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
The year 2016 is now in the books and what a year it was for both the U.S. bond and stock markets. The year was progressing in rather calm fashion through November 4 with the stock market (S&P 500) up just over 2% and interest rates sliding throughout the year from 2.25% (10 year US Treasury bond) to 1.35% around the start of the summer. There was more concern about the economy slipping into recession and mild deflation than anything else. Economic growth was anemic and interest rates around the world were falling, in some countries to 0% or below. Then wham! It happened. The November 4 election changed everything when every major poll had the results going the other way. We talked in our newsletter dated December 2015 about the stock market being fully valued based on earnings and fundamentals and how we expected 2016 to be a tepid year for stock market returns. We were looking fairly prescient until November 4! Since then the stock market has gained about 10% and interest rates have gone up by a full percentage point. Whether any of us liked the candidates in the race or how the results panned out a few things are abundantly clear. The upturn in interest rates that started in July was an indication the Wall Street and the markets were beginning to anticipate a strengthening in the economy above and beyond what we have been witnessing since the economy bottomed in 2009. The election results threw fuel on the fire. The incoming administration campaigned on cutting corporate and personal income taxes, easing red tape and regulations, reversing or retooling Obamacare, and investing billions in our country’s neglected and crumbling infrastructure. This is music to the market’s ears. Anything that reduces taxes and amps up the country’s growth rate will lead to increases in corporate earnings. Over longer periods of time corporate earnings growth drives stock prices.
The downside of the surprising election result is that we are all flying blind to some degree until enough time passes to determine if all of these new initiatives actually get passed and if so, what the ramifications will actually look like. The stock market is acting like everything mentioned above is a done deal when the President elect hasn’t even moved into the White House yet. Certain industry groups have appreciated strongly in the past 2 months while others have been left completely behind. The banks have performed particularly well closely followed by industrial stocks, the former because of potentially reduced regulation and the latter due to potentially stronger economic growth. Utilities, health care and consumer staples stocks have largely been left behind. You go to the doctor and go grocery shopping irrespective of what the economy is doing or where interest rates are at any given minute. Actually, that is what has made these industry groups such good performers over many years. These groups don’t rely on the economy to grow their earnings. As long as the population grows and folks continue to live longer, these guys should do just fine. On the contrary, recent year’s tepid economic growth has been a good back drop for the financial markets. Corporate earnings have grown enough to keep stocks on an upward trajectory while interest rates have remained at historically low levels. Low interest rates have made houses and automobiles more affordable while providing little to no competition for stocks. Going into your bank to find you can only get a percent or so interest on a CD is not likely to make you go out and sell your stocks. Bump that CD Rate up to 5% or 6% and things start to get interesting. In conclusion, we don’t want the economy to accelerate too quickly, at the risk of pushing inflation and interest rates up faster than anticipated. That would be the recipe for the Federal Reserve to clamp down on the money flow in turn potentially causing the next economic downturn and bear market in common stocks.
Given the aforementioned lack of visibility regarding government policy and the incoming administration, GSB Wealth’s affliction for high quality investments should serve us well in the months to come. We are currently looking, on the margin, to rotate out or reduce exposure to those investments that have logged strong gains since November 4 and reallocate to some of the sectors that have been left behind. The market is expecting corporate earnings growth to accelerate to 12% to 13% in 2017 and 2018. This would be a tall task and if it does pan out we might expect the stock market to do reasonably well in 2017. Should some of the policies of the new administration get watered down or strung out to future years, we may see a stock market pull back as a lot of positive expectations seem to already be built in. GSB Wealth will be closely assessing government policy as 2017 unfolds and will be making adjustments to client portfolios as necessary.
Sincerely, the GSB Wealth Management Team