It’s hard to believe, but the holiday season is now in full swing. I hope you all had a wonderful Thanksgiving holiday with friends and family as we all remembered how blessed we are, each in our own ways. It is amazing how time flies. That’s a trend I see in my life as I watch toddlers turn into teenagers in what seems to be an overnight fashion.
From an investment standpoint, 2017 has definitely been a surprise in a few ways.
Perhaps the most shocking thing about 2017 is how calm it has been. I’m referring to the financial markets, not the headlines. CNBC recently reported that we just experienced the least volatile months of September and October, ever.
Isn’t it ironic that we’d experience a year with such little drama in the financial world against the backdrop of so much drama in the news? To me, this is more than just an interesting factoid or an idle coincidence. I think it says a lot to remind investors of how markets work, and also how they don’t work.
To think we could endure threats of nuclear war in North Korea, could sustain social justice travesties like Charlottesville, and harrowing tragedies like Las Vegas – combined with natural disasters like hurricanes Harvey and Irma – and not experience so much as a modest correction lasting more than a few days in the stock market seems to defy logic.
One immediate thought on this point is that markets don’t always act logically to begin with. Much more often than not they do act logically, but simply put, they don’t always; at least not in the shorter term.
The markets typically focus on 6 to 12 month timeframes much more than the next few days or weeks. And throughout 2017 this meant the markets were focusing on the increasing strength of the economy, both here in the US and abroad.
Whether your personal political views want to believe the current upward moves in the economy are the follow-through momentum of Obama-era policies, or if you believe Trump has ushered in better growth, either way the economy is on solid footing and continues to gradually strengthen.
And here’s the bigger story – we are now experiencing synchronous global growth for the first time since the Great Recession. As stated in the article “Global Economies Grow in Sync” in the Wall Street Journal on August 23rd: For the first time since 2007, the world’s major economies are growing in sync with all 45 countries tracked by the Organization for Economic Cooperation and Development (OECD) on track to grow this year.
We have very likely moved beyond the days when the US was the only engine of global growth. This is important not only because so much of US corporate revenues come from abroad, but also because it allows the US a little wiggle room to stumble without creating global havoc. This luxury might come in handy as we look ahead to how the Fed will go about unwinding its balance sheet while trying to stay on the path to normalizing interest rates and overall monetary policy.
The strength of our global friends might also help buffer missteps that could come if we in the US are unable to make strides to improve our corporate and personal tax structure for all, not just some. Plus, this strength around the rest of the world greatly helps our corporate leaders know where to invest and deploy resources most efficiently for the security of their workforce and shareholders.
This is good news on global growth for sure, but let me underscore that this is still tepid global growth. We do not have, nor do I forecast, a full speed global economy now or in the upcoming year. But that’s perfectly fine. After all, without room for improvement, all that’s left is a weakening trend.
Instead, we are now possibly at the time when our domestic Plow Horse economy can morph into a Trotter.
As you know from my prior writing, I’ve characterized our economy as a Plow Horse mostly as a compliment these past few years. Plow Horses are dependable and get the job done. It’s not a pejorative term at all. A Plow Horse is always slow, but that slowness hides underlying strength.
We won’t transition from a Plow Horse to a Race Horse instantly. Before we run, we are likely to trot for a while.
The big question becomes how this improvement in the economy will play out through the financial markets. In short, it’ll be a nice tailwind but it won’t be so strong as to continue the market’s current pace.
The major concern I hear voiced most often nowadays is about the valuation of the stock market. Isn’t everything just too expensive? This is a popular question. And, unfortunately yes, things are a bit expensive.
“Value” is elusive and only seems to be artificially found in truly distressed companies. Remember that when it comes to catching falling knives in the hunt for something cheap, cheap can always get cheaper. And while current valuations within the market are above average by most historical standards, they are not necessarily excessive.
Everyone has their favorite valuation indicators – price to earnings, price to book value, or cash flow, or dividend payout, etc. Over the years I’ve grown most comfortable with a conglomerate approach, essentially a blend of these ratios along with other indicators that include comparisons to commodity prices, bond yields, interest rates, and even money flows and sentiment gauges.
From my vantage point, the broad domestic markets are above their fair value by only a modest amount. Meanwhile, the rest of the world is either at or slightly below their fair value. So we aren’t exactly in a nerve-racking situation. Especially when considering that the US valuation condition can be fixed by a pause in the market, a slight correction, or the continued increase in earnings. A significant drop in the stock market does not need to happen in order for us to move right back into the range of most historically accurate valuation gauges.
It’s also helpful to note that there has been no shortage of healthy stealth corrections within the market throughout this upward trend since the recession. These rolling corrections are nearly invisible since the broad averages don’t buckle much as money rotates from sector to sector internally. This is a very productive pattern since it wards off excesses in any given corner of the market.
It’s probably not hard to remember when the healthcare sector suffered its own correction around the time of the election. That sector of stocks fell against the backdrop of rising prices in other sectors. It’s also not hard to remember that financial stocks have taken it on the chin more than a few times in recent years while other sectors moved along nicely. But it might be harder to remember when the technology sector fell out of favor and lost nearly 15% back in 2015 and 2016. More recently, the leaders with the technology sector (think Apple, Facebook, Amazon, Google, etc.) actually paused and lost a few percentage points throughout the 3rd quarter of this year and the market continued onward without their leadership. It was feared that if these darlings stopped moving higher the markets were doomed. Instead, they fell back a bit as the market experienced yet another healthy internal rolling correction and actually moved higher on the whole.
This is important because it is in stark contrast with how past bull markets have ended. A healthy market has these corrections internally and the overall advance is ultimately quite broad. An unhealthy market is led by a very small leadership group that gathers almost all investor inflows and becomes wildly expensive as a result. It is this type of divergence from the pack that acts as a somewhat reliable leading indicator of danger in the financial markets. This isn’t the current condition; no matter how often you might hear about just a handful of reporter’s favorites.
Some evidence of this was shared recently by Bob Doll of Nuveen who commented that the combined weight of the largest 10 stocks in the S&P 500 Index is only 19%, which is lower than the long-term average of 20% and significantly below the 27% peak reached in 1999.
While there are more things that look comforting than frightening in the financial world, we aren’t without a few spots of bother.
We do have the nearly certain reality of higher borrowing costs for consumers and businesses in the years ahead as interest rates rise. But this is a natural aspect of a healing economy that I don’t expect to create much trouble. When it comes to interest rates and their impact on the economy, it’s the rate of the change in rates that matters more than the direction. In other words, if interest rates shot quickly up from roughly 2.5% to 4.00%, it would be a problem. But if that same path is taken at a steady and predictable pace, it is very manageable for consumers and businesses. This has been the story of the past couple years.
Consider that the Federal Reserve has finally moved away from a near-zero interest rate policy by moving rates from the all-time low of 0.25% to 1.25%. Consider also that yields on the ten year treasury notes have moved up from 1 ½% to 2 ½%. These shifts in rates have had very little if any impact on the economy as they’ve evolved over the past couple years. Hopefully we can navigate to higher rates in a similar way over the next couple years.
I don’t believe borrowing costs will surge in a way to stunt corporate growth opportunities and I also don’t expect mortgage rates to balloon in a fashion that destroys the housing markets. In short, I continue to believe the fears of a rising rate meltdown are overblown.
Also mounting on the negative side is something extremely emotional and non-scientific.
I am beginning to sense the gradual return of greed. For the most part, so far there is only anecdotal evidence. Sure, you can cite margin balances and a few other internal metrics to try to make the point statistically. But those figures are typically skewed in various ways.
There is however, no getting around the lusting greed-fueled intent of a few recent commercials I’ve seen. Like I said, these are not at all scientific reports, but when you see commercials about the dumbest kid in your high school buying a yacht, or that the first class section of an airplane is there to remind you that you aren’t first-class – and that your best course of action is “don’t get mad, get E*TRADE” – that’s a clear sign of how greed is creeping into the system.
Greed is an awful thing to see in the financial markets. Markets have a history of growing through fear and dying by greed. While it’s not science per se, it is a trend to be mindful of.
The takeaways:
Global growth is back and thank goodness its slow growth. If it were at or above historically full speed, we’d have to be a lot more nervous as investors.
It’s been a very long time since the broad market averages have had a correction, but a closer look inside the markets reveals hidden corrections that provide a healthier picture than meets the eye.
Even within this healthy environment, it would only be reasonable to expect more modest returns in the years ahead, but progress nevertheless. We should expect a slower pace to the current trend, but not a reversal.
Let’s keep an eye out for more evidence of excessive animal spirits in the markets. In other words – greed. As confidence grows, it leads to mistakes; especially by those who fear they’ve missed out on past gains and need to make up for lost time. One of my favorite axioms is “confidence is that nice warm feeling you get right before you fall on your backside”. A healthy dose of confidence is wonderful. Over-confidence is the proverbial Achilles heel.
From all of us here at Winn Partners Financial Group and the entire International Assets Advisory team, we wish you and yours the very best for the Holiday Season and throughout the New Year!
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