Marie Chapin Carpenter
“The Stars Might Lie but the Numbers Never Do” Mary Chapin Carpenter
Despite her profound lyrics and exceptional vocal quality, Mary Chapin Carpenter never achieved the mainstream recognition she deserved. Perhaps it was because she didn’t clearly identify with a single genre. She drifted somewhere between country, folk, and pop. Nevertheless, she is an outstanding artist and her words have never been more enlightening than they are today. Over the last few years, most of Bears have relied on their personal reading of the stars. “We are going to end up in a nuclear war etc.”, to reason that stocks are going lower. On the other hand, the Bulls have generally relied upon observable economic data to reason that stocks are going higher. We aren’t dismissing that the Bears may eventually be right, we are only acknowledging that we have no ability to forecast events such as war. Therefore, we don’t even try. Our process is often referred to as a naïve process. While we think this term is a bit dismissive of our cognitive abilities, we don’t mind so long as it keeps working. In a nutshell, our process looks at economic data relative to current pricing levels. We then decide what to buy or sell based on over or under valuation. There’s a lot more that goes into our process, but this is how we form our baseline thesis for market returns. Let’s review what some of the numbers are saying.
The S&P 500 fell 56.8% from August of 2008 until March of 2009. Since the March 2009 low, the S&P 500 has risen 327%. If the secular bull market continues, it will turn 10 years old in early 2019. During this period, we have had 5 corrections of 10% or more and 6 occurrences when the market went down more than 5% but less than 10%. In 2011 the market almost went into bear territory (a bear market is defined as a 20% correction), down 19.4% over 157 days. Let’s stop there for a minute. If the market went down another .6% in 2011, the press wouldn’t be talking about this being the second longest bull market in history. While we enjoy the media banter and “going for the record”, it shows the silliness of arguing the bull market has gone on too long. We subjectively assign definitions for bull and bear markets and somehow think our definitions matter. That said, it does make for a more interesting market discussion. In 2018 the S&P 500 rose 7.6% before retreating 10.2%. Currently the S&P 500 is up almost 7% for the year and is threatening to make new highs. We think this makes sense given that revenue and earnings are soaring, and multiples are reasonable. Revenues are expected to increase 7.9% this year and 5.1% next year. Q2 earnings are up 22% and Q3 and Q4 are estimated to be similar. Profit margins have increased to 12.3% from 11.1% before the tax cuts. Current multiples are 16.6X in a low inflation environment.
So, what can go wrong? Lots of stuff. Since the stars might lie we won’t try to forecast geopolitical events. We will look at some numbers that concern us. Specifically, interest rates. After the 2008 credit crisis, The Fed adopted a zero interest rate policy to help borrowers afford their loan payments. Now that the economy is starting to rebound, The Fed has been increasing interest rates. Since 2015 The Federal Reserve has increased rates 7 times, .25 each time, for a total of 1.75%.
While historically this number is not high, it’s a lot higher than “free” money. It gives more cautious investors a reason to take money out of stocks and get a minimal but safe return in assets like CD’s. This is called the substitution effect. The yield curve has also “flattened”. Meaning long term rates have not gone up as much as short term rates.
Expectations theory posits that the steeper a yield is, the more positive the outlook for the economy is. A steeper yield curve means investors expect growth in the future and therefore more inflation. There is strong evidence that a flat or inverted yield curve is a good indicator of an impending recession. A recession is a foolproof indicator of a bear market. The yield curve is now below 100 basis points, it's flattest level since before the 2008 crisis. We believe we are still safe for now but are keeping a close watch on The Fed. As we’ve expressed before, we believe The Fed’s Keynesian policies are misguided. https://docs.wixstatic.com/ugd/d356dc_4bd7712682ca4adbb39936f09d27449b.pdf The reason for raising interest rates is to contain inflation. Due to globalization and technology, inflation is not an issue as we’ve written several times in the past. We don’t think The Fed needs to aggressively raise rates. We also don’t think The Fed cares what we think so they will do what they want. So in summary, our biggest concern are rising short term rates, but we think we have a new stock market high to make first before we move lower. As for now, download (we know, millennials stream music but at least we didn't say go buy the record) some Mary Chapin Carpenter and enjoy the last month of summer. The GreenPort Team