Quarterly Commentary 1st Quarter 2019

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For the past several years, we have been profiling the dilemma facing investors as a “bet” between: 1) Reliance on traditional investment fundamentals reverting to their long-term means, which has always ultimately proven successful; or 2) Reliance on central bankers continuing to prevent securities prices from a reversion to historic fundamental averages, the approach that has prevailed for more than a decade. The most recent six months have demonstrated with vivid clarity how profoundly the Federal Reserve and other central bankers continue to dominate the investment landscape.

The stock market’s painful decline in the fourth quarter was brought on by a combination of extremely high equity valuations, rising interest rates, forecasts of slowing earnings and economies both nationally and internationally, trade tensions and the Fed pledging further tightening of monetary conditions. The result was negative returns for stock market indexes for full year 2018. Stock prices reached their lows on Christmas Eve and began a normal bounce from a severely oversold condition. On January 4, the third trading day of the new year, economic and political conditions remained largely the same as they had been three months earlier. Fed Chair Jay Powell, however, did a 180 degree turn from the Fed’s prior monetary tightening position and pledged “patience”—essentially saying that short term interest rates were on hold for at least the next few Fed meetings. With the powerful tailwind of Fed support, stock prices exploded upward and continued to rally into April, but have yet to fully recover their fourth quarter losses. And while some indexes are stronger than others, the New York Stock Exchange Composite, which includes all stocks on that exchange, is still below its level of 15 months ago. The broad market has made no progress over the past year and a quarter.

Since faith in central bankers has been reinforced by Powell’s pledge of patience, investors again assume that central bankers will be there to prevent recession and serious market declines. One regularly featured investment strategist recently expressed his confidence in no recession and no big downside market threat because the world’s central bankers are “all awake” and will not allow a recession, which has historically led to or accompanied a bear market. In fact, all other major central bankers are also leaning back toward stimulus and away from “normalization”. They are pledging to remain even longer in a state of the abnormal.

There appears to be little concern about the expectation that first quarter corporate earnings will come in below their levels of the same quarter a year ago, despite the fact that stocks are already selling at more than a lofty 21 times earnings on a Generally Accepted Accounting Principles (GAAP) basis. And at current prices, that multiple will rise if quarterly earnings do decline as forecasted. GMO’S James Montier recently pointed out that real corporate earnings growth has been below the rate of GDP growth, even after the significant boost to per share earnings from stock buybacks. He also highlighted the fact that between 25% and 30% of firms in the Russell 3000 are actually losing money. Goldman Sachs expects net profit margins for S&P 500 companies to fall to levels unseen since the financial crisis. These are hardly conditions that would normally prevail with stock valuations so close to all-time highs.

Just last week, the International Monetary Fund (IMF) once again dropped its estimate of world economic growth, this time to 3.3%, very close to recessionary levels for the world economy. According to David Rosenberg of Gluskin Sheff, the world experienced 3.4% growth in 1990 and 3.0% growth in 2008, both recessionary years. The World Bank and the European Central Bank (ECB) have similarly forecast that world growth will slow in the years ahead. In this country, the Fed sees GDP growth declining to 2.1% this year, slowing further to 1.9% in 2020 and 1.8% in 2021, ultimately settling into an average of 1.9% growth over the longer run. These rates are far below the growth levels that have characterized most of U.S. history.

The single greatest imponderable facing investors today is the question of tariffs. Will there be a meaningful resolution of the current trade dispute with China? If so, will tariffs be lifted or not? Will tariffs remain with Mexico and Canada? Will the new $11 billion of tariffs proposed last week against European products be levied? Could current and proposed U.S. tariffs plus reciprocals from foreign countries produce a similar result to that produced by the Smoot-Hawley legislation that dramatically deepened the Great Depression of the 1930s? Needless to say, the resolution of these questions will have enormous effects on the performance of investments in the years ahead. Such uncertainty typically drives stock prices to far lower levels of valuation than exist today.

Regular readers of our commentaries know that virtually all serious global financial unwindings since the Middle Ages have been precipitated or augmented by excessive debt. Today almost all major nations are saddled with historically high debt burdens relative to the size of their respective economies. In the U.S. both the volume and quality of our debt are worrisome. According to Bloomberg, student loan delinquencies hit a record high in the fourth quarter of 2018. The Federal Reserve recently stated that a record number of Americans were 90 days or more behind on auto loan payments. Credit card debt rose to a record high in the fourth quarter, surpassing the prior peak in 2008. In recent weeks, both the Fed and IMF have warned about risky loans, indicating the need for “continued monitoring.”

According to Gluskin Sheff, worldwide debt has skyrocketed from $100 trillion at the debt bubble peak in 2007 to $240 trillion today with nearly one-fifth of the world bond market in negative yield territory. How long can we logically expect negative rates (where lenders have to pay borrowers to borrow) to prevail? Elliot Wave International succinctly stated: “Properly functioning economies and debt markets do not have negative-yield bonds.”

While regulators may be expressing concern about the ongoing proliferation of debt and its deteriorating quality, the investing public is demonstrating an epic sense of complacency. Investors persist in their quest for scarce yield, accepting far less yield than the their assumed risk would seem to demand.

In the U.S., neither political party seems at all worried about burgeoning debt levels. Both want to spend more, raising deficits and debt totals. History demonstrates conclusively that no country ultimately gets away with that without serious damage, nonetheless, the commonly accepted attitude seems to be to do anything necessary to keep the bubble aloft for now. No debt collapse on my watch! Once again we have people in positions of responsibility proposing a nonsensical solution to the problem of excessive debt—piling on even more debt. Let someone else worry about it tomorrow. Now comes MMT, Modern Monetary Theory, which counsels us not to worry about deficits and debt—just print more money. Mirabile dictu! Why hasn’t anyone thought of that before? The rest of the world should, of course, be happy to accept all the money we can print. . . . maybe not. We may be testing that premise in the not-too-distant future.

Servicing all this debt has so far been manageable because the Fed and other world central banks have held interest rates near historic lows. With just a relatively small increase in interest rates, U.S. Government debt service rose by 26% in the past year. Any rise in rates back to historically normal levels would create huge deficit and debt problems.

Where does all this leave investors?

They still have to make a difficult choice. Recent central bank decisions make it clear that these captains of monetary policy are reluctant to let equity markets descend very far. Prior to the slowing economic data and sharp fourth quarter market decline, all the major central banks made it clear that they wanted to end quantitative easing as quickly as possible and begin or continue the “normalization” process. The pain of the decline clearly short-circuited those plans. And the rapid positive response by the markets shows that investors are relying on the Fed’s medicine at least temporarily overcoming the underlying disease. Central bankers would not be leaning back toward stimulus unless they were significantly afraid of present and forecasted economic and market conditions.

No one knows how long investors will retain their confidence in the willingness and ability of central bankers to support equity prices. Confidence could dissipate quickly with a surprise terrorist or military event or the collapse of one or more substantially overleveraged corporations. Weakening economic conditions could erode confidence just as significantly, although likely more gradually.

It is important to recognize that from present valuation levels, U.S. equity prices have never maintained current levels or better over the long run without first suffering a significant decline. That doesn’t mean they can’t go higher first — that depends on investor confidence. Unless it’s different this time from ever before, however, portfolio profits above this level will demand a well-timed sale to protect gains. Long-term buy and hold strategies will likely experience lower portfolio values than today’s at some point in the future, even if they increase in the near-term. And it could be critically important to recognize in a timely manner when to protect portfolio profits in light of the damage done in the last recession and bear market, which took away 13 years of equity price progress. And the repetition of such a decline is more than a random possibility with domestic and global debt levels at dangerous extremes.