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.
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.