Quarterly Commentary 2nd Quarter 2018

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Rising interest rates have made 2018 a rocky year for bondholders so far. The only beneficiaries have been short-term savers and those waiting for more attractive prices on equities or longer fixed income securities.

Notwithstanding the geopolitical drama and threats to world economic order from looming trade wars, not much has changed for U.S. equities since the first quarter. As the calendar turned to January, most U.S. stocks roared out of the gate to all-time highs and reached their peaks before month-end. Then in early February, a dramatic 10% two-week decline brought most major averages to their lows for the year. . Since then, brief rallies have alternated with brief declines with an upward bias through mid-year.

The tax cut provided a powerful boost to corporate earnings, which has supplemented aggressive corporate stock buy-backs in pumping up earnings-per-share. Unemployment is close to a two-decade low. These factors have boosted investor confidence to extremely high levels. And algorithms have remained ready to buy every price dip, overcoming selling that never rose to more than moderate levels in the second quarter.

To augment the positive side of the picture, the market is still demonstrating a bullish intermediate technical pattern, with cumulative forces of demand significantly dominating the opposite forces of supply. And positive supply and demand statistics are being confirmed by positive market breadth, with advancing issues markedly outpacing declining issues. Diminished strength in these measures typically materializes a few months before major market tops.

At the same time, however, all this is taking place with stocks nearly as overvalued as ever before in U.S. history, and domestic and worldwide debt levels at or near all-time highs relative to the size of the respective economies–both extremely dangerous conditions. U.S. equities are currently valued at cyclically-adjusted price/earnings multiples seen previously only in the two most notorious bubbles in history – 1929 and 2000. In each instance, massive stock market declines followed. And nobody rang a bell announcing those tops. In fact, Gross Domestic Product (GDP) growth was higher preceding each of those historic market peaks than it is today. Bad news typically shows up after market peaks, not before.

Dangerous valuation and debt conditions don’t cause market prices to fall, but rather set the stage for particularly significant declines when one or more catalysts provide the spark. Potential incendiary provocations could come from trade skirmishes evolving into full scale trade wars or from a loss of investor confidence, should disputes with either adversaries or allies escalate into economically destructive disagreements.

There is not one example in U.S. history of investors buying a broad list of stocks at valuations even close to today’s levels and not ultimately seeing them fall to far lower levels, even if they should rise first. Unless we experience an unprecedented market pattern, with patience, long-term investors will be able to acquire common stocks at far more attractive prices. Prices could continue higher from here, but to retain profits investors will need indicators that will accurately identify an appropriate time to lock in any gains before they disappear.

While every market cycle has unique features, there are great similarities in investor and market behavior from one cycle to another. In January 2000, I wrote:

“There can be no question but that a bubble exists for some stocks. The bigger question is how comprehensive the bubble is. If the market is fated to regress to its historically normal valuation levels for a dollar of earnings, dividends and book value, current price levels are ridiculously overextended. To reach historically average levels based on current earnings, dividends and book values, the market would have to decline from 50% to 75%. Investors whose careers extend to no more than 25 years can’t conceive of such an outcome. They’ve never seen anything close to that in this country. Is it even possible, especially in light of consumer confidence having just hit its all-time high?”

Beginning that month, the S&P 500 declined by 50%, and the Nasdaq Composite declined by 80% over the next two years.

In July 2007, I wrote:

“With a stock market still rising after more than a four year virtually uncorrected run, accompanied by record amounts of debt and leverage, investors may be facing their greatest risk/reward decisions in history. No one likes to turn away from a stream of profitable returns that could continue indefinitely if the virtuous circle of circumstances remains unbroken. On the other hand, as happened almost overnight to the “worthless” Bear Stearns hedge funds, a broader catastrophic unwinding of leverage in a debt default environment could lead to the greatest loss of asset value in world history. This is not a “normal market” question like: Will I make 15% this year if things go right, or could I lose 5% if thing go wrong? It is rather a question of whether you could make explosive returns if, in fact, we have entered a new era in which central bankers can provide massive liquidity with no negative consequence. Off-setting such a prospect, if things go very wrong, is the specter of a violent unwinding of unprecedented debt levels with huge, unpredictable financial consequences. Because of the massive intricate chains of derivatives that wrap around the world, which regulators admit they can neither quantify nor get their arms around, a major financial accident could produce its consequences overnight.”

Within three months, markets began a decline of more than 50%, taking price averages back to levels of 13 years earlier. And halting that decline necessitated the greatest government rescue effort in history.

That rescue effort, emulated by central banks around the world, has contributed significantly to record world debt of $247 trillion, according to the Institute of International Finance. That is 318% of global nominal GDP compared to about 250% of nominal GDP just before the bursting of the dot.com bubble in 2000. That increased leverage raises risk to an even greater level than levels preceding the last two crippling bear markets. And overindebted central banks are in far weaker positions today to bail out their respective economies and markets than they were after the 2007-09 financial crisis.

While investor confidence remains strong, and second quarter earnings are expected to be excellent, the U.S. Federal Reserve, the International Monetary Fund and the World Bank all see both U.S. and worldwide GDP growth peaking in 2018, declining in 2019 and declining further in 2020. In fact, the Fed’s long-term forecast for U.S. GDP growth is a meagre 1.9%, far below the 3.2% historical average. In May, the Federal Reserve Bank of San Francisco said: “We find that the current price-to-earnings ratio predicts approximately zero growth in real equity prices over the next 10 years.”

In a very high risk environment, we continue to see our job as one of assuming only prudent investment risks and concentrating on producing absolute returns over relative returns. Before this market cycle ends, we anticipate that our approach to protect and grow client assets will perform far better than a more aggressive “match the market” approach.

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