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%.
2017 ?

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.

|

Art Laffer Forecasts an Economic Boom – Maybe Not

A friend sent me second-hand notes of a recent talk by Dr. Arthur Laffer at the University of San Diego and requested my comments.  I sent him the following.

One quick anecdote.  When I headed a not-for-profit consulting office in the late-1970s in Washington, DC, a politically connected contact of mine asked if there were anyone in Washington that I particularly wanted to meet.  I told him Arthur Burns, then Chairman of the Federal Reserve Board.  He couldn’t get Burns, but he sent Art Laffer to my office, and we chatted for about an hour.  That was a few years after he famously sketched the Laffer Curve on the back of a napkin.

Regarding his forecast of a coming economic boom, while anything is possible, such a boom is facing formidable headwinds.  Let me comment on the four pillars of Laffer’s argument, as spelled out in the notes.

  1. Laffer is a staunch conservative, and he may be taking a political shot in saying that the Obama economy is the lowest bar in history.  True, the past eight years have marked the slowest recovery from recession since WWII, but the economy has been growing over that entire period, albeit slowly.  The economy today is far healthier than in 2008 when unemployment was very severe, the housing market was in shambles, and most major banks were insolvent, surviving only by the grace of a government rescue.  Obama inherited an economy in serious recession, and while growth has been slow, it has been growth.  Throughout U.S. history, there haven’t been many growth periods that have lasted longer, so for this to be the beginning of a boom period, it would have to break historic precedent in terms of longevity.
  2. Laffer’s contention that all powers are in line (President, House, Senate, Supreme Court, lower courts, etc.) is questionable.  Despite having legislative majorities, the Republican administration is encountering resistance within its own party.  There’s been less than unanimous enthusiasm for the first iterations of the attempted Affordable Care Act revision.  With economists of various stripes warning of potential negative economic consequences resulting from tighter immigration policies, unanimity in that area appears unlikely.  There is already healthy debate about the wisdom of a border adjustment tax.  A worst-case consequence could be violent retaliation, resulting in the kind of trade wars that prolonged and exacerbated the Great Depression of the 1930s.  The prospect of significant fiscal stimulus has already aroused concern among right-leaning Republicans, many of whom have cut their political teeth as debt and deficit hawks.  Many will not likely fall in line as good soldiers in the fight for fiscal stimulus. That the courts are not completely in line seems evident from the initial ruling against the administration’s first efforts at immigration restriction.  The President’s characterization of a “so called judge” is unlikely to win friends among the judiciary.
  3. Laffer’s third point sounds like his first, that the runway ahead is a long one because we’re starting from a rock bottom economy.  See my earlier comments.
  4. Tax cuts, to the extent that they are passed, will likely provide a boost to corporate earnings.  And Laffer has long been a believer that such an event will turbocharge the economy.  I’ve not spent any significant amount of time studying the effect of tax cuts through history, but I have certainly heard arguments that the hoped-for results have fallen far short of expectations.  It’s incontrovertible, however, that government actions in the aggregate – tax changes, governmental spending and central bank activity – have produced inexorably rising levels of debt.  In this country, and in most of the world, debt burdens have risen well beyond the levels that have preceded major economic slowdowns over many centuries.  In This Time Is Different, Reinhart and Rogoff spell out in copious detail the deleterious economic consequences that predictably follow explosive debt growth.  Invariably, populations experiencing excessive debt hear detailed explanations about why “this time is different,” and why such debt is not a serious threat.  Reinhart and Rogoff maintain that history demonstrates clearly how such thinking is typically penalized severely.

In the summary of Laffer’s talk that you sent, he apparently argues that California will be a prominent non-beneficiary in this coming economic boom.  If California is failing and failing quickly–“circling the drain” as Laffer put it–this will prove to be a very significant headwind facing the national success story.  It’s hard to imagine a national boom with the country’s largest economic component (13.3%) stagnating.

As I said earlier, anything is possible, but Laffer’s contention flies in the face of probability on several counts.  Since I was not at the talk and am reacting only to the notes taken, you have to evaluate the accuracy of the note-taker.  There could, of course, be nuances not reflected in his notes.

|

Quarterly Commentary 4th Quarter 2016

The year 2016 was a year like few others.  In the hours immediately following the closing of the polls in November, major stock indexes were trading below 2015 year-end levels.  As sentiment turned on a dime from fear of a Trump presidency to celebration of the prospect for new business-friendly policies, stock prices surged over the ensuing five weeks.  Interestingly, bond prices experienced exactly the opposite reaction, plummeting over the five weeks following the election.  The money investors made in stocks was erased by the money lost in bonds.

Just a few months earlier, investors were faced with the greatest dichotomy in the history of financial markets.  Interest rates were hitting record lows while U.S. stocks were just below record highs.  As I wrote in our October Quarterly Commentary, bonds were pricing in Armageddon, while stockholders were pushing prices of the majority of stocks to unprecedented levels of overvaluation.  As I write today, those extremes have only slightly moderated.

Third Longest Equity Rally

While bond prices, especially of longer maturity bonds, have been pummeled over the past two quarters, U.S. stocks continue to trade near all-time highs.  We are, in fact, experiencing the third longest stock market rally in U.S. history, now more than seven years and ten months long.  There is a commonly-voiced bullish argument that bull markets don’t die of old age.  That is probably true, but a close reading of history demonstrates that as bull markets lengthen, more and more people buy into the bullish rationale being voiced by analysts and commentators.  After all, as those analysts convincingly argue, market prices are proving their theses.  And bearish cautions are backhanded away as the bleating of worrywarts who have been wrong for years.  This explains why so many investors buy near market highs, the point at which the bullish case has been most persuasively demonstrated.  Extended market rallies provide ample time for the accumulation of excesses that ultimately are the most proximate causes of major market tops.

It is instructive to examine the outcomes of the only U.S. market rallies that have outlasted the current one.  The longest spanned almost the entire decade of the 1990s, covering the nine years and five months preceding the market peak in early 2000.  A painful 50% decline marked the onset of the new century, followed by an explosive rally and another destructive decline, leaving prices 57% below their early 2000 highs in early 2009.  The only other U.S. equity rally to exceed the length of the current advance lasted just a few weeks longer, topped in 1929, ushered in the Great Depression and bottomed in 1932 with stock prices down 89% from their peak less than three years earlier.  In other words, we have no example of a rally lasting this long that did not immediately precede a severely damaging, long lasting price decline.  The decline that bottomed in 2009 brought stock prices back to 1996’s levels, erasing 13 years of price progress.  The 1929 crash that bottomed in 1932 wiped out an even longer 18 years of price history.  Precedent does not dictate the future, but only the foolish would ignore a century or more of history.  There may be reasons that are not obvious that limit market rallies to a shorter duration than we are currently experiencing.

Excesses Have Grown

As I expressed earlier, when rallies lengthen, excesses that ultimately lead to market tops escalate.  Let me examine where we are today in terms of conditions that have commonly marked the end of stock market advances.

As a valuation-based firm, we always examine how much investors are willing to pay for corporate earnings, dividends, book value, sales and cash flow.  An aggregate of the most commonly employed valuation measures shows the overall equity market today at the second most overvalued level in U.S. history, trailing only the extreme overvaluation that characterized the dot.com mania at the turn of the century.  That bubble ended very badly.  Valuation measures of the median U.S. common stock are at their most extreme ever.  In other words, we’re paying more for the median stock relative to its underlying fundamentals than ever before.

Are there good reasons to expect that prospects for economic growth and corporate profits are similarly better than they have ever been before?  While conditions can always change, both domestic and international economic growth rates have been significantly subpar for years despite the greatest amount of monetary stimulus ever.  Corporate profits have also been stagnant for several years despite that aggressive stimulus.  With problematic demographics and very weak productivity growth, it is unlikely that we are at the dawn of a new age of economic and corporate profit growth.

For centuries, in our country and throughout the world, excessive debt – personal, corporate or governmental – has contributed mightily to the severity of economic and securities market declines.  Over the past few years, debt growth around the world has been unprecedented.  In the United States, combined debt levels are barely off their all-time highs relative to the size of our economy.  But for bankruptcies and foreclosures, which eliminated much debt, we would be at all-time highs.  The world’s second largest economy, China, is increasingly being seen as a ticking debt time bomb, with its debt levels exploding upward in recent years.  Major world central banks, especially Japan, the European Central Bank and England, have been flooding their economies with newly printed money, offset by an equivalent amount of debt, as though their economies were collapsing.  What do they see that they’re not revealing?  World debt has just reached its highest level ever at 325% of GDP.  It is distressing to realize that excessive debt has been an integral ingredient in virtually every major stock market decline in modern history.

Bullish analysts and commentators like to point to the historically low levels of today’s interest rates as justification for hopes for an extension of the current, lengthy stock market advance.  I believe it to be an open question as to whether one can look at current interest rates as we have looked at rates over past decades.  Never before have rates been as directly suppressed by central bankers worldwide as in recent years.  But rates, at least in this country, have begun to rise, and the Federal Reserve and most analysts expect them to rise sequentially over the next few years.  Fed rate tightening actions have typically put significant pressure on stock prices, especially when valuations are high.

Rising interest rates, of course, are also destructive to bondholders, as prices decline when rates rise.  That risk is especially relevant now, because the average bond today is at its longest duration ever, i.e., at its greatest sensitivity ever to rising rates.  The quest for yield has led investors to buy longer maturity bonds in an era of historically low rates.

Weak Long-Term Equity Prospects

John Hussman and Nobel Prize winner Robert Shiller have each done intensive historical analyses of stock market performance from various levels of equity valuation.  So extreme are today’s levels that their studies show the expected annualized equity return over the next 10 to 12 years to be in very low single digits.  Hussman’s work dictates that a 50-60% decline in that time period would be a normal expectation.  We believe that the most prudent investment policy in such an environment is to take steps necessary to prevent major declines in portfolio value in order to have plentiful buying power available when prices revert to historical means or below.

Conflicting Bullish and Bearish Conditions

While valuations, debt levels, the longevity of the current rally and rising interest rates all strongly suggest caution, most stock market technical conditions remain at least moderately bullish.  While momentum has slowed, far more stocks are still advancing than declining, and supply and demand figures remain bullishly configured.  Over many decades, growth in supply typically precedes major market tops by several months.  A dangerous buildup of supply is not yet obvious.

We find ourselves in a very confusing environment.  Notwithstanding more minor advances and declines, the technical conditions that normally precede a major decline do not yet appear to be in place.  On the other hand, fundamental conditions that presage very severe market declines are very much in evidence.  Even those who agree with that evaluation of the evidence may be tempted to try to squeeze a bit more out of this rally.  And that approach could succeed.  It is important to recognize, however, that adding to stock holdings at current levels will prove profitable only if prices never again dip below today’s level or if prices go higher and sales are strategically timed before a later decline.

Normal outcomes could also be dramatically altered by an economic, military or political shock.  In an environment of polarized political feelings in this country and around the world, the risk of such a surprise is hardly inconsequential.  Investors need to evaluate carefully their individual ability to assume such risks.

|

Is the Newfound Euphoria Warranted?

The powerful post-election stock market rally has turned a great many skeptics into hopeful, if not confident, speculators.  And while momentum should never be discounted, there are numerous reasons to pay close attention to contrasting risk and reward possibilities.

Events of the past several months—the Brexit vote, the Trump election and the Italian referendum— have cast grave doubt on the predictive accuracy of the world’s major pollsters.  Such surprise results have emboldened those looking for outlier outcomes.  And while low probability outcomes will periodically occur, oft-repeated precedent is a far safer bet.  Let’s examine today’s stock market conditions on a probability scale.

Many market commentators have dubbed the recent strong rally in U.S. stocks the “Trump rally”, and there can be no doubt but that many people have strong expectations that proposed regulation reduction, tax cuts and foreign profit repatriation will do marvels for corporate profits and, in turn, stock prices.  They have either ignored or downplayed the potential negative economic effects of proposed tariffs and more restrictive immigration.  However the interplay of those factors may unfold, it is unlikely that many proposed changes will have an immediate significant effect.  And while Trump will have a Republican majority in both houses of Congress, a sizeable number of far-right members of his party have developed their political careers on the principle of reduced debt and deficits.  It seems highly unlikely that they will find massive infrastructure spending an appetizing prospect.

The most optimistic bulls seem to believe that Trump brings to the presidency a “can do” spirit that will overcome objections on such mundane grounds as excessive debt.  Many project parallels to the positive effects on the economy and the stock market that unfolded through the eight-year presidency of Ronald Reagan.  While similar results could happen, dramatically different conditions exist today than at the beginning of the Reagan years.

The excellent Ned Davis Research Group outlined several striking differences between the two eras.  Reagan lowered the top income tax rate from 70% to 28%.  That same potential doesn’t exist today with a top tax rate of 39.6%.  Inflation was in double digits when Reagan took office but had begun its steep plunge to low single digits through most of the Reagan years.  Trump inherits low single digit inflation, which the Fed and all major world central banks are trying to push higher.  Having flooded their respective economies with freshly minted money, countries around the world face the potential of surging inflation if disinflationary forces fade and extreme money creation produces its historically normal result.

Interest rates declined through most of the Reagan years, but Trump appears ready to assume office with rates rising and forecasted to rise further by the Fed and almost all private forecasters.  Government debt was below $1 trillion when Reagan took office.  It will be more than 21 times that amount when Trump takes the oath of office.  With debt at such an extreme level, rising interest rates could have a devastating effect on the nation’s finances.

At the beginning of the 1980s, Reagan inherited a stock market that had been suffering through a long weak cycle since the mid-1960s and was trading at extremely low levels of valuation with price to earnings ratios in single digits.  By contrast, Trump takes office after eight years of a central bank-fueled stock market rally that has pushed U.S. broad market valuation levels to the second highest ever, trailing only those of the dot.com era at the turn of the century.  Today’s median stock is at its greatest valuation extreme ever.

Throughout global history, extreme levels of overvaluation have always returned to long-term norms by price declines, not by underlying fundamentals rising to meet elevated prices.  In the current instance, however, central bankers have successfully prevented stock prices from reverting to their historic means by verbal intervention and by unprecedented monetary largesse whenever prices appeared to be in danger of more than a moderate decline.  Investors are left with what we have characterized as “the bet”: a) whether to count on continuing central bank success in supporting overvalued stock prices or b) to expect a reversion of stock prices to their historic norms.

We continue to urge investors to evaluate not just the probability of rising or falling prices but also the potential degree of increase or decrease.  While there is no way to know how high a price ceiling might be, more than a century of data indicates that the growth potential over the next decade from even lower levels of valuation is minimal.  On the downside, when valuation excesses have been unwound in the past, many years of profit have been erased.  Most recently, the 57% stock market decline from late-2007 to early-2009 took prices back to 1996 levels.  Earlier market declines eliminated even more than 13 years of gains.  Retreats from severe levels of overvaluation can be devastating, no matter how long deferred.

Returning to more immediate matters, the current post-election rally is normal, although stronger than most.  Roughly 80% of the time, stocks rally from election day to the new president’s inauguration.  That pattern, however, has not typically foretold a continuation of the rally.  The first year of the four-year election cycle is on average the weakest, especially in the second half of the year.  Over the past 80 years, post-inauguration weakness has been especially pronounced when Republican presidents have succeeded Democrats, although the sample size of four is very small.  The average decline from inauguration through September of the first year has been about 13% in the Eisenhower, Nixon, Reagan and Bush administrations.  While the full eight years of the Reagan presidency saw good gains, the early years included a recession and a 25% market correction.  In fact, every Republican president in the past 70 years, with or without a majority in the House and Senate, experienced a recession in the first two years of his presidency.  A recession with valuations anywhere near today’s levels would likely lead to severe stock market losses.

With U.S. stock prices close to all-time highs and investor sentiment improving, it’s hard to imagine a drastic change in the near term.  And, frankly, many technical readings of supply and demand and new highs and lows point to likely higher prices in the months immediately ahead.  That makes “the bet” both confusing and dangerous.  Nobody likes to miss upside opportunities, but when stocks are severely overvalued, an unexpected economic, political or military event can crush stock prices very quickly.  The most dramatic example of a sudden change of sentiment and market direction followed the 1928 election of Herbert Hoover.  The new president was seen to be an excellent candidate to continue the strength of the Roaring Twenties, and stocks jumped by double digits between election day and his March 4 inauguration in 1929.  Positive sentiment continued for a few more months only to be extinguished late that same year by the most devastating stock market crash in this country’s history.  Thus began the Great Depression of the 1930s, exacerbated by isolationism and protectionism, which led to widespread trade wars.  President-elect Trump and politicians worldwide are campaigning on nationalistic themes that were direct forerunners of the trade wars that crippled world trade in the 1930s.  The dangers are there again today.  We can only hope that the world will not proceed too far down that potentially destructive path.

Adding to stock holdings at current levels will prove profitable only if prices never again dip below today’s level or if prices go higher and sales are strategically timed before a later decline.  Neither is a high probability option.

|

Quarterly Commentary 3rd Quarter 2016

At our annual client conference on October 6th, we were pleased to host a large number of guests.  I presented what I believe to be the most important issues I have addressed in my 47 years in the investment business.  While I will reprise those comments here in necessarily abridged form, we would be pleased to provide annotated copies of the conference’s presentation materials on request.

Investors today are faced with the greatest dichotomy in the history of financial markets.  Interest rates are hitting record lows while stocks are near record highs.  Bonds are pricing in Armageddon, while stockholders have pushed prices of the majority of companies to unprecedented levels of overvaluation.

The Bet

This unique paradox forces investors to make a critical bet. I use the word “bet” advisedly, because the resolution of the bet, at least over the next year or two, depends on factors independent of traditional investment analysis.

Investors have to choose between the following alternatives:

  1. Worldwide, stocks and bonds are more overvalued than ever before, yet global economic growth is scarcely above recession levels. If stock and bond prices revert to their historic valuation means, portfolio values could fall precipitously and stay down for years. Throughout history, prices have always ultimately reverted to their means.
  2. Our Federal Reserve and other central banks around the world are flooding their respective economies with newly created money. For the past 7 ½ years, central bankers have overcome weak fundamental conditions, while stock and bond prices remain near all-time highs. This could continue.

Central Bankers Good For Stock Prices

At least ostensibly, historic levels of central bank stimulus have been designed to boost the economy and stabilize the currency with about a 2% level of inflation (to lessen the negative effects on overindebted companies and governments). Unfortunately, while that stimulus has had extraordinarily powerful effects on stock and bond prices, it has done precious little for the underlying economy.

The positive effect of the various iterations of the Fed’s quantitative easing efforts is obvious when a graph of stock market prices is overlaid with one that traces the growth of the Fed’s balance sheet. Since 2009, stocks have powered higher each time the Fed has authorized additional money creation.  Yet stock prices have fallen from 13% to 17% at the end of each quantitative easing episode, only to have the declines halted by new central bank reassurance that monetary authorities stood ready to continue to support securities prices as needed.  In recent months, individual central bankers have quickly voiced their support to halt declines of as little as 2% or 3%, as though afraid that their entire monetary experiment will unravel if equity prices experience a significant decline.

Can This Continue?

Any analysis of the potential for the vast collection of domestic and international stimulus efforts continuing to work should include former Fed Chairman Alan Greenspan’s comments:

“This is an unprecedented period in monetary history. We’ve never been through this.  We really cannot tell how it will work out.”

“Monetary policy is largely economic forecasting. And our ability to forecast is significantly limited.”

Paraphrasing comments to the Council on Foreign Relations:

  • Boosting the economy via bond buying has not worked.
  • Boosting asset prices has been a terrific success.
  • I don’t think it’s possible for the Fed to end its easy-money policies in a trouble-free manner.

Negative Interest Rates

Normal central bank tools, even carried to historic extremes, have neither lifted economies, nor raised the level of inflation. European and Japanese central bankers have even resorted to negative interest rates to rev up their economies and inflation.

Today, there are over $15 trillion in negative yielding securities worldwide. Even corporate bonds have begun to show negative yields.  One commentator recently indicated that 16% of European Union investment grade debt is trading at negative yields.  The holders of such bonds are guaranteed to lose money if they hold the bonds to maturity.  The only way to realize a profit is for interest rates to go even further negative and for the investor to sell the bonds at that lower yield.  That is an incredible condition and threatens the viability of many banks and insurance companies.  And unless circumstances change dramatically, many pension plans will fall far short of meeting promised retirement benefits in the years ahead.  This shortfall could have immense negative consequences for the broader economy.

Negative interest rates have yet to improve the economic outlook where implemented. Ironically, in almost every country in which central banks have moved interest rates into negative territory, equity prices have suffered.

Central Banks Buying Stocks

Having tried virtually everything else without apparent success, a few central banks have decided to buy stocks, hoping that the resulting wealth effect would boost the overall economy. Japan has been the most aggressive buyer, with China, Hong Kong, Israel and Switzerland actively participating, the latter possibly as a surrogate for others (perhaps the US).  The European Central Bank has recently speculated about buying stocks.  Within the past month, Fed Chair Janet Yellen floated a trial balloon about our Fed buying corporate bonds and stocks, ostensibly to help in an economic downturn — a disastrous idea on so many levels!  When will Congress step up and rein in the Fed, which has assumed powers far beyond what was ever envisioned when they established the central bank in 1913?

Costs of Central Bank Intervention

All this economic masterminding comes at a cost. In its first 95 years of existence, the Fed grew its balance sheet to a bit over $800 billion.  In the past eight years, the Fed has grown that debt level to five times what it had taken nearly a century to produce.  This is our generation’s gift to our grandchildren and their grandchildren.  But all this financial legerdemain has produced record stock and bond prices for this generation.  Can they be sustained?

Risks To Bondholders

On the bond side, risks are that interest rates rise and/or companies or countries default. If interest rates rise, as is inevitable eventually, a great deal of money can be lost, even in very creditworthy bonds.  The ten-year US Treasury note, for example, trading today at 1.79%, would provide a negative total return for a year with a rate increase as little as a quarter of one percent.  Many investors shrug off such concerns, because they expect to hold their fixed income securities to maturity.  And certainly, if the issuing company or country does not default, the investor will get back principal and interest.  There is however, no guaranty of what that money will buy at maturity.  In the last rising interest rate cycle extending from early 1941 to late 1981, for example, a typical portfolio of government and corporate bonds lost over 2% of its purchasing power per year despite collecting regular interest payments.  Even unmanaged, risk-free US Treasury bills outperformed almost all bond portfolios for more than four decades.  Investors apparently do not recognize the dangers as they pour extraordinary amounts of money into bonds at historically low interest rates.  They can’t buy yesterday’s performance, only tomorrow’s.

Risks To Stockholders

On the equity side, dangers lurk in several areas. As indicated earlier, the majority of stocks are at their most overvalued levels ever.  When calculated by a composite of the most commonly employed valuation measures, the entire market is at its second most overvalued level, slightly behind valuations in the dot.com era at the turn of the century.

It is ironic that investors are so enthusiastic about stock ownership with the US and world economies sluggish and in many instances slowing. Just weeks ago, the International Monetary Fund lowered its global growth forecast to 3.1% for 2016, a number they have been steadily lowering.  This is barely above recession level for world growth.  The Federal Open Market Committee of the Federal Reserve Board also recently dropped its estimate of long-term US growth to 1.85%, the lowest level on record.  Despite unparalleled stimulus, the US continues in the slowest recovery from recession in three-quarters of a century.

Not surprising in a weak economic environment, corporate profits have been declining year over year for the past five quarters. And measured on a Generally Accepted Accounting Principles basis, profits are approximately back to 2007 levels.  Over the past six quarters, profits have fallen by about 20%.  Thanks to central bank support, stock prices are up in that time period.

Declining earnings growth is not limited to the US. According to Goldman Sachs, world earnings per share have increased over the past decade by less than 2% per year.  On average, European countries have actually seen earnings per share decline by more than 2% per year over that decade.

Debt A Threat

Those who have attended our conferences or who have read our commentaries over the years know that I consider extreme levels of debt in almost all major countries around the world to be the single most dangerous threat to our long-term economic wellbeing. In recent years, dramatically growing debt levels, on top of already excessive debt loads, have been controlled by central bankers piling on even more debt while effectively printing previously inconceivable amounts of new money.  History argues convincingly, however, that for centuries countries with debt levels even lower than most today have suffered extended economic malaise, often accompanied by significant inflation and severe market disruptions.

Investment Stars Voice Warnings

Over the past few months, some of the most successful investors of our era have sounded alarms about the danger in today’s markets. Stanley Druckenmiller, whose hedge fund produced 30% per year returns for 25 years before closing to outside money in 2010, summarized his concerns with: “Get out of all stocks.”  George Soros, a hugely successful hedge fund pioneer, returned to investment management from philanthropy to take advantage of opportunities on the short side.  He sees “a serious challenge which reminds me of the crisis we had in 2008.”  “The world is running into something it doesn’t know how to handle.”  Jeff Gundlach, CEO of DoubleLine Capital, a very successful bond manager, recently counselled: “Sell everything.  Nothing here looks good.  Sell the house.  Sell the car.  Sell the kids.”

So far, those concerns have not played themselves out in US markets. Equity prices in most other countries, however, have moved appreciably lower than they were at their highs a year and a half ago.

But More Stocks Going Up Than Down

Notwithstanding all those negatives, many more stocks in the US have been advancing recently than declining. And markets generally show a marked deterioration in such advance/decline figures before forming major tops.  To this point, central bankers continue to prevail.

Mission’s Approach

Where does Mission stand? As a deep discount value manager, we won’t bet heavily on the more speculative “central bank winning” side of the bet.  We are, however, willing to increase the risk-assumption level of any portfolio for clients who want that exposure.  We have, though, been in a similar position twice before in the past two decades where we leaned against the prevailing trend and ended up benefiting our clients handsomely.

At the turn of the century, we warned aggressively that equity prices were on thin ice because of the unhealthy combination of extreme levels of debt and unmatched levels of overvaluation. The vast majority of our clients employed our Risk Averse strategy, which targeted absolute, rather than relative returns.  Equity prices began a major decline in 2000.  Despite our concern with the overall market level, our bottom-up individual stock selection process found quite a few stocks that met all our purchase criteria.  Over the 2 ½ years from April 1, 2000 to September 30, 2002, Mission’s average client portfolio grew by over 17% while the S&P 500 declined by almost 38%, including dividends paid.  Mission’s stocks actually rose while most stocks fell precipitously.

By 2007, amidst massive speculation and the never-to-be-forgotten housing bubble, we were far more defensive than in the earliest years of the new century, but still finding some stocks that met our purchase criteria. The S&P 500 plummeted by more than 50% from November 1, 2007 to February 28, 2009.  Mission’s stocks lost money also in that horrendous decline but nowhere near as much as the S&P 500.  Because we had cut back so substantially on our risk exposure, our clients emerged from that excruciating bear market with a total portfolio loss of less than 1%.

Because we did not believe that the weak cycle that began in 2000 had ended, even after the initial 2000-02 bear market, we remained cautious and had limited risk exposure during the strong stock market rally up to the peak in 2007. That caution was eventually rewarded, as we avoided the portfolio decimation that many investors experienced in the 2007-09 decline.  In the almost nine-year period from early-2000 to early-2009, Mission’s risk-averse portfolios outperformed the S&P 500 by 10.6% per year.

As a manager that bases investment decisions on proven, historically sound data, Mission has been unwilling to assume significant market risk since 2009, a period in which, in retrospect, risk assumption was well rewarded. Central banker largesse has overcome far below normal fundamental data and Mission has lagged behind those willing to accept substantial risk.  If central bankers win “the bet”, it’s unlikely that Mission will keep pace with more aggressive managers.  On the other hand, if history plays out as it always has before, I expect Mission will again catch and pass those assuming substantial risk in the current, very dangerous environment.

Consequences As Well As Probability

While we can’t know the probability, at least in the short term, of which way the bet will be resolved, it’s important to evaluate the potential consequences of whatever the outcome might be. On the upside, we know what historically normal returns have been: about 10% per year for stocks, 5+% for bonds and 3.5% for risk-free cash equivalents with inflation about 3%.  These are 90 year averages, and, logically, they are computed from average levels of interest rates, valuations and economic conditions.  Today, not one of those conditions is average or normal, and because of that, we’re not likely to experience historically normal returns over the next few years.

On the other hand, there is significant danger to both stocks and bonds should investor faith in central bankers falter. If investors begin to doubt either the willingness or effectiveness of central bank efforts to keep stock and bond prices aloft, a nonsupportive air pocket exists below current stimulus-supported levels.  Not knowing the details of market history, most investors underestimate the damage that major bear markets can inflict.  The most recent serious decline that ended in 2009 brought stock prices back to their 1996 level, erasing 13 years of price gains.  That drop was actually less painful than the carnage unleashed by three prior US bear markets which erased price gains of 16, 18 and 28 years.  The bear market that began in Japan at the end of 1989 leaves prices today at levels of three decades ago.

Because markets have bounced back so robustly from the two precipitous declines since 2000, many investors have lost their fear of big declines. It is important to recognize that those rebounds were precipitated by unprecedented government support.  And government may be running out of ammunition.  It is sobering to recognize that prior to the last two major declines, it took 12, 16 and 24 years for stock prices to permanently exceed the price peaks at the beginning of the three big bear markets in the mid-to-late 20th century.

The Investor’s Dilemma

Every investor and investment manager has to decide how much of each side of the bet to accept. If you choose to align yourself with underlying economic and market fundamentals, yet prices continue to rise in response to central bank stimulus, you’ll inevitably wish you had assumed more risk.  If, on the other hand, you bet on central bankers and market conditions revert to their means as they always eventually have, you may be nursing portfolio wounds for years to come.  Any individual’s or organization’s ability to withstand such a risk undoubtedly depends on the depth of current resources and future earning power.  As indicated earlier, Mission will not bet heavily on central banks winning for any further extended period of time.  We may assume controllable risks on a strategic basis, but we anticipate that the next significant opportunity to profit from substantial stock and bond holdings will come with patience and at far more attractive valuations.  That approach has proven extremely beneficial twice since 2000, and we believe that the probabilities lie heavily on the side of at least one more repetition until the debt and valuation excesses are significantly reduced.

|