Quarterly Commentary 3rd Quarter 2019

Over the past year, the major factors affecting stock market movement—expectations of Federal Reserve policy and administration comments about the China trade disputehave remained largely the same. What has changed is that market reactions are unfolding in an increasingly compressed time frame.

At the long end of a three-year process of Fed interest rate “normalization”, the stock market announced its unwillingness to tolerate any further increase in short-term rates with a decline of 20% from the beginning of 2018’s fourth quarter through Christmas Eve. The decline covered almost the entire three months. The Fed then announced “patience” as a replacement for its “normalization” policy, and the market recovered its fourth quarter loss in just over four months.

A rapid 7.5% decline in May of this year began in response to President Trump’s threat to hike tariffs on $200 billion of Chinese goods. Many investors were surprised, because U.S and China negotiators had previously indicated that a deal was in the works. This decline and a bit more were recovered by late-July, which marked all-time highs for most major U.S. equity indexes.

From that peak, stocks fell by a sharp 6.5% in a single week, beset by a combination of new tariffs on Chinese imports and disappointment when the Fed cut rates by less than investors had expected. Most of that decline was recovered by mid-September.

The sharp ups and downs of the third quarter left major stock market indexes relatively unchanged—some up, some down, but none by much. As I write two weeks into the new quarter, most major averages are down slightly, but the beginning of the fourth quarter has been explosive on a day to day basis. Mixed with some surprisingly weak manufacturing and non-manufacturing data, rumors about reduced expectations on the trade front cost the Dow Jones Industrials 1,300 points from Monday, October 1, through the first hour of trading on Wednesday, October 3. Trade prospects experienced positive revisions, and the Dow rose about 900 points over the next two and a half days through mid-day Monday, October 7, only to fall about 500 points through Tuesday’s close. A handshake agreement on Phase One of a trade agreement produced a 600-point rally into the week’s close. The rally was stronger until trader skepticism about the deal’s lack of specifics cut 200 points off the Dow in the last few minutes of the week.

Clearly, the action of the first two weeks of the quarter does not represent fluctuating opinions of true investors. It is instead the footprint of what has come to dominate markets in recent years—short term traders, often computers programmed with algorithms designed to react to news headlines.

To a firm like Mission that bases investment decisions largely on fundamental conditions, these volatile market gyrations are nothing more than noise that will produce little or no long-term effect. We are far more attuned to the fact that all major international forecasting bodies—IMF, World Bank and OECD—see U.S. and global growth slowing in late-2019 and 2020. The latest Federal Reserve minutes talked about greater risks to economic growth both domestically and internationally. The Fed’s long-term U.S. growth forecast is for a minimal 1.9% GDP growth rate. On top of that, corporate earnings for all U.S. companies have declined from their peak in mid-2018 and are expected to decline on a year over year basis in both this year’s third and fourth quarters.

It’s hard to reconcile a slowing economy and declining earnings growth with equity valuations second only to those in the turn-of-the-century dot.com mania, from which stock prices declined 57% over the next nine years.

On the other hand, the last decade has shown that central bank stimulus can overcome economic weakness as long as the investment community continues to believe that those central bankers will remain both willing and able to keep stock prices above historically normal valuation levels. While the New York Stock Exchange Index, which includes all stocks traded on that exchange, is below its high of January 2018, 21 months ago, it is only a few percent below that high. Investors have largely put their faith in the Fed. Looking at Europe, however, could provide reason for concern. Despite even more aggressive stimulus by the European Central Bank, the Eurostoxx 50 Index, Europe’s leading blue-chip index, is still well below that index’s peak, set almost two decades ago in 2000.

The Fed, ECB and Bank of Japan are all expected to continue providing additional stimulus in their attempts to ward off recession. That prospect leaves investors throughout the developed world in a quandary. Should they trust that central bankers will remain in control, as they have for the past decade? Or will underlying economic fundamentals, as they always have before, lead stock prices to revert to historic valuation means that are far below today’s price levels? How that question is resolved will likely determine investors’ economic well-being for a decade or more.


Rein In the Fed

Would you borrow from your children to solve personal financial problems if you had no realistic way ever to repay them? If you knew it would leave them financially weakened and less able to live as well as you do now? We as a society are doing exactly that to our children as we allow the Federal Reserve and politicians of both parties to borrow from tomorrow to bail us out of past overindebtedness and to live more comfortably today.

Few see this as a moral issue. Without question, it is! Americans are happy to accept political and monetary largesse with scarcely a thought about the negative impact it will inevitably have on subsequent generations. Centuries of history argue convincingly that debt levels, even well below ours today, have almost invariably been punished by extended periods of sluggish economic growth, often accompanied by significant securities market losses. Those consequences will be felt most egregiously in coming decades.

Current legislators could take a major positive step by reining in the Federal Reserve Board. Through its first 95 years, the Fed acquired a balance sheet of a bit more than $800 billion. To bail the U.S. out of the 2007-09 Financial Crisis, the Fed abandoned all financial discipline and exploded its balance sheet to about $4.5 trillion through a series of money printing episodes. In its more recent attempts at “normalization”, the Fed has raised interest rates from the zero bound and gradually reduced the balance sheet by nearly $1 trillion. Investors, however, have rebelled against the withdrawal of monetary ease with sharp stock market selloffs. And the Fed has apparently conceded defeat, trading “patience” for preemptory easing. That concession makes Wall Street happy, and makes it convincingly clear that the Fed has indeed adopted a third mandate in addition to its Congress-dictated duo of maintaining a stable currency and maximizing employment. Inflation of 2% per year now masquerades as stability. And maximizing employment provides cover for virtually any Fed action to manage the economy. It makes no sense to invest any small group of primarily academics and regulators with the power to exercise massive influence on the domestic and, in turn, world economy. Rarely, if ever, does the Fed have even a single member who has ever successfully run a major corporation, much less has the credentials to guide the world’s largest economy. The Fed’s assumed third mandate leads them to make decisions far beyond their areas of experience and competence.

Allowing the Fed to wield the power it now has is also creating massive stock market distortions. So much market reaction flows from Fed proclamations that analysts spend an inordinate amount of time attempting to interpret the slightest variations in language or attitude of Fed voting members. For many strategists this deciphering has become even more important than the analysis of underlying fundamental conditions. That dynamic becomes blatantly obvious when we see markets surge on an announcement of disappointing economic news, as the prospect for more stimulus increases.

The single most effective antidote to the recent circus of political attacks on the Fed, a 180 degree Fed policy turn and investment strategists’ guessing game about upcoming Fed easing would be to establish a transparent rule-based system to determine monetary policy. Such a system would almost certainly be preferable to the frequently flawed Chair-led decisions heavily influenced by personal perceptions and biases. The arguments against relying on a rule-based system typically involve pointing out how such a system would likely have led to an arguably unacceptable monetary position in one or more instances– as if the existing system itself has not placed the country in an extremely dangerous position. If a rule-based system appears imperfect, improve the rules. Clearly, each voting member of the Fed relies on his or her own set of rules in making monetary decisions. Those rules are not, however, publicly known, so we are left to speculate on how voters, especially the Chair, will make their decisions. The securities markets would be far better served if analysts knew the rules on which monetary decisions would be based. Strategists could then abandon the psychological analysis of voting members and their probable decision-making patterns and return to an analysis of how the data align.

Notwithstanding the best of intentions, the Fed in recent years has bet America’s future on a flawed (now failed) experimental monetary policy. Until we speak up loudly, we remain at risk of continued experiments further decimating the future economic prospects of our nation and coming generations.

Congress needs to step up now to rein in Fed power.


Will Fading Forecasts Change Investors’ Behavior?

Our July Quarterly Commentary, released last week, highlighted that U.S. corporate earnings peaked in 2018’s third quarter. GDP data announced Friday indicated that second quarter corporate profits posted their largest annual decline in several years. Q2 marked the third consecutive quarterly decline, off 7% from year ago levels. In the annual GDP revisions, operating profits were lowered by significant amounts for both 2017 and 2018. According to the GDP data, there has been no growth in U.S. operating profits for the past five years. Remarkably, the S&P 500 has advanced by over 50% during the same time period. The Fed’s newly created money has obviously found its way into stocks and bonds, not into the economy, ostensibly the target of the Fed monetary policy.

Economic and corporate profit growth have been similarly sluggish in most of Europe, but European stocks have shown a far more logical relationship to the weak underlying fundamental conditions. Stocks surged when the European Central Bank (ECB) initiated its Quantitative Easing (QE) policy in early 2015, but, unlike in the United States, stock prices subsequently reflected weak economic conditions rather than central bank stimulus. The Stoxx 600, a broad European index, is 6% lower today than in April 2015.

The Fed, ECB and other major central banks are now expected to employ looser monetary policies beginning this week. Even factoring in that expectation, the vast majority of economists anticipate both 2019 and 2020 to show weaker economic growth than 2018. Last Thursday, Reuters announced the results of its poll of over 500 economists taken this month. The growth outlook for nearly 90% of almost 50 world economies was either downgraded or left unchanged for both this year and next. In answer to a separate question, over 70% of about 250 economists now anticipate a deeper global downturn than they previously expected.

If these economic forecasts prove accurate, the question facing investors is whether stock prices will nonetheless advance because of central bank stimulus, as they have for years in the U.S., or decline in concert with fading economic conditions, as has been the case in most of the rest of the world.


Quarterly Commentary 2nd Quarter 2019

“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.


Quarterly Commentary 1st Quarter 2019

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.


The Silliness of Financial Commentary

Nothing very serious here. Just a few musings on the silliness of some of the nonstop commentary we hear on financial TV.

Wall Street commentators have a large bag full of descriptions and definitions that defy common sense. One that has gained great currency over the past couple of decades is the definition of a stock market correction or bear market as, respectively, a 10 % or 20% decline from a cycle high without regard to elapsed time. Even more absurd is the treatment of those phenomena as places rather than processes. It’s not uncommon to hear a TV commentator exult that a stock market average exits a correction or a bear market if it rises to levels less than 10 % or 20% below its cycle high. Obviously, it could go back below such levels in a day or two and conceivably could descend much farther. The correction or bear market begins at the price peak and lasts until the tough is reached, notwithstanding vacillations above and below 10 % or 20% levels. The decline is a process, not a location.

The absurdity of such a quantitative definition becomes apparent if one examines the reverse concept of a bull market indicated by a 20% or greater rise from a prior low. The greatest stock market loss in US history was the 89% decline of the Dow Jones Industrials from September 1929 to July 1932, a period of 34 months. How many BULL markets would you expect to have encountered in a span of time that erased 89% of investors’ equity assets? Most people would say “none”. In fact, based on closing prices, there were five advances of 20% or more. Were they bull markets? Not likely.

That brings me to the concept of surprise statistics. Financial commentators would do well to ask their elementary school children to define “surprise”. Even the youngest could tell them that it’s the experience of something unexpected. As this quarter’s earnings season moves toward its close, it strikes me as humorous to have read a research report describing the percentage of earnings surprises as slightly higher than the norm (about 67% beating the consensus of analysts), yet the amount of the surprise typically was below the norm of about 3%. How surprised should we be when almost 2/3 of corporate earnings reports typically come in above the consensus of analysts by an average of about 3%? That’s hardly a surprise; it’s an expectation born of experience.


Quarterly Commentary 4th Quarter 2018

2018 proved to be a difficult year for investors throughout the world. Nothing performed well, and there were very few places to hide. In the United States, the majority of stock indexes reached all-time highs in January, only to suffer sharp declines over the next two months. A negative first quarter accompanied by worrisome foreign economic slowing led many to fear that the nine year bull market was coming to a close. However, the miracle of copious, nearly free money from the world’s central banks as well as a substantial domestic tax reduction revived the U.S. market, which climbed persistently to a new all-time high in early October. From there, equity markets assumed an entirely different complexion, with most indexes falling aggressively by almost 20% to the late-December lows. A rally in the last few days of the year left the S&P 500 down by 13.5% for the fourth quarter and 4.4% for the full year. Foreign markets fared even worse with the composite of world indexes excluding the U.S. down for the year by 14.1%.

Unfortunately, fixed income markets offered no productive counterbalance to the equity storms. Domestically, the Barclay’s Aggregate Bond Index provided a zero total return, and most foreign bond markets finished well into negative territory.

In a pre-Christmas email to clients, I indicated that those for whom we have full asset allocation responsibility had nothing to worry about over the holidays. Their portfolios were up both for the sharply negative fourth quarter and for the full year.

An old Wall Street aphorism suggests that stock prices go up on an escalator and down on an elevator. The fourth quarter was testimony to that venerable adage. At its trough in late-December, the price decline had erased 26% of the nearly 10 year S&P 500 rise since March 2009 and 28% of the rise in the Nasdaq Composite. It is remarkable to note that a single quarter’s decline wiped out the price progress of the past 18 quarters for the New York Stock Exchange Composite Index, which includes all common stocks traded on that exchange.

There is no way to know at this point whether the fourth quarter marks the first leg down in a far more serious bear market or merely a brief but painful interruption of the bull market that began in early 2009. Clearly, the consequences of the former could have monumental import. The past two bear markets in this country have cut stock prices by half or more. The bull market that began at the March 2009 trough required historical governmental efforts to pull the domestic economy out of what former Federal Reserve Chair Ben Bernanke indicated was about to become a depression, absent extraordinary rescue efforts. In retrospect, that entire ten year rally resulted from the creation of yet another credit bubble. While the banking system and most corporations have boosted their capital levels significantly since then, the increased amounts of debt assumed by governments and corporations could present an extreme danger when the next recession inevitably hits.

Notwithstanding an appreciable decline in price-to-earnings ratios in the fourth quarter, a composite of all the major valuation measures still rests not far below all-time highs. The combination of still very high valuations and historic indebtedness domestically and internationally poses a potentially toxic mix in the next bear market.

While very few analysts are forecasting a recession in 2019, almost all analysts anticipate a slowing economy and sharply reduced corporate earnings growth. The World Bank recently indicated that global growth is expected to slow to a very sluggish 2.9% – perilously close to recession level for world growth. Domestic growth, which normally underperforms global growth because of the effect of faster growing emerging economies, is expected by the Federal Reserve to decline to 2.3% in 2019, 2% in 2020, and 1.8% in 2021. Over the long run, corporate profits cannot be expected to outperform economic growth by any appreciable amount. Historically, while earnings growth has been decelerating, as it is now, the stock market has tended to struggle.

Economies worldwide have begun to slow as central bank loose money policies have been tightened. It is eminently logical that halting the monetary generosity that has provided an unparalleled tailwind to economies and equity markets for the better part of a decade will challenge a number of the world’s economies that have yet to demonstrate the ability to grow without central bank support.

The powerful fourth quarter stock market declines in both the U.S. and China prompted their respective central bankers to offer soothing assurances that looser policies may once more be forthcoming should stock prices fall far enough. Having allowed debt to rise to unprecedented heights, central bankers appear unwilling to let markets, economies and interest rates adjust to their natural levels. Elevated interest rates would lead to unsustainable debt service burdens for many highly leveraged governments and corporations. Additionally, a significant recession could lead to the demise of many companies whose credit ratings have declined to junk bond levels. At the risk of promoting even larger debt burdens, the Fed and other central bankers appear unwilling to allow their respective markets, economies and interest rates to function unaided.

Relative to the question of danger from excessive debt, Fed Chair Jay Powell spoke tellingly earlier this month before the Economic Club of New York. Asked about the ballooning amount of U.S. debt, Powell answered: “I’m very worried about it . . . The long-run FISCAL NONSUSTAINABILITY of the U.S. federal government isn’t really something that plays into the medium term that is relevant for our policy decisions.” [However], “. . . it’s a long-run issue that we definitely need to face, and ultimately, will have no choice but to face.” In other words, according to Powell, the very financial survival of the U.S. government is ultimately threatened by the ballooning U.S. debt. Yet current conditions are so fragile that Powell and his fellow Fed governors may be approaching the point at which they may reestablish the loose monetary policies that have already magnified the debt. Investors face the question: at what point does this debt burden becomes a front burner issue? Centuries of history, as recounted in copious detail by Carmen Reinhart and Ken Rogoff in “This Time Is Different”, demonstrate that excessive debt always ultimately calls countries to account, sometimes with destructive economic and securities market consequences. The United States and many other countries have already passed the level of debt relative to the size of the economy that has typically triggered dire negative consequences down through the centuries.

Supplementing the problems of excessive debt, overvaluation and slowing economies is a broad array of economic and political uncertainties: Brexit, riots in France, trade disputes with China and other countries, North Korean nuclear arms, the Mueller investigation, seemingly irreconcilable differences in U.S. political philosophies and the ongoing U.S. government shutdown.

Many of these concerns were cited as reasons for one of the worst Decembers and fourth quarters in U.S. stock market history. By December 24, the markets were severely oversold. From there, a dramatic bounce-back rally closed the year and continues into the new year as this is written. Rallies this powerful normally lead to even higher prices over the ensuing six months, not, however, on an uninterrupted path. Almost always, prices retreat to test the earlier low. Complicating this history is the previously mentioned fact that stocks typically struggle when corporate earnings growth is decelerating, as it is currently. Additionally, the prevalence of algorithmic and other computerized trading has made some historical patterns less predictive, especially in the short run.

Of utmost importance is correctly choosing the long-term investing path to follow. In recent years, we have characterized the choice that all investors (as contrasted with short-term traders) must make as a “bet”. One alternative is to remain relatively fully invested in equities, trusting that central bankers will continue to provide loose monetary support whenever stocks threaten a significant decline. Such central bank actions have promoted one of the longest stock market rallies in U.S. history, so far only briefly interrupted by 2018’s fourth quarter losses. The second alternative is to trust that stocks will ultimately revert to their long-term fundamental means, as they always have throughout every decade prior to the most recent ten years. Should such a price reversion occur quickly, stock prices would plummet, as they have twice since the turn of the century. With debt having risen to current levels, recovery from such a decline could likewise take longer than ever before.

In this uncertain environment, Mission continues to employ its value-based investment strategies designed to pursue absolute rather than relative returns. In high risk environments, we hold a limited number of risk-bearing securities, increasing risk exposure when valuations become historically more attractive.

2019 offers the prospect of tremendous volatility as markets react to unfolding economic and political surprises. Great volatility offers the potential for great opportunity as valuation and risk levels rise and fall over a broad range. We will work to provide protection when needed and exposure to profit when favorable opportunities present themselves.


Quarterly Commentary 3rd Quarter 2018

In the third quarter, markets unfolded much as they had in the prior several months with a considerable level of calm prevailing in the major domestic investment asset categories. Beneath the surface, however, change was brewing and has broken out in the equity market in the beginning of the fourth quarter.

In late September, we were pleased to welcome clients and guests to our annual investment conference. As I try to do each year, I profiled the major forces that affected the markets and the economy in the prior year, and those likely to influence economic and investment activity in the period ahead. In this commentary, I will highlight the main points from the conference and will update market conditions, outlining risk and reward potential in each of the major asset categories.

Short-Term Cash Equivalents

As part of the bail-out of the major banks in 2008, the Federal Reserve brought interest rates effectively down to zero, where they stayed for seven years. Rates began a steady rise in late-2015 that continues through today. At its September meeting, the Fed raised its risk-free rate by another 25 basis points to the 2% to 2.25% range. They indicated their intention, subject, of course, to changing conditions, to raise rates by another 25 basis points in December, by three more quarter percent increments in 2019 and another in 2020. This increase in rates has been greatly beneficial for those unwilling to accept the risk of longer fixed income securities or equities. Many of those clients have asked us to manage assets exclusively in short-term, essentially risk-free securities. Using only government-guaranteed securities over the past ten years, Mission earned more than 1.6% per year above the risk-free rate. If the Fed stays on its intended path, short rates should continue to rise over the next two years. Short-term cash management will likely be more productive than investment in longer fixed income securities in the years just ahead, despite such longer securities having higher interest rate coupons today.

Longer Fixed Income Securities

With longer interest rates rising since mid-2016, the total return on US Treasury securities with maturities ranging from five to thirty years (combining interest payments and changes in bond prices) has been negative, with the loss on the longest bonds in double digits. Interestingly, junk bonds provided positive total returns over that rising interest rate period, and CCC-rated bonds, the lowest quality bonds just one step from default, provided the highest returns. That inverse relationship between quality and returns is indictive of the environment in which we have lived for several years. Investors accepting the highest risks, even risks that have typically been severely penalized, have reaped maximum rewards.
Many analysts are predicting that the next financial crisis will occur in the area of corporate debt. According to S&P Global, 37% of companies worldwide are carrying excessive debt. That compares with only 32% in 2007, just before the economy collapsed in a serious recession that Fed Chairman Ben Bernanke said would have turned into a depression without the government’s rescue. On top of the dangerous amount of debt on corporate balance sheets, the quality of that debt is declining. The median corporate credit rating has deteriorated to BBB-, just one notch above junk status. We now have the junkiest corporate bond market ever.

There is no way to know how long or how far interest rates may rise in this cycle. It is instructive to note, however, that in the last long rising interest rate cycle, risk-free cash equivalents outperformed any diversified longer fixed income portfolio for more than four decades from the early -1940s to the early -1980s. It could be a significant mistake to mandate a permanent portfolio allocation to longer fixed income securities in the years ahead, especially if inflation should begin to rise more virulently.


Although not uncommon, there are numerous conflicting bullish and bearish factors facing investors. By itself, each provides a rationale to be either excited by or fearful of equity ownership. I will profile bullish factors first.

• We are now experiencing the longest bull market ever.
• Domestic stock prices ended the quarter at or near all-time highs.
• In 2018, corporate profits are very strong, due largely to the substantially reduced corporate tax rate and the more generous depreciation allowance.
• Second quarter GDP growth was a strong 4.2%.
• The 3.9% unemployment rate is the lowest in years.
• Increased deficit spending has boosted economic growth.
• More infrastructure spending may be coming.
• Historically high levels of corporate stock buybacks are overwhelming stock issuance. This activity has provided a huge boost to stock prices, and 2018 is expected to be a record year for companies buying back their own stock.
• Some major central banks (European Central Bank and Bank of Japan) are still printing money. Money created anywhere easily crosses borders and helps to boost stock prices everywhere.
• Credit remains readily available.
• Interest rates are still historically low, although they are rising in many parts of the world.
• There will be lower taxes going forward for corporations and many individuals.
• Consumer and business optimism levels are extremely high.
• There is an abundance of corporate cash, although it is concentrated in a few huge corporations.
• Intermediate-term technical conditions are still positive. We have not yet seen the signs in supply and demand statistics and buying power and selling pressure patterns that normally appear a few months before a major market top.
• Central banks, like the Bank of Japan and Swiss National Bank, and sovereign wealth funds in oil rich countries like Norway, Kuwait and Saudi Arabia are large, powerful, non-price sensitive entities gobbling up equities around the world. They have staying power and are not accountable to stakeholders. There is no way to know how long they will continue to buy.

Wall Street analysts and strategists regularly point to many of these factors as justification for even higher prices in the months and quarters ahead. Needless to say, however, there are significant bearish factors as well.

• The current US economic expansion is already the second longest ever, nearly double the length of the average economic expansion. Some of history’s biggest stock market declines followed the longest economic expansions.
• The Fed continues to raise rates and reduce its balance sheet, which reduces the liquidity that has fueled the lengthy stock market expansion. A few weeks ago, Jeffrey Gundlach, the current “Bond King”, said: “We are doing something that almost seems like a suicide mission. We are increasing the size of the deficit while we are raising interest rates so late in an economic cycle.”
• Other major central banks are becoming more restrictive. The Bank of England has taken its first steps in raising short rates. The European Central Bank has said it will stop its quantitative easing at year-end and begin to raise rates some time in 2019.
• Longer-term interest rates are rising, which will make conditions tougher for the economically important housing industry.
• Higher interest rates will hurt corporate profits and possibly lead to bankruptcies for companies that are overleveraged.
• Geopolitical risks are extensive. J.P. Morgan Chase CEO Jaime Dimon recently warned about Brexit, flareups across Europe including Italy and Turkey, the Middle East and Latin America. The US has its own contentious interactions with longstanding European and North American allies, plus ongoing disputes with China, Russia, Iran, and North Korea — any of which could escalate to more troublesome levels.
• Equity valuations are near all-time extremes.
• Investor sentiment (a contrary indicator) is extremely optimistic.
• Domestic and global debt levels are at or near all-time highs. For centuries throughout the world, excessive debt has established the framework for some of the most severe economic and stock market declines.
• The quality of debt is deteriorating significantly.
• Trade disputes could become trade wars. Trade wars were a major contributing factor to the length and depth of the Great Depression of the 1930s. Many dozens of US companies have already complained of increased costs and reduced sales from US tariffs.

One major negative factor that we spent some time on at the conference was the diminishing likelihood of significant future economic growth, as measured by Gross Domestic Product (GDP). While there have been peaks and valleys, GDP growth has trended markedly lower for the past 70 years. And although the current economic expansion is the second longest in US history, it is the weakest in the post-World War II era. I have long argued that excess debt is the principal cause of declining economic growth. The record shows very clearly that as the ratio of US debt-to-GDP began to explode upward in the early 1980s, the rate of GDP growth began to plummet. That pattern has continued for almost 40 years. Ironically, in the financial crisis a decade ago, the Fed and other central banks around the world tried to solve a problem of excess debt by multiplying the amount of debt outstanding. Worldwide debt levels today are at all-time highs, which will likely penalize GDP growth for years to come.

While tax reductions have given a significant boost to 2018 economic and corporate profit growth, all well-recognized forecasters see this as the peak year with GDP falling off progressively in 2019 and beyond. The Congressional Budget Office (CBO), the Fed and the Wall Street Journal Survey of Private Economists see GDP growth this year coming in at 3.0% to 3.1%, then declining to 2.4% to 2.5% in 2019. The Fed’s estimate of the long-term US growth rate is a mere 1.9%. The European Central Bank’s growth estimate for the Eurozone is an even less lustrous 2.0% this year and 1.8% next. Notwithstanding strength in corporate earnings this year because of the tax reduction, it is important to recognize that corporate earnings on average do not grow much more than a couple of percent more than GDP growth.

It is hard to imagine stock prices remaining anywhere near current levels if GDP and corporate earnings growth fall off as forecasted. Stock valuations are priced for perfection with a composite of the most commonly used valuation measures just below the highest levels of all-time, the period around the dot.com mania at the turn of the century. That valuation extreme was penalized by a 50% decline in the S&P 500 index by 2002 and a total of 57% down from the 2000 peak by early 2009.

At the end of my conference presentation, I showed a graph of the Japanese Nikkei index from the mid-1980s to present. In the 1980’s, Japan’s economy was the envy of the world, thought to be the embodiment of the new industrial paradigm. Japan’s stock prices powered upward through the decade and, in 1989, its stock market was the world’s largest. I included this graph, not as a forecast, but rather as a caution. With the government standing strongly in support of its banking system and general economy, few thought that any significant harm could befall investors in Japan. That confidence turned out to be badly placed.

The Nikkei peaked on the last trading day of 1989. It declined by more than 60% in less than three years, eventually more than 80% to its ultimate bottom during the 2008 financial crisis. Even with the subsequent worldwide rally, the Nikkei today, nearly 29 years later, remains more than 40% below its 1989 high.

The purpose in showing this depressing precedent was to shake attendees from the complacency born of dramatic recoveries from the two traumatic bear markets so far in this still young century. The US barely escaped depression a decade ago because of an unprecedented government rescue, which has left the country massively indebted. Rescues from inevitable future recessions may be far more difficult to engineer.

The environment remains problematic for investors and investment managers alike. As indicated earlier, if the Fed’s forecasts prove even reasonably accurate, intermediate and long fixed income securities will have a difficult time providing even minimally positive total returns. High quality, short-term cash equivalents will provide a growing, but still not exciting positive return. Those willing to assume the serious risk attendant to common stocks at these levels of overvaluation in a late cycle economy laden with historically high levels of debt can still profit so long as sentiment holds up and central bankers signal a willingness to prevent equity prices from declining too significantly. As a deep discount value firm, Mission will always look for strategic opportunities. In the meantime, we will maximize safe returns while awaiting more attractive valuations before committing a substantial portion of assets to equity positions. The potential for a severe, long-lasting decline beginning in the next year or two is extremely real.


Quarterly Commentary 2nd Quarter 2018

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.


Quarterly Commentary 1st Quarter 2018

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.