All of us at GSB Wealth Management hope you had a great Holiday season and a Happy New Year! We enter 2019 on a much different stock market trajectory than we have witnessed in much of the past 10 years. In fact, 2018 is the first year since 2008 that domestic stock markets finished the year in the red. At first glance it didn’t seem so bad as the S&P 500 stock index and Dow Jones Industrial Average finished the year down from 6% to 8%. However, the Russell 2000 stock index dropped over 25% from its peak in September to the trough just a couple of weeks ago. The Russell 2000 index is a much broader representation of the stock market as it represents 2000 companies as opposed to 500 for the S&P index and 30 names for the Dow. So exactly what is happening may you ask? We call it “welcome to the new reality”.
Outside of the stock market, reality doesn’t seem too bad. A good friend of mine is the CFO of a small construction company and when I ran into him last week, he asked me what the heck was going on in the stock market. Down 500 points several days in a row then up 1000 points the next day. He tells me his construction business hasn’t been this strong in over a decade. “Everyone who wants a job has one, wages are going up and I hear on the news that consumer confidence is at a multi decade high”. To which I replied, exactly! He paused and looked at me like I was some kind of comedian or something. He says to me BDubbs (referring to my initials of BW), you do this financial money managing thing for a living and you are telling me the market is wobbling because things are so good? Have you lost your marbles? I assured him that was certainly not the case as I explained to him the new reality. I began by telling him that the stock market is driven by corporate earnings growth and that growth is now coming into question. He says, “I just told you our business is booming”. I get that. Everybody knows that after last year’s corporate tax cut earnings growth was terrific. That is now in the rear- view mirror. The new reality is being driven by several factors, all of which are weighing on investor’s minds: 1) Unemployment is at a multi decade low and consumer confidence was recently at a multi decade high. The stock market tends to struggle after these indicators reach such favorable levels. 2) Wage growth is accelerating. Many companies have raised their minimum wage to $15 an hour. This eats into corporate profitability. 3) Interest rates have risen at the short end. Most companies borrow to finance and grow their business. Paying higher interest rates eats also into profitability. 4) Political uncertainty – are more tariffs coming? Are we going to build that wall? China and North Korea – are our diplomatic relations with our friends and/ or enemies getting worse? 5) Can the stock market and economy keep growing after ten strong years? Most of these concerns didn’t exist a few years ago. They do now.
Getting back to my friend’s construction business. Assume I am Mr. Market (the stock market) and I am interested in potentially buying the construction firm. I would have been willing to pay more for it a year or two ago. Here is why. A couple of years ago, I estimated after reviewing the books that I could pull out $200,000 to pay myself every year. For that I am willing to buy the business for $1 million. Fast forward to today. I am going to need to finance a portion of the purchase price by borrowing from the bank. Two years prior I could borrow at 2%. Now it is going to cost me 4%. Because of that I am only willing to pay $950,000 for the business. Now I have been told that all of the office help has been given a raise to $15/hour to keep the staff from defecting to Wal Mart. That is going to increase my costs so my purchase price drops to $900,000. I also learned that because of the recent tariffs on wood, steel and aluminum the business costs have gone up by $50,000, so I can now offer to pay only $850,000. Finally, my confidence in the health of the future economy has cooled. Where I before thought I could grow the sales of the business to $1.1 million in the first year, now I’m not so sure. With a slowing economy potentially on the horizon, what if my sales instead drop to $950,000? That makes me nervous, so I think I will only offer $800,000 for the company. There you have it. That is why the average stock has dropped by 20% or so. This phenomenon is called “valuation compression”, or the willingness to pay less for businesses or for stocks because things have indeed changed.
The key going into 2019 is, has this “valuation compression” run its course or is there more coming? To this no one knows the answer. The market has certainly adjusted to the new reality so perhaps the sailing will be smoother as the year unfolds. At GSB Wealth we have been monitoring the economy and markets closely and have made adjustments where necessary. Our dogmatic adherence to only the highest quality investments is specifically designed to pull us through periods of turbulence as we are now witnessing. Great businesses tend to withstand the test of time.
We are always happy to hear from you should you have any questions or concerns. Until then we hope you enjoy a prosperous and healthy new year.
Your GSB Wealth Management Team