2017 has turned out to be quite a year in the financial markets. We can think of few individuals who thought that the stock market (S&P 500) would return close to 20% when all were prognosticating in January of last year. We have to admit that GSB Wealth management was surprised as well but we are happy to take what we can get while we can get it. We have discussed in recent newsletters that the stock market seems fully valued, if not over valued yet there is nothing in the immediate future that looks to us to knock the market off of its perch. Many clients have called us with concern about recent goings on in Washington, threats from North Korea, the new tax bill, income inequality, and a myriad of other things reported in the daily news. In reality, these issues have little effect on the long-term health of the stock market and economy. What is reality is that the U.S. economy is picking up steam from the subpar growth trajectory we have been witnessing since the recovery began in 2009. Corporate earnings growth drives stock prices and earnings growth has been gaining momentum as interest rates remain at historically low levels. Should this continue in 2018, we may expect common stocks to log returns in line with the growth in corporate earnings, which would be a welcome sight coming off the solid gains witnessed in 2017. The strengthening economy is something we will be closely watching as stronger growth has the potential to start putting upward pressure on interest rates. We have been in a “goldilocks” economy for several years now. Not too hot nor too cold. Corporations have benefited greatly from low interest rates. Favorable borrowing costs have been a boost to earnings as firms refinance older high cost debt or borrow cheaply to invest in modern technology and new equipment. Low financing costs have also allowed companies to buy back their own stock, reducing shares outstanding to goose earnings growth. Finally, higher interest rates would give investors an alternative to owning stocks. Think back to 1987 leading up to the 22% drop in one day in October. The stock market had performed in a spectacular fashion through late summer and had become highly valued, as it is today. At the same time interest rates had been increasing and peaked with the 10-year Treasury Note hitting 10% by August. This in part contributed to the crash. Stocks now had serious competition in a 10% return from a guaranteed government bond. Such does not exist today but bears watching as the economy strengthens.
Changing direction, GSB Wealth Management intends to no longer distribute quarterly performance reports in the future, preferring to review such information on an ad hoc basis at client meetings or during periodic conference calls. Reporting quarterly seems to us to go against the very philosophy of GSB Wealth Management at its core. We structure client portfolios with a long-term view, taking each client’s risk tolerance into consideration and constructing portfolios with time tested securities of high quality. Constantly comparing against a particular index (and there are hundreds to choose from) doesn’t make sense to us and threatens to have one take his/her eyes off the ball or potentially change philosophy in order to chase an index that may have little resemblance to the securities in one’s own portfolio. We saw this happen in 1999 as many investors capitulated and bought into the internet stock craze in an effort to keep up with “the market”. Shortly thereafter the train went off the tracks and crashed. We made this decision only after careful consideration and thought, backed up by the thinking of Warren Buffet, John Bogle (founder of Vanguard) and other well renowned professionals in the investment management field. We will still have performance data at our fingertips at any given moment and are happy to share that data at any time and will do so on request.
As always, we of course are open to your suggestions and/or concerns and encourage you to contact us at any time for further discussion. We hope you have a great New Year.
Your GSB Wealth Management Team
This quarter’s newsletter will be somewhat abbreviated compared to previous newsletters as many of the trends we spoke about in June are still in place. The stock market, as defined by the S&P 500 has gained approximately 14% year-to-date. We are somewhat surprised by such a move given the ongoing political turmoil, risk of nuclear war, Federal Reserve interest rate hikes, and other concerns surrounding global markets. The stock market doesn’t seem to care and continues to plumb new highs. As a result stocks are now being valued, on a number of measures and ratios, near or above high points seen in 1987, 1999, and 2007. High valuations are a poor predictor of just when the next drop will come. However, the margin for error now looks to us to be fairly extreme so we are proceeding with caution. As we know, there is no insurance policy when investing in stocks and bonds. The closest thing to insurance is investing when stocks are depressed or trading at low valuations based on many decades, if not centuries of history. At the stock market lows in March of 2009, High quality blue chip stocks were trading at historically low valuations. If you were astute enough to put money in the market in March of 2009, you could have thrown darts at a stock board and done well. If you hit Procter & Gamble, Johnson & Johnson, Honeywell, McCormick – all have done well as stocks were cheap. Just the opposite is true today. GSB Wealth Management is being very selective in deploying new money and have been taking profits or trimming exposure to stocks where appropriate. Our bias toward quality is intact and we do not chase fads or “new eras”. We are cognizant that Amazon, Netflix and Tesla have been flying high and leaving many “blue chip” stocks in the dust. We saw this in 1999. Once the internet bubble burst, the high fliers were decimated and many of the stocks lost over 75% of their value. Some went to zero. At the same time, the stocks mentioned above held up relatively well and continued to prosper in the years to come. We have found repeatedly that sticking to our knitting makes financial sense, even if at times we look a little stodgy when the rocket stocks hit the launch pad.
Speaking of rocket stocks, we thought we would make a few comments on Amazon. Amazon is clearly a market disrupter, taking over market after market, the latest being the grocery industry. There is even a term for it called being “Amazoned”, as if Darth Vader comes in with his magic wand and suddenly an entire industry goes “poof”. Amazon’s share price is approaching $1000 and the market capitalization (the value of all Amazon stock outstanding) is approaching $500 Billion, one of the largest companies on the planet. What many folks don’t realize though is that Amazon makes very little in profit. For some reason Wall Street has given Amazon Carte Blanch to earn very little, year after year, as if one day they will flip a switch and earn billions. Doubtful this can happen. To flip the switch would mean raise their prices on goods they sell. And Wall Street continues to turn a blind eye. Imagine if Procter & Gamble were to come out and say they are lowering the price on Tide and Pampers and Gillette products until their profit nearly went to zero. The stock would likely get penalized harshly, falling from $90 to $50 overnight, if not lower. Yet Amazon continues along, earning next to nothing while its stock flies high. It almost seems unfair. While other companies must earn a healthy profit to garner a high stock price, Amazon gets away with earning little yet is able to disrupt industry after industry using its highly valued stock as currency. This same phenomenon was rampant at the top of the internet boom in 1999. Then it hit the wall. At GSB Wealth Management we prefer to stick with high quality companies selling at reasonable valuations, even it means giving up some relative performance in an aging bull market. We feel now is the time to focus more on managing risk than chasing return.
Sincerely, The GSB Wealth Management Team
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