Posts Tagged capital markets

2018: A Challenging Year Might Be Ahead

“Whatever has the nature of arising, has the nature of ceasing.” – The Buddha

 

First thing first: I hope you had a wonderful Thanksgiving with your family and loved ones, and wish you a great Holiday Season, Christmas, News Year….under whatever name, shape or form you enjoy celebrating. My usual attitude I have adopted from a longtime friend is: “Is there something to celebrate? What are we waiting for?”

If you have read my previous newsletter, you might recall the above quotation and might be wondering if I have forgotten something. No, I haven’t. When I sat down to produce this quarter’s letter, I realized that I couldn’t have found a better quote, so I kept it.

As we’re approaching a new year, following a period of strong performance, many of you are probably nervous or wondering if a deep correction is due. Common questions are: Is this time to sell? Is there more room for growth? Should I invest now or wait for a downturn?

For those looking for quick answers: not yet; probably yes; and what about dollar cost averaging?

It all depends on your goals, time horizon and risk appetite. To demystify my answer, let’s dive in.

Cry Wolf

The current market regime we are in might be best described as the “most hated bull market in history.” For years, many participants have been calling for a correction and yet here we are, with solid returns.

I can not tell you how many client meetings I have had since 2011, making a bullish case, settling a client’s nerves, who had just read a report suggesting that huge losses were ahead.

There is actual research showing that some republican leaning investors had missed out on the “Obama rally”. It looks like now it is the democratic and liberal leaning investors’ turn to sit on the sidelines and watch the market that they so “hate”, to run up.

Looking at valuations and extreme optimism, is this “the” time to go out and save the shepherd from the wolves? If we do so, will we look like fools, again? There is a third way.

Don’t Throw the Baby Out with the Bathwater

There is plenty of research that shows that the majority of portfolio returns come from asset allocation decisions. In other words, whether or not you will be invested in stocks, bonds, alternatives or stay in cash, is the most important decision. The effect of security selection, is miniscule compared to this very fundamental decision.

That being said, like most things, it is not black and white. You should make buy all, or sell all decisions. Better said, fine tune your asset allocation, to fit the current investment regime.

We are not bound to decide whether to fully get out of the market, or blindly stay in it. Instead, we need to keep our eyes on current market drivers, pay close attention to our time horizon and investment goals, and make adjustments accordingly.

Current Market Drivers

I am fortunate to serve many clients who are smarter and better educated than myself. One of them once told me “I don’t get what you’re doing, it seems so complex.” Coming from a man with a PhD in computer science, I was humbled, but to tell you the truth, it isn’t all that complex, it all boils down to:

  • Markets go up because there are more buyers than sellers.

 

  • Economies grow because more money is spent this year than last.

So, the two most important components are: 1 – How much money is out there? 2 – What is the investor/consumer sentiment? In short, it’s all about the FED and psychology.

How about valuations? Research shows that valuations are better indicators for long term (5-10 year) returns, but have a terrible record for shorter term (1-3 year).

The FED, crowd psychology, the economy and politics are undoubtedly interrelated but the end-result on investments has to be separately and carefully analyzed.

We still have a friendly FED, an overly optimistic crowd, a strengthening economy and a market friendly tax bill on its way.

Not too shabby, however the key word here is “overly”. In spite of Keynes’ famous quote “Markets can stay irrational longer than you can stay solvent.” overly optimistic sentiment usually gets punished shortly after.

So…2018?

If you think I am giving mixed messages, that’s because I am. On one hand, I know that when the FED is friendly, the crowd is optimistic, the economy is strong and politicians are market friendly, fighting against this picture is foolish.

On the other hand, looking at historically high valuations, very little cash sitting on the sidelines, and extreme investor optimism, this might be the time to give the shepherd who cried wolf, the benefit of the doubt.

Action Items

How to reconcile these two sentiments?

  • Clarify the purpose of your investment. If you have a long-term goal, short term fluctuations shouldn’t scare you away from investing, but if you may need these funds within a year, this might not be the best time to get in.

 

  • Brace yourself for volatility. 2018 probably has one or two 5-10% pull back(s) built in to it. So, consider how to lower stock exposure, raise cash, or prepare yourself to ride the roller coaster, and have a 10% drop in US stocks as one of your what if scenarios.

 

  • Make sure you’re diversified. Usually, what went up the most, comes down the fastest. In the current case, it is the tech stocks. Make sure your tech stock exposure is in line with your risk appetite.

 

  • Have some international exposure. While the US FED is raising rates, European and Japanese central banks are still in their easing mode, most likely till the end of 2018. These countries, along with Emerging Markets may offer better value.

 

  • If you’re overly concentrated in any particular security, look for strategies such as put options.

 

  • Don’t be afraid of raising cash.

 

  • Watch for earnings because the market is priced for perfection and a negative surprise could be the black swan in the lake.

In Short

2018 will likely end up being a positive year, but returns may be muted and may come with volatility. So adjust your strategy accordingly.

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

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.

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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

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

 

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.

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