WARNING:  Fairly long post…podcast to follow–click here to subscribe to the YouTube channel so you don’t miss “You’ve Got 3 Choices in This Type of Market…”)

If you are an active participant in today’s markets whether through your company 401k or otherwise, you’ll want to keep reading…

It doesn’t take a genius to see that equity markets have pretty much gone straight up for the last 10 years…you just about doubled your money through January 31st 2018.  (Learn about how Dow Jones Industrial Average hit an all-time high on 1/26/18)

end of january

(chart courtesy of morningstar.com)

But then comes the “month of love”–not for the stock market though…

 

February

(chart courtesy of finance.yahoo.com)

Isn’t this what we want though?  Maybe…

The question is always how fast…and why?

I’ve come up with 3 things that make me think that what we’re experiencing (Dow plunges 1,175 points–worst in history) is a sign of bad things to come.

But first some backdrop to my musings…

The end of 2007 marked one of the worst recessions on record (info on the Great Recession) and the way out (as our government saw it) was to ease interest rates.  Easy monetary policy as they call it is designed to stimulate growth.  The caveat is inflation potentially (in the turnaround),

fredgraph (2)

 

and the expansion of the federal balance sheet (see graph above ), but the alternative is deflation (learn about deflation) and high unemployment–two things that will wreck an economy (just study the Japanese economy).  When our government eased interest rates, it made it much cheaper to borrow and borrowing is what makes the world “go round”.  This, in turn, stimulated demand for the products that corporations sell.  Those sales, in turn, produce revenue, and that revenue produces profits.  The question then becomes “what is that profit worth both now and in the future?”

Let’s talk about that…

Is the market cheap or expensive
When a company turns a profit or has “earnings”–its value is constantly debated amongst multiple perspectives through an exchange like the DOW or S&P.  Despite what you may believe, this is a fairly efficient process with nearly 100 million trades per day with millions of participant–statistically significant numbers for your math nerds.  In those terms, what someone will pay for a share in a company is really an indication of that company’s value (i.e. the value of future earnings).

If you take what the company trades at (its price) versus what it earns you have what is called a P/E ratio–a common metric to measure the worth of a company (cheap or expensive) relative to history or its peers.

Now let’s talk about valuations for a second…

Historically, the stock market has traded with a P/E ratio in the mid-teens …it is now at 31 (or double, at the time of this writing).

 

CAPE

(chart courtesy of multpl.com)

So what drives valuations?  Wait for it…(here come my 3 thoughts)…

  1. Equity prices have been propped up for a while, so they are bound to fall from where they currently are.
    Since the late 1970s, corporations have shifted the burden of funding retirements to the consumer in the form of defined contribution plans like your company 401k.  (I’ve covered this subject in a previous podcast, click here to access.) This has largely done a couple things: It saves them a ton of expenses associated with pensions and it removes the obligation from their balance sheets…without these liabilities, companies have a stronger balance sheet.Fundamentally, this is good for those companies, however, it’s replaced “smarter” institutional trading with “cost-efficient” indexing so that the average investor can access those markets.  Consequently, the “balance of power” has shifted from asset managers to retail investors which has lead to a “buying in one direction” through index funds and passive investment vehicles.  As a former institutional trader that has taken advantage of these trends, the net effect is obvious–a lot of dollars have been invested primarily into equities which have boosted their prices regardless of their valuations.

    Likely suited as an argument for another day, this trade has largely been executed by Baby-Boomers which will eventually need to withdraw their investments for retirement living expenses which will cause further selling pressure for equities long-term…
  2. Fixed Income yields are really low and will have to rise from where they currently are.
    Ever since the recession our government has been a big purchaser of US debt (see chart above of FED balance sheet).  Their purchases induced other market participants to buy also–after all, if the cook can eat his own cooking, so can I, right?  That narrative will be changing with the US government becoming net sellers of their debt.  For those of you that don’t know, bond yields and prices have an inverse relationship so as bond prices are driven down by sellers, yields will rise.  My question is who will buy all this debt?  I also didn’t mention that the government is also issuing more debt to fund deficits and particularly to pay the interest on previously issued debt, which just exacerbates the problem.  What you have the makings for
    is a debt market flooded with bonds and not enough [willing] buyers of those bonds.  Granted, banks have a lot of reserves since the recession, but if they

    fredgraph (3)
    use all that cash to buy existing government debt (at record low-interest rates), will they have enough to keep in reserves to lend to consumers as interest rates rise.  It’s safe to assume that banks make more money from charging a spread on the money they lend out versus holding low-yielding government debt.  As far as the government is concerned, there is also the problem of demand for the (existing) debt at such low yields and that more new debt can’t be issued at higher yields without increasing the cost of servicing that debt.  This will affect social programs like Social Security, Medicare, etc. [Learn about government shutdowns]

  3. Monetary policy and fiscal policy are competing against each other.  What gives??
    Monetary policy is largely how our government worked its way out of the last recession (stated above).  This process was a combination of recapitalizing banks and lowering interest rates–all tools of the Federal Reserve Board.  Fiscal policy involves the change of laws.  I, like many other market participants, am scratching my head wondering why our economy needs further stimulation (already accomplished through easy monetary policy for the last decade) with fiscal policy changes (like our new tax reform).The move seems largely political in nature and has very little or no economic reasoning behind it (all just my opinions).For a government that seems underfunded, why erase $1.5 Trillion from future tax revenue and give it (largely) to corporations that are already over-valued?  I know there were individual tax breaks, but they pale in comparison to what corporations received (in breaks) and this doesn’t even begin to mention the SALT issue.For starters, there is now less money to service debt (mentioned above) and fund other government programs.  You do have to wonder what the trickle down effect will be for the US economy and consumer sentiment in the coming years…it can’t be good.  The tax cut probably won’t stimulate the economy long-term…I’d love to be wrong, but it doesn’t make sense that companies will use their tax savings and the ability to repatriate funds (at 8%) to bring jobs to America.  Why?  Because the fundamental reason why jobs left was not that of high taxes (although that was a problem), but mainly because corporations sought cheaper economies in which to produce their goods.  Corporations are in business to make profits, and if publicly traded, to appease shareholders.  I don’t think this mandate has changed, nor will it be materially affected by 10 years of lower tax rates.  It will allow for short-term stimulus by the way of CAPEX spending in capital-intensive industries.Further, the argument can be made that at 4% unemployment (notwithstanding the labor participation rate), America is near full employment and GDP increases will largely come from productivity increases.  My bet is that tax savings will be spent on making companies more profitable and retaining key talent versus building more factories and hiring new workers.  The former has always been an easier way to profitability although retaining key talent will put pressure on wage growth thus stoking the embers for inflation.  So although the current administration sold this tax reform as a way to bring back jobs to America, I’m skeptical that the savings will be used to do that–it might just cause inflationary pressures sooner than we expected.

What does this mean for the investor?
Investors really three alternatives (click here for a  preview of my podcast on this topic):

  1. Get real defensive and go to cash.  This “put your head” in the sand approach will definitely cause you to miss out on any upside that is left in the rally (just look at the last 10 years).  Would you have expected markets to basically double since 2009?  I think we could run quite a bit further upwards before we get a 15-20% correction.  However, if you are nearing retirement you might consider this as your only viable option.
  2. Get somewhat defensive, by pausing. The feeling that things are moving way too fast is natural.  So if you sold some winners (if you still have any) and took profits, I couldn’t blame you.  The only problem is trying to gauge when to get back in…it’s like a game of “hop-scotch” or worse if this is retirement money we’re talking–it’s more like “chicken”.
  3. Stay the course and/or put idle cash to work.  To me this is a great strategy.  Timing will obviously be key, but if you dollar-cost average through all these dips, you’ll be ok if 2008-09 is any indication.   Even if you don’t have idle cash to put to work, “staying the course” seems like the most natural path for most.  Especially given the statistics of average market returns over periods of 10 years and beyond.  The caveat being similar things happened right after the dot-com crash and the euphoria that lead us to Sept/Oct 2007.  It seems that every 6-7 years there is something that “resets” equity prices and we are long overdue at 10 years and counting in this bull market.

Any strategy must be evaluated prudently and carefully.  I’d advise sitting down with a professional that has experience in creating solutions to help you best navigate a course based on your goals.

For more information about DJH Capital Management, LLC, you can visit https://djh-capital.com