july 1, 2017


John Kenneth Galbraith once remarked that the only function of economic forecasting is to make astrology look respectable. This comment, while made in jest at the time, carries more than a hint of truth today. Despite evidence that the overwhelming majority of professional economists have been unable to identify in advance the major economic bubbles of our time, their voices seem to come through louder and with more confidence than ever.

As neoclassical economics grew in stature among the social sciences in universities and mainstream thought in the second half of the 20th century, in part due to the extraordinary growth in the financial sector, its underlying theories have come to be treated as conventional wisdom. Today it would not be unusual to hear an economist speak of the Phillips Curve or Rational Expectations Theory as though they govern the behavior of markets the same way Newton’s Law of Gravitation governs the movements of physical bodies. In reality, human beings are not always the self-interested, rational actors that economists make them out to be. The Ultimatum Game is a classic showpiece of “irrational” behavior: take two players, A and B, where player A is given $100 to decide how to divide the money between himself and player B. Player B can either accept the proposal or reject it, in which case neither player receives any money. Classical economic theory, which assumes we are all rational calculating machines, suggests player A would keep $99 for himself and offer $1 to player B, who would naturally accept the offer because $1 is of course better than nothing. Behavioral studies, however, have shown that this is far from reality: player A will typically divide the pot somewhat evenly and player B will only accept the offer if the pot grants him at least $30 to $40.

All this is not to say that we don’t spend time contemplating economic analyses; we do. They are useful in assessing the present environment, historical trends, and different scenarios that may materialize. Our goal is to look ahead only as far as we can see, while keeping in mind that psychology plays a major role in market behavior.

We have often quipped in client meetings that we are sailing in unchartered waters, facing unprecedented economic conditions. JP Morgan’s chief, Jamie Dimon, captured this notion in a recent comment: We’ve never had [quantitative easing] like this before, we’ve never had unwinding like this before. Obviously that should say something to you about the risk that might mean, because we’ve never lived with it before. When that happens of size or substance, it could be a little more disruptive than people think. We act like we know exactly how it's going to happen, and we don’t.”

Stock market gains since the Great Recession have been substantial; yet real GDP growth in the 10-year period ending in 2016 has averaged a meager 1.3% annually (roughly equivalent to the growth rate in the 1930s), almost half of which has been driven by debt expansion. In that same 10-year period, revenue gains among S&P 500 stocks averaged only 1.6%. Profit margins have improved, in large part from cost cutting at the expense of labor, and valuation multiples have soared to near-highs on the back of “free” money from the Federal Reserve.

These factors have contributed to what is often referred to as the most hated bull market of all time. Market participants appear divided between one camp that believes the massive monetary stimulus has removed the risk of significant losses from financial markets, and the other camp that believes loss potential has been amplified by the speculative buying that the central bank has promoted. From our perspective the market is expensive by any measure and even the boring, ignored, and transiently out-of-favor securities (the kinds we like) have benefited from the rising tide in financial markets, not without help from a surge in index investing.

A common misconception is that risk levels fall in economic upturns and rise in downturns, when in reality risk increases in the good years and decreases in the bad. In other words, the worst investments are made in the best of times. The following table illustrates how higher prices (expressed by price-to-earnings multiples in the center column) generally translate to lower prospective returns among S&P 500 stocks.

Although today’s market multiple has been inflated by unusually low interest rates, which have compelled investors to reach for yield, it is clearly high enough to warrant a cautious approach, particularly given elevated debt levels throughout the financial system and the Fed’s ongoing transition towards monetary tightening.

Since we can’t change market conditions, we must choose from the options that exist. As we compare the risk/return profile across the spectrum of investment alternatives, we view cash as an increasingly attractive asset class. Although its returns are negligible, and in some other parts of the world negative, cash is an opportunity to buy things cheaper in the future, as well as a cushion against market corrections. In fully-invested accounts we are picking spots to modestly raise cash from more richly-valued positions while keeping tax issues in mind. In newer accounts, we continue to deploy cash into asset classes further out on the risk spectrum with caution.

From our perspective the main pillars of Trumponomics, deregulation, tax reform, and infrastructure spending, will take several years to impact the real economy and will ultimately be a tailwind for stocks to the extent the reforms are able to get through Congress. That said, stock price appreciation since the election has discounted a more robust and faster materialization of these benefits than we see achievable, which should limit upside for stocks in the near-term. In the meantime, we maintain our approach of collecting dividends as we await more attractive valuations. Perhaps the most significant and underestimated phenomenon in the markets is the massive shift in demographics that is occurring in the US and most developed markets, and the secular growth in demand for income this aging will create. We’ll save a more thorough discussion of this trend for a future issue…

Peter C. Hatfield, CFA®