Quarterly Commentary 2nd Quarter 2019

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“Is the market going up just because of the Fed?” – asked of an investment strategist by a CNBC announcer. “No, the economy is incredibly strong.” This interchange took place immediately following the strategist’s prediction that the Fed will lower short-term interest rates in July by 25 basis points, possibly by 50. Even if illogical, Wall Street is at least consistent. Strategists regularly paint a rosy picture of the economy and prospects for the stock market. At the same time, they lobby the Fed for lower rates, typically employed only to prevent a faltering economy from falling into recession.

Very clearly, both the domestic and world economies are slowing. The World Bank, International Monetary Fund and Federal Reserve all forecast 2019 and 2020 to be weaker than 2018. The Fed’s long-term U.S. GDP growth forecast is a meager 1.9% per year. Similarly, corporate earnings, both here and abroad, are losing altitude. Ned Davis Research points out that profits for all domestic corporations peaked in 2018’s third quarter at $2,321 billion, falling to $2,311 billion in the fourth quarter and $2,252 billion in this year’s first quarter. FactSet is currently estimating that S&P 500 earnings will decline year over year in both the second and third quarters. In my 50 year investment career, I can’t remember another instance in which stock prices remained near historic highs with domestic and world economies growing very slowly and weakening and corporate earnings declining on both a sequential and year over year basis. Wall Street, nonetheless, remains bullish.

For several years, stock price advances have very clearly followed bullish comments and policy changes by central bankers around the world. Over the past several weeks, it has become even more apparent that markets are responding to the likelihood of the Fed employing more monetary stimulus rather than to fundamental strength or weakness. Bad economic news has become good for equity prices. In recent weeks, relatively rare positive economic news has typically led to stock market declines, whereas stocks have risen aggressively on days following downbeat announcements. Investors clearly prefer weak conditions that raise the likelihood of additional Federal Reserve assistance. While not a healthy or ultimately sustainable state of affairs, it has been the path to stock market advances for the better part of the past decade.

Governments around the world began the greatest ever episode of money creation to rescue their respective economies from the Financial Crisis and Great Recession. In the last two years, most central banks have expressed their intentions to “normalize” interest rates and to reduce their bloated balance sheets, the result of the unprecedented money creation process.

Despite the best of intentions, 2018’s negative market reactions demonstrated that investors were not ready for “normalization”. Virtually all major world equity markets provided negative total returns in 2018, several by double digits. As central banks tried to reduce their balance sheets, interest rates rose and bonds also produced negative total returns. Consequently, central bankers have given up “normalization” and have returned to the abnormal conditions that have rewarded investors for the past decade. That has led to powerful bounce-backs by both stocks and bonds so far in 2019. While several major U.S. stock market indexes are close to all-time highs, the main contributors have been a relatively small number of very large companies selling at extremely high price-to-earnings multiples. The average stock’s progress has been far less impressive. The New York Stock Exchange Composite Index, which includes all stocks traded on that exchange, is still below where it was in September and January of 2018, about 9 and 17 months ago respectively. Powerful rallies and declines have essentially offset one another with no net gain for the past year and a half. Most foreign equity markets are even further below their respective former highs.

On the fixed income side, the story has been much the same. This year’s bond market rally has simply offset rising interest rates that characterized the prior two years. From the interest rate lows in mid-2016, annualized total returns on intermediate U.S. Treasuries have been 1% or less.

Weak economic conditions are exacerbated by ongoing extreme levels of stock market overvaluation and excessive debt. Despite severe overvaluation for several years, stocks have been able to rise with central bank support. It is important to recognize that prior to this decade, however, equity purchases made near these heights of overvaluation in the past 130 years have experienced losses or minimal positive returns over subsequent 7 to 12 year spans. And the existence of historically high amounts of debt worldwide increases the risk should any of the many economic, military or political uncertainties eventually undermine investor confidence.

Seeing that equity price rewards come from anticipating ongoing central bank stimulus rather than sound fundamental economic growth puts investors in a very difficult position. To make money, they have to assume positions that historically have been punished but which have recently remained productive because central bankers continue to provide relatively free money, pulling consumption forward and passing the resultant debt along to our children and grandchildren. The question: Should investors bet on the Fed and other central bankers’ ability to push equity prices even higher despite deteriorating economic fundamentals? No one knows the correct answer to that question, but every investor has to weigh the probability of a continuation of central bankers’ past success versus the consequences of markets reverting to long-term levels of normal valuation.

The answer to the question is not likely to determine simply whether stocks rise or fall 10% or so in the years ahead. Since the Great Recession, trusting central bankers has produced far higher returns in most years. On the other hand, in the first decade of this century, the U.S. equity markets suffered two declines of 50% or more because of extreme overvaluation and excessive indebtedness. We have solved neither of these problems. The government rescue that provided the powerful equity results of the past decade has, in fact, magnified the debt problem. And fundamentally, using normalized five-year averages, the U.S. is today running at lower measures of GDP, productivity and wage growth than those that led to the Great Recession more than a decade ago. And the current market is more overvalued than it was at the 2007 market peak before the 57% collapse that took away 13 years of stock market price progress.

U.S. investors have become complacent because, as destructive as the 2000 and 2007 bear markets were, the government was successful in rescuing the economy and the markets, and prices today are substantially higher. A sobering reflection, however, is that the current environment resembles Japan in the late 1980s more than the U.S. in the late 1990s. Markets today are not rising on new era enthusiasm like that which characterized the dramatic evolution of the internet at the end of the century. Today’s market advance is much more a result of confidence in central bankers providing gobs of free money and underwriting risk assumption, as was the case in Japan in the 1980s. At its peak, the Nikkei was the largest stock market in the world. Almost inconceivably, that market fell by more than 80% and 30 years later is still over 40% below its 1989 high.

Markets may or may not behave as they have in the past, but precedent is a safer bet than the unprecedented. Should central bankers remain in control for a while longer, equity investors who continue to profit will still have to make a timely sell decision to retain those profits, unless central bankers are also able to eliminate the business cycle and keep prices elevated above current levels.

As indicated earlier, the vast majority of Wall Street firms are mildly bullish and are not forecasting an imminent recession. They never have. Goldman Sachs, however, notes that its historically accurate quantitative Bull/Bear Market Indicator recently registered a greater degree of risk of a bear market than that before the two prior bear markets in this century and is at the highest risk level in 50 years.

Every investor needs to weigh carefully his/her/its ability to withstand a significant and potentially long-lasting equity market decline against the desire to maximize returns in the years immediately ahead. The past decade has demonstrated the durability of profit potential, but current conditions are unique and fraught with uncertainty and risk.