Current Commentary

It’s de ja vu all over again, as Yogi Berra might have said. Late last year the markets concerned themselves with the health of the economy in the face of two policy issues: interest rates and trade wars. Here we are again. But much like our assessment at that time when it started almost a year ago, we are focusing on the underlying fundamentals. To be sure, these policies are very important and have the potential to derail the aging economic expansion. They should be taken seriously and we are doing so. At the same time, we are still enjoying a pretty strong economy with historically low unemployment and tight labor conditions, increasing wages, improving productivity, and better-than-expected second quarter preliminary GDP gains. As an aside, do you ever wonder why every economic report is characterized as “better than expected”, or “worse than expected”? You’d think these economists would start getting better at their expectations! In any event, the 2.1% GDP gains, while exhibiting some slowing from the previous growth pace, beat consensus analysts’ 1.9% projection. And, to top it all off, quarterly earnings reports have been surprising to the upside significantly. In other words, while the trade and interest rate issues do bear watching, the economy is doing quite well, and that’s what really drives long-term stock direction, along with subdued inflation and accommodating borrowing costs – something we are enjoying on both those fronts.

The investing class was disappointed mid last week when the Federal Reserve announced only a quarter-point easing, but more tellingly it telegraphed no urgency to keep that going. Interest rate watchers were hoping for about half a point and some guidance regarding further declines. They didn’t get it. The markets started drifting down as a result. Then, late last week, President Trump announced additional 10% tariffs on another $300 billion of Chinese imports. Today’s reaction to that, after having digested it over the weekend, is decidedly negative. The one bright spot in all this, is that last week’s declines came in lighter volume, indicating no real appetite for dumping stocks among professional money managers.

As with the 2018 fourth quarter declines, we expect a bit of continued sliding and some kind of catalyst to reverse course. Perhaps it will be the Fed making some sort of musing about “re-assessing conditions”, as they did last Christmas Eve. Who knows? But what we don’t want to do is sell into steep declines when underlying fundamentals are strong. The weakening global economies are of concern, but the domestic economy is holding up nicely. If we were seeing data points indicating an impending recession, that would be one thing. But we’re not at this point.

The question is, how long in the face of slowing non-US economies and continued world trade burdened by tariffs, can the American consumer keep corporate earnings rising?

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The last few weeks have seen a dramatic level of fluctuation in the stock market indexes. Speculation is rife as to the causes, but it’s safe to conclude a few things about this. First, it’s been an exceptionally long time since a significant sell-off of any lasting value has occurred prior to the first quarter of this year. Investors will recall that after the trade tariff rounds started in the early part of this year, the market regained its composure and went on to post strong gains, leading indexes to new highs just weeks ago. This current round of volatility seems to be centered on increased fears of the Federal Reserve raising rates too quickly and slowing down the economy too abruptly. And, while a trade deal with Canada and Mexico was codified, lingering trade fights with China don’t seem to be getting resolved. Also, of course, mid-term elections are causing anxiety because the current strong economic and employment performance is predicated on continuation of recent policy changes. If the Democrats take over control of Congress, concerns are legitimate that the economy will suffer again, and revert not just to the slow growth of the previous decade, but an actual recession. On the other hand, bills won’t become law if the president vetoes them. We’ll know about that outcome in a week.

But this sell-off, punctuated with recovery days, doesn’t appear to be the start of a nasty bear market. Analysis of the last 65 years of the S&P500 and the past 27 years of the MSCI All Country World markets done by Morgan Stanley, indicates sharp, initial declines are more consistent with run-of-the-mill corrections, not a slide into bear markets. And this has definitely been sharp, with the NASDAQ dropping about 13% and the S&P500 about 10% just this month. It’s scary, but not unusual. In contrast, when bear markets begin, it is with deceptively gentle declines, making it hard to discern what’s going on. Judging from history, this looks like a correction. In the ten largest 35-day selloffs, stocks ended up bouncing back in nine cases. Only one eventually turned into a bear market. The current decline ranks seventh of those ten. Our last bear market in 2007 didn’t even look like this, with no dramatic early plunges. But bear markets come along with recessions. We just received the 3Q GDP report last week, showing the economy continuing to steam along at a 3.6% rate. Unemployment remains at multi-decade lows. This is not an economy sliding into recession. For sure, eventually we will have another bear market and appropriate changes to portfolios will need to be made. At this point, this doesn’t appear to be happening now.

Bull markets don’t die of exhaustion – they die of harmful policy inputs. The smart money rides through most corrections – and this is definitely a correction – as most of them are relatively shallow and short-lived. The key for a long-term investor is to stay put and be invested when the next uptrend starts. It will come without warning and when least expected. If the slide continues to gain steam, we’ll appropriately defend portfolios.

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Current Commentary

Last week’s market slide has been a long time coming. It’s been a couple years since we’ve seen a correction within what is now this 9-year-old bull market. We’ve been getting concerned about the unabated strong run-up lately. Markets periodically need to pause and digest gains in order to stay healthy and keep overall risk for the trend at reasonable levels. Last week, the Dow Jones Industrial Average shed 4.1%, with a one-day 666-point drop coming on Friday. Other indexes were off a little less. While large numerical movements like this can seem concerning, the percentages are what needs to be focused on, and that translates to 2.5%. Long-time investors may recall the market crash of October 1987, when the DJIA fell 508 points. But back then, that represented over 22%! The point is, with an index around 26,000, it takes large point movements to make impacts of some percentage.

Our concern has been complacency. Many have gotten so used to weekly gains that they’ve forgotten about normal levels of volatility. In fact, the last time the technical indicators were listed as remotely cautionary was last August. The catalyst for Friday’s action was ironic: too strong economic data. Year-over-year wage growth was up a healthy 2.9%. Wage growth was one of the many missing components to the lackluster “recovery” from 2009-16. But the concern among market watchers is that this could lead to inflation, which in turn would spur the Fed to raise overnight fund interest rates even faster than they plan to. That drove up the 10-year Treasury yield to 2.852%, creating a bond market selloff. This may or may not be overblown. While Keynesian theory holds that higher earnings are inflationary, that notion discounts productivity gains and myriad other factors and there is scant data supporting this conclusion. But, that fear has some warrant to it since our policy makers buy into this theory, and therefore have a history of acting on it.

However, it bears keeping in mind the big picture. Last week’s collective decline is in the 4% range from peak – not at all worrisome and as we mention above, overdue and in our view welcome. In fact, we’d like to see this pull back at least 5% or more to shake out some fear and build caution. Today, the losses are less, but helping to get there. Also, recent economic data show the nation’s growth rate in the 3% range, which is double the rate over the aforementioned “recovery” period. Globally, the world’s major economies are in sync, which is unusual but positive. Additionally, unemployment is at low levels and most important in this area is labor force participation, which has been climbing out of the doldrums. Recent actions slashing wasteful and burdensome regulations and the brand-new stimulus affects of the just-passed tax reform package are already evident and will keep things moving along nicely. Stock prices are driven by corporate earnings, interest rates, and inflation. The Fed has been concerned of late that inflation has long been stuck well below its target level of 2% (deflation is a major problem, so some level of inflation is necessary). Maybe now, that target will be achieved. Interest rates are rising, but not to dangerous levels and are still quite accommodative for financing growth. And, corporate earnings are being reported as quite strong and will likely strengthen further with more people working and getting paid more, thereby investing and buying goods and services with those proceeds, creating demand.

In short, while we’re always on alert for significant market declines that may warrant protective strategies, the smart money holds steady in most declines since they are usually short-lived and shallow and knowing the start and end of them in advance is impossible. Missing the rebound is more likely to hurt long-term performance than help. So, we welcome this pullback, but will keep an eye on it to make sure we weather it successfully.

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Current Commentary

Global markets are reacting negatively to the results of Britain’s “Brexit” vote to pull out of the European Union. This came as a shock to the collective analysis around the world. We supported the exit, but expected the “remain” side to prevail just as virtually all others did. In fact most markets, including in the United States, actually rallied the day of the vote in anticipation of the “remain” side winning the referendum. British book makers placed the odds of Brexit failing at 9:1, so those guys are certainly licking some deep wounds now! As with most events where the effects of the resulting outcome are uncertain, over-reaction and panic drive markets initially. If there’s one thing financial markets hate – even more than bad news – it’s uncertainty. Bad news can be priced in allowing you to move on. But what do you do with the unknown? And, admittedly, with political, market, and economic uncertainty globally so heightened, this timing wasn’t ideal.

The first trading day after results were published wasn’t pretty. Asian and European bourses took hits ranging from around 6% to over 12%. Interestingly, the one country most affected by this, the United Kingdom, sold off the least. Our own markets open much later, but by the closing bell on Friday the S&P 500 had shed 3.6% and the NASDAQ declined 4.1%. The Japanese Yen and American dollar were the only major currencies to increase in value amid steep declines in other countries’ exchange rates, as a result of a flight to safety. More losses followed today, notably for our portfolios which have very little foreign exposure (thankfully, but by design), the S&P posted an additional decline of 1.8%. So that’s what’s happened so far. But what can be made of this going forward?

Our view is the doom-and-gloom prognostications are overblown for a number of reasons. It appears the main concern regards trade deals amongst the now-27-member EU and the UK, and other trading partners of the UK as well, like us. The fact is, the British economy is the second-largest in Europe and by some measures, it is in the best shape. The global community that trades with them now will want to continue to do so, and they will also want to continue trading with their partners. So trade deals will be made, and on terms likely not much different from those in place now, lest further restrictions reduce trading volume for both sides. Since the beginning the UK has maintained its use of the pound sterling, eschewing the euro as a currency. So nothing different there. The UK had already negotiated with the EU for more control of cross-border movement prior to this. So that’s little changed, but whatever changes on this front are in store, it should be better for Britain. And let’s not forget that the exiting provision of the EU agreement – article 50 – has flexibility as to when it’s invoked and only then does that start date commence the clock ticking for two years to accomplish the transition to complete removal. The EU itself has announced it is in no hurry for that invocation to start and has suggested it should be done by the next prime minister. David Cameron has announced he will step down in October, so they won’t even have a new government for a few months to even start the two-year process. So, there is plenty of time to hash out agreements and transition protocols. By then, President Obama, who crudely inserted himself in the British citizenry’s internal decision by threatening to move them “to the end of the queue” for trade deals with us, will not be the one leading our own negotiations with them, which is a positive.

To be perfectly honest, having analyzed European economics and politics for decades, we’re surprised it took this long for chinks to appear in the armor. Europeans are a wonderful but very diverse group, and for centuries haven’t really gotten along all that well. The divide between north and south, as well as east and west, has always been wide. The idea of fusing them all together forcibly, to be governed by a collection of rotating non-elected bureaucrats out of Belgium, who have made a slew of oppressive rules and regulations, bonding their finances together forcing the taxpayers of the more responsible wealthier nations to bail out the petulant profligacy of the economically-weaker more socialist nations, with each country enduring exploding welfare expenses, adding open-border policies that are now stressing the cultures of the individual nations to the brink especially with the influx of middle-eastern refugees and terrorists from a culture diametrically opposed to pluralistic western civilization, and all the while creating a weaker defense alliance as each nation thinks all the others will come to their defense so no one spends anything themselves on it, and expecting all of that to work indefinitely is really pretty unrealistic. We Americans wouldn’t want to live in an alliance like that, so it shouldn’t be hard to understand Europeans re-thinking this now that they’ve endured it for a while. We expect other nations will start to grumble about the union too.

Let’s also keep in mind that some European nations have never been part of this union and it hasn’t hurt them any. Norway and Switzerland have been sovereign all along and were never part of this system. Other countries, like Denmark, have maintained their own currency along side of using the euro, allowing them certain exemptions. Our opinion is that this is a good thing, certainly for Britain but also for the rest of Europe, even though it will cause some early pain. The citizens of mainly-free democratic countries need to control their governance by elected representation without interference. Free people need to chart their own destiny, not have it dictated to them, and be able to maintain their own unique cultural distinction. This applies to both political and economic liberty. We have every confidence the great people of the United Kingdom will prosper, and those of us who remain their allies will do just fine as well. It will take some time to bring equilibrium back to the world financial markets, but perhaps not even as much time as many fear. We will watch developments closely, but maintain our heads while those around us are losing theirs.

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