2019 4th Quarter Market Commentary
As we head into the decade of the twenties, welcome to the casino! You can double your money on red or black, or you can lose it all. Never in the lifetimes of people living today have speculators faced the alternative of investments so ripe with positive potential while simultaneously saturated with the risk of significant loss. And the determinant likely will not be a set of traditional investment criteria.
For several years, we have characterized the dilemma facing equity investors as a bet between whether common stocks would revert soon to long- term valuation means, far below current levels, or whether the Federal Reserve and other major central banks could continue to support stocks whenever prices threatened a significant decline. Because the Fed’s actions remain on a winning streak, the risks on the other side of the bet have been ratcheted up higher and higher.
After multiplying the size of its balance sheet by a factor of more than five to extricate the US from the Financial Crisis and to sustain the recovery, the Fed attempted to “normalize” its monetary policy in 2018. Investors threw a tantrum in that year’s fourth quarter, indicating clearly that they would tolerate only the extreme abnormality they had become accustomed to. All asset classes lost money in 2018, but as the Fed returned to its loose money ways in 2019, investors celebrated with all asset classes once again rising.
On a larger scale, that same alternating pattern has played out over recent decades. Unless market timing was precise, very little money could be made in equity markets from the mid- 1960s through 1974. That lengthy period of weakness, however, led to the booming 1980s and 1990s, interrupted only by the painful but brief stock market collapse in 1987. So enduring was market strength that a generation of investors began to see Wall Street as a one-way thoroughfare. That feeling of invulnerability culminated in the dot.com bubble at the end of the last century. Such excesses in debt and overvaluation emerged in the 1990s that the first decade of the new century produced the weakest stock market performance since the Great Depression of the 1930s. Most investors came out of the 2000s poorer than they went in. The resulting severe economic distress prompted a dramatic government rescue effort. A decade of unprecedented stimulus and direct market intervention produced powerful gains in both stocks and bonds, even though the recovery from the Financial Crisis has been the weakest economic recovery in the past three- quarters of a century. Years ago, we suggested that a possible outcome of persistent central bank stimulus, although unlikely, was that it might inflate prices of everything. So far, however, the unprecedented stimulus has inflated only securities prices. It has failed to promote a broader inflation, even to its minimal 2% target. An unfortunate, and potentially dangerous, consequence has been the creation of a wealth disparity unlike anything seen in this country since the end of the Roaring 20s. That earlier episode didn’t end well.
A decade of powerful stimulus produced in the 2010s the first decade in US history without even a single stock market decline of 20% or more. It simultaneously produced a relatively weak economic recovery, but one that has now extended longer than any before. On its face, that would seem to augur well for continued stock market strength. In fact, an oft- repeated Wall Street mantra is that bull markets don’t die of old age. That is true, but they do die in old age, typically of excesses that have had more time to develop in extended expansions. Perhaps a yellow caution flag is raised when we realize that the second and third longest economic expansions immediately preceded the decade of the 2000s and the period from 1969 to 1974 respectively, lengthy periods in which investors lost more money than they made.
While Wall Street analysts in the aggregate are always bullish, it is instructive to recognize that the consensus of analysts has forecasted not even a single one of the seven recessions that have unfolded since World War II. Unbiased entities like the Federal Reserve, World Bank, European Central Bank, International Monetary Fund and Organization for Economic Cooperation and Development are far less bullish and unanimously forecast meager economic growth both in this country and globally for the next few years. More ominously, the Congressional Budget Office, the Fed and the European Central Bank forecast sub- 2% GDP growth over the longer term in their respective economies. And these forecasts have been declining in recent quarters.
Incongruously, notwithstanding these unbiased economic forecasts, financial media highlight Wall Street analysts and administration spokespeople who characterize the economy and its outlook as strong, –even as the best ever. That’s simply not true. Economic growth below 3% is not only not strong, it is below the long- term historical average. And this moderate level of growth is all that is produced with the Fed still providing the most aggressive stimulus in history.
It’s also difficult to reconcile strong stock market gains with the fact that corporate earnings are not growing. With full year S&P earnings not yet fully announced, they are forecasted to be flat to slightly down for the full year. And when all US corporations are tallied, earnings are about flat for the last five years. Bank of America Global Research pointed out that at year- end the gap in profit growth between S&P 500 earnings per share and all US corporate profits had grown to the widest in its study’s history going back to 1955. That gap can be attributed to corporate buybacks and other financial engineering by companies in the S&P index.
As a firm that bases its investment policy on sound corporate and economic fundamentals, Mission pays constant close attention to valuation levels of individual companies and overall market indexes. We have spent a great deal of time discussing valuations in past publications and seminars. By way of updated summary, a composite of the most common valuation measures, such as price-to-earnings, -dividends, -book value, -sales or -cash flow plus market capitalization-to-GDP or -GDI shows US stocks to be at their highest level of overvaluation ever—virtually identical to dot.com levels and far above those of 1929, 1973 and 2007. Stock prices have never ultimately done well from valuation levels even close to today’s.
Compounding the valuation problem, in a study that goes back to 1986, Bank of America researchers recently pointed out that investors are willing to pay 50% more than normal for stocks relative to their long-term earnings growth expectations. To correct such severe overvaluation, stock prices either need to fall significantly or earnings need to grow much faster than expected.
Notwithstanding many logical and well-expressed prognostications, no one knows what the markets will do over the next months, quarters or years. Perhaps the world’s central bankers will be able to overcome the gravitational forces of valuations and less than enthusiastic economic forecasts and keep world securities prices rising. After all, they’re on a decade-long run of success.
On the other hand, history argues strongly that investors should pay attention to the aphorism famously attributed to Warren Buffet: In the short run, the stock market is a voting machine; in the long run, it’s a weighing machine. Popular narratives can entice investors to load up on equities even in contravention to longstanding standards of value. Eventually, however, stocks have always ultimately reverted to the gravitational force of underlying fundamentals even if they trade for years at stretched valuations.
Buy and hold investors in stocks today will benefit if 1) it truly is different from ever before, if 2) underlying fundamentals rise sufficiently to justify current valuations (which has never before happened from extreme levels of overvaluation), or if 3) a later sell decision precedes any significant and long-lasting market decline.
If markets instead eventually react to severe overvaluation, as they always have, by erasing many years of prior price gains, most investors will find themselves faced with substantially reduced assets and a difficult decision about whether or not to hang on when the then current economic news is potentially problematic.
Mission has managed client assets over the past quarter century through the run-up to the dot.com mania, through the painful bear markets of 2000-02 and 2007-09 and through the Fed-sponsored rally to present levels of overvaluation. We have always focused primarily on positive absolute returns rather than relative returns. And when we have been responsible for asset allocation, we are pleased to have been able to provide a positive return in 23 of our 25 years. The two negative exceptions saw returns barely below zero. We welcome the opportunity to discuss the appropriate level of risk assumption with each of our clients as unprecedented monetary policies seriously complicate the investment picture.
By Thomas J. Feeney, Chief Investment Officer