Thank you to all who joined us at our “annual” Fall Seminar on October 24. Quite a few clients were at their very first Monarch seminar. We will host a couple of lunch seminars this winter, as we do every winter. Stay tuned….
Also a huge thanks to Lakeland Financial CEO, David Findlay, for taking the time to join us and talk about how well Lake City Bank is performing. His presentation morphed into a fireside chat with Dave. The two Daves recalled how we first bought into the bank in 1999, around the time that David joined Lake City, and about how the bank navigated the financial crisis. We bought a lot more stock when they exited TARP in November, 2009. The stock price has more than quadrupled since then. At the end of the day, David says the bank’s formula for success is pretty simple: putting customers and employees first. And yet, it is virtually the opposite of how most big banks are run.
We want to use this occasion to share a synopsis of our market presentation, for those who couldn’t make it, because it encapsulates our current thinking on the market. People ask us everyday whether we are near the top of the bull market. We revamped the Strategas “Bull Market Top Checklist,” which shows 9 conditions which were met at the end of the bull markets in 2000 and 2007. None of these are present today (although we might be adjusting our thinking in the last week…read on). We then provided a graph for context for each of the 9 conditions. Guess what…we’re going to show you all the graphs! Since there’s no cost of paper and postage, why not?
First, the revamped Checklist:
As you can see, the “x” indicates that the condition, such as “heavy inflows into equity funds,” is not prevalent today.
Mutual Fund Flows
Below is our famous “mutual fund flows” chart, which tracks the cumulative amount of money which has flowed into (and out of, in the case of U.S. stocks) mutual funds and ETFs of each asset class. It’s not surprising that bond funds attracted a lot of money during the financial crisis and even in the wake of it. Investors had a right to be wary and nervous about stocks after a debilitating 60% drop in the S&P 500. But years later, investors are still pulling money out of U.S. stock funds (when the line slopes down) and piling into bonds (when the line slopes up). Even in 2017!! Pretty much every bull market ends AFTER everyone has piled into stocks, and that hasn’t even begun yet.
The further we get into an economic expansion, the more corporate mergers take place. This is because companies become a lot more willing to take on new risk as the previous recession becomes a lot more distant in the rear-view mirror. The chart below would seem to indicate that a lot of deals have taken place this cycle, especially when the red line (showing total $ amount of the mergers) peaks in 2015. Still, this line should be a lot higher than either of the previous peaks, simply because the economy is a lot bigger now than then, which is why it gets an “x.” Although admittedly, it could just as easily be a checkmark. Our best guess is that we see another spike in M&A before the expansion ends.
This has been a very unusual cycle for IPO’s, with far fewer of them than in previous cycles. There is one big reason for this: new companies are staying private a lot longer than they did in the past. There are hundreds of billions of funds piling headlong into private companies, which absolves the new companies of the need to go public. Furthermore, most companies that have gone public have found their stocks languishing at valuations much below similar companies that are still private. So, going public results in a valuation markdown. This is irrational, but it has persisted for many years now.
Yield curve steepness
We have always watched the yield curve like a hawk, because it is one of the greatest leading indicators for the economy. Great because it is almost infallible and because it gives you a year or two before the recession starts and the bear market commences. Virtually every recession (the blue columns on the chart below) is preceded by an inversion, meaning that short-term interest rates (the white line represents 90-day treasury bills) yield more than long-term interest rates (the yellow line represents 10-year treasury bonds). This is highly unusual, because the investor deserves to get more yield from longer-term bonds simply because they are riskier. But somehow, the bond market figures out when the Fed has raised interest rates too far, and people start buying long bonds, which pushes their yield down. Right now, short-term rates keep heading up as the Fed keeps gradually raising rates. Long rates have see-sawed a bit in the 2 years of rising short rates, but are still comfortably above the short rates. If the economic expansion continues, we would expect to see both rise for a time, followed by long rates dropping below short rates at some point.
Another very reliable leading indicator to recessions is hourly earnings growth, or wage inflation. As you can see on the chart below, wage inflation has exceeded 4% in each of the last 3 cycles, but not much more than 4%. Why is it seemingly detrimental to the economy to be filling employees’ wallets with more cash? The problem is that companies start to question hiring decisions once labor gets too expensive for them to be able to grow profitably. And, it always comes at the same time that the Fed is raising interest rates, which is a double-whammy hit to their bottom-line. As for right now, we’ve seen wage inflation inch up closer to 3%, but we’re a long way from 4%, despite very low unemployment rates.
Erosion in Breadth / Shift toward Defensive Leadership
The following chart is harder to explain. It shows how many stocks are currently trading close to their 52-week highs (within 10% of the highest stock price, the blue column), how many are down 10-20% from their highs (the pink column), and how many are down more than 20% from their highs (the light green column). They are organized by sectors. So, in Financials, Tech, Industrials, and Materials almost all stocks are trading close to their highs. Even in Health Care, Consumer Staples, Real Estate, Discretionary, and Utilities, most are close to their highs. Only in Energy and Telecom (a sector which has only 3 stocks anyway) are there more laggards than leaders. This shows that breadth in the market is still widespread; investors aren’t crowding into just a couple sectors like they did in the late 1990s (tech, telecom, media, megacaps) or 2006-08 (banks, REITs, then energy and materials). When that happens, it soon marks the end of the bull market. After that, when the market enters a bear market, consumer staples tend to perform the best, with utilities and/or telecom holding up pretty well usually, as well as health care….these are called the “safety sectors.” Clearly right now, these are not the leading sectors.
That said, we are starting to notice more crowding suddenly, especially into growth stocks and out of value stocks. This typically happens at the end of a bull market too: companies which aren’t growing are dumped, and money flows into faster-growing companies, and especially those whose stocks have a lot of momentum. Even though the S&P is +16% in 2017, 356 stocks in the Russell 3000 Index are down more than 20% this year! That sounds like an argument against breadth.
Think about a rubber band being stretched a lot, so that the two ends grow farther and farther apart. Eventually, it snaps and a mass reversion to the mean results, meaning that the growth stocks pull back, and value stocks are winners. This happened big-time in 2000, after the market peaked. The reversion was violent, and persisted until the end of the bear market in 2002. There were thousands of stocks which actually rose during the bear market, when the S&P 500 lost 50% of its value. Thankfully, we owned quite a few of them…that tends to help performance a lot.
As for this crowding, we would say it shouldn’t mark the end of the bull market yet, but we’ve possibly entered the late innings. There is a difference…if you’ve been watching the World Series, you’ve seen how many home runs have been hit in the 9th inning or later!
Junk Bond Spreads
The longer a bull market goes, the more investors tend to forget about risk. Risk-seeking can be measured tangibly by how much extra yield you get by buying junk-rated bonds, less that of treasury bonds. That “spread” is now at 2.95%, which is historically low. Historically, the spread bottoms out before the recession, by a few years, before rising a lot during the recession. Yes, it is possible to lose a lot of money in bonds; we avoid it like the plague.
At the end of the bull market, investors really cram into the hottest part of the market, and the chart of that part of the market shoots straight upward. This happened to the tech stocks in 1999-2000 (Nasdaq—green line below), homebuilders in 2004-05 (blue line), and oil stocks in 2007-08 (red line). The thing to notice about these is the shape of the line. No part of the stock market resembles this right now, unless you count Bitcoin.
So, the bottom line is that we still think this bull market isn’t over yet, though it’s probably pushing into the late innings.
A look at some of our stocks: the good and the…not as good
Dave (Meyer) then looked at the long-term fundamental charts of a couple of our big holdings. These are created by a research group called SRC, and they show 5 lines: stock price (navy blue), moving average (bright blue), earnings per share (green), dividends (red) and relative performance versus the S&P 500 (purple). First up to bat is Procter & Gamble:
P&G would be an example of a company with a long track record of success routinely broken up by periods of sluggish performance. Consumer staple stocks typically don’t grow all that rapidly, but some of the sluggishness this cycle is self-inflicted…notice the green line (earnings) is basically flat since 2009. We first bought the stock in 2000 after it crashed, so it was a very good holding for many years. Though it has hit an all time high this year, it underperformed the market this whole cycle.
Then we looked at the good. This was a strategic choice, with the intent of lathering up the crowd in anticipation of our guest speaker. But Lakeland Financial is very deserving. Note all those upwardly-sloping lines.
Finally, we showed what a “non-growth” stock looks like, Ford Motor. Ford has the distinction of being the only one of the Big 3 American automakers to survive the financial crisis in one piece. But Ford is earning less money than it did in the 1980’s. Therefore its stock is lower now than it was back then.
If you have any requests, we’d be happy to send you a chart on your favorite stock!