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Stock Market

Priced for Perfection

Skeptical people aren’t fun at parties. They always find something wrong and nothing is ever good enough. However, we think it’s important to be realistic about the markets and economy.

The US stock market has had a tremendous run this year. Ten plus years into the current bull run, equities surged to fresh all-time highs throughout 2019.

As we think about what to expect going forward, such strong performance seems unlikely to continue. At the end of the day, stock prices reflect their underlying fundamentals, and the economy isn’t as perfect as the stock market would have you believe.

Leading indicators of growth have declined, suggesting that growth is decelerating, not accelerating. Highly economically-sensitive areas of the economy such as manufacturing are weakening, and safe-haven asset classes such as gold have seen prices rise.

On the other hand, surveys of how people are feeling, such as consumer confidence, remain very healthy as spending continues to drive growth. Monetary policy adjustments, the potential for a trade dispute resolution, and other external factors remain plausible stopgaps for any additional slowdown.

It remains unclear whether we are heading for a recession, but for us, that isn’t the point. The point is that the stock market remains priced for perfection, and regardless of whether the economy rebounds or continues slowing, the underlying fundamentals still suggest caution.

For us, it isn’t about trying to perfectly time the next drawdown. We think it is simply about being realistic.

The Best Time to Stock Up

We have chopped the market into three ranges: ‘cheap,’ ‘normal,’ and ‘expensive.’ Historically, when stocks are expensive performance has been much worse. We have spent most of the last three years in the normal or expensive ranges.

S&P 500 Price-to-Earnings Ratio: Median 5-Year Forward Returns (Monthly Data, Annualized Price Returns). Cheap range is 0%-25%, Normal range is 25%-75%, and Expensive is 75%-100% range.

Bond Market

The Interest Rate Paradox

Knowing when and how to best deploy monetary policy is a subject of constant debate. For central bankers, and at the Federal Reserve (Fed) specifically, balancing the often opposed goals of price stability and maximum employment is a tricky task.

Fed Chairman Jerome Powell’s decision to lower interest rates several times during the second half of 2019 was met with consternation from many sides. On one hand, it is uncommon for the Fed to cut interest rates when unemployment is so low, on the other, economic growth remains sluggish.

By lowering interest rates, Chairman Powell prioritized economic growth concerns over price stability. That’s his prerogative, but interest rates can only be cut so far. The Federal Reserve’s most recent ‘mid-cycle adjustment’ leaves the US policy rate only a handful of turns above zero. Should the economy slow further, the Fed could run out of room to cut rates quickly.

With few other tools to stimulate economic growth, global central banks have become more creative. The unwinding of the Fed’s crisis-era balance sheet expansion, also known as quantitative tightening, was short lived. Its balance sheet, as well as those in Europe and Japan, have already risen significantly.

Today, inflation remains low, enabling central bankers to maintain ultra-easy monetary policies, and that’s the rub. Low rates may be stimulative for borrowers, but for savers, they make it harder to earn yield.

In today’s income-starved fixed income world, a return to ever lower rates is rather unwelcome. It is no wonder investors are concerned.

Interest Rates are an Obstacle for Good Savers

Lower interest rates tend to be good for borrowers but bad for savers

Borrowers It is cheaper for people to borrow money to spend

Savers Investors have to save more to make up for the loss in yield

Economics

Demographic Destiny

Much has been made of the graying of America. As the Baby Boomers retire, programs like Social Security and Medicare are coming under greater pressure, but this isn’t news.

With more people retiring instead of working, these challenges will be difficult. Lost in all the negative demographic discourse is the Millennials’ latest shift, and this one is more optimistic.

Unlike Boomers, who are aging out of their peak earning years, many Millennials are just now entering their economic prime. After having been forced to delay major life events in the wake of the financial crisis, Millennials are finally moving out.

Aided by historically low interest rates, household formation is at a post-financial crisis peak, ballooning real estate prices and all the spending that goes with it (e.g., appliances, home remodeling, car ownership, etc.). Investors should take note.

The “echo-boom” is already changing the economy. The iPhone, social media, Uber, Netflix, and more are reshaping the world, molding it in Millennials’ image. This socially-conscious generation has given rise to companies with charitable tie-ins (e.g., Toms, Warby Parker), as well as trends like sustainable investing.

At the end of the day, this mini-demographic bump will help, but it can only do so much. Economic growth will still remain secularly challenged by broader debt and demographic trends. The Baby Boomers are leaving the labor force at the same time we are already seeing elevated debt levels for governments, corporations, and households alike.

Even if growth remains sluggish, there are opportunities if you know where to look. For investors, there is a difference between nostalgia and just being stuck in the past.

Drivers of Economic Growth

Economic growth is driven by three factors: how many people are working, what tools they are working with, and how efficient those people are at using those tools.

In the 1970s, the number of workers in the labor force expanded at an average of 2.5% per year, a sizeable annual boost to growth. In the 2010s, labor force growth had fallen to just 0.5%.

	Labor Force A larger population or more workforce participation, leads to more output
	Productivity New innovations, technological discoveries, and other productivity enhancements that allow the economy to create more with less
	Capital Deepening Business investment in new plants, properties, & equipment, as well as public infrastructure that boosts overall economic potential

Behavioral Finance

How to Prepare for the ‘Unknown Unknowns’

The stock market hates surprises. That’s why some of the biggest market setbacks come from the challenges you don’t expect. Investing in an uncertain world is scary enough, but even the best-prepared among us can succumb to paranoia.

A market-moving bogeyman could come from anywhere. Trade, politics, and geopolitical unrest are today’s monsters in the closet. They are already affecting markets and have the potential to produce even more disturbing outcomes.

People are predisposed to fear the negative. It’s in our nature to fixate on what can go wrong, and we feel the pain of losses more acutely than the thrill of a win. This risk aversion impacts us all, even the most seasoned investors.

Understanding the severity of possible downside outcomes is necessary to be an effective investor. Gathering data, researching the world, and analyzing possibilities helps us judge what is more likely to occur. But, investors can only study and analyze what they can see.

We know what we can read and measure. We also know, or at least can recognize, what we can see even if it can’t be measured. But, it is the risks that we can’t see or measure that are often the most significant of all. These ‘unknown unknowns’ are also the most difficult to predict.

When times are good, this leads investors to be too optimistic about these risks; and when times are bad, investors are often too pessimistic about how things can turn around. Sentiment is deeply behavioral, and these biases can impact decision-making.

That is why we employ a repeatable investment process. When markets panic, we stay calm and focus on the fundamentals. Avoiding biases helps us take advantage of opportunities amid the noise.

Investing doesn’t have to be unnerving. As your partner, we are dedicated to helping you manage what is in your power, controlling the controllable, so you are better prepared for the surprises that aren’t.

Behavioral Biases

There are many biases working against an investor’s ability to make rational decisions:

	Endowment Bias Placing greater value on something you already own
	Anchoring Bias Focusing too heavily on the first piece(s) of information you receive
	Hindsight Bias Misremembering past events as more predictable than they actually were
	Confirmation Bias Prioritizing information that supports a preconceived thesis
	Framing Bias Information that is more available to you affects your decision making disproportionately