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by Jonathan Goudy / News
Since the end of the financial crisis in June 2009, the current economic expansion has lived for nearly eight years. Counting from the last major market low in February 2009, the current bull market is now more than eight years old. The Fed has hiked its benchmark interest rate three times in the past few years, while a strengthening dollar over the same period further tightened financial conditions. Arguably, this economy is starting to show its age and anxieties are becoming more difficult to ignore. A review of the anxieties held by investors (you) and investment professionals (us) follows.
Equity Valuations – “The stock market is just too high” is something heard from clients more and more these days. True, after a near 20% rally in large cap domestic equities in a short period of time, it may seem that stocks are expensive, but considering the recovery in corporate profitability as shown in the chart on page 3 (“Earnings Recovery in S&P 500”) perhaps these stocks were just too cheap last year and are now back to where they should have been all along. We think a bottoming of earnings growth rates is illustrated in the right side of the chart. The trend of rising corporate earnings can be seen as well.
Often investors cite the price-to-earnings ratio (P/E) in relation to historical average as a measure of relative value. However, this comparison must be done carefully to consider the impact of changes in inflation rates. Since the early 1970s inflation has declined. During periods of lower inflation, P/E ratios can arguably be higher without being considered too expensive. A simple approximation of an inflation adjusted P/E ratio would be the sum of P/E and an inflation measure, like the Consumer Price Index (CPI). The chart on page 3 (“Inflation Adjusted P/E”) graphs P/E, CPI and the sum of P/E plus CPI. Observing that unadjusted P/E ranges between 10-25 while inflation adjusted P/E has a higher bottom range of 15, one might conclude that current valuation levels may not be as expensive as first thought.
Rising Interest Rates – A worry of fixed income investors is that rising interest rates can serve as a drag on the performance of their bond portfolios. Though our efforts to provide diversification through broad exposure to maturity ranges, industries and geographies are expected to reduce risk, investors who focus on quarter-to-quarter or year-to-year results have a right to be concerned. However, since the Federal Reserve’s first rate hike in December 2015, yields and prices for benchmark 10-year Treasury bonds are essentially unchanged. In November 2015, the U.S. 10-year had yields between 2.2% to 2.3%. As recent as March and April 2017, they yielded between 2.2% to 2.4%. Considering how Gross Domestic Product (GDP) growth rates continue to average less than the 2.5% aim of the Fed, it seems unlikely to us that the pace of rate hikes will dramatically accelerate. Therefore, longer rates should not make a sudden lurch higher, but rather match the Fed’s slow pace. Expectations of a gradual rise in rates showing up as paper losses until maturity while collecting coupon income along the way ought to be satisfactory for bond investors.
The Trump Administration – In discussions of the economy and markets, we refrain from partisan political commentary. However, when objectively viewing the results of what the Trump administration has accomplished in terms of legislation thus far, a fair observation could be that it has been less than what the campaign promised. The reality of governing could serve as a check on then-candidate Trump’s bold promises being enacted.
Earnings Recovery Stalls – A deeper analysis of the recovery in corporate earnings can give us concerns. At a broad level, there are two issues. First, the low base of previous years has made it easier for managers to achieve profit targets, especially after guiding these lower. Second, there is a casual perception that the earnings recovery may be concentrated in energy and financial sector stocks. Energy companies have benefited from oil rallying from the low $20s to $50 over this time. Banks have actually earned income on their excess reserves while prior to the hikes they did not. Our hope is that the rebound in earnings will not remain limited to only these two sectors, but will expand to the broad market.
Chair Yellen Raises Rates Too Quickly– With more inflationary pressures than a few years ago our worry is not that the Fed has begun to hike interest rates. Rather, our concern is that the Fed hikes too quickly and forces an unexpected deceleration of economic growth. A recession that starts prematurely invites deflationary pressures similar to those last seen in 2008-2009. Also, with little progress being made in per capita income since 2007, a recession beginning before average Americans experienced any wage gains could turn off another generation of investors from investing in stocks.
The Trump Administration – If President Trump is unable to deliver on any of his headline campaign promises, or even only delivers but a pale shadow of them, he could be
a one-term president. It is worth noting here that America’s economic progress during recent one-term presidents (Carter, Bush 41) pales in comparison to those two-term presidents from both parties.
Our sympathies are with those who feel anxiety over the stock and bond markets. Rather than lament the dearth of opportunities, or wax nostalgically for the higher returns of bygone eras, truly successful long-term investors will focus on using the stock and bond markets to earn the highest rate of return in relation to their risk tolerance. Part of the reason nominal bond yields and equity valuations may seem unappealing today is that investors forget the punishing inflation of bygone eras. In an era where global central bankers have demonstrated they can thwart inflation, the sustained purchasing power of today’s dollars is an often overlooked component of portfolio return. Investors whose assets are properly allocated among stocks, bonds and lower correlated alternatives should have nearly the same opportunity for rewards as they always have.
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