“It takes considerable knowledge just to realize the extent of your own ignorance.”
— Thomas Sowell
As equity markets flirt with new record highs many market analysts again turn bearish as overvaluation, the Fed, and perception of a slowing economy with a flattening yield curve signal a market top. The September to mid-October period is historically weak as managers review portfolios and tax considerations are implemented. The lower 3Q2017 earnings estimates are fortifying the bearish convictions. The so-called “Wall of Worry” grows higher but as has happened many times in the not-too- distant past, forecasting the death of the secular bull market will prove premature.
The bears began the attack in 2013 after the resurrection of a weakened Europe and slowing economies of China and Japan threatened global recession. US markets ignored the dire predictions and the S&P 500 Index rose 29.6% on the back of rising earnings (+11.5%) and a 2% economy. In 2014, oil prices fell 46%, and along with a rising dollar, the end of Fed tapering, the S&P 500 Index rose 11.4%. Our view throughout these two years was for slow but continued growth (averaging about 2%), led by a transition to a healthier consumer supplemented by falling energy prices. The 9.8% market selloff during the September 19, 2014-October 15, 2014 quickly reversed, and by December 5, 2014 the S&P 500 was 14.2% above its October lows. The Compass Reports during that time stated our optimism that the Fed was employing the correct policy, oil sector weakness would not bring down the 2% economy, and the financially healthy consumer would anchor the next phase of growth moving forward.
Throughout the 2013-2014 period, the bears overreached in their analysis of the record levels of margin debt, China and Japan economic weakness, and once again, overvaluation. The real experts, Permabears, believe they added to their credibility by including the views of “some of the brightest minds in finance sounding the alarm about a stock market bubble,” (CNN Money, 8/19/14). Joining the chorus was Noble Prize winning economist, Robert Shiller’s valuations at “worrisome levels,” hedge fund king Carl Ichan’s belief that “we are in an asset bubble,” and former Treasury Secretary Robert Rubin’s comment that the “excesses caused by artificial interest rates could create another financial crisis.” A centerpiece of the bearish argument was the ineffective policy advocated by the Fed which was proven wrong and discussed in the Compass entitled “Market Listens as Chicken Little Speaks” on August 4th 2014:
“Underlying the bearish argument is the assumption that after tapering concludes, any Fed policy actions will fail as inflation will rise well-above expectations and interest rates are forced higher than anticipated. The prospect of tightening would create broad selloffs in both stocks and bonds and may even result in a bear market depending on the extent of economic weakness. As investors it makes little difference whether the Fed raises interest rates in early-2015, mid-2015 or late-2015. Last week the Fed stated that it will be a “considerable” time before rates are raised. Even if the Fed begins to raise rates 25 basis points at every other meeting, it would take 2 years to reach 2%. Traders are obsessing when the Fed will begin to increase rates, but to investors it is a sign the economy is normalizing and not an unintended consequence, but Chicken Little Lives.”
Going forward into 2015, earnings were dominated by losses in the Energy sector. By mid-July the S&P was up only 2.4%, but had reached its highs for the year. A correction of 12.5% from July highs resulted in a double-bottom in August and September, stocks then rallied to close the year with the S&P 500 down 0.3%. All major indices fell with the exception of the NASDAQ Composite (+5.7%) led by Technology and Biotech. Needless to say, Fed interest rate policy, the weakness in oil, contagion from a possible Greek default, and China’s deteriorating economy put the bears in charge. Technicians were claiming a wild assortment of negative formations, the Permabear elite (Roubini, Faber, and Rosenberg) were all over the media predicting the next global recession. Our Investment Policy became cautious in late- March 2015 based on the slowing economy and the outlook for earnings. Markets were dominated by high volatility as evidenced by caution in our October 19, 2015 Report written after stocks had rallied. High volatility exacerbated the market weakness as traders dominated. At that time we stated:
“Traders participate in both up and down markets without any regard for fundamental economic value placed on individual stocks or indices. Computer programs react to specific trading patterns which offer the best chances for success. These algorithms are limited by a finite number of profitable trades. Volatility is the key to profit and the more the algorithmic traders, the higher the volatility. In periods like those experienced in the last few weeks, markets become casinos increasing the possibility of flash crashes and mass losses of investment funds.”
Stocks began 2016 with selling dominated by high volatility that once again resulted in a double-bottom in January and February. The S&P 500 declined 14.5% from its highs in early-November. Sentiment deteriorated to levels not seen since 2009. Oil fell from $37 a barrel at year-end 2015 to $26 a barrel on February 11, 2016. Traders were still shorting at these ridiculously low levels as rationality in the pits was non-existent. Stocks became closely correlated to oil as the downward spiral accelerated, indicating to bears that the global recession was now on the horizon. US corporate earnings were forecasted to decline through mid-year and the economy was slowing, and deflation would soon follow.
With oil and stocks joined at the hip our strategy “To Sit Back and Wait” in early January was reaffirmed. Our cautious outlook continued through most of 1Q2016 however, as we stated repeatedly throughout the chaos, long-term investors should consider any corrections as buying opportunities. Skies began to clear and by late-April the markets regained nearly all losses and as markets began to discount the improving economic and earnings outlook. Since February 2016 the S&P 500 is up 38.5%, oil has doubled, earnings turned positive in 3Q2016 reaching double-digit growth in 2Q2017. Interest rates remain low and inflation remains below 2%. Global growth is estimated by UBS at 3.7% for 2017. For these reasons and document in the Compass, our strategy moved to outright optimism in early-May 2016.
The purpose of this exercise is to focus on the inability of bearish analysts to go beyond the short-term and put forth a rational long-term strategy. Some, like Marc Faber and Jim Rogers, have been bearish for decades, others (Roubini, Shiller and Rosenberg) have not been right since calling the bear market prior to the financial crisis, with substantial lead-time. Should the current weakness in technology stocks spread to the broad market and continue for more than a week, bears, as well as the reconstructed Fed naysayers, will once again dominate financial media harping on overvaluation. In isolated instances bears have correctly called small corrections, but tend to remain focused on the cause even when the effect is minimal. Tunnel vision has limited their ability to see only short-term negatives, extrapolating them into a bear market often accompanied by an economic recession. Permabears will be right at some point, but most likely after they turn bullish.
Energy Redux
Markets have been at or near record highs for much of 2017. Year-to-date the S&P 500 has risen 11.8% and the NASDAQ Composite is up 19.4%. Large-Cap Technology stocks (XLK), although volatile recently, have risen 19.3%, followed by Healthcare (XLV) +18.0%, Materials (XLB) +13.8%, and Industrials (XLI) +13.6%. Energy (XLE) is the biggest loser, down 9.4%. However, over the past two weeks, the XLE has been the biggest winner, up 5.5% despite a sharp reduction in 3Q2017 earnings forecasts. Caution is advised for investors when looking at the Energy sector because of its international geopolitical exposure and rapidly improving technology in fracking, which has dropped break-even prices per barrel on average below $45. Inventories are still high and there is an abundance supply “on the high seas.” With crude prices over $50 and holding for about two weeks, money has flowed into these stocks as if the supply/demand equation will soon balance, but future prices will be determined by innovation. With more oil and gas between the rocks than under the sand prices will depend on free market principles, rather than OPEC. Why else would Saudi Aramco be planning an IPO for 2018?
Investment Policy
Our investment policy remains optimistic. A selloff of not more than 5% is possible, but our view does not assume a meaningful decline resulting in a market correction of 10% or more. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderate rate increases, and strong consumer confidence. Despite the short-term negatives of two hurricanes, we expect the economy to break 2% annual growth in 2H2017 as slowly improving wages, housing, and Internet retail continue to reflect a healthy consumer willing to spend. It is highly unlikely given the increasing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, a successful implementation of the Fed’s balance sheet reduction, will result in increased earnings and multiple expansion giving further upside for select domestic Large-Cap Consumer Discretionary, Technology and Industrial sectors, and selected Financial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.
Authors: David Minor and Rebecca Goyette
Editor: William Hutchens, CFA
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