Quarterly Commentary 3rd Quarter 2017

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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.

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