Posted by David Tillson - Third Quarter Commentary
"You've got to be very careful if you don't know where you are going, because you might not get there." Yogi Berra (1925-2015)
October 1st marks the end of summer, shorter days, unsettled stock markets, and the coming end of baseball season. This September also marked the passing of Yogi Berra, widely remembered as one of the greatest catchers in baseball history and also as one famous for his unintentional witticisms. His countless expressions and phrases were memorable because most of them didn’t make any sense – but at the same time, every one had some truth to it. He did acknowledge the popularity of his Yogi-isms, whether actually his or attributed to him, with: “I never said most of the things I said.”
Turmoil, confusion, disappointment, fear, havoc and uncertainty are all words that may come to mind when thinking about the past three months. Greed, however, does not. The stock market has been trendless – unable to rise and unwilling to fall materially. Investors now seem to want to protect what they have rather than add to their wealth. They are nervous; they had become accustomed to a constantly rising stock market so that the 6.5% decline in the third quarter came as an unpleasant surprise. The last quarterly decline was in 2012 and it was minor while the last major decline (-14%) was four years ago. Traders, hedge funds and short term investors are unhappy because the market has not been behaving in a predictable manner. The unhappy crowd can’t figure out if the market is trying to bottom or is setting itself up for a new leg to the downside. There are numerous reasons for this indecision including struggling economies around the world, a strong U.S. dollar, weaker than expected corporate earnings, Mideast turmoil, and yet another delay in the Fed’s desire to raise interest rates. As we have done throughout our careers, we look to history to gain some insight as to what might be in our future and how we should proceed. From Yogi Berra: “It’s tough to make predictions, especially about the future.” As we analyze the long term historical data, we always appreciate that “The future ain’t what it used to be.” Technologies, politics, laws and regulations change; peoples’ emotions and instincts do not. What makes planning for the future so difficult is that the timing of peoples’ reactions is unpredictable. Stock market bubbles, for example, last a lot longer than they theoretically should and when they pop, it is a lot faster and more violent than most people expect. This chart plots the quarterly returns of the S&P 500 Index over the past 20 years and shows that it should not have been a surprise that a market decline was overdue. In fact, negative returns in any 12 month period have occurred more than 20% of time over the past 55 years. In this still young century, two major bear markets popped the tech and housing bubbles and investors are still worried that they may soon experience yet another. We are skeptical of that happening, in part because too many investors believe that it is possible. When all the experts and forecasters agree, then something else is likely to happen. Furthermore, the fundamentals of the stock market do not indicate that valuations or earnings are excessive. In fact, S&P earnings are currently 10% below their expected level based on the past 90 years’ trend. The open questions are: “Is a recession imminent?” and if not, “When will economic growth accelerate?”
Janet Yellen, Chair of the Board of Governors of the Federal Reserve, has been assuring us that interest rates would remain low for a while longer but that eventually, a stronger economy and inflation would allow for rate increases. Investors have been divided as to the implications of a rate increase. Some believe that higher rates mean lower prices; others focus on the proposition that a stronger economy drives prices higher. The Fed’s easy money policy has had the desired effect of stemming deflationary pressures in housing and financial assets. It has not, however, led to the desired levels of inflation, economic growth or wage increases. In the past, as unemployment went down, inflation went up. Some Fed Board members, the hawks, argue that with unemployment at 5.2%, inflation will begin to rise. The doves say that relationship isn’t what it used to be. A third argument is that no one really knows how well the last seven years of Fed policy has worked. If the central bank cannot be sure of what happened in the past, it will be hard to decide on the future. Researchers on Fed policy have found that rate cuts affect rich and poor consumers differently. For example, lower rates have resulted in more bank credit being extended, but while borrowers with low credit scores spent more of what they were able to borrow, those with credit scores above 740 didn’t spend any of their increased borrowing power. A report prepared for the Lima, Peru, meeting by the Group of Thirty (a body of central bankers, regulators and economists) reached the conclusion that among developed economies, the rich have gotten richer and they are the least likely to spend more. This does not bode well for reviving economic growth in most of the world. If central bankers agree with this conclusion, and if they have an alternative, it may lead to an earlier end to the Quantitative Easing programs that have been the “go-to” solution for the last seven years.
Furthering the “end-of-QE-programs” discussion is Ben Bernanke, the former Fed chairman. He has said that the Fed’s initial response to the crisis in 2008 was bold and effective, but insufficient. “I often said that monetary policy was not a panacea – we needed Congress to do its part. After the crisis calmed, that help was not forthcoming.” In his memoir, “The Courage to Act: A Memoir of the Crisis and Its Aftermath,” he chastised Congress in several instances for doing outright damage to the economy (i.e. the 2013 government shutdown). He was frustrated that fiscal policy makers, instead of helping the economy, appeared to be actively working to hinder it. Whether Bernanke or Congress’s defenders are correct will never be known. What is certain is that the economy did not collapse as in the 1930’s, but it also has not recovered with the same vigor as witnessed in past recessions.
In summary, we have not been surprised with the flat but volatile 2015 stock market. We are disappointed that the Fed has not yet raised interest rates and we have been modestly surprised that the U.S. economy has not been stronger. Possible explanations are the more-severe-than-realized weakness in China, the impact on emerging markets from the sharp decline in commodity prices (especially oil), the strong dollar hurting our exports, and low wage growth hindering consumer spending. Seven years of ever increasing government regulatory oversight, while likely preventing a recurrence of past mistakes, has also probably reduced productivity. Our view is that the Fed delayed raising rates because of these factors and some pressure from international leaders. We are not only hopeful, but expect the Fed to raise rates within the next three months, barring a major catastrophe. If they do not, they risk losing all credibility. Also, the IMF and others are beginning to warn of the fallout of undoing years of cheap debt. While there may be some turmoil as rates normalize, we do not expect a recession any time soon and we do not think that higher rates will slow growth nor negatively impact stock prices. Change is the one constant in life, and 2016 will present new challenges and opportunities. The market is always faced with indecision. Once again, the Great Yogi Berra has the answer: “When you come to a fork in the road, take it.”