Letter - July 2017

 

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Don't Think Twice, It's All Right

Bob Dylan’s 1963 ballad, “Don’t Think Twice, It’s All Right” could well be considered the international anthem for investors over the last eight years as the bull market surged higher. An easy money policy of artificially low interest rates by central banks world-wide has provided ample ammunition to stock prices. Any downturn, of which there were few and those shallow, brought new money to the market (buying the dips) fueling new highs. Shocking challenges to the existing international order, both political and economic, be damned: The Great Recession, the near collapse of the international banking system, anemic post recession GDP growth, the rise of ISIS, the war in Syria, the Russian annexation of Crimea, the rise of a nuclear North Korea, to name a few. Nothing has stemmed the tide of rising stock prices. “Don’t Think Twice, It’s All Right” just about captures investors’ mindset.

Looking forward, we ponder whether things continue to be all right. There is little disagreement that stock valuations are decidedly high at 18-20 times forward looking earnings. Nor is there much disagreement that the high valuation reflects growing corporate earnings and the anticipated implementation of pro-business policies championed by the Trump administration, notably deregulation and tax reform. These policies promise, in the medium term, to foster higher GDP growth than otherwise would be the case. (Long-term, there is the threat of unsustainable levels of government debt and debt financed entitlements.) As for the Fed, it is committed to raising interest rates, but at a slow and leisurely pace through 2018 and beyond. Things seem all right.

The appropriate valuation of stocks is largely tied to the outlook for inflation-adjusted GDP, corporate earnings growth and sentiment. Of the three, we would say that sentiment is the most fickle, the most difficult to parse. And it can change unannounced. While the outlook for GDP and corporate earnings looks all right, what is the appropriate price/earnings for the market? How highly should earnings be capitalized. Is a P/E of 20 high or low?

Though we don’t know the answer to the question posed above, we do feel that market valuations are vulnerable to the down-side. The current economic expansion is eight years old, one of the longest on record, making it conceivable that a recession might be on the investment horizon. The Fed is determined to raise interest rates over the next few years. Markets rarely applaud rising rates. It is not clear that the Trump administration has the skill and support needed to achieve its pro-business policy goals, a possible setback for the market. Debt levels are elevated. Aside from a few large companies with cash stranded overseas, many companies have been borrowing heavily at low rates in order to raise earnings per share by buying back large amounts of their common shares in the open market and/or raising dividends to shareholders. High levels of debt often accompany the onset of a recession.

Recently, a certain amount of volatility has crept into the stock market. Technology stocks like Amazon and Tesla have sold off modestly but noticeably. Meanwhile, money seems to be rotating to underperforming sectors such as automobiles and pharmaceuticals. If such a rotation were to continue, it would be positive for the market. New leadership by lower valued stocks would be welcome, but a sign of an aging bull market.

Perhaps the market is growing weary of “Don’t Think Twice, It’s All Right” and it's time to dust off the old vinyl record of Dylan’s, “The Times, They Are a Changin’.”

 

Tom Herzig

 


 

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