I sold some stock positions the other day in many accounts for individual clients, positions that were declining more rapidly than the benchmark S&P 500 Index, which is now down over 8% over the last month and has lost all its gains for the year. This is not an attempt at short-term market timing. Rather, it is reducing risk during a market decline while we re-think long-term allocations and adjust our holdings from growth to value. Models in 401(k) plans will be adjusted shortly. I’ll explain why below.
Market Correction or Bear Market?
Every so often the stock market declines 5%-12% as a way of wringing out excess greediness and too little respect for risk. Often, this occurs when the S&P 500 gets too far above its long-term moving average, like a hunting dog that gets too far afield and is called back in. I use 15% either side of the long-term average as a pretty good rule of thumb as to whether it is a correction or likely to be a bear market. If a correction, the stock market then resumes its upward march a little more cautiously.
The Way it Was
If I thought that’s what was going on, we would just keep things the same. I don’t think that is what we have here. I think rather it is the end of a long party that started when the stock market announced a half-off sale in March of 2009 and politicians and government banks threw everything they had at stimulating economies and markets. You remember the huge spending increases under President Obama that were continued with President Trump, the Federal Reserve’s strategy of flooding the world with excess money that found its way into stock and bond markets begun by Ben Bernanke and continued with Janet Yellen.
The money from the Central Bank pushed markets higher because with more to spend came more demand. You remember the long stretch of record-breaking low interest rates that far outlived the crisis and caused massive borrowing and thus spending. The result was a tremendous growth in profits for companies from higher sales and lower costs. Add to that stimulus tax cuts and regulatory easing and repatriation of overseas money and you have a tremendous boost for profits and stock prices.
The Way It Is
That was enough to send markets much higher. But, as often happens, when citizens see the market making a lot of money, it becomes more popular and people become willing to pay more for earnings. So, stocks go up because their profits are going up and they go up more because people are willing to pay more for those profits. The second can be measured by what is called the price to earnings ratio, or P/E for short. The stock market recently sold for a P/E of 24. Ignoring the spikes in P/Es that you get in recessions, that 24 P/E last month was only exceeded by the 30 P/E in 1999. In other words, only once in the last nearly 90 years have investors been willing to pay more, and that didn’t end very well, as you remember.
The Way it Will Be
But, as Bob Dylan put it in his offbeat, nasal voice, The Times, They Are a’Changin’. Profit growth for companies is slowing down a lot, from 20%+ growth earlier this year to more like 7%. More companies are disappointing investors so far this reporting season. That growth may come down even more and you may find that we are close to the peak in earnings. Here’s why.
The long run of extremely low, almost free money is over and rates are on their way back up toward normal. Normal is quite a bit higher, and Jerome Powell, the fairly new chair of the Federal Reserve Bank, thinks normal rates may be higher rates than many forecasters are saying, so get set for several more rate increases. My guess is that short rates will go up enough to be higher than long rates, a situation that normally triggers a recession.
At the same time, the Federal Reserve has stopped flooding the world with money. Instead of massively buying bonds, the Fed is letting its bond portfolio shrink. That removes from circulation money people were spending on stocks and bonds. This is often referred to as “taking away the punch bowl.” So, less money for buying stocks and bonds plus higher interest rates.
Higher rates mean less spending on cars and houses and those slowdowns are already evident, but it also means that business costs are going up in many industries and that means lower profits for many companies. Wage inflation and inflation on goods, especially with President Trump’s backfiring trade war with its growing list of tariffs, means costs are going up for consumers and businesses, and that means less spending for both and lower corporate profits. Slowing and even falling profits means stocks and bonds should fall too and with that will come less infatuation with stocks, which means lower prices.
Could the market jump up tomorrow? Sure. It could also accelerate its decline. Day to day, who knows?
Could I just be wrong about the overall theme? It’s possible, but I don’t think so. I didn’t just start doing this yesterday. If I’m wrong, the most likely error is being early. As you know if you’ve been with me for a while, I try to think long-term and in the end, that pays good dividends.
There are other ways to make 7%-10% returns aside from stocks. Real estate, now made much more liquid by what are called interval funds, that is, limited partnerships set up so that they have frequent tender offers (some as often as monthly or quarterly), is one possible way. Another is alternative energy partnerships with long-term leases. I plan to direct more client money to these areas for those clients not already fully invested there. I am looking at other alternatives as well.
Stocks will still have a place, but it will likely be value investing’s time to shine again after ten years of growth investing outperforming it. Small and international stocks will have a place again too, but I’d like to see them much cheaper.
Floating rate and short-term bond funds, which have absolutely been the place to be this year in fixed income will continue to be good holdings for us. Good old cash may get an allocation again. I will also continue to recommend alternative income funds.
There will be some counter-trend rallies in stocks. But, this year’s high fliers still have a good ways to come down before they are bargains again. It will pay to strongly consider what you’re paying for growth.
We Make Money the Old-Fashioned Way
The end of that old commercial, is “we earn it.” This is a time for guidance. This is when a financial advisor is most valuable. The sun is setting on the days of picking low-cost index funds and doing fine. Just like it was easy in the 1990s and tough in the 2000s, then easy in the 2010s, the pendulum has swung back again.
So, I will be meeting with all clients over the next couple months to adjust strategy. If you have any questions or concerns, call me. Thanks.