At the Matheson Financial Conference last week in Dallas, Kenny Polcari and I gave the keynote entitled “Next Stop Dow 20,000 or 30,000?” It was very well received (mostly because Kenny is very likable and dynamic), and there were a lot of questions about the long-anticipated market downturn as well as our current ideas for cash.
Anticipating stock-market declines is another way to describe apprehension or worry. An old Wall Street adage says that markets climb walls of worry. The translation of this adage is that a healthy level of risk aversion can very often be a positive indicator for future market returns because it implies that many underinvested market skeptics remain who can be converted into believers over time. These late-to-the-party investors represent a source of untapped demand for stocks that might not exist if optimism were more widespread. Of course, the inverse of this adage is that if none are worried, then peril could be at hand. Market strategists refer to this risk as complacency. It occurs when there is overwhelming conviction that markets can only go up, thereby creating a false sense of security. And, since most of the investing public is already heavily invested, there is a lack of incremental demand to take stocks higher. Furthermore, any unanticipated negative news developments could send the weaker hands running for the exits, leading to a market correction.
It is hard to argue that there is an undue amount of either complacency or risk aversion right now. There are undoubtedly some very formidable challenges that we will be facing over the coming years, such as the possibility of trade wars, rapidly rising budget deficits, rising inflation and interest rates, geopolitical tensions (Iran and North Korea, for instance), economic inequality, weak labor productivity and unfavorable demographic trends. But it is hard to argue that these risk factors are not well known, understood and appreciated by the investing public. Few investors appear to be wearing blinders. Though Kenny Polcari is more bullish than I, I’m far from gloomy and he’s far from Pollyannaish. I would better describe myself as cautious or defensive and Kenny as more constructive. These differences are what make markets.
As I write the Dow is about 24,700, oil is $71.40, the 10-year Treasury Note is yielding 3.10% and the Euro/USD exchange rate is $1.18. Stocks appear fully but not excessively priced given the level of both earnings growth and interest rates. Oil has moved higher as the US has withdrawn from the Iran nuclear agreement and moved its embassy to Jerusalem. Both events threaten to disrupt the flow of oil from the Middle East. To wit, if supply gets reduced, prices rise. Some investors are worried that a sharp spike in energy prices could lead to more widespread inflation and cause the Fed to increase interest rates more aggressively. As such, the increase in Treasury yields is the now at the forefront of investor concerns. Treasury bonds are trading at their highest yields in several years. If you think about interest rates as the cost of money (what a borrower must pay), then borrowers will now have to pay more for loans of all kinds. Consumers will pay more to finance cars and houses, and businesses and government will pay more too. Higher costs create headwinds for growth. And the major driving force behind rising asset prices since the Great Recession has been low interest rates. What now? Oh, and the dollar has been strengthening in recent weeks and that means foreign goods are cheaper and US goods are more expensive. As the dollar rises, the trade deficit will widen – another economic headwind.
The point is that there are concerns about the vibrancy of an aging bull market, but there is no cause to administer last rites either. While the winds may be less favorable, the US economic ship continues cruising forward. Unemployment is very low. Corporate profits are high. The housing market continues to grow. Consumers continue to spend, and inflation and interest rates are still low (for now). The overriding question has become whether or not the current pace of US economic growth is sufficiently robust to endure and prevail against a higher interest-rate environment (especially given very high levels of economy-wide debt). Time will tell. Stock prices can always find reasons to fall, but they can also continue in their current expansionary path for longer than anyone thinks.
The increase in interest rates over the past 18 months has benefited prospective bond investors. This has been especially good for financial institutions that can once again find earnings from short-term and money-market assets. We have a number of clients who have recently invested some larger amounts in short-duration, tax-exempt municipal bonds. The liquidity and quality are high, durations are short, and yields are in the 2.5% range. While we do not advocate market timing, it is encouraging to again find reasonable returns again for risk-averse investors. Please let us know if we can be helpful in any way.