We have made it half way through 2017 and a number of interesting scenarios are playing out as referenced further along in this letter. Surprising to most, the domestic stock market, as evidenced by the S&P 500 index, has returned 8.24% since the first of the year. Interest rates continue to be muted with the 10-year Treasury Note yielding 2.3%, little changed from the 2.45% level at year end 2016. We referenced in our December 2016 letter how the presidential election results fueled the stock market with talk of tax cuts, regulatory reform, trade reform, etc. As this letter is written there is some doubt regarding just how many of these initiatives will be enacted.
The stock market hasn’t cared so far. Hope is eternal. Prevailing wisdom is that if aforementioned new policies were enacted it would lead to stronger economic growth, more jobs, higher interest rates and higher inflation. This would be true if the country were coming out of recession but today that is hardly the case. The economy has been growing for eight years (one of the longest expansions on record) and the stock market has been following along, pretty much un-interrupted, since February 1, 2009. The unemployment rate is plumbing new lows yet wage gains continue to be muted and inflation seems to be well contained. Productivity growth has been anemic – i.e. how many widgets a worker can produce in a given time period compared to what he/she produced one year ago. Corporations have been more interested in buying back their stock and increasing their common stock dividend than investing in automation and technology to produce more widgets.
An economy can only grow as fast as two main variables over time- population growth added to productivity growth. Currently both variables are growing in the 1% range, hardly the recipe for considerably faster economic growth. Having said all of that, a slow growing economy in tandem with low and stable interest rates are generally a good environment for common stock investors. However, since we have been in this environment for years now, stocks have ascended to valuation levels that are quite high historically speaking. Having said that stocks can remain at elevated valuation levels for years, so long as some type of unexpected event doesn’t occur. What it does mean is that future returns on domestic common stocks should in theory be lower than what has been witnessed in recent history. Common stocks are driven by two primary variables.
Earnings growth, which has averaged around 6% over many decades, and valuation (i.e. what investors are willing to pay for that stream of earnings growth). The valuation story appears to be about tapped out so we may need to rely on earnings growth to push stocks higher from here. GSB Wealth Management has also been watching several other recent market activities which deserve scrutiny. As referenced in the financial press one month ago, five technology stocks (the so called FAANG stocks) have been driving the market higher in a disproportionate fashion. Investors are piling into these high- flying stocks despite the risks. We witnessed this in 1999, though to a much wider degree. That being said, it sniffs of a speculative environment where buyers are more afraid of being left behind than employing prudent judgement and risk aversion. Another cause for concern is the growth in “indexing”, where a mutual fund or ETF simply invests to track a particular slice of the market, say the S&P 500 index.
While indexing in itself is harmless and can be an effective way to get market exposure at low cost, its very proliferation has driven up the aforementioned FAANG stocks as these stocks are the largest holdings in the index. Chasing one’s tail, so to speak. Another quote we recently read, and makes more and more sense every day, is “The tide always turns, and while out of favor today, preserving capital and managing risk will be back in vogue once more, but only after a decline occurs”. Finally, the Federal Reserve has been slowing pushing up short term interest rates for over a year now in an effort to bring rates up to a more “normalized Level”, whatever that is. Somewhat surprisingly, long term interest rates have not responded in kind and have remained stable or even dropped somewhat. This is not indicative of higher economic growth and inflation in the future. Typically, a “flattening yield curve” where short term rates ratchet higher while long term rates don’t respond is a sign of weaker economic growth and inflation and is often a precursor of economic recession.
So, what are we at GSB Wealth Management doing in the face of all of this? Namely sticking to our discipline, closely managing risk, and not chasing fads that often end badly. We are slow to deploy new cash and have selectively reduced exposure to stocks we felt ran up too quickly. We continue to search for high quality instruments that seem to us fairly valued or undervalued. We will continue to monitor the market, economy, and new administration closely. If we feel adjustments need to be made, we will make them.
The GSB Wealth Management team
"Wisdom is not a product of schooling but of the lifetime attempt to acquire it." ~ Albert Einstein