Market Update January 28th 2018


While stocks remain our favorite asset class, after such a strong market surge at the end of last year and beginning of this year, I thought it was time for a big-picture overview and update.   
We believe this bull market is likely just now transitioning from the second (“normalization”) phase of a bull market, to the third and final (“speculative”) phase, which historically lasts several years and provides around 40% of a bull market’s total return. Our job at this point in the cycle is usually to remain disciplined, resist temptations to sell too early, and let the market work its “speculative phase” magic. However, we also acknowledge that markets are probably getting overdue for another bull market correction (which by definition means a pullback of 10% or more).  The problem with bull market corrections is they are nearly impossible to time and trade, and the markets may be 20% or more higher by the time we get that next 10% correction. Market corrections during bull markets tend to be brief and recover quickly, as opposed to transitions into bear markets, which typically roll over more gradually.  
As we know, stock market trends often go on far longer than seems reasonable, but one way or another, this current powerful market surge will at least eventually run out of steam. And when the next correction comes, we know that it can at least temporarily make us feel like greedy dummies if we didn’t take some profits (at least until the next surge takes the market to new highs again). So if you find yourself worrying about either your overall portfolio, or a couple of your investments that have run up a lot, now is a good time to sell down to your sleeping point. Having that peace of mind is one of the biggest keys to having success in the stock market, and having a little extra cash on the sidelines can help us think positively about the inevitable next correction, by giving us more opportunity to take advantage of it.
As always, I will be letting you know if anything changes that makes us feel it is time to be more aggressive about taking chips off the table and moving to more conservative allocations.
For now, U.S. and global earnings continue to accelerate (stocks follow earnings above all else), U.S. and global economic growth is accelerating (which is a precursor to better corporate earnings), and we don’t yet see any warning signs on the horizon of a coming recession or bear market. We haven’t seen recessions happen without the index of leading economic indicators first falling below zero, and for now it remains at a healthy positive level and continues to trend upward.
However, markets are also now priced for a lot of good things to happen, so even though we see accelerating economic and earnings momentum in both the U.S. and most foreign markets, we know something could scare investors and cause a short-term correction at any time. The margin for error is becoming especially thin for the handful of everyone’s favorite growth stocks. Those momentum stocks can tend to continue to lead during the final bull market phase, and some may be leading growth stocks for years to come, but their downside risk on any misstep has grown significantly.
Without getting into too many additional details on the factors that keep us confident and optimistic for now, the bottom line is most measurables still point to continued economic and earnings growth, and higher stock markets. Especially now that the rest of the global economy is finally getting more traction (where the U.S. was several years ago) and has become a tailwind rather than a headwind for global economic and earnings growth.
I want to focus for a moment on psychology and investor sentiment, which has been one of the factors that has kept us comfortable riding this long, slower-than-normal bull market and economic recovery. So far we believe too many investors remain too conservatively invested. In fact, this recent strong market surge can probably be largely attributed to investors that have been too conservatively invested…finally realizing they are too conservatively invested, and repositioning more of their portfolios back into stocks.
I believe many academics and other brilliant people tend to make the mistake of viewing economics and stock markets too much like a physical science. I believe they are at least half social science also. So much of both stock market prices and economic growth depend on consumer and investor optimism or pessimism. When people are pessimistic and fearful they reduce their spending for fear of losing their jobs, and they move their investment dollars to what they feel are safe havens. And when they are confident and optimistic, risk taking in investments and business increases.
I am not surprised that this entire 8 1/2 year economic recovery and bull market has been slow and gradual (we call it the "plow horse” recovery, as opposed to the "race horse" recoveries of the 80’s and 90’s), with the masses still too conservatively invested this far into a bull market and economic recovery. After the 1929 stock market crash and Great Depression it took decades before the average investor would invest in stocks again. Should we be surprised that after just going through two of the four worst bear markets of all time (2000-2002 and 2008-2009), and the worst recession (Dec 2007 – June 2009) since the Great Depression, that investors are still overly cautious and are too conservatively invested? (Especially having happened just as the demographic with the most of our nation’s wealth, the baby boomers, were starting to retire or about to retire.)
Usually the final “speculative phase” of a bear market doesn’t end until the masses crowd into stocks too aggressively, almost behaving as if there is no risk. This usually stocks to not only become overvalued, but usually excessive, if not extreme stock overvaluation. We believe we are probably still quite far from that point today. So far the only place we see excessive investor exuberance is in exotic speculative markets like cryptocurrencies.
One of our favorite market strategists, Richard Bernstein, made some good points on this topic in an interview last week:  
Bernstein first commented about why he believes so many people have completely missed this bull market, saying “what they’ve completely ignored - because they’ve been so worried about another 2008 - is the opportunity cost of not being in the stock market". Bernstein pointed out that "In the last five years stocks have outperformed bonds by 15% per year. That’s a monstrous fee to pay for protection.”
(And by the way, even the unluckiest of investors who invested all of their money in the stock market indexes at the highest point before the 2008 market crash, would have earned over 8% per year on average through today, so remember that when you hear those radio ads telling you to invest in gold or other stock market alternatives “to avoid losing everything in the stock market again like 2008”.)
Bernstein also said he remains perplexed that both private and public pension funds remain so underfunded today, after this second longest bull market in history. He said "it’s because they haven’t had a correct allocation to equities…because they have been scared that 2008 was going to come back". “People have to be much more dispassionate about assessing perspective, expected returns and risk.” “It’s amazing that it’s still influencing asset allocations this many years later.” “People have also set their asset allocations assigning very high probabilities to low-probability events.” “Why in the world would you structure a portfolio for something that has an extremely low probability of occurrence?” “Do I structure a portfolio for 1% probabilities, or do I structure a portfolio for 75% probabilities?”
Bernstein also pointed out that money flows into mutual funds and Exchange Traded Funds (ETF’s) have only in the last couple of months begun to favor equities over bonds. Another example of what he calls the misallocation of assets during the last eight years. He also thinks people are ignoring inflation risk. “Everybody says, oh, people have been waiting for inflation to come back forever and nothing is happening. That is just completely untrue. That’s bond investors trying to rationalize why they won’t buy anything but bonds” Bernstein said. “If you look at bond returns since inflation expectations troughed in 2016, what you’ll find is bonds have returned about 1% total, and stocks have returned about 35%. The notion that inflation is not a risk, and we should ignore it, just isn’t true."
(I agree completely. Inflation pressures are building, even though inflation may rise slowly, and even though inflation is not showing up equally throughout the economy. Technology continues to drive prices down in many industries, and the “Amazon effect” in retailing have kept downward pricing pressure on a lot of consumer products. But inflation has been finding its way into other areas of the economy that Amazon and technology haven’t impacted as much, like housing/real estate, collectibles, restaurant prices, etc.. And now that the unemployment rate is below the rate considered to be “full employment”, and below the Fed’s target level, we are finally seeing wage inflation. And wages have recently started rising fastest in the lowest third of wage earners, which is typical of the later phases of an economic recovery.)
Bernstein also remains bullish on stocks, saying "We have pretty close to the highest equity allocation we can have in our portfolios for equities. We have the lowest fixed income allocation we can have. And what fixed income we have is extraordinarily short duration.” (Again, I agree.)
Bernstein elaborated…“There are three things for us that we always look at. Profits, liquidity and sentiment/valuation. Profits are still accelerating around the world, there’s a ton of liquidity out there, and sentiment and valuation look fine." “Look, it’s not March of ’09. I’m not trying to overplay my hand on this one, but we’re nowhere near extremes.” “What would make us change? If profits rolled over, if liquidity dried up too much, and if people were truly euphoric about equities. That would do it for us.”
We agree with Rich Bernstein. We don’t believe stocks are in bubble territory. Yes P/E ratios are now high relative to long-term historic averages, but earnings look like they should continue to accelerate, and capitalized profits models continue to tell us that even at these levels stocks remain undervalued given current interest rate levels. And we think many of the more plain vanilla, high-quality stocks that produce growing cash flows and rising dividends continue to look undervalued.
We think we are likely to see double-digit stock market returns in the U.S. again in 2018, and we think foreign stock markets could even outperform U.S. stocks for the second year in a row. Their stock valuations are generally lower, and their economic recovery cycles are more like where the U.S. was several years ago. However, we think the U.S. economy is likely to experience add-on growth from the tax cuts that has yet to be priced into stocks, so we certainly don’t want to bet against the U.S. market.    
We remain very cautious with bonds. Interest rate cycles have historically averaged between 22 and 39 years in duration, and interest rates in this cycle have fallen for 35 years (reaching an all-time low in the summer of 2016), and now have been basing and starting to rise since then. We believe both interest rates and inflation are just beginning to enter longer-term rising cycles. They may be slow and gradual, but they also may startle markets with periodic surges.
(Interest rates earned on cash in your accounts (currently .95%), and on short-term CD and Treasury securities have climbed quite a bit in the last 18 months, making these temporary safe havens at least more palatable than they have been for several years. While we continue to try to avoid interest rate risk in bonds for now, we think laddering 3-month to 2-year CD’s or Treasuries now offers a safe alternative that at least nearly keeps up with inflation. The most attractive maturity on the CD and Treasury yield curve right now in my opinion is probably the 2-year, currently yielding 2.3% to 2.4% or so. I don’t see much reason to extend maturities much further than that for now.)
Remember, we are investors, not speculators or traders, and investing is a game of probabilities, not certainties. With our style of investing through big-picture allocation and broad diversification, we never believe we will lose money permanently. We just may have to hold some investments longer than we initially intended to. But such is the nature of stock markets.
The greatest investment in the history of the world has been owning businesses, and the stock markets allow us to own the greatest companies in the world. Stocks have been the best performing asset class over most extended periods of time. Yet what makes stock investing so difficult is volatility. The stock market gives us the ability to own great companies with immediate liquidity, but the cost of that liquidity is volatility, and that volatility keeps many people from ever investing in stocks, and it causes others to permanently harm their wealth if they let their emotions drive bad timing decisions.
Remember Warren Buffet’s comments about stocks and risk:
“The biggest mistake most individual investors make is confusing volatility with risk. My definition of risk is will each of my investments be likely to outpace inflation over my intended holding period. If the answer is yes, then it isn’t risky…even though the price will fluctuate all over the place. Yet many non-fluctuating assets are laden with risk if they aren’t likely to keep up with the rate of inflation.”  
We are continually trying to position every client portfolio for the highest probability outcomes given individual risk and time parameters. While we continue to believe that stocks are the asset class that has the most favorable risk/return trade-off both for growth and income for now, market volatility may increase during this final bull market phase. So while we want to stay disciplined and hang on, this is a good time to review all risk and time parameters and adjust portfolio allocations if necessary.

As always, let me know if you have additional questions, concerns, or material changes to your current situation.

Darren