Quarterly Commentary 3rd Quarter 2017
Recently announced Nobel Prize winner Richard Thaler commented: “We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping. I admit to not understanding it.” Legendary stock market veteran Art Cashin stated on CNBC: “I’ve been doing this for over 50 years, and I’ve never seen anything like it.” Such skepticism hasn’t even caused the U.S. stock market to pause. Normally even the strongest of bull markets inhale and exhale. There has not been even so much as a 3% decline so far in 2017, the longest such stretch since 1996. Such a lack of price volatility is rare throughout U.S. market history. Does this bode well or ill for stock market investors in the months and years ahead?
As we move into this year’s final months, let me examine the factors bullish analysts tout as justifications for ongoing market strengths and weigh those against the arguments put forward by the bears. The most commonly voiced rationales for continuing market strength include: growing corporate earnings, economic growth both domestically and internationally, restrained inflation throughout most of the world, low interest rates, central bankers still committed to extremely easy money, a sounder banking system, the administration’s promise of a package of reduced governmental regulation, tax reduction, tax reform and repatriation of overseas cash, plus attractive technical conditions. Uncontested, that looks like an imposing compendium of reasons to justify higher stock prices. Not surprisingly, however, there are those who question the strength of some of these factors, while others believe that the bulls are ignoring some powerful negatives. Let me explore the pros and cons of each of these arguments.
Since the 2007-2009 Financial Crisis, corporate earnings are up substantially if measured by earnings per share, with forecasts for continued growth. Many argue, however, that earnings per share do not represent the corporate earnings picture accurately. Following unprecedented levels of corporate stock buybacks, earnings per share have been boosted because fewer shares are now divided into corporate profits. And if we look at the nation’s total corporate profits, we see that they are the same in this year’s first quarter as they were five years ago in the first quarter of 2012. Corporate taxes through the third quarter of this year actually declined 2.4% year over year despite significantly higher earnings per share.
Bullish analysts point to the fact that the U.S. and most foreign economies continue to grow. That, however, is a celebration of direction over level. Just this month the International Monetary Fund raised its estimates of global growth by 0.1% for both 2017 and 2018 to 3.6% and 3.7%. Except for significant strength in China, India and Indonesia, most foreign economies are only minimally above recession levels, while growing modestly. And the U.S. continues to muddle along barely above the 2% growth level. This remains the weakest recovery from recession in the post-World War II era. On top of that, IMF forecasts have proven to be far too optimistic in each of the past five years.
Restrained inflation throughout most of the world would normally be celebrated by governments, business and consumers. While it is beneficial to consumers, minimal inflation has contributed significantly to businesses’ lack of pricing power. Most governments today are bemoaning their inability to boost inflation to avoid the dreaded spectre of deflation, which can be a disaster to the seriously indebted, including most countries throughout the world.
Low interest rates are also typically considered advantageous to governments, business and consumers. While they certainly are beneficial to all who have outstanding debts, they discourage saving. In recent years, minimal interest rates resulted in levels of saving that historically have accompanied below average economic growth and hiring. While today’s interest rates clearly reflect massive government bond buying programs, they may also indicate an expectation that the economy may lack the strength to ward off recession much longer.
Although the Federal Reserve has ended its quantitative easing programs, the other major world central banks are continuing with massive stimulus, which has had a tremendous positive influence on stock and bond values across the globe. While such programs were ostensibly begun to boost economic growth, they have met with minimal success in that regard, but they have been an unqualified success in boosting stock and bond prices. The Fed begins its balance sheet reduction program this month, and it looks likely to continue its interest rate “normalization” program with additional interest rate increases over the next year or more. And while the Bank of England and the European Central Bank have indicated likely reductions in stimulus, far more money will be printed for several quarters than will be withdrawn by the Federal Reserve. That money could well find its way into securities and serve to boost prices.
When asked whether we could again experience a market and economic collapse similar to the recent Financial Crisis, many respond that the banking system today has taken big strides to bolster bank balance sheets. No doubt banks today are stronger than they were a decade ago, but there are still many weak links around the world. In this country, former head of the FDIC Sheila Bair has argued strongly that leverage is still too great and that “too big to fail” banks could again become taxpayer liabilities in another crisis.
Virtually every bullish analyst points to the promise of the Trump administration’s proposed stimulus program. Reduced government regulations, reduced taxes, tax reform and repatriation of corporate cash from overseas, to the extent that they are realized, should increase corporate profits. Given the intense political divisions that characterize America today, however, there is considerable uncertainty that such proposals will be implemented. Investor reaction to the finished product could be highly problematic. Would reality match the much-hyped expectation? What trade-offs were made to negotiate the deal? Would we encounter a “buy the rumor, sell the news” phenomenon?
When a market goes up virtually without interruption, it is not surprising that technical conditions are strong. And, indeed, with few exceptions, they appear to be. Admittedly, stocks are significantly overbought and in need of a correction. Sentiment, which at extremes is an important contrary indicator, is clearly overly optimistic, which similarly puts stocks in danger of at least a meaningful correction. On the other hand, the longer a market goes essentially in one direction, the more investors become converts to the momentum gospel. As a result, more and more dollars are ready to buy any dip, which tends to make dips smaller and smaller. Bulls are emboldened by the fact that advance/decline statistics are confirming price advances. And perhaps most importantly, studies of supply and demand have not yet given indication of the kinds of weakness that normally become evident before major stock market declines, sometimes even many months before such tops.
All those seemingly positive factors notwithstanding, there are a great many factors that should legitimately give investors pause: massive political divisions in many parts of the world, the prospect of trade wars, central banks turning from extreme ease toward tightening, the probability of rising interest rates, unprecedented investor complacency, aging demographics, multi-decade lows in productivity, forecasts of growing deficits, irrational exposure to risk in the search for yield, capitulation with even the most bearish managers almost fully invested, historically high domestic and international debt, and nearly all-time levels of overvaluation. Oh yes, and potentially credible threats of nuclear war. Can you even imagine a more favorable environment for all-time stock market highs?
If one concentrates on the market’s technical conditions, a strong case can be made for a market that continues to rise to new highs. So long as investors retain their faith that central bankers will remain both willing and able to support stock and bond markets, there is no ceiling to prices.
Should that faith be lost, underlying fundamentals and valuations would struggle to support prices anywhere close to current levels. Unpleasant as it is, it’s instructive to recognize what markets have done throughout U.S. history when sentiment changes, as it always inevitably does. In this short century, we have already experienced two declines in excess of 50%. The decline to the 2009 trough took stock prices back to 1996 levels, wiping out 13 years of price progress. In the twentieth century, there were two declines that took away even longer stretches of price progress, and there were several instances in which it took more than a decade to get back to prior price peaks, one instance covering a quarter of a century.
Given today’s polarized conditions, investors are faced with extremely difficult decisions. If the Fed and other major central banks can continue their now eight year long successful monetary experiment, you want to own a full complement of stocks. Should the market revert to its long-term fundamental means, especially if it should happen quickly, stocks could suffer severe and potentially long-lasting pain. The buy and hold approach could be penalized for the first time in many decades. We are not in an up or down 10% environment. Each investor has to evaluate his/her financial and psychological ability to assume the risks the current environment presents.
Is 7 an Unlucky Number?
Interviewed on CNBC Wednesday, UBS’s Art Cashin, a great market historian, indicated that in years that end in “7”, market declines have often begun in August’s first three weeks. I explored that claim for the Dow Jones averages back to the Dow’s initiation in the 1880s. Hand-drawn daily graphs produced by the late Richard Russell of Dow Theory Letters fame were my data source, so percentages are approximate. Notwithstanding the lack of any logic for such a number-related pattern, the results are interesting. Make of them what you will.
|1887||12 stock average (10 railroads, 2 industrials) An approximate 5% decline through the second half of August was simply a continuation of a 17% decline from May to October.|
|1897||New 12 stock industrial average – A consistently strong August followed immediately by an 18% drop from early-September into November.|
|1907||A significant 11% early-August decline was merely another step down in the 45% “Panic of 1907” which extended from January into November.|
|1917||New 20 industrials, initiated in December 1914 following the multi-month market holiday – August’s 12% decline from the first week high covered the rest of the month and simply contributed to the 33% decline from January into mid-December.|
|1927||A slightly greater than 4% decline marked two weeks in the beginning of August, but the powerful 1920s rally resumed in mid-month on its way to the historic 1929 peak.|
|1937||Mid-August marked the beginning of the 1937 crash, which saw the index plunge by 40% into November. Markets bounced around for the next five years with a downward bias. Down 52% from the 1937 high, a great bull market began in 1942 that lasted into the 1960s with only relatively minor disruptions.|
|1947||Pretty consistent small declines in August comprised the bulk of a greater than 6% total decline that began in late-July and continued into September.|
|1957||Prices dropped sharply through most of August as part of the 19% decline that extended from mid-July into mid-October.|
|1967||A 3% to 4% August pullback interrupted the market’s rally to this year’s September high, followed by a 12% decline into 1968.|
|1977||Prices declined pretty consistently through August as a continuation of the 26% decline from the beginning of the year through February of 1978.|
|1987||The Dow Industrials peaked on August 25 and began the decline that culminated in the 508-point plunge on October 19. That 22.6% one-day decline is still by far the most destructive day in U.S. market history. The entire two-month decline from the August high came to 36%.|
|1997||An almost 8% decline covered most of the month of August as the initial stage of a 13% drop into late-October.|
|2007||From the second week in August, stocks dropped a sharp 6% in about a week, before rallying into an early-October peak. Over the next 17 months the Dow was crushed by 54%.|
Only one of the 13 profiled “7” years avoided at least a 3% decline at some point in the month. In 1897, prices marched steadily upward, but suffered an 18% decline shortly after the month ended.
Many Augusts simply continued existing declines – 1887, 1907, 1917, 1947 (mild), 1957, 1977.
1927’s 4% plus decline marked just a brief interruption of the Roaring ‘20s rally, which introduced the Crash of 1929 and the Great Depression. Similarly, in 1967 the relatively small 3% plus decline did not initiate a more significant retreat, but it was followed just a few weeks later by a 12% decline.
August of 1937 and 1987 marked the beginning of two of this country’s most destructive stock market crashes. And August 2007, while not initiating the 2007-2009 54% market collapse, issued a clear warning that stock prices were in danger. The ensuing decline took away 13 years of price progress.
None of this tells us what will happen in August 2017, but it does raise a caution flag.
Quarterly Commentary 2nd Quarter 2017
Would you accept an 80% chance to earn 10% on your money if there were a 20% chance of losing 40%? Such percentages may or may not be precisely descriptive of the current situation in the equity market, but they frame the dilemma today’s investors face.
As we have discussed frequently over the past year, stocks are extremely overvalued by traditional measures of valuation. In fact, a composite of the most commonly employed measures of value show today’s stocks more overpriced than ever before but for the period of the dot.com mania. Should stocks suddenly revert to historically normal valuation levels, prices would plummet. On the other hand, our Fed and the world’s other major central bankers have resolutely prevented any significant stock or bond market decline for the past eight years. As long as investors stay confident that central bankers will remain both willing and able to support securities prices, investors accepting equity market risk can continue to profit.
What happens to equities is extremely important, because other asset classes have been non-productive for years and likely will remain so over the near-term. While the Fed has begun to “normalize” its monetary policy by very tentatively raising short-term interest rates, risk-free investments still offer almost nothing. Because central bankers have aggressively poured newly created money into longer maturity fixed income securities, those yields have been suppressed for years. Nonetheless, interest rates have been rising, albeit slowly. Since interest rates bottomed in July 2012, the ten-year U.S. Treasury yield has risen from 1.39% to 2.30% at quarter-end. Total returns on such holdings have been barely 1% per year for almost five years. With the Fed and most analysts forecasting higher rates, returns on existing fixed income securities are likely to be minimal over the next several years as well.
We have long maintained that today’s investors are faced with making a “bet”. Will stock prices revert to their traditional valuation means, which they have always ultimately done, or will the Fed and other world central bankers continue to prevent significant declines in stock and bond prices, a task they have executed most effectively for the for the past eight years?
Investors who stay abreast of financial news and opinion have frequently heard analysts justify their forecasts of continuing price gains by pointing out that the economy is good, that corporate profits are growing nicely and that valuations are reasonable. Not one of these points is accurate.
The economy is growing, but very slowly. Despite more monetary stimulus than ever before, the domestic and world economies are slogging through the slowest recovery from recession in modern times. While there are intermittent spurts of growth in one economic segment or another, domestic and world economic growth is significantly below its historic norm. Notwithstanding optimistic consumer and investor sentiment, the International Monetary Fund, the Organization for Economic Cooperation and Development and the Federal Open Market Committee are forecasting minimal economic growth over the next few years. The majority of forecasters expect long-term U.S. growth to fall just above or below 2%–far below typical past levels.
The Bank for International Settlements has recently voiced serious concerns about downside risks. In the Bank’s 2017 Annual Report, head of the Monetary and Economic Department, Claudio Borio said: “[T]he risky trinity are still with us: unusually low productivity growth, unusually high debt, and unusually narrow room for policy maneuver.” Also “Leading indicators of financial distress point to financial booms that in a number of economies look qualitatively similar to those that preceded the Great Financial Crisis.”
Corporate profits of domestic companies showed significant growth in 2017’s first quarter on a year-over-year basis, largely because profits in the first quarter of 2016 were so heavily penalized by severe losses at major oil companies. Financial engineering has also magnified the appearance of corporate profits. Because companies are having a very difficult time finding attractive projects for which to make capital expenditures, they have borrowed heavily to buy back huge amounts of their outstanding shares. Reducing the number of shares outstanding has the effect of boosting earnings per share despite the overall level of company profits remaining constant. Since 2009, earnings per share have grown by 221% with corporate revenues up a mere 28%. And despite significant earnings per share growth, total corporate profits in 2016 were the same as in 2011. Over that same period of time, the S&P 500 rose by 87%. All is not what it seems.
Securities analysts and strategists have a habit of picking and choosing data that justify their almost always bullish conclusions. While almost no one contends that stocks are cheap, most commentators skip over discussions of valuation with a kind of off-handed remark that stocks are reasonably priced. The reality is that they remain screamingly overvalued. As mentioned earlier, by a composite of the most commonly employed measures of value, they are more overvalued than ever before but for the period immediately surrounding the dot.com mania. From lower levels of overvaluation, stocks declined by 89% from the peak in 1929, 45% from 1973 and 57% from 2007. From the peak of the dot.com bubble in early 2000, stocks fell 50% and, after a recovery and an even bigger decline, were 57% lower nine years later. Prices were back to 1996 levels, having erased 13 years of price change. From even lower levels of overvaluation, there are no examples of investors permanently escaping severe declines taking prices back to historically normal valuations.
Compounding the problems of a sluggish economy, moderate (at best) corporate profit growth and severe overvaluation is the unprecedented overindebtedness throughout most of the world. While economies and securities markets don’t fall simply because they are over-leveraged, that condition creates the environment in which even relatively small disturbances can quickly devolve into crises. We are currently on shaky ground.
Standing in the way of apocalyptic consequences is our Federal Reserve Board and other major central banks which have assumed as a mandate the prevention of anything more than minor price dips in either stock or bond markets. With monetary printing presses rolling more industriously than ever before over the past eight-plus years, they have warded off even normal price corrections, much less bear markets.
So confident are investors that central bankers will continue that support, they buy every dip. If that confidence remains strong, there is no upside limit to the current rally. Should that confidence wane, however, prices could seek more historically normal levels very quickly. By way of illustrating the danger, imagine all central banks suddenly pledging no more support in any form for stock and bond prices. The rush for the exits would be breathtaking, and exit doors would prove far too small. We could be faced with market holidays, as in 1914 or 1933. While central bankers are not going to suddenly swear off all support for markets, the level of investor complacency is unjustified in an environment of economic and monetary uncertainty and great geopolitical instability.
Last Week: Major Forces Conflict
Last week provided a vivid example of the powerful forces currently influencing stock prices. On Monday and Tuesday, prices rose, reaching all-time highs on some market indexes. Despite underlying fundamental conditions that have historically corresponded with far lower valuation levels, short-term traders continued to buy even the smallest price dips. After more than eight years of financial stimulus from the Fed and other major world central banks, fear of market declines has virtually disappeared.
Then came news that ex-FBI Chief James Comey had taken contemporaneous notes of his conversations with President Trump that included a request from the President that Comey not continue the investigations of former National Security Advisor Michael Flynn. Stock prices gapped down by about 125 Dow points on Wednesday morning, reflecting fear that stepped-up investigations of alleged administration collusion with Russia could derail or at least seriously delay highly anticipated business-friendly Trump administration tax, deregulation and foreign money repatriation proposals. The buy-the-dippers largely stepped aside for the full day, and fear prevailed with the Dow closing at its low for the day, down 372 points. Volume increased substantially.
Selling pressure pushed Dow prices down another 50 points in Thursday’s early trade, but algorithms elevated prices off that low. One can only estimate the collective attitude of traders, but it would be logical to expect that sellers would stand aside to see if the early rally “had legs”. When no significant selling materialized after the morning rally, another “algo-like” advance took prices up again in mid-afternoon (New York time). Some selling came in in the last hour and a half, but the market closed up on the day.
No follow-through to Wednesday’s massive decline and some friendly comments by Fed Governor Jim Bullard gave traders the courage to make another run for the highs on Friday morning. The rally gained strength through the day until stories hit the newswires that 1) the President had told the Russian Foreign Minister and Ambassador in the White House that his firing of Comey had greatly eased pressure on him relative to the Russian investigation and 2) that an unnamed current senior member of the White House staff was a “person of interest” in the Russian collusion investigation. That news release cost the Dow about 75 quick points. Nonetheless, the market retained most of its strong gain for the day and closed the week down about 100 Dow points, less than one-half of one percent. That’s a relatively small decline given some significant volatility.
The week’s activity showed us a few things. Traders are still eager to push prices higher, and they retain a high degree of confidence that central bankers will continue to step in if danger of a significant market decline presents itself. At the same time, however, the market shows its nervousness about political news that could distract from the proposed legislative agenda or, worse, tie the country up in a vitriolic impeachment fight.
With valuations and debt levels in extremely dangerous territory, it is essential that investors retain their confidence if prices are to remain near record levels or to advance further. For investors with largely irreplaceable capital, the potential for negative surprises should dampen willingness to expose large portions of that capital to overvalued equities.
Quarterly Commentary 1st Quarter 2017
The first quarter marked a continuation of the behavior characteristic of the stock market and economy for the better part of the past several years. Stock prices sustained their post-election rally through the end of February, rising over 7% in the year’s first two months, then giving back a bit more than 2½ % to mid-April. At the same time, the economy has grown, but at an extremely sluggish pace.
Newspaper headlines and investment firm research trumpet the good news of increasing employment statistics and growing wages. More houses are being built and sold at increasingly higher prices. And economic growth is widespread, not restricted just to the United States. There is, however, a “but…” associated with each of these apparent positives.
Employment rolls are growing, and unemployment statistics are shrinking, but largely because millions of former workers have opted out of the labor force, many discouraged about job prospects. Wages are rising, but at a far slower pace than in prior economic recoveries. More houses are being built and sold, but the numbers are far below levels of a decade and more ago. These statistics look good only in comparison with the extremely depressed numbers that resulted from the Financial Crisis. And the global economy is growing, but at a rate only marginally above stall speed.
Add to these qualifiers slowing vehicle sales, sluggish consumer spending, stalling bank loan growth, declining individual and corporate tax receipts at the state level, and bond yields reflecting significant economic uncertainty, and there is good reason to question a bullish economic outlook. The Atlanta Federal Reserve Bank, which has issued the most accurate forecasts in recent quarters, has dropped its most recent forecast for GDP growth to just 0.5%, a barely perceptible rise.
According to Evercore ISI, improving stock and housing prices since the Financial Crisis have raised household net worth relative to disposable income to an all-time high in this country. Logically, more wealth in the pockets of potential investors and consumers should bode well for tomorrow’s stock market and economy. Ironically, in the 70 years of this study, the only two prior instances that approached today’s wealth level marked the stock market and economic peaks following the dot.com and housing bubbles. Those peaks preceded serious recessions and declines that cut stock prices by more than half.
Since the election, consumer, executive and investor surveys have displayed remarkably strong levels of optimism. Such surveys are called “soft data.” Unfortunately, “hard data” (real economic results) have been coming in surprisingly weak. In fact, in recent years, there has never been a disparity this great between hard and soft data. It brings to mind Warren Buffett’s famous line that in the short run the market is a voting machine, but in the long run, a weighing machine. Bullish attitudes have “voted” stock prices higher, but “weighing” fundamental conditions could result in far lower prices.
Because corporate earnings were so depressed in the first quarter of 2016, largely because of oil price weakness, analysts expect to see a significant –possibly double digit– jump in this year’s first quarter results. Earnings per share (EPS), however, have become increasingly deceptive over the past several years. Since 2009, corporate EPS are up 221%, the sharpest post-recession rise in history. Corporate revenues, however, have increased by just 28% in the same period. The Wall Street Journal accused corporations of “…clever exploitations of accounting standards that manage earnings to misrepresent economic performance.” Share buybacks, which have become commonplace in recent years, increase EPS without companies increasing overall corporate profit. Total corporate earnings, not EPS, through the fourth quarter of 2016 were at 2011 levels despite the S&P 500 having advanced by 87%. The only thing that has soared has been the price-to-earnings (PE) multiple. Over many decades, periods of PE multiple expansion have been followed cyclically by multiple contraction. The current cycle of year-over-year multiple expansion has lasted 57 months, the longest on record. The two prior longest cycles ended in 1987 and 2000 with two of the U.S.’s most devastating stock market crashes. Excesses are inevitably followed by reversion to the mean.
As I have explained repeatedly in recent quarters, despite minimal economic progress, stock prices have been boosted mightily by the historic levels of monetary stimulus provided by the Federal Reserve and other major world central banks. That stimulus has extended well beyond traditional interest rate and money creation measures. As early as 2014, Financial Times reported that central banks, especially the People’s Bank of China, had bought more than $1 trillion in equities. In more recent years, the Bank of Japan has committed so many assets to equities that it has come to dominate that country’s exchange-traded-fund market. I have long maintained that our Fed, either directly or, more likely, indirectly, has been supporting U.S. stock prices at strategic moments.
This historic stimulus, which continues at an aggressive pace in Europe and Japan, has created unprecedented levels of debt worldwide. For more than the past century, the major countries of the world have experienced GDP growth at far faster rates when national debt has been low rather than when high. This paradox places a major hurdle in front of the world economy as it struggles to grow in an era of unprecedented debt burdens.
Let us revisit the “bet” which I have discussed in each of our last two Quarterly Commentaries. It is a fact that stock prices have always ultimately reverted to their fundamental means. At valuation levels far out of synch with underlying fundamentals, today’s portfolio values are at substantial risk should that reversion happen quickly. That outcome is the safe bet, at least in the long run. On the other hand, the central banks of the world are on an eight-year run in which they have been able to overcome weak fundamentals with an avalanche of new money and other market-supportive stimulus. It is not unreasonable to bet that central banks will remain both willing and able to keep market prices aloft. Unless the current instance permanently flies in the face of historic reality, however, profiting from equity purchases from current levels will demand that markets continue to rise before suffering substantial losses, and investors will have to make a timely sell decision before prices eventually decline to align with underlying fundamentals.
Let me introduce a few more conflicting items for your consideration. All but very short-term technical conditions continue to look reasonably bullish. Supply /demand and advance/decline figures still offer the probability of further equity price advances over the intermediate term. And while the Fed has begun to “normalize” its monetary policy in very gradual steps, it is unlikely to abandon its support of investment markets should other factors begin to put meaningful downward pressure on prices. On the other hand, the thirteen Fed rate hike cycles since World War II have led to ten recessions, a 77% rate. And, without making a political statement, every new Republican administration since Ulysses S. Grant’s (14 in all) has been in recession within two years of its inauguration. Interestingly, most experienced significant market advances from election day into the administration’s early months, as is currently the case. Complicating matters even further, both U.S. and Russian warships are steaming into contentious waters. Obviously there exist a great many highly unpredictable crosscurrents.
I’ll refer once again to the wisdom of Warren, listing two more of Buffet’s famous aphorisms: “Most people get invested in stocks when everyone else is. The time to get invested is when no one else is. You can’t buy what is popular and do well.” And: “Be fearful when others are greedy and greedy only when others are fearful.”
Such advice gets difficult to follow when abnormal conditions persist for years. It is important to remember that inevitable reversions to fundamental means can take back many years of profits. Most recently, the 2007-09 decline took stock prices back to 1996 levels, eliminating 13 years of gains. It’s critical for all investors in pursuit of profits to evaluate carefully their individual financial and psychological ability to withstand risk and losses, especially if markets should go through extended periods of weakness.