Quarterly Commentary 1st Quarter 2018

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Volatility is back! This year’s first quarter broke a nearly two year pattern of historic stock market calm. Before February’s sharp but brief decline, the market had completed 311 sessions without even a 3% dip and 405 sessions without a 5% decline. In a normal year, investors experience three 5% declines. In recent years, the confidence that central bankers would prevent any significant price damage led to a buy-the-dip approach that effectively eliminated all but the smallest declines.

Since volatility picked up in early February, every day has held the potential for real adventure in one direction or another—often both. The first quarter saw eight 300-point declines in the Dow compared to just one in all of 2017, and we experienced two more in the first week of April. Because dramatic up days were also common in the first quarter, the S&P 500 ended the quarter with a loss of just 0.8%.

As volatility accelerated, it became increasingly clear that trading volume on many days resulted from computers trading with other computers. Algorithms dominated. A perfect example unfolded on February 5. With slight rounding and counting only moves of 100 Dow points or more, the day unfolded as follows: -360, +180, -100, +270, -120, +120, -310, +100, -280, +170,  -1280, +810, -260, +340, -130, +100, -320, +170, -220, +110, -170. All that activity took place in a single 6 ½ hour trading session, on average more than three big moves every hour. The Dow was down about 1600 points at its trough and closed down more than 1100.

While the market’s moves were violent, there was no clear trend. Prices bounced up and down, ending down a little for the quarter. By my rough count, on 33 of February and March’s 40 trading days, the Dow Jones Industrials opened in the first few minutes of the day up or down by triple digits from the prior day’s close. Such a pattern made it clear that short-term traders were dominating true investors.

The fixed income markets were far less violent, yet even less friendly to investors, as interest rates rose over the year’s first three months. The broad Barclay’s Aggregate Bond Index lost 1.5% for the quarter.

One advantage of the rise in interest rates, however, is the increased return on assets waiting to be invested in longer term securities at more attractive valuations.

The stock market volatility in early 2018 has done nothing to improve the extreme overvaluation that has characterized the U.S market in recent years. A composite of all the major measures of valuation remains at the second most extreme level of overvaluation in U.S. history. Current levels trail only those of the dot.com era, which preceded declines that left the market more than 50% lower nine years after the turn-of-the-century peak.

Market bulls point to the expected jump in 2018 corporate earnings as strong justification for markets’ potential to perk up again during the rest of this year. For that view to prevail, however, enthusiasm for stocks will have to overcome several fundamental hurdles. Even if the most optimistic earnings estimates are realized, stock prices will remain overvalued at a level that has seldom rewarded equity investors.

While lower corporate tax rates will boost earnings, there is little expectation that the domestic and international economies will grow strongly. Thanks to benevolent central bankers, the current economic expansion is the second longest on record in this country. At the same time, however, it has been the slowest advance in 70 years. And while the Federal Reserve expects the U.S. economy to grow by about 3% this year, it expects the rate of growth to decline in 2019 and 2020. The Fed’s estimate of the economy’s long-term growth potential is a mere 1.9%, virtually its lowest estimate ever. For a broader economic outlook, the World Bank’s view is that global growth may have peaked. They see growth in advanced economies slowing from 2.3% last year to 2.2% in 2018 and 1.7% by 2020. Declining growth in investment and total factor productivity over the past five years underlies the World Bank’s pessimistic outlook. It is unlikely that corporate earnings can continue to grow if such forecasts are realized.

Compounding the problem of slow and declining growth over the next several years is an unprecedented and growing volume of debt worldwide. Rapidly growing levels of debt have been tolerable in recent years because major central banks have pressed interest rates to, or in some places, below the zero bound. With the Federal Reserve and other central banks now in the process of reversing their essentially “free money” policies or planning to do that within the next year or so, servicing the world’s massive debt load will become increasingly more difficult as interest rates rise. In this country, we are already seeing the pressure on lower quality credits as, according to the FDIC, banks are writing off an increasing amount of credit card and consumer loans. In the first quarter, the U.S. corporate debt-to-GDP ratio hit an all-time high. The number of defaults by highly leveraged companies could rise significantly as central banks tighten their monetary policies.

We’re seeing heavy borrowing for stock ownership as well. Margin debt relative to GDP has also reached an all-time high. Such borrowing can be a powerful force that pushes stock prices higher, as it has done, but it simultaneously raises risk levels. It is instructive to note that the last two instances in which that ratio even approached current levels marked the two peaks that preceded 50% and 57% market declines in the first decade of the 21st century.

Weak economic forecasts, historic levels of debt and overvaluation and rising interest rates are accompanied by the threats of trade wars and of nuclear confrontation with North Korea. Stock prices could continue to rise, however, if nine years of positive momentum overcomes recent market volatility. On the other hand, if markets respond to the above mentioned negatives as they typically have for more than a century, prices could retreat dramatically. At some point, stocks will again represent attractive value, but it likely will occur at significantly lower levels.

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Quarterly Commentary 4th Quarter 2017

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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.

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