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.

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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.

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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.

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