A Mixed Bag of More of the Same
“Thinking is difficult. That’s why most people judge.” – Carl Jung
Many observers are surprised with the current levels of US Stock Indices. There is so much talk about stretched valuations, Trump Trade being over, the potential damage of rising interest rates, trade/currency wars, political uncertainty, rising inflation and last but not the least, the aging economic growth cycle, that given all this, stock prices seem unjustified.
Looking at this wall of worry, one might conclude that “the winter is coming” and it’s time to run to the hills away from the White Walkers, short sellers and bearish bets.
In the past, I have seen how Republican leaning investors, commentators and strategists have allowed their political views to cloud their judgement, and how this led to misguided conclusions, most of which, have been proven wrong.
Unlike the popular rhetoric, the stock market rallied during Obama years, the dollar got stronger, inflation has been tamed, unemployment dropped like a rock, the economy grew and the US has become the safe house in a shady neighborhood.
The thorns of this rosy picture have been stagnant incomes, and stubbornly elevated public debt.
Learning from this experience, investors need to set aside their political views and think with facts in hand, not allowing their preconceived notions to get in the way.
I will address these concerns, and conclude that the stock market still has room to grow, pullbacks are likely and they should be used as buying opportunities.
Concern 1: Stretched Valuations
No matter how you slice and dice it, stocks are expensive. Questions to follow:
1 – How expensive? 2 – Can they go higher from here?
They are extremely expensive when you just look at absolute, traditional, isolated price to earnings ratios. If this is your only gauge, the answer to the second question is a short “no”, and they can’t get go much higher from here.
But when you look at relative factors, especially when compared to other investment vehicles like bonds, real estate, commodities and currencies, stocks still seem to provide growth potential. Roughly a third of US domestic stocks’ dividend payout rate is higher than the yield on 10 Year US Treasury.
In other words, when compared to especially low bond interest rates, stocks are only moderately expensive and the answer to the second question in hand is a “yes”, they can still go higher.
Also, from a purely investment strategy point of view, all we really care about is the asset price action and when we dive in to it, we get good and bad news.
The bad news is that high valuation is a pretty reliable indicator of investment returns in the following 10 years. The good news is that the same cannot be said about the following 3 years. So, if history is any guide, one can conclude that the investment strategy could be to ride the wave while it lasts, especially in the next 3 years but moot your expectations for the next 10 year returns.
Concern 2: Aging Economic Expansion and Bull Market
We are in the eighth year of a stock bull market and economic growth. On average, economic expansions last about 5-7 years and the longest has been 10 years (1992-2002). The stock market not only hasn’t seen a bear market since 2008, it also hasn’t seen a 10% correction for 287 market days as of 4/1/17. So justifiably, some argue we may be approaching a rest stop with a horrible vista point.
I will counter this argument and hope to offer some consolation with 3 supplemental sets of facts.
1 – First let’s get the 287 market days without a 10% pull back, out of the way. Assuming we are in a long-term bull cycle, this is well within historical averages.
2 – The US stock market hasn’t seen bear claws since 2008, but came pretty close with a 15% correction (Q2 2015 – Q1 2016). During the same period, global stock market did face the bear with many developed economies’ losses of well over 30%.
3 – If we expand the above-mentioned period to Q1 2014 – Q1 2016, we’ll see a stock market that was flat for two years (consolidation). Such periods can and do act like a bear market, especially when they last for two years.
On the topic of economic expansion, the key thing to remember is that in spite of its duration, the growth level is still well below past recoveries, and current indicators do not waive the checkered flag for the stop pit.
Concern 3: Rising Interest Rates
It is true that stocks struggle during rising interest rate environments. The reasons for that are plenty but the usual suspects are: 1 – Increasing cost of money, makes it costlier to do business and invest; 2 – Some fixed income securities’ yields start to look attractive compared to risk adjusted equity returns.
That being said, current levels are low enough to give us some time before the danger zone. If you’d like me to be more specific, the 10 Year Treasury Yield is at approximately 2.5% and historical tendencies point to a 4% rate as the line in the sand in the tug of war. Based on FED actions, it may take us till the end of 2018 or into 2019 to reach that point. Since I try not to make predictions that far in advance, knowing what I know now is good enough to conclude that the current rising rate environment may not hinder equity returns.
Concern 4: Political Uncertainty
Markets have welcomed Trump’s presidential victory as they saw four arrows in his quiver:
1 – Tax cuts 2 – Lower regulations 3 – Fiscal expansion 4 – Trade wars.
Except for trade wars, the rest are deemed to be business friendly and hence will boost earnings. Well, this is a typical case of confirmation bias at least from the earnings point of view. As of 3/31/17, S&P 500 Operating Earnings Per Share has gone up 22.1% (Source: S&P Dow Jones Indices).
In other words, the earnings environment is the best in years and this is due to the pre-Trump economic environment, finally acknowledged by Republican leaning market participants, who for years have advocated a recession. (Sorry to sound speculative and like a sour cherry here.)
I welcome this development as it not only reflects domestic facts more accurately, but also global positive economic surprises.
For those curious minds, the biggest jump came in materials and technology sectors, 36% and 32% respectively, while the biggest loser was real estate by -32%.
In other words, given that a simpler tax code is better for business and the economy, smart deregulation can translate in to a more robust business environment and fiscal expansion is past due because of the FED’s inability to stimulate, setting politics aside, current stock levels may be justified.
Summary
For those readers who look for the blue or the red pill type of conclusion from all this, here is your takeaway:
- Yes, the market seems moderately stretched
- Therefore, a correction may be around the corner
- “Sell in May, Go Away” strategy may prove prudent this year as we approach seasonally weak summer months
- That being said, long term economic and market trends are in tact
- Therefore, dips should be seen as buying opportunities
- Volatility may increase, so tighten your seatbelts and keep your eyes on your long-term objectives
Disclosure
The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.
The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.