze each issue and explain why they might be more bark than bite, or why they are probably already factored into the market. However, I do have a real concern that the market will have to reckon with, valuation. The market is priced to perfection at about 20x 2022 earnings. Interest rates need to go up for long-term economic stability, and the market valuation math means the market valuation multiple needs to decline. The decline in valuation will not be absolute since it will be offset by presumably rising earnings. Theoretically the multiple could contract without a nominal decline in the market, given sufficient earnings growth, especially in an environment with a healthy dose of inflation. However, I expect interest rates will go up and the market will have an adjustment on the order of a 10% decline sometime within the next 6 – 12 months.

That would be a healthy part of normalization and allow for better long-term returns. Part of the past 3 years gains can be attributed to the Fed’s persistent stimulus. We may be beginning the pause that refreshes. The underlying economy is sound. Supply constraints are preferable to waning demand.

Investing involves risk, including possible loss of principal. Choose wisely.

The Underlying Strength of the Economy Is Unchanged

The underlying strength of the market has not changed. The pandemic is likely to end soon, perhaps by Memorial Day. Disbursement of the just passed $1.9 trillion stimulus is pending, with an additional likely $2.2 trillion coming with Biden’s just proposed American Jobs Plan to be spent over the next 10 years. Finally, the Fed remains committed to keeping rates low until they can persistently hit the inflation target of 2%.

With rising inflation concerns and a 4th COVID wave, crosscurrents made it a bumpy ride. At the end of the first quarter of 2021 the S&P 500 gained about 6.2%. I will spare you the economic scenario analysis and leave it at this. The long-term trend is up, but the short-term is impossible to know. I think the US equity markets are about 5% overvalued. Given the amount of stimulus and the fading pandemic, valuation is not a big concern.

Press On

Last year we wondered about the biggest risk to the markets. Was it the threat of persistent low-interest rates and the implied inflation threat, Government budget deficits, tax hikes, or valuations? Media and headlines covered pundits’ messages illustrating what could go wrong.

In retrospect, none of that mattered. The problem was something no one talked about because no one knew about it. A virus-induced pandemic ensued and led to a shutdown of large parts of the economy.

The important takeaway is that the greatest risk might be what you do not see coming. If you are not aware, it is hard to prepare. However, I will point out one more time that I covered the bases by listing plagues among several caveats to my sanguine outlook.

Like earthquakes in California, you know they will happen. You will not know when. In the stock market, we seem to have a big one, a 40 to 50% decline, about once every 10 years. We also average about two recessions every 10 years. Despite dramatic declines, the long-term trend continues up as billions of people around the world get up every morning to do something productive to improve their lives.

I do not know when the market will go down, but history shows that it always comes back. Most of the time recoveries occur within a few years if not months. Some risks are more apparent than others. But for whatever the reason for a correction, the important thing is to avoid selling into a distressed market.

Source Yahoo Finance, S&P 500 Total Return 1/1928 to 1/2021, Monthly, Log Scale

Planning requires anticipating how much money you are likely to need from your portfolio and reducing risk in part of your portfolio to reduce your potential need to sell in a distressed stock market.

Now what about 2021? The 5 key drivers of current market strength include Federal fiscal stimulus, vaccine rollout, divided government, dovish monetary policy, and no double-dip recession. Each of these factors favor continued gains, but none is certain. Near term, I can make the case that the market is on the expensive side. I do not think the options (cash, bonds, hard assets, real estate) are more attractive on a risk-adjusted basis.

As Calvin Coolidge observed, “Nothing in this world can take the place of persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent. The slogan Press On! has solved and always will solve the problems of the human race.” I remain focused on long-term value creation.

With 2020 behind us, we’ll press on.

Investing involves risk, including loss of principal. Past performance does not guarantee future returns.

About That Little Correction

I attribute every stock market correction or bear market to one of two reasons. Either valuations were too high and needed to correct to reconnect valuations with reality, or there could be a real-world problem (pandemic, war, recession, taxes, regulation, rising interest rates, etc.) that creates concern about the value of future cash flows.

In my last quarterly update from July 1, I observed, “Near term, the market does not seem to have a lot of upside until we have a Covid-19 vaccine.” Now we know how bad I missed on that prediction. The S&P 500 rallied 14.9% from July 1 to September 2, with the help of the best August returns in about 30 years.

Using the Morningstar Market Valuation chart, the market was about 1% overvalued on July 1. Earnings in July and August were strong, and analysts’ estimates moved higher. Still, by September 2, the chart indicated that the market was overvalued by 8%. The greater the variance of the market from fair value, the more likely the market price is to correct to the analysts’ more rational view. That is what just happened. As of the close on September 8, the market was back to 1% over fair value. However, the S&P 500 was still 6.9% higher than on July 1, when the quarter started. The difference is that earnings exceeded analysts’ estimates and fair value estimates were adjusted accordingly.

What does this mean? It means we need to buckle up for the ride, considering all the reasons to run for the hills. Volatility will not hurt you. As I described, that uncomfortable market experience you just had made you better off. Today the S&P 500 tacked on another 2.01% gain to rebound from part of the correction. That puts us about 3% over fair value, but well within the normal range. For reference, I usually cite 10% above or below fair value as a level to make tactical allocation adjustments, sometimes called market timing, because I think risk becomes materially asymmetric.

Let’s hope the 3rd quarter ends on a good note.

Investing involves risk, including loss of principal. Past performance does not guarantee future returns. Sources include Yahoo Finance and Morningstar.

We Had a Good Year, Now What?

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!

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 spread between the 10 and 2-Year Treasury is Worth Watching. When it goes negative, it is inverted.

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.

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.