Quarterly Commentary 4th Quarter 2018
2018 proved to be a difficult year for investors throughout the world. Nothing performed well, and there were very few places to hide. In the United States, the majority of stock indexes reached all-time highs in January, only to suffer sharp declines over the next two months. A negative first quarter accompanied by worrisome foreign economic slowing led many to fear that the nine year bull market was coming to a close. However, the miracle of copious, nearly free money from the world’s central banks as well as a substantial domestic tax reduction revived the U.S. market, which climbed persistently to a new all-time high in early October. From there, equity markets assumed an entirely different complexion, with most indexes falling aggressively by almost 20% to the late-December lows. A rally in the last few days of the year left the S&P 500 down by 13.5% for the fourth quarter and 4.4% for the full year. Foreign markets fared even worse with the composite of world indexes excluding the U.S. down for the year by 14.1%.
Unfortunately, fixed income markets offered no productive counterbalance to the equity storms. Domestically, the Barclay’s Aggregate Bond Index provided a zero total return, and most foreign bond markets finished well into negative territory.
In a pre-Christmas email to clients, I indicated that those for whom we have full asset allocation responsibility had nothing to worry about over the holidays. Their portfolios were up both for the sharply negative fourth quarter and for the full year.
An old Wall Street aphorism suggests that stock prices go up on an escalator and down on an elevator. The fourth quarter was testimony to that venerable adage. At its trough in late-December, the price decline had erased 26% of the nearly 10 year S&P 500 rise since March 2009 and 28% of the rise in the Nasdaq Composite. It is remarkable to note that a single quarter’s decline wiped out the price progress of the past 18 quarters for the New York Stock Exchange Composite Index, which includes all common stocks traded on that exchange.
There is no way to know at this point whether the fourth quarter marks the first leg down in a far more serious bear market or merely a brief but painful interruption of the bull market that began in early 2009. Clearly, the consequences of the former could have monumental import. The past two bear markets in this country have cut stock prices by half or more. The bull market that began at the March 2009 trough required historical governmental efforts to pull the domestic economy out of what former Federal Reserve Chair Ben Bernanke indicated was about to become a depression, absent extraordinary rescue efforts. In retrospect, that entire ten year rally resulted from the creation of yet another credit bubble. While the banking system and most corporations have boosted their capital levels significantly since then, the increased amounts of debt assumed by governments and corporations could present an extreme danger when the next recession inevitably hits.
Notwithstanding an appreciable decline in price-to-earnings ratios in the fourth quarter, a composite of all the major valuation measures still rests not far below all-time highs. The combination of still very high valuations and historic indebtedness domestically and internationally poses a potentially toxic mix in the next bear market.
While very few analysts are forecasting a recession in 2019, almost all analysts anticipate a slowing economy and sharply reduced corporate earnings growth. The World Bank recently indicated that global growth is expected to slow to a very sluggish 2.9% – perilously close to recession level for world growth. Domestic growth, which normally underperforms global growth because of the effect of faster growing emerging economies, is expected by the Federal Reserve to decline to 2.3% in 2019, 2% in 2020, and 1.8% in 2021. Over the long run, corporate profits cannot be expected to outperform economic growth by any appreciable amount. Historically, while earnings growth has been decelerating, as it is now, the stock market has tended to struggle.
Economies worldwide have begun to slow as central bank loose money policies have been tightened. It is eminently logical that halting the monetary generosity that has provided an unparalleled tailwind to economies and equity markets for the better part of a decade will challenge a number of the world’s economies that have yet to demonstrate the ability to grow without central bank support.
The powerful fourth quarter stock market declines in both the U.S. and China prompted their respective central bankers to offer soothing assurances that looser policies may once more be forthcoming should stock prices fall far enough. Having allowed debt to rise to unprecedented heights, central bankers appear unwilling to let markets, economies and interest rates adjust to their natural levels. Elevated interest rates would lead to unsustainable debt service burdens for many highly leveraged governments and corporations. Additionally, a significant recession could lead to the demise of many companies whose credit ratings have declined to junk bond levels. At the risk of promoting even larger debt burdens, the Fed and other central bankers appear unwilling to allow their respective markets, economies and interest rates to function unaided.
Relative to the question of danger from excessive debt, Fed Chair Jay Powell spoke tellingly earlier this month before the Economic Club of New York. Asked about the ballooning amount of U.S. debt, Powell answered: “I’m very worried about it . . . The long-run FISCAL NONSUSTAINABILITY of the U.S. federal government isn’t really something that plays into the medium term that is relevant for our policy decisions.” [However], “. . . it’s a long-run issue that we definitely need to face, and ultimately, will have no choice but to face.” In other words, according to Powell, the very financial survival of the U.S. government is ultimately threatened by the ballooning U.S. debt. Yet current conditions are so fragile that Powell and his fellow Fed governors may be approaching the point at which they may reestablish the loose monetary policies that have already magnified the debt. Investors face the question: at what point does this debt burden becomes a front burner issue? Centuries of history, as recounted in copious detail by Carmen Reinhart and Ken Rogoff in “This Time Is Different”, demonstrate that excessive debt always ultimately calls countries to account, sometimes with destructive economic and securities market consequences. The United States and many other countries have already passed the level of debt relative to the size of the economy that has typically triggered dire negative consequences down through the centuries.
Supplementing the problems of excessive debt, overvaluation and slowing economies is a broad array of economic and political uncertainties: Brexit, riots in France, trade disputes with China and other countries, North Korean nuclear arms, the Mueller investigation, seemingly irreconcilable differences in U.S. political philosophies and the ongoing U.S. government shutdown.
Many of these concerns were cited as reasons for one of the worst Decembers and fourth quarters in U.S. stock market history. By December 24, the markets were severely oversold. From there, a dramatic bounce-back rally closed the year and continues into the new year as this is written. Rallies this powerful normally lead to even higher prices over the ensuing six months, not, however, on an uninterrupted path. Almost always, prices retreat to test the earlier low. Complicating this history is the previously mentioned fact that stocks typically struggle when corporate earnings growth is decelerating, as it is currently. Additionally, the prevalence of algorithmic and other computerized trading has made some historical patterns less predictive, especially in the short run.
Of utmost importance is correctly choosing the long-term investing path to follow. In recent years, we have characterized the choice that all investors (as contrasted with short-term traders) must make as a “bet”. One alternative is to remain relatively fully invested in equities, trusting that central bankers will continue to provide loose monetary support whenever stocks threaten a significant decline. Such central bank actions have promoted one of the longest stock market rallies in U.S. history, so far only briefly interrupted by 2018’s fourth quarter losses. The second alternative is to trust that stocks will ultimately revert to their long-term fundamental means, as they always have throughout every decade prior to the most recent ten years. Should such a price reversion occur quickly, stock prices would plummet, as they have twice since the turn of the century. With debt having risen to current levels, recovery from such a decline could likewise take longer than ever before.
In this uncertain environment, Mission continues to employ its value-based investment strategies designed to pursue absolute rather than relative returns. In high risk environments, we hold a limited number of risk-bearing securities, increasing risk exposure when valuations become historically more attractive.
2019 offers the prospect of tremendous volatility as markets react to unfolding economic and political surprises. Great volatility offers the potential for great opportunity as valuation and risk levels rise and fall over a broad range. We will work to provide protection when needed and exposure to profit when favorable opportunities present themselves.
Quarterly Commentary 3rd Quarter 2018
In the third quarter, markets unfolded much as they had in the prior several months with a considerable level of calm prevailing in the major domestic investment asset categories. Beneath the surface, however, change was brewing and has broken out in the equity market in the beginning of the fourth quarter.
In late September, we were pleased to welcome clients and guests to our annual investment conference. As I try to do each year, I profiled the major forces that affected the markets and the economy in the prior year, and those likely to influence economic and investment activity in the period ahead. In this commentary, I will highlight the main points from the conference and will update market conditions, outlining risk and reward potential in each of the major asset categories.
Short-Term Cash Equivalents
As part of the bail-out of the major banks in 2008, the Federal Reserve brought interest rates effectively down to zero, where they stayed for seven years. Rates began a steady rise in late-2015 that continues through today. At its September meeting, the Fed raised its risk-free rate by another 25 basis points to the 2% to 2.25% range. They indicated their intention, subject, of course, to changing conditions, to raise rates by another 25 basis points in December, by three more quarter percent increments in 2019 and another in 2020. This increase in rates has been greatly beneficial for those unwilling to accept the risk of longer fixed income securities or equities. Many of those clients have asked us to manage assets exclusively in short-term, essentially risk-free securities. Using only government-guaranteed securities over the past ten years, Mission earned more than 1.6% per year above the risk-free rate. If the Fed stays on its intended path, short rates should continue to rise over the next two years. Short-term cash management will likely be more productive than investment in longer fixed income securities in the years just ahead, despite such longer securities having higher interest rate coupons today.
Longer Fixed Income Securities
With longer interest rates rising since mid-2016, the total return on US Treasury securities with maturities ranging from five to thirty years (combining interest payments and changes in bond prices) has been negative, with the loss on the longest bonds in double digits. Interestingly, junk bonds provided positive total returns over that rising interest rate period, and CCC-rated bonds, the lowest quality bonds just one step from default, provided the highest returns. That inverse relationship between quality and returns is indictive of the environment in which we have lived for several years. Investors accepting the highest risks, even risks that have typically been severely penalized, have reaped maximum rewards.
Many analysts are predicting that the next financial crisis will occur in the area of corporate debt. According to S&P Global, 37% of companies worldwide are carrying excessive debt. That compares with only 32% in 2007, just before the economy collapsed in a serious recession that Fed Chairman Ben Bernanke said would have turned into a depression without the government’s rescue. On top of the dangerous amount of debt on corporate balance sheets, the quality of that debt is declining. The median corporate credit rating has deteriorated to BBB-, just one notch above junk status. We now have the junkiest corporate bond market ever.
There is no way to know how long or how far interest rates may rise in this cycle. It is instructive to note, however, that in the last long rising interest rate cycle, risk-free cash equivalents outperformed any diversified longer fixed income portfolio for more than four decades from the early -1940s to the early -1980s. It could be a significant mistake to mandate a permanent portfolio allocation to longer fixed income securities in the years ahead, especially if inflation should begin to rise more virulently.
Although not uncommon, there are numerous conflicting bullish and bearish factors facing investors. By itself, each provides a rationale to be either excited by or fearful of equity ownership. I will profile bullish factors first.
• We are now experiencing the longest bull market ever.
• Domestic stock prices ended the quarter at or near all-time highs.
• In 2018, corporate profits are very strong, due largely to the substantially reduced corporate tax rate and the more generous depreciation allowance.
• Second quarter GDP growth was a strong 4.2%.
• The 3.9% unemployment rate is the lowest in years.
• Increased deficit spending has boosted economic growth.
• More infrastructure spending may be coming.
• Historically high levels of corporate stock buybacks are overwhelming stock issuance. This activity has provided a huge boost to stock prices, and 2018 is expected to be a record year for companies buying back their own stock.
• Some major central banks (European Central Bank and Bank of Japan) are still printing money. Money created anywhere easily crosses borders and helps to boost stock prices everywhere.
• Credit remains readily available.
• Interest rates are still historically low, although they are rising in many parts of the world.
• There will be lower taxes going forward for corporations and many individuals.
• Consumer and business optimism levels are extremely high.
• There is an abundance of corporate cash, although it is concentrated in a few huge corporations.
• Intermediate-term technical conditions are still positive. We have not yet seen the signs in supply and demand statistics and buying power and selling pressure patterns that normally appear a few months before a major market top.
• Central banks, like the Bank of Japan and Swiss National Bank, and sovereign wealth funds in oil rich countries like Norway, Kuwait and Saudi Arabia are large, powerful, non-price sensitive entities gobbling up equities around the world. They have staying power and are not accountable to stakeholders. There is no way to know how long they will continue to buy.
Wall Street analysts and strategists regularly point to many of these factors as justification for even higher prices in the months and quarters ahead. Needless to say, however, there are significant bearish factors as well.
• The current US economic expansion is already the second longest ever, nearly double the length of the average economic expansion. Some of history’s biggest stock market declines followed the longest economic expansions.
• The Fed continues to raise rates and reduce its balance sheet, which reduces the liquidity that has fueled the lengthy stock market expansion. A few weeks ago, Jeffrey Gundlach, the current “Bond King”, said: “We are doing something that almost seems like a suicide mission. We are increasing the size of the deficit while we are raising interest rates so late in an economic cycle.”
• Other major central banks are becoming more restrictive. The Bank of England has taken its first steps in raising short rates. The European Central Bank has said it will stop its quantitative easing at year-end and begin to raise rates some time in 2019.
• Longer-term interest rates are rising, which will make conditions tougher for the economically important housing industry.
• Higher interest rates will hurt corporate profits and possibly lead to bankruptcies for companies that are overleveraged.
• Geopolitical risks are extensive. J.P. Morgan Chase CEO Jaime Dimon recently warned about Brexit, flareups across Europe including Italy and Turkey, the Middle East and Latin America. The US has its own contentious interactions with longstanding European and North American allies, plus ongoing disputes with China, Russia, Iran, and North Korea — any of which could escalate to more troublesome levels.
• Equity valuations are near all-time extremes.
• Investor sentiment (a contrary indicator) is extremely optimistic.
• Domestic and global debt levels are at or near all-time highs. For centuries throughout the world, excessive debt has established the framework for some of the most severe economic and stock market declines.
• The quality of debt is deteriorating significantly.
• Trade disputes could become trade wars. Trade wars were a major contributing factor to the length and depth of the Great Depression of the 1930s. Many dozens of US companies have already complained of increased costs and reduced sales from US tariffs.
One major negative factor that we spent some time on at the conference was the diminishing likelihood of significant future economic growth, as measured by Gross Domestic Product (GDP). While there have been peaks and valleys, GDP growth has trended markedly lower for the past 70 years. And although the current economic expansion is the second longest in US history, it is the weakest in the post-World War II era. I have long argued that excess debt is the principal cause of declining economic growth. The record shows very clearly that as the ratio of US debt-to-GDP began to explode upward in the early 1980s, the rate of GDP growth began to plummet. That pattern has continued for almost 40 years. Ironically, in the financial crisis a decade ago, the Fed and other central banks around the world tried to solve a problem of excess debt by multiplying the amount of debt outstanding. Worldwide debt levels today are at all-time highs, which will likely penalize GDP growth for years to come.
While tax reductions have given a significant boost to 2018 economic and corporate profit growth, all well-recognized forecasters see this as the peak year with GDP falling off progressively in 2019 and beyond. The Congressional Budget Office (CBO), the Fed and the Wall Street Journal Survey of Private Economists see GDP growth this year coming in at 3.0% to 3.1%, then declining to 2.4% to 2.5% in 2019. The Fed’s estimate of the long-term US growth rate is a mere 1.9%. The European Central Bank’s growth estimate for the Eurozone is an even less lustrous 2.0% this year and 1.8% next. Notwithstanding strength in corporate earnings this year because of the tax reduction, it is important to recognize that corporate earnings on average do not grow much more than a couple of percent more than GDP growth.
It is hard to imagine stock prices remaining anywhere near current levels if GDP and corporate earnings growth fall off as forecasted. Stock valuations are priced for perfection with a composite of the most commonly used valuation measures just below the highest levels of all-time, the period around the dot.com mania at the turn of the century. That valuation extreme was penalized by a 50% decline in the S&P 500 index by 2002 and a total of 57% down from the 2000 peak by early 2009.
At the end of my conference presentation, I showed a graph of the Japanese Nikkei index from the mid-1980s to present. In the 1980’s, Japan’s economy was the envy of the world, thought to be the embodiment of the new industrial paradigm. Japan’s stock prices powered upward through the decade and, in 1989, its stock market was the world’s largest. I included this graph, not as a forecast, but rather as a caution. With the government standing strongly in support of its banking system and general economy, few thought that any significant harm could befall investors in Japan. That confidence turned out to be badly placed.
The Nikkei peaked on the last trading day of 1989. It declined by more than 60% in less than three years, eventually more than 80% to its ultimate bottom during the 2008 financial crisis. Even with the subsequent worldwide rally, the Nikkei today, nearly 29 years later, remains more than 40% below its 1989 high.
The purpose in showing this depressing precedent was to shake attendees from the complacency born of dramatic recoveries from the two traumatic bear markets so far in this still young century. The US barely escaped depression a decade ago because of an unprecedented government rescue, which has left the country massively indebted. Rescues from inevitable future recessions may be far more difficult to engineer.
The environment remains problematic for investors and investment managers alike. As indicated earlier, if the Fed’s forecasts prove even reasonably accurate, intermediate and long fixed income securities will have a difficult time providing even minimally positive total returns. High quality, short-term cash equivalents will provide a growing, but still not exciting positive return. Those willing to assume the serious risk attendant to common stocks at these levels of overvaluation in a late cycle economy laden with historically high levels of debt can still profit so long as sentiment holds up and central bankers signal a willingness to prevent equity prices from declining too significantly. As a deep discount value firm, Mission will always look for strategic opportunities. In the meantime, we will maximize safe returns while awaiting more attractive valuations before committing a substantial portion of assets to equity positions. The potential for a severe, long-lasting decline beginning in the next year or two is extremely real.
Quarterly Commentary 2nd Quarter 2018
Rising interest rates have made 2018 a rocky year for bondholders so far. The only beneficiaries have been short-term savers and those waiting for more attractive prices on equities or longer fixed income securities.
Notwithstanding the geopolitical drama and threats to world economic order from looming trade wars, not much has changed for U.S. equities since the first quarter. As the calendar turned to January, most U.S. stocks roared out of the gate to all-time highs and reached their peaks before month-end. Then in early February, a dramatic 10% two-week decline brought most major averages to their lows for the year. . Since then, brief rallies have alternated with brief declines with an upward bias through mid-year.
The tax cut provided a powerful boost to corporate earnings, which has supplemented aggressive corporate stock buy-backs in pumping up earnings-per-share. Unemployment is close to a two-decade low. These factors have boosted investor confidence to extremely high levels. And algorithms have remained ready to buy every price dip, overcoming selling that never rose to more than moderate levels in the second quarter.
To augment the positive side of the picture, the market is still demonstrating a bullish intermediate technical pattern, with cumulative forces of demand significantly dominating the opposite forces of supply. And positive supply and demand statistics are being confirmed by positive market breadth, with advancing issues markedly outpacing declining issues. Diminished strength in these measures typically materializes a few months before major market tops.
At the same time, however, all this is taking place with stocks nearly as overvalued as ever before in U.S. history, and domestic and worldwide debt levels at or near all-time highs relative to the size of the respective economies–both extremely dangerous conditions. U.S. equities are currently valued at cyclically-adjusted price/earnings multiples seen previously only in the two most notorious bubbles in history – 1929 and 2000. In each instance, massive stock market declines followed. And nobody rang a bell announcing those tops. In fact, Gross Domestic Product (GDP) growth was higher preceding each of those historic market peaks than it is today. Bad news typically shows up after market peaks, not before.
Dangerous valuation and debt conditions don’t cause market prices to fall, but rather set the stage for particularly significant declines when one or more catalysts provide the spark. Potential incendiary provocations could come from trade skirmishes evolving into full scale trade wars or from a loss of investor confidence, should disputes with either adversaries or allies escalate into economically destructive disagreements.
There is not one example in U.S. history of investors buying a broad list of stocks at valuations even close to today’s levels and not ultimately seeing them fall to far lower levels, even if they should rise first. Unless we experience an unprecedented market pattern, with patience, long-term investors will be able to acquire common stocks at far more attractive prices. Prices could continue higher from here, but to retain profits investors will need indicators that will accurately identify an appropriate time to lock in any gains before they disappear.
While every market cycle has unique features, there are great similarities in investor and market behavior from one cycle to another. In January 2000, I wrote:
“There can be no question but that a bubble exists for some stocks. The bigger question is how comprehensive the bubble is. If the market is fated to regress to its historically normal valuation levels for a dollar of earnings, dividends and book value, current price levels are ridiculously overextended. To reach historically average levels based on current earnings, dividends and book values, the market would have to decline from 50% to 75%. Investors whose careers extend to no more than 25 years can’t conceive of such an outcome. They’ve never seen anything close to that in this country. Is it even possible, especially in light of consumer confidence having just hit its all-time high?”
Beginning that month, the S&P 500 declined by 50%, and the Nasdaq Composite declined by 80% over the next two years.
In July 2007, I wrote:
“With a stock market still rising after more than a four year virtually uncorrected run, accompanied by record amounts of debt and leverage, investors may be facing their greatest risk/reward decisions in history. No one likes to turn away from a stream of profitable returns that could continue indefinitely if the virtuous circle of circumstances remains unbroken. On the other hand, as happened almost overnight to the “worthless” Bear Stearns hedge funds, a broader catastrophic unwinding of leverage in a debt default environment could lead to the greatest loss of asset value in world history. This is not a “normal market” question like: Will I make 15% this year if things go right, or could I lose 5% if thing go wrong? It is rather a question of whether you could make explosive returns if, in fact, we have entered a new era in which central bankers can provide massive liquidity with no negative consequence. Off-setting such a prospect, if things go very wrong, is the specter of a violent unwinding of unprecedented debt levels with huge, unpredictable financial consequences. Because of the massive intricate chains of derivatives that wrap around the world, which regulators admit they can neither quantify nor get their arms around, a major financial accident could produce its consequences overnight.”
Within three months, markets began a decline of more than 50%, taking price averages back to levels of 13 years earlier. And halting that decline necessitated the greatest government rescue effort in history.
That rescue effort, emulated by central banks around the world, has contributed significantly to record world debt of $247 trillion, according to the Institute of International Finance. That is 318% of global nominal GDP compared to about 250% of nominal GDP just before the bursting of the dot.com bubble in 2000. That increased leverage raises risk to an even greater level than levels preceding the last two crippling bear markets. And overindebted central banks are in far weaker positions today to bail out their respective economies and markets than they were after the 2007-09 financial crisis.
While investor confidence remains strong, and second quarter earnings are expected to be excellent, the U.S. Federal Reserve, the International Monetary Fund and the World Bank all see both U.S. and worldwide GDP growth peaking in 2018, declining in 2019 and declining further in 2020. In fact, the Fed’s long-term forecast for U.S. GDP growth is a meagre 1.9%, far below the 3.2% historical average. In May, the Federal Reserve Bank of San Francisco said: “We find that the current price-to-earnings ratio predicts approximately zero growth in real equity prices over the next 10 years.”
In a very high risk environment, we continue to see our job as one of assuming only prudent investment risks and concentrating on producing absolute returns over relative returns. Before this market cycle ends, we anticipate that our approach to protect and grow client assets will perform far better than a more aggressive “match the market” approach.
Quarterly Commentary 1st Quarter 2018
Volatility is back! This year’s first quarter broke a nearly two year pattern of historic stock market calm. Before February’s sharp but brief decline, the market had completed 311 sessions without even a 3% dip and 405 sessions without a 5% decline. In a normal year, investors experience three 5% declines. In recent years, the confidence that central bankers would prevent any significant price damage led to a buy-the-dip approach that effectively eliminated all but the smallest declines.
Since volatility picked up in early February, every day has held the potential for real adventure in one direction or another—often both. The first quarter saw eight 300-point declines in the Dow compared to just one in all of 2017, and we experienced two more in the first week of April. Because dramatic up days were also common in the first quarter, the S&P 500 ended the quarter with a loss of just 0.8%.
As volatility accelerated, it became increasingly clear that trading volume on many days resulted from computers trading with other computers. Algorithms dominated. A perfect example unfolded on February 5. With slight rounding and counting only moves of 100 Dow points or more, the day unfolded as follows: -360, +180, -100, +270, -120, +120, -310, +100, -280, +170, -1280, +810, -260, +340, -130, +100, -320, +170, -220, +110, -170. All that activity took place in a single 6 ½ hour trading session, on average more than three big moves every hour. The Dow was down about 1600 points at its trough and closed down more than 1100.
While the market’s moves were violent, there was no clear trend. Prices bounced up and down, ending down a little for the quarter. By my rough count, on 33 of February and March’s 40 trading days, the Dow Jones Industrials opened in the first few minutes of the day up or down by triple digits from the prior day’s close. Such a pattern made it clear that short-term traders were dominating true investors.
The fixed income markets were far less violent, yet even less friendly to investors, as interest rates rose over the year’s first three months. The broad Barclay’s Aggregate Bond Index lost 1.5% for the quarter.
One advantage of the rise in interest rates, however, is the increased return on assets waiting to be invested in longer term securities at more attractive valuations.
The stock market volatility in early 2018 has done nothing to improve the extreme overvaluation that has characterized the U.S market in recent years. A composite of all the major measures of valuation remains at the second most extreme level of overvaluation in U.S. history. Current levels trail only those of the dot.com era, which preceded declines that left the market more than 50% lower nine years after the turn-of-the-century peak.
Market bulls point to the expected jump in 2018 corporate earnings as strong justification for markets’ potential to perk up again during the rest of this year. For that view to prevail, however, enthusiasm for stocks will have to overcome several fundamental hurdles. Even if the most optimistic earnings estimates are realized, stock prices will remain overvalued at a level that has seldom rewarded equity investors.
While lower corporate tax rates will boost earnings, there is little expectation that the domestic and international economies will grow strongly. Thanks to benevolent central bankers, the current economic expansion is the second longest on record in this country. At the same time, however, it has been the slowest advance in 70 years. And while the Federal Reserve expects the U.S. economy to grow by about 3% this year, it expects the rate of growth to decline in 2019 and 2020. The Fed’s estimate of the economy’s long-term growth potential is a mere 1.9%, virtually its lowest estimate ever. For a broader economic outlook, the World Bank’s view is that global growth may have peaked. They see growth in advanced economies slowing from 2.3% last year to 2.2% in 2018 and 1.7% by 2020. Declining growth in investment and total factor productivity over the past five years underlies the World Bank’s pessimistic outlook. It is unlikely that corporate earnings can continue to grow if such forecasts are realized.
Compounding the problem of slow and declining growth over the next several years is an unprecedented and growing volume of debt worldwide. Rapidly growing levels of debt have been tolerable in recent years because major central banks have pressed interest rates to, or in some places, below the zero bound. With the Federal Reserve and other central banks now in the process of reversing their essentially “free money” policies or planning to do that within the next year or so, servicing the world’s massive debt load will become increasingly more difficult as interest rates rise. In this country, we are already seeing the pressure on lower quality credits as, according to the FDIC, banks are writing off an increasing amount of credit card and consumer loans. In the first quarter, the U.S. corporate debt-to-GDP ratio hit an all-time high. The number of defaults by highly leveraged companies could rise significantly as central banks tighten their monetary policies.
We’re seeing heavy borrowing for stock ownership as well. Margin debt relative to GDP has also reached an all-time high. Such borrowing can be a powerful force that pushes stock prices higher, as it has done, but it simultaneously raises risk levels. It is instructive to note that the last two instances in which that ratio even approached current levels marked the two peaks that preceded 50% and 57% market declines in the first decade of the 21st century.
Weak economic forecasts, historic levels of debt and overvaluation and rising interest rates are accompanied by the threats of trade wars and of nuclear confrontation with North Korea. Stock prices could continue to rise, however, if nine years of positive momentum overcomes recent market volatility. On the other hand, if markets respond to the above mentioned negatives as they typically have for more than a century, prices could retreat dramatically. At some point, stocks will again represent attractive value, but it likely will occur at significantly lower levels.
Quarterly Commentary 4th Quarter 2017
It has been more than 400 days since the U.S. stock market experienced as much as a 3% decline–the longest stretch ever. Stock prices have risen for 14 straight months–also a record. And it has been almost nine years since there has been a meaningful correction lasting as much as a year. The longer markets rise without significant declines, the more fear is removed from the minds of investors. That explains why throughout history, investors have bought far more aggressively at high stock prices than at low prices. Stocks, ironically, are about the only commodity that buyers seek more avidly at higher prices than low. It is instructive to recognize, however, that lengthy rises and lack of fear have characterized all major U.S. stock market tops. That does not mean that stocks cannot continue to rise from current levels, just that today’s conditions are similar to those that have preceded this country’s most destructive bear markets.
Stock Prices Have Outrun Corporate Profits
After such an extended market rise, one would logically assume that the economy and corporate profits had grown at far above normal rates over those years. Remarkably, the U.S. economy has grown at a far below normal rate, while stock market prices have risen at a far faster rate than have corporate profits. What accounts for such phenomena is the benevolence of the Federal Reserve Board, which has handed out trillions of dollars of essentially free money, ostensibly to boost the economy. Because companies failed to sufficiently put that money to work to boost the economy even back to an average level, those funds found their way into stocks and bonds, boosting each to record levels.
Central Bankers To The Rescue
Because Fed members feared that a significant stock market decline would undermine their attempts to keep the economy from slipping into recession, they provided support whenever the market showed evidence that it might be ready to fall enough to worry investors. That support happened so consistently that investors began to count on it. Price dips became smaller and smaller as traders became intent on stepping in front of others who subscribed to a “buy the dip” approach. As a result, there are historically low levels of cash in most portfolios, with stock prices at all-time highs and bond yields near all-time lows.
Stocks And Bonds Massively Overvalued
What has gone on for almost nine years can go on for another year or more, but that will require events that have never occurred before. According to a Deutsche Bank study going back to 1800, the 15 largest developed countries are at their highest level of overvaluation combining both stocks and bonds. Given that condition, the single most important ingredient for further market growth will be continued investor confidence that central bankers will remain both willing and able to support securities markets.
Wall Street Almost Unanimously Bullish
Wall Street analysts, in the aggregate, have never forecast even a single recession. Since the beginning of this century, the consensus of analysts has similarly not forecast even a single down year for the stock market, missing two of the worst bear markets in U.S. history. They again remain steadfastly bullish, despite this now being the third longest economic expansion in U.S. history, albeit the weakest since World War II. Those analysts almost universally said: “This will end badly” when U.S. monetary authorities began their “free money” stimulus policies. Although those programs have gone far beyond any logically imagined levels, analysts have abandoned their concerns in the quest to remain bullish– apparently a Wall Street requirement.
Analysts justify the rally and their bullish forecasts on a fundamental basis: growing corporate earnings and synchronized worldwide growth. Much of the earnings growth in recent years has been the result of corporate buybacks reducing the number of shares, not because overall corporate profits have been growing appreciably. And earnings per share forecasts are for growth again in 2018. While earnings per share have significantly overstated actual corporate profits, investors have been willing to look past that point and have so far been eager to pay progressively more for each dollar of profit. And yes, while there is economic growth around the world, except for three large emerging market countries, that growth is far below historically normal levels – and this despite the most aggressive monetary stimulus ever. The market’s continuing rise is more a celebration of direction over level of growth.
The most bullish factor in the short run is the technical picture. Supply/demand statistics and advance/decline figures are markedly bullish. We have not yet seen the deterioration in these indicators that has almost always preceded major market declines by several months.
History Argues Against Lasting Strength
On the negative side, the full scope of market history argues against equity prices remaining permanently above current overbought, overvalued levels without a major bear market eventually taking prices far lower. By a composite of all major valuation measures, the U.S. market is more overvalued than ever before except for the period around the dot.com mania top in 2000. Most current valuations are getting very close to that earlier extreme. No market in 200 years of U.S. history even remotely close to current valuations has failed to experience a severe bear market that ultimately took away more than a decade of price progress.
Almost daily on business television you can hear someone counter concerns about the longevity of this almost nine-year rally by saying that market advances don’t die of old age. That may be true. They do, however, die in old age. Human beings, likewise, don’t die of old age but rather of one or more conditions that typically arise in old age. By the time market rallies even approach this market’s length, they tend to have precipitated any number of excesses which have proven fatal to innumerable rallies over the years. Besides stock market valuations, extremes are evident today in high end real estate, fine wines, art prices (like the $450 million Da Vinci sale) and cryptocurrencies. Over the decades, such excesses have been dramatically reduced when stock prices eventually descend.
Central Banks Are Reducing Stimulus
The aggressive monetary stimulus that has boosted stock and bond prices since 2009 is being reduced or eliminated in most of the world. The U.S. Federal Reserve has begun to raise short-term interest rates and reduce its bloated balance sheet. The Bank of England and the European Central Bank have both indicated plans to tighten their policies. Among major central banks, only the Bank of Japan remains in full blown stimulus mode, but even they are hinting about reductions. As helpful as monetary expansion has been for stock prices worldwide, it’s hard to imagine that the elimination and reversal of such stimulus will not have a significant negative effect in the next few years.
The Danger Of Extreme Debt Levels
As we have noted many times during this monetary expansion, the newly printed money is offset by the accumulation of debt on the central banks’ balance sheets. It is unlikely that all of this debt will be allowed to roll off over the next several years, which means that much of this debt will be a legacy that this generation leaves its children and their children. Over the centuries, debt levels well below those in most of today’s major countries have invariably led to significantly slowed economic growth for a decade or more, often accompanied by severe stock market declines. Even former Fed Chairman Alan Greenspan maintains that it is unlikely that the Fed can normalize this extreme monetary policy without severe pain.
Warnings From Top Managers
Some of this generation’s most successful investors (Stanley Druckenmiller, Howard Marks and Jeff Gundlach) have recently issued warnings about overstaying this lengthy rally. A few weeks ago, in a CNBC interview, Druckenmiller said: “The longer this goes on, the worse it will be.” He indicated that when what he called “monetary radicalism” ends, all the world’s extremely overvalued assets will go down.
Weighing Opportunity Versus Danger
Nobody rings a bell at market tops, nor does anyone know when this market advance will end. While all of these concerns seem superfluous–even counterproductive–while prices rise persistently, such concerns have always ultimately led to market declines that take away many years of price progress. Those remaining heavily invested in stocks will continue to profit if the market extends this rally. And it could continue if investors retain their confidence in central bankers. Unless this time differs from all past market instances of severe overvaluation, however, regardless of the level at which the rally ends, a timely sell decision will have to be made to lock in gains before the next bear market takes prices below current levels.
Some investors believe strongly in the buy and hold approach. That method can be appropriate for those with a very long time horizon and the financial and psychological ability to stay committed even during gut-wrenching declines. On the other hand, there are no guarantees that markets will bounce back as they did from the bottoms in 2002 and 2009. Down 57% from the 2000 stock market peak, the S&P500 by March 2009 had erased 13 years of price progress back to 1996 levels. Only extraordinary actions by the Treasury and the Federal Reserve rescued the banking system and kept the economy from what government officials described as a probable depression. With its rescue measures severely stretched (some would say irrationally stretched), it is unlikely that the Fed would be to be able to provide a similar emergency rescue in the next several years.
As we have discussed in past seminars, any adherent to the buy and hold philosophy needs to evaluate an uncomfortable precedent. At the end of the 1980s, the Japanese stock market was the largest in the world, and the Japanese economy was considered the prime example of the new industrial paradigm. It was widely believed that the Japanese market was immune to the normal dynamics that could take down other major world markets. From its peak at the end of the 1980s, however, the Nikkei’s price dropped about 80% over the next few years, and is today still down almost 50% from its peak of 28 years ago. In another cautionary domestic example, it took a quarter century for the Dow Jones Industrial Average to get back to its 1929 peak level. Very few investors have time frames that long.
Today’s investors are faced with a significant dilemma. Prices have been strong through most of the past nine years, heavily supported by essentially free money from the Federal Reserve and other world central banks. Additionally, several usually reliable technical indicators have not yet given signs that the market advance is in its final stages. On the other hand, stocks are extremely overvalued, and markets have never before permanently retained levels of even less severe overvaluation without first enduring a substantial and lengthy bear market. An added problem today is the intended reversal over the next few years of the monumental stimulus that has supported the market’s advance. Every individual and institutional investor should carefully weigh the potential for continued equity profits against his/her/its ability and willingness to endure a lengthy decline should history repeat in an era of historic levels of overvaluation and indebtedness.