To My Clients, Friends, & Observers
When and how does this nine year old bull market end? That’s the question preoccupying much current reading. Of this much I’m certain: bull markets don’t end in fear, they end in ebullience.
I interpret much of the cautionary advice from the major banks and investment mills as their attempt to slow down the pace of rising equity prices. While the market appears fully-priced at almost 25 times earnings, yielding 1.78%, earnings continue to accelerate and rates are still historically low. Rates on Treasuries range from 2.8% to 3%, 5 years to 30 years. The earnings yield from the S&P 500 is 4%, compared to the historical average of 7.37%. The current earnings growth rate is 15.11% compared to a mean of 24.65% and a median of 12.01%.
Currently the P/E ratio of the Brae Head aggregate is 21, the dividend yield 2.2%. In the event of a retreat I keep a list of all securities we manage, ranked in order of P/E ratio from high to low. That generally will dictate the order and extent of liquidation.
Over $2 trillon of U.S. Treasury securities are held by China and Japan. China has ceased purchasing U.S. debt and both have been liquidating. Average maturity is 5 years. A U.S. recession is not in any nation’s best interest. The Fed has committed to liquidating its own bond portfolio. All this liquidation has to lift bond yields. Two scenarios present themselves: either an inverted yield curve as the Fed raises short rates; or a positive yield curve as longer rates rise faster. I suspect the latter is more likely.
Presently, artificially low rates have forced investors to seek higher yields elsewhere, as in private equity, real estate and the stock market. Real estate, especially commercial, appears to be (finally) peaking. Anecdotally, pension funds and insurers have been avoiding public equity markets in favor of private equity and real estate, but sovereign wealth funds are pulling out of private investments because of too much money chasing too few deals. And international buyers have slowed purchases of U.S. residential real estate by 21%, the biggest one-year drop ever.
Second quarter GDP rate was 4.1% and will likely exceed 3.5% for the year. Economic growth and corporate earnings had better accelerate for the U.S. to accommodate its growing debt service. This is the greatest threat overall. A recent editorial in our local newspaper chided the President to “Leave Interest Rates And Fiscal Policy To The Federal Reserve.” Attention, please: fiscal policy is NOT the purview of the Fed, it is the constitutional responsibility of Congress, as former chairman Bernanke so often reminded his interrogators there.
If not when, how?
Sooner or later the market will correct. Corrections we can handle. Calamities we avoid. Though I remain optimistic, some current conditions concern me.
Over the years I’ve commented on the development of technology in financial services and the securities industry. A recent article in the Financial Times contends that the rise of algorithmic trading systems endangers the markets. The predominant systems are “agnostic of human-based warnings and insights” and trade simply on momentum. It reports that only 10% of stock trading is done by discretionary human traders. The implications of this passive investing – which has grown with the proliferation of ETFs (Exchange Traded Funds) - are potentially volatile swings in prices and liquidity. We do not invest in ETFs.
ETFs are potential weapons of financial mass destruction. When one component of an ETF cannot be priced, the entire ETF cannot be accurately priced. The corresponding market trades without it while the ETF has to be halted and all trades cancelled. This already occurs regularly. In a major market sell-off, ETF holders could be stranded without execution.
“Passive investing” in ETFs presents another danger. A mass selloff of an ETF index compels a systematic selloff of all its underlying components, accelerating falling prices.
Some of the tensions between Americans – the haves and have-nots, the working class and the investor class- are highlighted by the tax code. Taxes are highest on workers’ “earned income,” 22% starting at $38,700 up to 37% over $500,000. For the investor, federal taxes on qualified dividends and capital gains are 0%, 15% or 20%, depending on tax bracket. However, the wealthy have lost unlimited deductibility of state taxes and mortgage interest.
After 20 years
My first full year of measured total return was 1999. Through 2017 my aggregate, average, annual, unweighted, total return performance has been 7.34%. The S&P 500 Index has returned 6.09%. The aggregate includes all of our managed portfolios which also have included a lot of cash. The time frame included the tech blowout of 2000 to 2002 and the financial crisis of 2008.
The ultimate commodity is time; the ultimate asset is health; the ultimate return is peace of mind.
Dennis M. O’Connor