Newton's Law of Inertia

Why does the stock market continue to rise? 

It seems like the market has been rallying on news of tax reform since Trump’s election win in November, 2016. Sure, tax reform is one reason for the rally, but we’ve known about that for months.  Corporate earnings have been strong, but not abnormally so.  Economic growth has been good, but not dramatically above average.  Lately it seems that the stock market simply goes up for no reason at all. 

Isaac Newton’s first law of motion may give us the answer.  Newton’s law of inertia states (paraphrased) that “an object put into motion will remain in motion unless acted upon by an outside force.”  Simply put, the stock market is going up because it has no reason not to.  It will remain in the uptrend until acted upon by an outside force.  The law of inertia was always my personal favorite of Newton’s!

What may cause it to end?

What ‘outside forces’ could halt the motion?  The obvious suspects like war and terrorism are always possible.  Bad corporate earnings could cause a reversal, but that’s unlikely in light of the new tax reform.  International concerns like we saw from Greece in 2012 or China in 2016 could spook investors.  Higher interest rates could become problematic.  Either way, at some point, an outside force will stop the trajectory of the market.  Until that time, however, let’s continue on the assumption that the market will remain in motion. 

When might it end?

The economy generally follows a pattern of expansion (early cycle), peak (mid cycle), contraction (late cycle), and trough (recession).  Equity performance tends to be best from the trough to the peak.  With that said, it does appear that we may be transitioning from the peak (mid cycle) to the late stages of the business cycle.  The business cycle is generally more predictable than the stock market, but that’s not super helpful because it tends to be a lagging indicator.  In other words, the stock market tends to head south before the actual economy does.  I believe we are seeing the early stages of a rotation into “late-cycle” dynamics. 

Generally, in the later innings of the business cycle we begin to see sectors like Utilities and Real Estate underperform the general stock market as interest rates increase.  On the other hand, we see the outperformance of sectors like Energy and Materials.  The Energy sector is often a classic late-cycle indicator.  Fidelity’s paper The Business Cycle Approach to Equity Sector Investing researched performance of each sector throughout various business cycles and stated, “Looking across all three analytical measures, the Energy sector has seen the most convincing patterns of outperformance in the late cycle, with high average and median relative performance.”  As the economy matures, the Energy and Materials sectors often see the biggest gains from the heightened demand and benefit from increased inflationary pressures.

According to Fidelity’s research, once the market enters the later phase of the business cycle, which generally lasts a year and half, stock market performance slows.  However, the performance is still positive, averaging roughly 5% on an annualized basis.

In the last thirteen weeks the best performing sector in the market is…. Drumroll…. Energy (+16.32%) as of 1/23/18, measured by Morningstar research.  The worst performing sector over the same time is…. You guessed it….Utilities (-7.54% courtesy of Morningstar), followed by Real Estate (-2.78%).  It appears that a changing of the guard is taking place, and it’s pretty easy to make the argument that we are entering the later stages of the business cycle.

The Problem with Predictions...

A Bullish Call

Wall Street's Seers Forecast More Gains for Stocks Next Year.

Indeed, the dozen seers we've surveyed all have penciled in higher stock prices (for next year), although their estimated gains vary widely, from 3% to 18%. On average, the group sees the Standard & Poor's 500 … about 10% higher

-Barron’s Magazine

 December 17, 2007

 

Wall Street analysts missed it in 2008.  By about 47%.

It’s that time of year again.  The time when investment gurus from big investment firms such as Goldman Sachs, JP Morgan, Merrill Lynch, Bank of America, etc., make predictions about the coming year.  Allow me to save you some time.  They’re optimistic.  They’re always optimistic.

Every. Single. Year. Since 2000, the consensus of Wall Street analysts has been bullish.  The average return for stocks predicted by Wall Street firms was 9.5% each year according to research done by Bespoke Investment Group as reported by the New York Times.   Not once has the consensus predicted a down-market, even though there have been five such instances over that time frame for the S&P500.  

Salil Mehta is an independent statistician who was formerly the director of research and analytics for the United States Treasury’s Troubled Asset Relief Program and for the federal Pension Benefit Guaranty Corporation.  Mehta studied the public forecasts of Wall Street firms going back to 2000, 186 in total.  92% of the forecasts called for positive year in the market.  Only 8% called for a negative year. 

The worst three years in terms of market performance over the past 18 years were 2001, 2002, and 2008, with returns of -12%, -22%, -37% respectively.  Collectively, there were 23 forecasts released from the Wall Street firms during those three years.  Not one of the 23 forecasts called a negative year.  The forecasters were 0 for 23 on the direction of the market, let alone the actual performance!

So, in summary, be careful what you read about market forecasts for 2018.  No one knows what 2018 holds; just like no one forecast the bursting of the dot-com bubble in 2000 or the mortgage crisis in 2008.  In light of that, we maintain that the best investment strategy for 2018 is to remain diversified, focus on yield rather than growth, and react to changing conditions as the market dictates. 

We remain cautiously optimistic, but fear that much of the good news about the economy is already baked into the recent runup in prices.  At some point, news of the tax reform will subside and investors will look for the next market catalyst.  Perhaps they will find one, perhaps not.  Either way, my personal forecast for 2018 will likely be no better than the large Wall Street firms.  And I’d rather not be wrong in writing.

That Eerie Silence

My home is humming with life most of the time.  My wife Christen and I have two sons (14 and 11), three dogs (Bailey, a maltipoo;  Maggie, a snoodle;  Lieutenant Dan, a three-legged mutt), and a cat (Mr. Hemingway).  Among the eight of us, there is almost always a buzz of activity and noise.   It’s only when things get quiet that I become concerned…

To say that things have been quiet in the market lately would be an understatement.  It’s eerily quiet.   With November’s close, the S&P 500 has now gone higher every month for 13 consecutive months.  The longest stretch for consecutive “up” months is 15 months in a row during 1958-1959. The truly strangest part of the rally has been the calmness of the upward ride. 

From 2010 to 2016 the S&P 500 had 417 trading days in which the index went up or down by at least 1% or more.  That’s an average of roughly 60 days per year of at least a 1% swing.  So far, in 2017, we’ve had exactly 10 such days, the lowest reading since 1965.  Politically, this year has been anything but calm, but markets have continued to ignore the headlines and have moved higher month after month.

The calmness isn’t confined to the US.  The Wall Street Journal provides daily data on forty stock markets around the world. Thirty-nine of the forty are “up” on the year.  The only exception is Israel, which is down 2.4% as of 11/28.  And it’s not just stocks.  Fifty-five of the fifty-seven bond indices reported by the Wall Street Journal are positive this year (bond indices in Germany and the Netherlands are down less than 1%).  Everywhere you look, it’s as if risk has disappeared.  It’s… eerie. 

Employment numbers in the US increased for 83 consecutive months before being derailed by the hurricanes in September.  Still, the number of months set the record for the longest consecutive streak of job growth in US history.  Retail sales for Black Friday also set records, and Adobe Analytics forecasts that online retail sales will surpass the $100 billion threshold for the first time ever. 

We will all likely look back on this time as a uniquely nice, but strange, anomaly.  We are currently living in the “good ole days” of the market.  It’s enjoyable.  It’s kind of boring.  It’s eerie.  And it may even last a bit longer… but it’s also somewhat concerning.

Source: MFS “By the Numbers” November 27, 2017             

And the Winner is...

Welcome Jerome Powell

Donald Trump recently unveiled his nominee for Chairman of the Federal Reserve.  Pending Congressional approval, Jerome Powell will replace Janet Yellen as the next Chairman of the Federal Reserve… which is a pretty big deal.  Aside from the President himself, a strong argument could be made that the Chairman of the Federal Reserve is the second most influential job in the country.  Former Chair Ben Bernanke illustrated such by being named TIME Magazine’s Person of the Year in 2009.  He was also named the 6th most powerful person in the world by Forbes.  The Pope was Number 5.

The Fed

The Federal Reserve (Fed) is the central banking system in the USA.  Tasked with a “dual mandate”, the Fed has two primary goals:  pursue price stability and promote full employment.  It attempts to accomplish this by controlling interest rates, the money supply and bank regulation. The job requires delicate balance.  If the Fed makes too much money available too cheaply, inflation may increase; if it contracts the money supply or increases interest rates too high, it risks a slowdown with high unemployment.

Role of the Chairman

The Chairman of the Fed holds one of the twelve official votes that determine the direction of policies.  However, he or she exerts tremendous influence on the agenda by establishing which issues in the economy are worthy of discussion. 

The Federal Reserve system is designed to remain separate from politics.  After appointment, neither the President nor Congress can fire the Fed Chair.  The expectation is that the Fed will act in the best interest of the economy, rather than support the policies of any specific political party.  It doesn’t always work that way, as was the case in the early 1970s with Former Fed Chair Arthur Burns.  Many believe that Burns was instrumental in printing too much money for too long in an effort to stimulate the economy enough to get President Nixon re-elected.  The excessive money printing ultimately led to inflationary pressures in the late 1970s & early 1980s. 

Expectations from Trump’s Nominee

That brings us to today, and Trump’s decision to appoint Jerome Powell.  Most economists expect Powell’s approach to closely resemble that of current Fed Chair Janet Yellen.  During her term, interest rates have remained relatively low, and money has flowed freely, boosting the economy and the stock market.   

Sixty-four year old Powell has served as a board member for the Federal Reserve since 2012.  Prior to that, he held positions with various Wall Street investment banks, focusing on mergers and acquisitions.  He also worked for the US Treasury Department in the early 1990s.  The market didn’t respond heavily one way or the other to news of Trump’s nominee (which is encouraging).  Based on Powell’s appointment, our outlook for interest rates remains the same; we continue to expect interest rates to tick higher in a methodical way over the coming months. 

Time will tell more about Jerome Powell’s policies and outlook; in the meantime, he has suddenly become one of the most important men in the country.

Should We Hope For Tax Reform?

Headlines in coming weeks will likely focus on the details of the Republican plan for reducing taxes and reforming the tax code.  The logic behind the tax cuts is pretty straight-forward: reducing taxes will give Americans more money to spend, thereby increasing consumption and economic growth.  Most Americans tend to take that point for granted.  The main debate over tax reform generally shifts to “should the tax breaks go to the rich or the poor?” with various reasons for either side.

Rather than focus on the beneficiaries of tax cuts, let’s examine the idea of tax cuts as a whole.  Do they actually stimulate the economy? Furthermore, does the economy need stimulating?

Will a tax cut stimulate the economy?

In the 1920s tax rates fell from a top bracket of 70% to less than 25%.  Over that time, the economy improved, personal income rose, and the stock market boomed.  In the 1980s, President Reagan enacted dramatic tax cuts and again the economy improved, personal income rose and the stock market boomed. Simple, right?  Not so much.

President George W. Bush enacted tax cuts in 2001 and 2003 with disappointing results.  President Clinton actually increased taxes in 1993 and the economy experienced a tremendous boom.  Upon closer inspection, it appears that tax cuts and tax hikes tend to have to far less of an impact on the long-term economy than many realize.  In fact, from 1870 to 1912 the US had no income tax rate at all.  Contrast that extreme to the 1947-1999 timeframe when the highest marginal tax rate was 66%.  Still, the economic growth rate from 1870-1912 was identical to the growth rate from 1947-1990; 2.2%.

A detailed study titled “Tax Rates and Economic Growth” (by University of Rome professors Padovano and Galli, 2001) found that a 10% reduction in marginal tax rates, i.e. a pretty large tax cut, increased growth on average by 0.11% (minimal increase in economic growth) in the first year.  Another paper “Optimal Taxation of Top Labor Incomes” (Piketty, Saez, and Stantcheva, 2011) examines tax rates and economic growth from 1960-2010 in 18 different countries (mostly Europe, US, and Canada).  In the end, the research finds no direct correlation between tax cuts and economic growth.  In other words, sometimes tax cuts create growth, other times they don’t.

Will a tax cut stimulate the economy? Perhaps, but it’s less of a slam dunk than most want to believe.

Does the economy need stimulating?

Reagan’s tax cut in the early 1980s were very successful.  Why?  The tax cuts came a time when the US was coming out of a recession.  Interest rates were double digit in the US; unemployment was nearly 10%; stocks traded at a P/E ratio in the single digits!!  The tax cuts worked because we needed tax cuts. The same could be said for tax cuts in the early 1920s.  The unemployment rate in 1921 was more than 11%. (economist.com)  

Today, interest rates are near historic lows, the unemployment rate is below 5%, and stocks trade at all-time highs.  It’s tough to make an argument that the economy needs further stimulation.  Tax cuts are an important tool that can be used to help lift an economy from recession.  However, by enacting sweeping tax cuts now, we may not have the weapon to use later when we actually need it.

Finally…

Tax cuts should, by definition, bring in less tax revenue in the near term.  This means that the US government will be forced to run a larger deficit unless they cut spending (unlikely).  Because of the deficits, the government will borrow more money, going deeper into debt. While this likely doesn’t pose an immediate threat, it begs the question – does the government really need to borrow money to try and stimulate a perfectly good economy?

China Concern

The last five years have been good for most stock investors, with the Dow Jones Industrial Average gaining more than 60%.  Occasionally, I’m asked about risks that could derail this bull market.  The one big risk that I’m watching is China.   

On the surface, China may seem like an unlikely candidate to disrupt a bull market in the US.  China’s economy is still growing at an annual rate of over 6% (source: World Bank), and economic projections are that the growth rate will continue for the next several years.  History, however, suggests otherwise. 

Morgan Stanley’s Chief Global Strategist Ruchir Sharma recently wrote an interesting book titled The Rise and Fall of Nations.  In his book, Sharma points to China’s debt as a pressing concern.  “The amount of debt that China has taken in the last five to seven years is unprecedented,” he writes.  “No developing country in history has taken on as much debt as China on a marginal basis.”

It’s not so much the total debt burden, as it is the growth rate of debt that Sharma found to be the best predictor of which countries will go bust or at least experience dramatic economic slowdowns.  This month marks the 20-year anniversary of one such debt- fueled meltdown that’s worth considering.

Here is the brief story:

From the mid-1980s to the mid-1990s, Thailand’s economy grew at the fastest rate in the world.  Money flowed into the country from Wall Street as investors eagerly sought to benefit.  Mercedes sales in Thailand nearly tripled from 1992 to 1995, and the country briefly becoming the eighth largest market in the world for the luxury automobile maker.  Thai citizens developed a taste for the finer things in life, becoming the largest per capita consumer of 12-year-old scotch in the world in the mid-1990s.  

As the globalization movement of the 1990s caught on, Thailand began attracting the attention of major global companies eager to utilize the cheaper Asian labor.  Ford and General Motors were early pioneers, committing to Thailand projects of $500m and $700m, respectively, during that time. 

Literally, billions of dollars flowed into the country from similar foreign sources, some of it directed at plants and facilities; most of it, however, flowed into Thailand’s stock market or purchased speculative real estate in hopes of a quick return.  Thailand’s stock market and real estate market boomed.

In late 1996, the economy began to slow and the stock market weakened.  Headlines featured overleveraged companies struggling to meet their debt obligations.  By the summer of 1997, roughly 25% of all bank loans were either delinquent or in default.  Thailand’s stock market continued to decline.  The Thai currency began to weaken as well, as investors withdrew money from the country, and currency speculators placed bets that it would fall further.  The Thai government was forced to step in and buy the falling currency in an effort to prop it up.  The government’s currency reserves began to deplete.

In July of 1997, the government, having lost billions of dollars defending the currency, abandoned their strategy and allowed it to revalue.  Within hours of the announcement, the Thai currency (known as the baht) fell almost 20%.  It continued falling, losing 40% of its value during the next six months.  

The initial response from the US was muted, but as the crisis worsened, US markets took note, with the Dow falling 13% from August through October, 1997.  The final selloff in the US culminated in a flash crash in late October when the Dow fell 7% in one day, but recovered soon after.  As for Thailand, however, the damage to investors still remains.  The country’s stock market has yet to recover more than 20 years after the fall.  After peaking at 1,754 in 1994, the index sat at 1,561 in mid-August 2017. 

There are a few notable takeaways from the Thailand crisis.  The first is that unforeseen overseas drama can spill over into US markets and cause unanticipated losses.  More importantly, the Thailand crisis illustrates how an explosive growth in debt can derail a fast-growing economy.  According to Sharma, Thailand’s average annual increase in debt from 1992-1997 was the second highest growth rate ever recorded.  The record holder?  Present-day China, whose debt load has more than quadrupled in the last decade, growing from $7 trillion to roughly $33 trillion (Reuters). 

History is fraught with examples of countries that went on a debt binge and enjoyed years of outsized growth, but ultimately each suffered the consequences of a slowdown fueled by the over-leverage.  China may likely be no different.  Never before has a country increased its debt burden faster than China.  While a debt- fueled crisis is not imminent, it’s certainly worth watching, and it’s worth taking a moment to reflect on the 20-year anniversary of Thailand’s similar (although smaller) crisis that could be a model for future headlines. 

(Source: Rise and Fall of Nations, Ruchir Shamra, 2016)

Worth Watching

There are interesting forces at play that aren’t making headline news, but could significantly impact the economy and your finances.  A lot has been made of the healthcare debate on Capitol Hill, and admittedly it is a whale of an issue.  However, at this point, it doesn’t seem to be impacting the overall market, although healthcare stocks keep chugging higher, gaining about 18% thus far this year.  Rather than focus on healthcare reform, which won’t likely be resolved anytime soon, I’ll share some interesting dynamics at play that may have noteworthy influence on the economy.

Fed Unwinding the Balance Sheet

Remember back in the fall of 2008 when the Federal Reserve began buying lots of mortgages, bank debt and Treasuries, enacting something called 'Quantitative Easing'?  Over a six month period, the Feds bought about $1 Trillion worth of bonds.  The program appeared to work as the stock and bond markets began to stabilize.  The Feds pressed on and continued buying more bonds in an effort to keep the ship afloat.  In the investment world, we referred to each step of bond purchases as ‘QE 1’, ‘QE 2’, ‘QE 3’, and then we all stopped counting and started referred to it as ‘QE infinity’ (true story). 

All those bond purchases over the years added up to around $4.5 Trillion in assets that the Federal Reserve now holds on its balance sheet.  By purchasing the bonds, the Fed essentially created $4.5 Trillion worth of demand that didn’t exist before it began buying the bonds.  This has helped keep interest rates low over the past nine years.  Now that the economy is on more stable footing, the Fed has decided to begin unwinding its holdings and slowly sell these bonds back in the open market in an orderly fashion. 

The unwinding of the Fed balance sheet is set to begin later this year.  If all goes well, it will likely become an irrelevant side note to the saga that was the Great Recession.  Still, many investors are watching closely to see how bond prices may be impacted.  In essence, the Fed is about to add a whole lot of new supply to the bond market.  According to basic economic theory, adding excess supply can lead to falling prices.  Demand for the additional bonds may be adequate to make up for the additional supply and, if so, prices may remain flat.  We shall see.  From an investment standpoint we don’t recommend making major allocation changes based on this possibility, but our stance may change as the unwinding begins.

Weak Dollar

Back in February I wrote that the US dollar was at a 14-year high relative to other currencies.  That has changed as the US Dollar has weakened dramatically since then.  Year to date, the dollar is now 8% lower against a trade weighted basket of currencies (Bloomberg).  This is a bad thing for international travelers (because their dollars buy less as the dollar weakens), but it could be a nice tailwind for multinational US companies that sell their goods overseas.  As the dollar weakens, it makes US products less expensive, and thus more appealing to international consumers.  In theory, this should help American companies sell more shampoo, toothpaste, jets, hamburgers, etc., to consumers overseas.  Morgan Stanley analysts project that the weak dollar could add as much as 6.5% to net earnings estimates for next year, which would be a nice unexpected surprise.

We continue to be cautiously optimistic on the US markets, but haven’t lost sight of the fact that US stocks continue to trade at a notable premium, which generally isn’t a good thing for long-term returns.

 

Halftime

I hope everyone had a lovely 4th of July! 


As the first half of 2017 comes to a close I’d like to put things into some perspective and give a few thoughts for the second half.

Fact #1: Thus far, the largest pullback of the SP500 has been a little more than 2%.  According to Bloomberg, since 1980, the average annual pullback has been 14% at some point during the year.  In fact, there was only one year that didn’t experience at least one 5% pullback at some point: 1995.  In 1995, the worst pullback was only 3% all year.  

Odds are: we may see a 5%+ pullback in the second half of the year.

Fact #2:  Over the last 30 years, there have been 13 times when the S&P500 was up 6% or more in the first half.  In 12 of those 13 years the market went even higher in the second half.  The only year to post a negative 2nd half: 1987, when stocks fell more than 20% in a single day in October (source: CNBC).

Odds are: the second half of the year may finish with more gains.

Fact #3: US Stocks, Bonds and Gold prices all rose in the first half of 2017.  The same can be said for almost all major asset classes including real estate, emerging market stocks and bonds, high yield bonds, and municipal bonds.  To the surprise of most, in spite of Trump’s rhetoric, Mexican stocks were up 23% in the first half.  Didn’t see that coming!  The losers were Russia (down 11%), and oil stocks (down 14%).  (Source: Yahoo Finance)  

Odds are: investors should be pretty happy.

Fact #4: Oil prices fall by 14% during the first half of 2017, the worst start to a year since 1998 when prices were down 19% over the first half.   In 21 of the last 30 years oil prices have increased in the first half of the year.  In the 8 years previous instances that it decreased in the first half, it was a coin flip for the second half.  Four up and four down. (source: CNBC)   

Odds are: there are plenty of surprises in store for the second half of 2017.