Happy Fall! I say this as it is over 80 and humid to be followed with temps in the 40’s later tonight. Only in New England! We spoke in our last quarterly newsletter about navigating through this economic and political environment like a pilot flying IFR (instrument flight rule) where visibility is low and the pilot can’t see the runway. Unfortunately, the skies have yet to clear and the fog is even thicker than before. Adding to the trade war with various overseas nations and the political bickering in Washington is now impeachment proceedings against the President. Remarkably, the stock market has taken all of this in stride and was up around 18% year-to-date. The past two days have been a different story. We mentioned earlier how interest rates have been in a free fall for much of the past several months, at the same time the stock market was hitting new highs. This seemed a bit peculiar to us as interest rates typically increase when the economy is strong and the stock market hitting new highs. Economic reports of the past few days are pointing to a weakening economy via contracting industrial production numbers. This in itself doesn’t necessarily mean anything bad is going to happen. Industrial production fluctuates month to month based on a number of factors including seasonality, temporary plant shutdowns due to re-tooling/modernization, weather anomalies and other factors. Having said that, given all of the other worries investors have been fretting over these past few months, the industrial production reading may be giving folks reason to reassess how much risk they are taking within their portfolios.
At GSB Wealth Management we have been assessing these worries and concerns on a daily basis. Should pessimism start to seep into the markets in the ensuing days/months we may well get a market adjustment similar to that of late 2018. Many of the excesses seen before major bear markets of the past don’t seem to be prevalent, at the moment. That doesn’t mean something can’t come out of the clear blue and blindside all of us. It has happened before. On the plus side the market doesn’t usually crash when everyone thinks it will crash. We can tell you from personal experience that many of our clients are on edge, if not downright pessimistic. There are enough things to worry about to fill a bathtub. National banks are said to be well capitalized and in sound financial shape. It was the banking industry’s over exuberance that exacerbated the downturn 11 years ago. Economic growth continues to muddle along at a comfortable pace; hence the Federal Reserve has seen no need to jack up interest rates to tamp down growth. Regarding interest rates themselves, they are low enough that they don’t offer much competition for stocks. Explained – I harken back to 1987 when I was a young man in the CNB trust department with barely three years of experience under my belt. By August of 1987 the stock market had gained 40% for the year. Interest rates had been increasing right along with the stock market and a 10- year Treasury Note could be had with a 10% yield to maturity. My mentor, a more seasoned portfolio manager named Scott, looked over at me and said “Brant, pull some of your client’s money out of stocks and reinvest it in bonds”. Fortunately, I listened. When the market crashed a couple of months later, Scott and I were comfortably sitting at our desks while all of the other portfolio managers in the office where huddled around our tiny little quote machine as if the next season of Seinfeld just went on air. Today’s environment is quite different. Dividend yields on many blue- chip stocks eclipse the interest rate on the 10- year Treasury Note.
Something we have written about in the past that should be revisited is the phenomenon known as “valuation compression”. I mention this because if a more pessimistic attitude starts to infiltrate Wall Street, valuation compression could influence many stocks. All stocks have a valuation, commonly referred to as the price earnings (P/E) ratio. Simply put, a leading money center bank may sell for $50 per share and have expected per share earnings this year of $5, hence the price earnings ratio is 10. Some stocks have no price earnings ratio at all because they currently have no earnings to report, think of the ride share companies. Thinking of a leading spice, seasoning, condiment and hot sauce company we know (we aren’t allowed to mentioned specific names) that five years ago was selling for $70 per share. They earned $3.50 that year so the P/E ratio was 20, a bit high compared to many other companies but this is a high- quality company, so no worries. Fast forward to the present. Wall Street has become quite enamored with our spice maker so the stock sells for $150 per share. Earnings have advanced nicely over the period and now should come in around $5 this year; hence the P/E ratio has expanded from 20 to 30. Should investors become more pessimistic, the P/E ratio on our spice maker could fall back to 20, wiping out one third of the stock’s value even though they have done absolutely nothing wrong. Valuation compression becomes more of a risk in the later stages of common stock bull markets as investors become giddy and bid up prices. Thinking back to 2009 valuation compression was of little risk. The stock market was flat on its back and everything was already depressed and compressed. As usual we will be watching all of the above variables closely.
We are always happy to hear from you should you have any questions or concerns. Until then we hope 2019 continues to be a prosperous and healthy year.
As a side note, should you change residences and/or telephone numbers please let one of the GSB Wealth team members know.
Your GSB Wealth Management team
"Wisdom is not a product of schooling but of the lifetime attempt to acquire it." ~ Albert Einstein