Since the results of the presidential election this past November stock markets both here and abroad have been on quite a run. It’s been interesting reading the numerous alternative explanations in the financial press for what has caused the market to go and what might ultimately cause this rally to experience the widely anticipated and “long overdue” correction.
The idea that a business-friendly tax bill is on the relatively near term horizon is widely credited for the stunning rally since Trump’s electoral win. The “miss” by the Republicans on the first pass at repeal and replacement of Obamacare may have slowed that enthusiasm a little, but the market continues its grind higher nevertheless.
A Republican majority in DC may represent a more business-friendly environment than we have had in a while, but that’s probably only a part of the explanation for the extended rally. How much that “business friendly environment” explains higher stock prices is up for some debate. After all, getting legislation passed through a deeply divided Congress is yeomen’s work and we don’t know whether the new administration has learned to be effective at making that brand of sausage just yet.
Brian Wesbury, Chief Economist for First Trust has been optimistic longer than most… and he’s been right so far. Politics is part of the answer, but his thesis is more about productivity and real earnings growth. In his April 10 “Monday Morning Outlook” he writes:
“For the past eight years, the US economy has expanded on a wave of new technology. Fracking, 3-D Printing, composite materials and mapping the genome are huge. Bandwidth, the cloud, apps, smartphones and tablets are bigger.
Technology has never moved this fast. And while some analysts argue that productivity data are not improving, that is really hard to square with near record levels of corporate profits.
Jobs are growing. Incomes are rising. Profits are rising. The stock market is still undervalued. And inflation is on the upswing – not rapid, hyper-inflation – but a steady acceleration in prices is in the cards for the quarters and years ahead.”
His point is a good one. And, as we mentioned- he’s been right in the face of the inevitable pessimism that accompanies any 8-year (and counting) bull market. Lots of prognosticators have been waiting for the next shoe to drop for a long time and their arguments are often persuasive. The point is, the length of the rally doesn’t dictate when it must end; if we see continued prosperity and positive earnings, this rally can keep on going… much as that may sound difficult to believe this far removed from the last major decline.
But…as the old saying goes; “buyer beware!”
Several potential early warning signals are beginning to show. Of course, these are purely anecdotal so they aren’t necessarily harbingers of impending doom, but in the spirit of the reality that history rarely repeats but it often rhymes, the last several months have produced some data points that could be considered a little unnerving to anyone that was paying attention to the markets prior to the last two melt-downs.
- On April 10, CNBC published a note quoting Morgan Stanley’s new Chief U.S. equity strategist: “Morgan Stanley says huge 30% stock surge could be ahead; like 1999, ‘cannot afford to miss it.’ I found this profound since I have been telling folks this market felt like the late 1990’s for the last year. In the second part of this letter – “The Big Picture” – we observe similarly high broad market valuations based on historical earnings. The problem for investors is that risk aversion in those last years before a bust (i.e. going to cash and waiting for the break) can be more psychologically taxing than most can handle. Missing out on a 30% gain makes the most resolute question themselves and often give up on their investment discipline at just the wrong time.
- On the same day, Piper Jaffray analyst Alexander Potter upgraded Tesla to an “overweight” rating, raising his price target by 65% and saying “we sympathize with bears – but their (arguably rational) arguments probably won’t matter.” The most fascinating part of the story? He simultaneously reduced his earnings estimate for 2017 from a gain of $0.42 per share to a LOSS of $4.83 per share! Eerily reminiscent of the days of “alternative valuation” metrics that drove stock prices at the end of the tech bubble, like counting eyeballs and views instead of earnings. Tesla is a stock that hasn’t earned a dime yet, and is still heavily dependent on government subsidies for its existence…maybe they truly change the world, or maybe the optimism is a bit overdone?
- The proliferation of indexing is beginning to signal late cycle investor behavior. In the last 3 years, money flows into Vanguard are 8.5 times all other fund families combined! This represents an unprecedented level of dispersion. We often observe that an index fund is a spectacular tool, but it isn’t necessary a good strategy. Many investors have the two ideas confused and the inevitable effect of that seemingly indiscriminate use of indexing is a narrowing of market leadership; since the election Apple stock alone has accounted for about 10% of the total market gain. While absolute valuations still haven’t reached the crazy heights of the internet bubble, this is the same phenomenon those of us employed in the industry witnessed in the late 1990’s. Active value managers with decades of good performance were forced to shutter operations due to investor demand for growth and index funds, where asset flows continued to inflate cap weighted stocks in the index (dominated by technology names), which in turn attracted even more asset flows.
Interest rates are still hovering near all-time lows putting immense pressure on retirees, pension funds and other investors that historically counted on the relatively safe earnings streams from fixed income investments to finance spending needs. Those investors have been forced to employ strategies that have much higher allocations to stocks at a time when expected returns for stocks are near a cycle low, meaning the risk of loss of principle is high and rising.
Sitting in cash or even “safe” short term bond funds means near zero returns after inflation, but being in stocks brings risks of principal losses that can be insurmountable for many people living off of “systematic withdrawal” strategies from their savings.
At a time when measures of market volatility are languishing at very low levels, while market valuations are simultaneously high it makes sense to take a hedged approach to market exposure. Diversify your investments by both asset classes as well as strategies that can dynamically respond to changing market environments.
Simple math dictates that avoiding 100% of large losses means you don’t need 100% of the gains to grow your account values better than buy and hope. Just be sure that the strategies are well defined disciplines that don’t rely on instinct or emotion. Call us if you want to discuss what that looks like in more detail.
Information provided in this report is for educational and illustrative purposes only and should not be construed as individualized investment advice. The investment or strategy discussed may not be suitable for all investors. The S&P 500 is an unmanaged, weighted index of 500 stocks providing a broad indicator of price movement. Individual investors cannot directly purchase an index. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Technical analysis is based on the study of historical price movements and past trend patterns. There are also no assurances that movements or trends can or will be duplicated in the future. In a rising interest rate environment, the value of fixed income securities generally declines.