A Market’s Mindset — April 2017

April 26, 2017

Dow Jones Average: 20,996
S&P 500 Index: 2,389

A Market’s Mindset

The stock market is prone to the occasional bout of emotion, especially at extreme highs or lows. More often than not however, it is a cold arbiter of financial data. News and events that have limited effect on corporate profits are largely ignored by investors. The market climbed in the first quarter, alongside generally positive economic indicators, earnings reports and an improved outlook for many companies. The combination of good economic news and lofty expectations for the current year led the market to new highs reached on March 1st.

At the same time, it is easy to feel skittish as an investor today when looking at growing tensions and a political populism that feels like it is upending an established order. The next litmus test for this movement will be a series of European elections that may potentially reshape the European Union. However, it is worthwhile to look back at other moments of immense change or tension and recognize that the effects on markets were often minimal. At the height of the Cuban missile crisis the stock market declined only 6% and recovered fully in the span of just twelve days. More recently, Britain’s decision to leave the European Union caused their market to fall 6% and took only four days to recover. Other major events such as Pearl Harbor, the Kennedy assassination, and the Iran hostage crisis, had such a negligible immediate effect on markets that they are not worth outlining in detail. Rather, recessions and asset bubbles that brought with them significant declines in earnings were monumental events for markets and created losses that were severe and long-lasting. The stock market bubble of the late 1990s and the housing bubble of the 2000s left deep recessions in their wakes, cut markets in half, and took years from which to recover. Other recessions in recent decades have not been quite so dramatic, but were still punishing for investors. It is clear that, as an investor, it serves one well to focus on the state of the economy and its prospects going forward, and discount most everything else.

Stock valuations are based on expectations of future growth, and thus reliant on one’s best guess of how the economy will fare. Given that subjectivity, we believe there are three basic narratives an investor can write for the U.S. economy, and with that, three possible outcomes for the stock market. The first story is of an economy that has been held back by reversible forces, such as a crisis of confidence and a regulatory stranglehold on businesses. People espousing that view believe that a major shift in government policy can take the country’s growth rate back to its longer-term historical trend of 3-4% annually. The second starkly opposing narrative holds that we sit near the end of a normal economic cycle. Proponents of this position believe that after seven to eight years of growth, and having reached near full employment, the economic expansion will succumb to tightening monetary policy (increasing interest rates from the Federal Reserve) and a consumer who is spent out. These more aggressive arguments by the bulls and bears mark a departure from current economic and market trends. We subscribe to a third opinion, which simply calls for a continuation of the current economic expansion, albeit at a slower pace than most historical precedents. We believe there are more fundamental, demographic constraints on growth that are very hard or impossible to overcome. Yet we also see little evidence that this economic expansion is near an inflection point that precedes a recession, and to guess at that prematurely can be a very unrewarding endeavor for investors.

Current Strategy

The stock market in the United States feels fairly range bound after the recent run since election day. There are strong underpinnings for the market at current levels. Our long-running economic recovery continues. Unemployment is low and real wages have been rising since 2014. The consumer continues to spend more and our industrial economy is improving after ebbing in 2015 and early 2016. European economies are finally showing some signs of strength after many years of dragging behind the U.S. The pillars of the stock market as of late have been the technology giants. Apple, Google, Microsoft, Facebook and Amazon are now valued at $2.7 trillion, representing one-tenth of the entire stock market, and for good reason, as their collective prospects have arguably never been better. Conversely, much of the above is priced into current stock valuations in our view. Many companies are richly valued and these valuations appear contingent on an economy that can shift into a higher gear. If this economic acceleration does not materialize, it will limit how much markets can climb from here, especially if legislative failures make the odds of a political catalyst less likely.

Politicians of all stripes take undue credit for the roles they play in the economy and markets. This market rally likely occurred in spite of the current administration just as easily as it did because of it. Very little of what Congress and the President have and have not accomplished in their first one hundred days is of any consequence to the average company in America or the stock market at large. Perhaps the only thing that caused some hand wringing on the part of investors was the failed attempt at health care reform. And this is not because that reform particularly mattered to most investors. Rather, it illustrated the difficulty Republicans will have in passing legislation that appeals to the varied factions that they now represent, which we spoke of in our last update. The challenge they face in crafting a broad and unifying platform for such a diverse constituency also threatens passage of any significant corporate tax reform, which is perhaps the political issue of the day that does have the ability to move markets higher. Should the corporate tax rate fall dramatically, it would immediately increase the earnings of many publicly traded companies in the stock market.

We have responded to this climate in a few ways. First, we have increasingly looked to European shares, and in most accounts we now have positions in three or more European companies. At the beginning of the year, the average company in Europe sold at a discount to its U.S. counterpart, a discount that felt unfair given improving economic prospects there. Many of these companies have done reasonably well since the start of the year. The discount is no longer so wide, but we continue to search overseas for compelling investment opportunities. We also are seeking out smaller, high growth companies, often in the technology space, where their particular product cycle and innovation can outrun most economic concerns. This is not particularly easy, as most companies offering reliable growth have run out of reach for a value-oriented investor, but there are opportunities in all markets and we hope to have found some for clients in the most recent quarter. Finally, for the majority of clients we have a slightly conservative allocation to stocks. This will hopefully mitigate the effects of any general market correction, should that come to pass, and offer flexibility for further buying in that event.

Finally, the Federal Reserve raised rates in March by a quarter of one percent and indicated it will likely do so two more times this year. This is good news for most investors, who have been looking for higher returns on their cash and short-term bonds. We continue to look for appealing rates on money market funds, Treasury notes, and short-term corporate bonds. Where recently all these instruments offered zero to negligible rates of interest, an investor can now find yields that range from 1 to 3%. It is certainly not exciting, but it does help in piecing together an overall return that is more satisfying.

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