Happy Friday the 13th! Hopefully your life is filled more with Christmas cheer than Halloween spookiness these days. The stock market continues to be on Santa’s Nice List as we approach the end of the year, with a new high set yesterday. Brexiteers certainly got what they’ve been asking for (for 3 ½ years!?) in the form of a runaway majority for the Tories in the U.K. election yesterday.
Stateside, the Fed is now officially “on hold” after neither raising nor cutting the Fed Funds rate Wednesday. Also in the Wide World of Washington, Congress is on the verge of forging a spending plan to avoid a government shutdown, and Trump says he is near a deal with China. Perhaps in this crazy world, at least for one moment, all might be calm and bright.
We hosted a gleeful gathering of customers Tuesday at Fort Wayne Country Club for our annual Christmas lunch seminar. The ballroom was festively full of good folks and good food. For those who couldn’t make it, we’ll try to get you up to speed.
John introduced the Monarchians (8 of whom were among the group), and in particular, it was noted that the newbies – Stephanie, Adam, and Debbie – had all congregated at the “rookie table.”
We reminded the crowd what a difference a year makes. Last December, we had gathered amidst a market that was in the process of getting shellacked thanks to the Fed’s decision to raise rates a 4th time in 2018 and (critically) predict they would continue raising rates in 2019. Virtually every asset class, including bonds, lost money in 2018. The opposite effect has been borne out in 2019, with pretty much every asset class in the black, even hedge funds! Hedge fund investors, plagued by mediocre results for 11 years running, are surely rejoicing for the +6% return produced by the HFRI in 2019. The big story in 2019 – again – is that U.S. stocks still reign supreme over all.
We acknowledged that perhaps 1 or 2 customers might want to know our thoughts on where the market is headed as we approach a new decade, a year in which you would think we would all have great visibility thanks to the number (20/20). John instead turned the tables and surveyed the crowd, asking them, by a show of hands, to predict the return for the S&P 500 in 2020. The crowd could vote for 1 of 4 return buckets: negative, up 0-5%, 5-10%, or more than 10%. The bears who voted for negative returns tallied roughly 15% of the vote (remarkably, most were at one table in the back…was the coffee not as fresh?), roughly 50% voted for up 0-5%, and 33% voted for up 5-10%. One lonely person voted for double digit positive returns…and it was none other than Dave Meyer! If that comes to fruition next year, and it might very well, just remember to give him the credit.
We admitted that we don’t have 20/20 vision just yet on 2020. And while we risk being seen as the proverbial “two-handed economist” who will predict something on the one hand, but immediately forge a caveat on the other hand, we showed just a few of the conundrums we ponder on a daily basis:
To the 3rd point, the chart below shows just how much more value stocks have right now compared to bonds. The black line is the “earnings yield” of the S&P 500. This is how much earnings are generated by the companies in the S&P, as a percent of their market value. So, it’s a measure of how much earnings bang you get for your buck. We compare that to bond yields (the 10-year treasury bond yield in this case), and then look at that comparison over time. This chart goes back to 1959 and shows that earnings yield and bond yield very much travel together, and have been fairly close to each other until this cycle. In this cycle, earnings yields have been stubbornly higher than bond yields, normally by at least 3%. This confirms a lot of data and sentiment on the “stocks vs bonds” cage match. Even with the fantastic stock market since 2009, more money has flowed OUT OF U.S. stock funds than INTO them. In EVERY other cycle, stock funds accumulate hundreds of billions of new money every year of bull markets. In this cycle, all the new money has gone into bond funds, helping to keep bond yields low:
In 1999 and 2000, the S&P’s earnings yield was actually BELOW the bond yield by nearly 3%! What happened over the next decade? It was the worst ever 10-year period for stocks, and a very good period for bonds. Speaking of the late 1990s, another feature of that bull market was that U.S. stocks dominated the rest of the world. The following chart compares the S&P 500 (gray line) to the ACWI ex-US index (all stock markets except the U.S.). The gain from 1997 to the peak in March, 2000 was +106% for the S&P and only +48% for the ACWI-ex US. After a nasty bear market for both regions, the next cycle went to the rest of the world, emerging markets and Europe in particular, +216% to +101%. After the financial crisis, all regions emerged fairly evenly until 2011. At that point, they completely bifurcated, with the total return since 2009 now at +340% for the S&P to +107% for the rest of the world. Will this revert back against us, and when? Good questions!
Our final conundrum is how much we should care about the $23 trillion national debt, and $1 trillion annual budget deficits. Clearly, we should care a lot for the long-term, but in the shorter-term, it should be known that state and local government debt are decreasing as a percent of GDP. Banks are much less leveraged than they were last cycle. And the consumer has NEVER been healthier, if you consider the “household debt service ratio”:
This data series calculates how much “debt service” consumers are paying every year, as a percent of their income. So, this would include not just interest, but principal payments too. The important feature of this is looking historically. You will not find a lower reading than the current one. Notice the sharp drop starting in 2009. This was partly a function of falling interest rates. But mostly, this was a result of households decreasing their debt load…by losing their houses via foreclosure. That’s not the way you want to see consumers reducing their leverage, but the more important point is that the consumer has not – at all – leveraged back up this cycle. Despite home prices that have risen back to their old highs, and despite what you hear about student loan debt and auto debt, household debt is not too high. While total household debt is now 10% higher than the previous cycle peak, at $14 trillion, let’s not forget that our economy has grown by 48% since then. So as a percent of GDP, household debt is a whopping 33% lower now than last cycle. Even better, interest rates are much lower, which is why this data series above looks especially good.
This aroused some questions from the crowd about the sustainability of interest rates this low. And that is true, that if we are to see 4-5% interest rates (and 6-7% mortgage rates), no doubt this would have a big impact on loan demand across the board. The spotlight would shine particularly brightly on federal debt service, which would start to crowd out all other federal spending, including entitlements. Fiscal austerity would be mandated. This whole cycle, we have been concerned about a reversion to higher interest rates (especially as the labor market continued to strengthen), but it hasn’t really materialized. Rates started to rise in earnest last year, as the Fed raised rates in an attempt to “normalize” them at higher levels, but the bond market grew concerned that the trade war would damage the economy and ultimately the bond market convinced the Fed it had raised rates too far and needed to cut. We saw the first part coming when Jay Powell was hired as Fed Chair. Given his stature at nearly 8 inches taller than Janet Yellen, the chart below shows it was inevitable that he would want higher rates….Fed Chair height and rates are strongly correlated:
Paul Volcker, the giant on the left side, passed away on Monday. As Fed Chair in the late 1970s and well into the 1980s, he had a large role in getting the U.S. economy out of the doldrums and back onto the path of global competitiveness.
We noted that 2019 has marked a time when the yield curve either inverted, nearly inverted, or kind of inverted, depending on how you look at it. The most common way of measuring an inversion is to compare the 2-year treasury yield (a proxy for where short rates are headed) to the 10-year treasury yield (long rates). If the 2-year yields more than the 10-year, that’s a message from the bond market that the outlook for Fed policy is too tight. The 2-year remained under the 10-year for the whole year until August, when it poked its head above for 6 days. Since then, both have gone back up, but the 10-year now has a gap of 0.2% (black line is the 10-year; yellow line is the 2-year):
Looking at the actual yield curve below, with short-term rates on the left and long-term rates on the right, you’ll see the blue line, which was the yield curve on August 31. A classic inversion, as we saw in 2000 and 2006, would look instead like a line consistently going down as you move from left to right. Recessions followed within 2 years in each case. August 31’s was more V-shaped, and we saw similarly shaped curves in 1998 and 1966, which did not immediately precede recessions.
Now, the black line shows a very normal-looking curve, upward-sloping from left to right. Did we dodge the bullet? Is a soft landing now preordained? Obviously we all hope, and the stock market appears to be starting to price that in. But there are no certainties, especially given the tenuous circumstances of the trade war.
So, what do you do after a year when stocks are up 25%? Does that automatically mean you need to take profits and trim positions? No it does not. But it might be cause for rebalancing. If you had a target asset allocation of, let’s say, 70/30 (70% stocks, 30% bonds) at the start of the year, by now it’s probably closer to 75/25 if no trades had been made to rebalance. Here’s what it would look like to rebalance back to 70/30….assume a $1 million portfolio to start the year:
With your stocks up $190,000 (from $700,000 to $890,000), you would need to take $60,000 out of stocks and put it into bonds. How you react to that proposal probably says a lot about how you feel about risk management right now. If your first thought is “great idea, take some profits, claim victory, de-risk back to my target,” then you have some measure of risk aversion…a healthy measure most likely. If your first thought is “why would I want to put it into bonds at these yields?” then you have less risk aversion, and your time horizon is probably longer. You might be looking out 10 years and saying to yourself, “I can lock in 2% yield for 10 years in a treasury (or less for a muni), or I can collect dividends which are currently at 2.5% yield, and even considering a modest 4% growth rate in dividends over 10 years, would equate to a 3.7% yield on cost after 10 years. Even assuming a dire forecast for stocks of 0% return over 10 years, I come out ahead on the income.”
Who’s right? Both, either! I mean, it probably depends on what actually happens over the next 10 years, but our job is to get you through those bear markets intact so you can harvest in the good markets. Suffice it to say, we are initiating a lot more of these conversations lately, just given how far the stock market has come. Again, we never try to time the market, but rebalancing is a healthy exercise. Note that in the above case, the investor gets $60,000 added to their $300,000 bond portfolio. That’s a bigger safety net, but it’s also more bonds that can be turned into stocks someday at cheap prices. Buying during bear markets is the easiest way to generate excess returns as an investor. But you need some dry powder to buy the stocks. Bonds can be that dry powder. Look at the rebalancing exercise that is the opposite of the above (a bear market):
If your stocks fell 20%, or $140,000 from $700,000, your allocation would fall to 65/35. Time to rebalance back up to 70/30! In doing so, you would sell $43,000 of bonds and that affords you $43,000 to buy stocks at cheap prices. Eventually, this will have most certainly been a fantastic idea.
We aren’t calling for the end of the bull market just yet. Our much-ballyhooed “Bull Market Top Checklist” still has only 2 of 10 boxes checked:
As a reminder, all 10 of these conditions were present at the peak in both 2000 and 2007. The flattening yield curve already happened and is starting to steepen again. M&A is usually a good signpost because at the end of a cycle, companies start to grow desperate for growth, because they see their ability to grow internally growing slimmer. As profits have stopped growing in the last couple quarters, we see that is part of it, but also, large companies are still flush with cash thanks to the corporate tax cut, the tax-free repatriation of cash from their overseas operations, and low borrowing rates. Wage inflation is hovering in the low-mid 3% range, which is denting profit growth, but we are surprised it hasn’t gone higher given how low unemployment is and that we are in year 11 of this economic expansion. No other variables are even close.
We understand how far the stock market has come, and how well investors have done, especially if they had a lot of American stocks. To some, this re-launches the eternal debate about income inequality in the U.S. George presented some data on wealth, using federally-reported data series that stretch back a long way. He stressed that he is not trying to prove any points, but if, say, you anticipated spending the holidays with some family members who don’t share your view on the issue, perhaps the data will support a healthy debate. Here’s what we showed:
A lot of focus has been on the bottom half, the percentage share of wealth. The share of the top 1% has grown to 29% from 23.5% in 2009. The 2009 year marked a very low point for not only stock values but also housing values, but the share of 24.9% in 1999 would seem to be more of an apples-apples comparison, confirming that this cycle has seen big gains accruing to the top. On the other hand, the top half of the table shows that the dollar value of assets for the bottom 50% has grown considerably, and consistently, in each of the last 3 decades. This may be surprising to some.
That said, the median of household net worth in this country is only $97,000. That means the richest family within the bottom 50% group, totaling 64.2 million households, has $97,000 in financial assets and home equity combined. Half of the country’s households are below that. In a time when political aspirants have no qualms about suggesting that the rich forfeit as much as 8% of their assets every year, it’s easy to see that a lot of folks could use an extra few bucks. While higher taxes would help bills get paid, even better would be for some of the tax dollars to be an investment for the longer-term (the saying of “teach a man how to fish” comes to mind). This could take the form of advanced education, medical care, a better housing situation, or healthier food.
As you would expect, that $97,000 is higher than it was in the past. It is cyclical, but it has grown every cycle, as the top section above confirms. In other words, income inequality may be a burning issue today, but then it’s always been a burning issue. In fact, we have other data that show that share of wealth nestled among the top 1% used to be considerably higher in the U.S. prior to 1913, when the first income tax (1% of income!) was introduced. How high could/should income taxes go before they turn the country into a “sinking tide” (as opposed to a “rising tide” which lifts all boats)? As investors, hopefully we won’t try to replicate Europe’s success, or lack thereof… The pan-European Stoxx 50 Index has yet to even catch eyeshot of its 2007 or 2000 highs:
In summary, if you’re still reading this, we wish you the happiest of holidays, the Merriest of Christmases, and a healthy and prosperous New Year!