What Happens From Here?
February 28, 2017
Our Stock Market View
Some investors may have far too much of their portfolio in cash. In some cases, they are 100% cash, expecting a negative reaction to Trump’s election. When asked, “Why so much cash?” their answer is, “I’m waiting for a pullback in the markets.” When asked what research was used to make such a rash decision, the answer is almost always their gut feeling. In our opinion, these investors are making a huge mistake. Let me explain why.
End of the Earnings Recession
As we’ve discussed in several previous educational pieces, the S&P 500 suffered from six straight quarters of year-over-year operating earnings declines. Last quarter was the first uptick in year-over-year earnings, and the expectations for earnings in 2017 and beyond look very bullish. This should help propel the S&P 500 to further highs.
The U.S. Economy Is Sound
As a client of Polaris Greystone, you know that we base our portfolio decisions on our proprietary four pillars of investing. We are a top down manager, meaning we begin by looking at the macroeconomic conditions of the world’s largest economies. We begin with the United States since it is the largest economy in the world and has the world’s largest consumer market. The top graph below shows the Conference Board Coincident Economic Index, a measure of current economic activity. The bottom chart is the Chicago Fed National Activity Index. The red line is a three month smoothed average of our current economic activity. Zero means average economic growth. If the line were to move up through the top dashed green line it would indicate inflation, while a retraction below the lower dashed green line would indicate that we were in a recession. As you can see, our current economic activity indicates steady, normal growth.
The S&P 500 Is Technically Strong
One of the other things that our investment team constantly assesses is the strength or weakness of the market on a technical basis. There are many ways that we look at the market’s technicals. Below I have provided one of them, a monthly price chart showing the S&P 500 dating back to 1997. The blue line in the top part of the chart shows the tops of the market in 2000 and 2007. The second part of this chart shows the MACD indicator, a momentum indicator based on moving averages. As you can see from this chart, the previous three times the MACD had a “crossover” (which I circled), the S&P 500 has made significant positive moves, rewarding stock investors. Will this “crossover” bring equal rewards? Time will tell.
The Markets Are Properly Valued
Those of you who have attended my presentations know that we also consider the valuation of the S&P 500 to understand possible risks. We believe that looking at the 25 year averages of valuation measures such as the price-to-earnings ratio, dividend yield, and price-to-book ratio, is an accurate way of viewing current valuations. As you can see from the chart below, the markets are very close to being properly valued.
Remove Politics From Investing
Our client base spans the full spectrum of political beliefs. As the Chief Investment Officer of Polaris Greystone, it is my job to remove the emotions of investing from our decision making. Our current political environment is a perfect reason to be as clinical as possible. We have already featured what we believe is political rhetoric versus an actual platform that this government plans to act upon. While we believe that much of this administration’s comments are nothing more than rhetoric, there are things that should be good for our economy:
My Biggest Fear
My biggest fear is not the stock market. While I don’t have tomorrow’s newspaper, Polaris Greystone is constantly monitoring the overall risk of the stock market and we feel comfortable navigating these unchartered waters.
Just recently I’ve begun showing the chart below. It’s untitled on purpose. It shows an almost twenty percent loss between July 2016 and December 2016. What if I told you this was a major index? Would that have you more concerned? More importantly, why has the media not been reporting on this major index's losses? Which index is this?
It is the Barclays Capital U.S. 20+ year U.S. Treasury Index. Bond investors are in for a rough ride in the years to come. The Federal Reserve has already indicated that they intend to normalize federal fund rates. What does that mean? They’ve indicated that they want to have rates at 3% in the next few years. As you can see below, there is only a 4% chance that the Fed will leave rates where they are this year. Most predict that the Fed will raise rates 25 basis points, or .25%, at least two times this year (see below).
To illustrate our point further, I thought it important to show the impact that a one percent move would have on different areas of the bond market. The adjacent chart shows that a one percent increase in interest rates would mean that a 30 year U.S. Treasury would lose over 17% of its value. Corporate and municipal bonds would each lose over 6%. A 10-year Treasury would lose over 8%.
The S&P 500 is well positioned to make further moves to the upside. This does not mean there might not be some bumps in the road, but our fundamental and technical research certainly point in a positive direction. The same can’t be said for bonds. The headwinds facing bond investors look to be strong and long-lasting. Bond investors will have to be more vigilant in the coming months and years to protect and grow their portfolio. This is why Polaris Greystone tactically manages its portfolios. We attempt to overweight areas we believe will have strength and underweight or eliminate areas of perceived weakness. 2017 will definitely have its own surprises. Every year does. We look forward to navigating them with you.
As always, I welcome your comments and questions.
Jeffrey J. Powell
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