Happy 9th, What’s Next?

The 9year bull market run for the S&P 500 that began on the morning of 3/10/09 has gained +381% (total return) through last Friday 3/02/18, an annualized return of +19.1% per year.  Source: BTN Numbers, MFS, Feb 26, 2018. The second longest run in history- and on track to become the longest in terms of number of days. It’s got amazing genes as it has survived all sorts of shocks, crisis and fears, EU debt crisis, terrorism, the threat of war, tsunami, hurricanes, and more. In another 6 months, it will become the longest ever bull market to live adding more than $25trillion in market wealth since its birth. The good news is that bull markets don’t die of old age and the bad news is that no bull market lasts forever. Even though this animal has defied skeptics since its birth as with any 9-year-old’s birthday party, the enjoyment and exuberance can turn to tears at any time.  And despite how good it’s been, this is the most unlikely, unloved, and un-lauded bull market of modern times. This is the Rodney Dangerfield of bull markets – “I can’t get no respect!”

In the wake of this stellar market, I am frequently asked: When will the market correct? Are we at the end of the bull market?  What’s next?  I believe these are wrong questions to ask. Instead, one needs to understand what’s your breaking point? 

Your breaking point is the point during a market correction at which you panic and wish to sell your portfolio and move to cash.  I believe most investors would not be concerned about losing one dollar, and most would be distraught if their portfolio dropped 95% overnight.  But between those two extremes, only you can say at what point you would begin to panic – down 5%, 10%, 25%, perhaps 50%?

Source: First Trust, Wesbury Bowen, Q1, 2018.

As you consider, what your breaking point is, review the chart above. It shows the last Financial crisis- the fall and the rise! Stocks won over gold, bonds, oil, real estate and cash which looked like safe havens during the crisis- the breaking point saviors! This chart comes as a welcome reminder for anyone worried about going to cash in the fear of a coming correction or bear market. Staying invested in the market had a better outcome than capitulating at your breaking point! As the market turns, remind yourself, your portfolio has long-term decisions inbuilt while market corrections tend to be short-term in nature.

I find that letting the situation tell you what’s happening is a reliable method for looking at future events. Let’s look at data to see what the numbers tell us:

1) Valuations and Stock Buybacks: The market is expensive is common knowledge and the Price/Earnings chart for S&P 500 shows the same.

Source: https://www.wsj.com/articles/stocks-still-have-momentum-as-aging-bull-market-turns-9-1520571660

Are there any opportunities in this expensive market? While the technology, consumer discretionary sectors have been on fire, financials, telecom, and energy stocks have had a more subdued performance and thereby cheaper valuation. First Trust’s table below shows the attractiveness of these sectors, using projected earnings growth, price to book and long-term debt to capital as factors, these sectors look more attractive than the rest. They might be worthy of a second look.

Corporate earnings look strong and many analysts expect the gains to continue given the tailwind from corporate tax cuts, a weaker U.S. dollar and stabilizing commodity prices. However, replicating 15% earnings growth in Q4 from the year earlier (Factset estimation for S&P 500), might be a tough act to follow with rising rates and higher price squeeze putting pressure on earnings, which would push valuations even higher.
Stock Buybacks might keep the markets elevated as many corporations are using the tax break windfall to buyback stocks of their company. J.P. Morgan noted that buybacks will be a support for stocks as their analysts are expecting a combination of improving economic growth and lower taxes to contribute $100 billion of buybacks. Repatriation is expected to contribute about $200 billion. Source: https://www.marketwatch.com/story/sp-500-companies-expected-to-buy-back-800-billion-of-their-own-shares-this-year-2018-03-02

2) Sentiment: As the most unloved bull market of its times, we are missing the exuberance that typically resulted at the end of bull market runs. We are missing the dot.com mania. 

The American Association of Individual Investors shows that only 26% of individuals believe the stock market will rise over the next 6 months. To investors who believe bull markets drown when euphoric investors begin taking extreme risks, the current, relatively contained level of enthusiasm is a welcome sign. As a contrarian, that would be a bullish sign for the market gains to continue.

3) Recession: Fears of the recession continue to escalate as interest rates rise. Recession fears seem to be premature.  Brian Wesbury, Chief Economist, First Trust’s, used the Federal Funds Rate Model to show the Federal Reserve as the #1 cause of the recession. He examined the differential between Federal Funds rate and the change in GDP.

In the chart, each time the blue line (Federal Funds Rate) crossed the orange line (Change in GDP), usually, a recession (R) followed as higher rates slowed down economic growth. Currently, there is a gap between the lines and the gap will narrow as rates are predicted to rise this year. Watch this data point closely for a recession!

4) Inflation and Rates: In 1990, inflation was at 6.1%. In the last 27 years, 1991-2017, inflation has averaged just 2.3% per year and has been as high as 4% in only 1 year in 2007. Source: BTN, MFS, Feb 26, 2018. Lately, wage inflation and inflation expectations appear higher than in the recent past. Inflation expectations have been one of the key reasons for recent market volatility. After years of missing the inflation target, the Fed seems more upbeat on getting around the 2% target. Federal Reserve governor Lael Brainard, said: “Although last year we faced a disconnect between the continued strengthening in the labor market and the step-down in inflation, mounting tailwinds at a time of full employment and above-trend growth tip the balance of considerations in my view.”
Source: https://www.wsj.com/articles/feds-brainard-sees-rate-increases-as-appropriate-as-inflation-firms-1520380821

Today’s job numbers data (labor force participation rate rose to 63.0%) and a 17 year low in the unemployment rate of 4.1%, echo the same sentiments. Inflation expectations and inflation itself may continue to keep the markets volatile as it figures out how high and quickly rates rise in response to the moderately growing inflation.

5) Fear of Trade Wars: Impact of President Trump’s imposed 25% tariff on steel imports and 10% imports of aluminum are yet to be seen. History says that tariffs have not been favorable for a country and while they are good in theory, they have been bad in practice. The Smoot- Hawley Act of 1930, The George W. Bush Steel Tariff Act of 2002, the 1970’s tariffs on Japanese televisions are all examples of such. In my mind, actions such as these tariffs are inherently inflationary, and generally negative for growth. This might increase the market volatility and investor anxiety as we saw the 400+ points drop in DOW last week.

Trade tariffs are also a reminder of how protectionism and populism are revealing the nationalist posture of global politics. As the world economy globalized, so did the source and destination of goods and services. But there’s a widespread misconception about the trade deficit- that the trade deficit is “bad” for the U.S. economy. Economies have continued to grow long-term, with or without tariffs as capitalism does not allow the political theatre to take over. Similarly for investing, mixing politics and investing strategies is a “big mistake”, quoting Warren Buffet.

Putting it all together.  It is easy to imagine that you can take on more risk today when the market is up 30% in a year. However, as we saw in 2008-2009, market downturns do occur.  As you seek to pinpoint your own breaking point, I encourage you to recall how you felt during those months of harrowing declines and reminiscence what the market did after the downturn.

History has shown that markets have reasserted themselves and economies have grown regardless of the crisis du jour be it trade wars, recession or inflation. The markets are irrational in the short term, they defy all attempts to predict short-term performance, and have proven to be rational long term.

A well-diversified and managed portfolio can provide comfort and confidence during the market’s inevitable “bumpy rides”. The goal is to help your clients earn competitive, risk-adjusted rates of return and protect their portfolio against the ravages of inflation over the long-term, all while minimizing investment risk and portfolio’s volatility. If you have questions about how your portfolio is structured to reflect your breaking point, please reach out to me at aradhana@investmentconsults.com.

 

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