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"The Beat Goes On" - Market Commentary - October 2017

Overcoming a brief retreat in the first half of August, the stock market continued its march higher posting solid gains in the third quarter.  Now up 14% and 22% for the year, the S&P 500 and NASDAQ seem to set new highs daily.  The MSCI All-World international index is up 22% year-to-date.  The strong international gains have been a welcome development for Woodmont given our steps in recent years to increase investment exposure to cheaper overseas stocks with appreciated U.S. dollars.  Even the small-cap Russell 2000, which just six weeks ago was essentially flat for the year, is now up 11% year-to-date after a huge bounce on renewed enthusiasm for a successful tax reform bill. 

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These market gains, or at least the lack of volatility, keep surprising many on Wall Street.  The Street’s anxiety regarding market valuations, the drum beat of which has only increased as this bull market grows older, is regularly featured in the media.  Main Street investors are more difficult to pin down.  There’s some complacency, yield chasing, and popular trades such as crypto currencies and volatility-focused exchange traded funds (ETFs) that often surface around the latter stages of a bull market.  Yet on the other hand investors are far from euphoric.  A recent Gallup poll of retail investors found that 54% anticipate a market correction this year.  This is down from 62% in 2013 (a great time to have been buying), but hardly the bullish sentiment that typically foretells the end of a market run. 

Amidst the market’s many different beating drums, it is prudent to maintain a healthy skepticism for the actions of the herd (Main or Wall Street) and avoid the temptation to call tops or bottoms by jumping in and out of stocks.   Consistent with the discipline of increasing investment risk when stocks are cheap and reducing it when they are more expensive, we are either holding some cash or have a tactical tilt toward a modestly more defensive allocation for portfolios.  While tough to appreciate when the markets are on a steady climb, these steps should help preserve dry powder to invest when the music slows or stops.  

Unless You Plan to Unplug, You Must Take Precautions! 

Equifax’s recent data breach affecting 143 million Americans is just the latest in a growing list of high-profile incidents that highlight the risks of an online and connected world.  Our growing propensity to shop online and share life’s details with loved ones and total strangers alike will only increase the chances for identity theft and cyber fraud.  Since we don’t expect anyone to unplug, we offer a few tips for protecting your data in the piece accessible via this link.  You can also find guidelines for how to deal with the Equifax breach and protect your credit profile via this link.  If you are hesitant to click either link, give us a call and we can send you the documents in the mail.

Is Cyber Space All Risk and No Reward?

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We’ve briefly discussed what artificial intelligence (AI) may mean for our economy in p revious commentaries.  Suffice it to say, the ramifications for the AI that is in motion today, not to mention what advancements will emerge, will be profound and likely represent the core of another technological revolution. 

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 Besides AI, two technology enabled innovations that have garnered lots of attention this year are Bitcoin and Blockchain.  Bitcoin is a “crypto currency” with a theoretically limited supply, which was created by an anonymous computer wizard in 2008.  Many copycat digital currencies, such as Ethereum and Potcoin have emerged.  According to the Wall Street Journal, there were 105 “initial coin offerings” in the third quarter or almost twice as many as in the first half of the year.  This digital money can be used to buy goods and services if the seller accepts it as payment.  Since its introduction, the demand for Bitcoin and its price have increased dramatically.  Priced at less than a dime in 2008, Bitcoin is now around $4,400, despite frequent cautionary statements from many respected market participants.  The CEO of J.P. Morgan, Jamie Dimon, recently predicted the crypto currency explosion will end badly.  He explains that ultimately governments have an incentive to regulate currencies and could declare any “digital” currency illegal.  In fact, China issued a ban on Bitcoin last month.  Considering the S&P China debt downgrade around the same time, the Chinese government’s timing seems to support the thesis of Bitcoin enthusiasts, which is anchored in general distrust of financial institutions and monetary policy.  

When clients ask if they should buy Bitcoin, we can appreciate the attraction considering the seemingly infinite upside.  We urge caution, however.  After all, like any currency its value depends solely on the sentiment of buyers and sellers versus the utility from owning an asset that generates earnings for the benefit of its owners.  Put another way, if the buyers lose interest, today’s Bitcoin could turn into yesterday’s tulips. 

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A discussion of potentially transformative technologies is incomplete without considering Blockchain.  In a recent interview with the Wall Street Journal, one Silicon Valley entrepreneur explained “Bitcoin is a way to have programmable scarcity. The Blockchain is the data structure that records the transfer of scarce objects.”  The net effect?  If the transfers are accepted by enough people you have a Blockchain that can facilitate transactions for practically anything of value or that is recorded in today’s ledgers.  Blockchain becomes the “Internet of Money,” eliminating the need for many back office functions and staff.   Companies are quickly moving to explore the possibilities to gain a competitive advantage, or for fear of being left behind.  Adoption of Blockchain hinges on confidence and the buy-in from industry participants, which can prove tenuous.  But unlike a “crypto currency,” that confidence will be augmented by the pursuit of the efficiencies that may be necessary for a company to remain competitive.

Resilience in the Face of Global Uncertainty

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Recent events have further complicated an already tumultuous geopolitical and economic landscape.  North Korea continues its sabre rattling having launched more missiles including now over Japan. Political factions in Europe have clouded the leadership and policy picture, China’s debt has been downgraded, and political party in-fighting and divisions seem to have paralyzed Washington at a time when American leadership at home and abroad is desperately needed.  Nevertheless, on the surface markets remain calm.  So calm, the S&P 500 is without a 2% up or down move this year, and traders are emboldened to bet against volatility as evidenced by the current net short position in the Volatility index (VIX).   Only time will tell whether this is dangerous complacency or a reflection of changing market structures and new investing instruments we’ve discussed before.

Valuations:   So Where Does All this Market Resilience Leave Stocks? 

The year-to-date decline of the dollar versus other major currencies has proven a tailwind for U.S. companies’ earnings.  This has been no small boost given over 40% of S&P 500 earnings are from outside the U.S.  In addition, modest economic growth, and companies still finding ways to do more with less and thus preserve operating margins, have contributed to solid earnings growth in 2017.  With two quarters left to report in 2017, the consensus Wall Street non-GAAP earnings estimate for the S&P 500 is $131.  This is up 10% from 2016.  At 19X 2017 earnings, stocks are trading at valuations near the upper end of historical averages but far from some previous market peaks.  While a little early to hang one’s hat on the 2018 picture, the current consensus is for $145, implying a market price to 2018 earnings multiple of 17X.  The recently proposed Republican tax plan includes a reduction in the corporate tax rate that most estimate could add $7-$10 to 2018 earnings.  How much of this earnings accretion has already been anticipated by the market is tough to say.  We’ve been anticipating some variation of corporate tax reform all year.  While we are sticking with that call, we took note last week when Tennessee Senator Bob Corker commented that “tax reform is going to make healthcare look like a piece of cake.”    

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International stocks, even after strong gains in 2017, are trading at a P/E ratio of 14X forward year earnings.  While foreign stocks historically trade at a discount, the current U.S. premium to international stocks is greater than any time in recent history.   Both subjective and objective factors have contributed to the discount over the years.  More recently, these factors include U.S. investors’ allocation to passive investment vehicles that favor large U.S. companies and a general investor bias toward owning high-profile U.S. growth companies such as the F.A.N.G. stocks.  The success of these companies are part of the reason why remarkably just 6% of U.S. public companies produce 50% of all public company earnings.  However, increased regulatory risks for many of those large companies, and prospects for faster emerging market earnings growth, suggest this relative international stock discount still looks attractive.

Let the Tapering Begin

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The Ten-Year U.S. Treasury yield ended the quarter at 2.3%, which was up from September’s intra-quarter low of 2.1%.  This was a modest increase in the context of historical Ten-Year Treasury yields of around 5%, but a welcome development for those sectors that benefit from rising interest rates.  For example, the financial sector rallied 5% in September.

Contributing to the bond market pullback and thus higher yields were comments that the Federal Reserve would begin to allow bonds in its portfolio to mature without repurchase.  The Federal Reserve’s goal is to shrink (at a measured pace) the portfolio from $4.5 trillion today to under $3 trillion by 2022.  We’ll have to wait and see if other central bankers around the world follow suit.  Their efforts to keep rates low have been even more aggressive than in the U.S.  For instance, German and Japanese Ten-Year debt yields just 0.5% and 0.1%.  Credit quality spreads have stayed narrow too with two-thirds of European high-yield debt yielding less than 2.5%.  Needless to say, central bankers are sensitive to this unwinding and want to avoid another “taper tantrum.”  Either way, the chances of rates creeping higher are real and thus we continue to avoid long duration bonds. 

Neighbors Helping Neighbors

During the quarter and in quick succession, devastating hurricanes hit Texas, Florida, and much of the Caribbean, including Puerto Rico and the U.S. Virgin Islands.  The personal and economic toll of these storms for anyone in their paths was severe.   For many cities and neighborhoods that endured a direct hit or flooding, it is proving catastrophic.  It will take months for the magnitude of the impact to unfold, and millions of people in the Caribbean are facing a real-time crisis of resources and stability.   Yet in a period in our history when our divisions are constantly front and center, it has been impressive and encouraging to see millions cooperate with authorities and neighbors helping neighbors under the most stressful of circumstances. 

Thank you for your continued confidence, and best wishes for a terrific fall season.  As always, please don’t hesitate to contact us if you have questions or we need to revisit your investment plan given any changing circumstances or new goals.

  

 

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