Market Commentary - October 2016

Glass shattered, in slow motion, when Ella Fitzgerald reached a sufficiently high note during a 1971 television commercial. Her recorded voice, subsequently played back on audio cassette, replicated the results, giving birth to a classic advertising slogan, “Is it real or is it Memorex?” ⁽¹⁾

This note will focus on the identification of what we deem “real” in an increasingly distorted atmosphere.

The Election News Cycle: An Echo Problem

We only care about your portfolio and have zero political agenda here. The financial markets are not red or blue, but pure green. ⁽²⁾ Predictably, CNBC and Investor’s Business Daily devote considerable attention to the pending Presidential election. Their business model, unlike ours, is supported by advertisers and requires excessive focus on short term results. We liken this to the sports betting room in a Las Vegas casino where bettors are seduced on the outcome of such inane events as the first touchdown or the most fumbles, details long forgotten when the season ends and the champion is crowned.

If we were willing to be recklessly indulgent, we could highlight aspirational differences between the two candidates, but, we have no intention of making investment decisions on the basis of who might win the Presidential election because:

• There is a gap between candidates’ words and their real intentions.
• Presidential proposals are not always supported by Congress.
• There is a tendency for the stock market to anticipate and set prices in advance of real events. In order to profit from an occurrence, one must interpret and invest before the market reaches the same conclusion. Think of Brexit when huge bets were placed, with trust in the polls, only to be unwound immediately after the tally. The Mexican Peso dropped for several days in advance of the first Clinton-Trump debate but rallied the morning after. The markets move rapidly on tidbits of information.
• The lack of empirical data. Our review of Wall St. reports reveals conclusions based on past observations, with short time horizons and inferential leaps between correlation and causation. JP Morgan proudly concludes that “a divided government” matters most. In horse racing parlance, this is tantamount to an “exacta”– a low probability bet predicated on picking not one, but two winners.
• The positive long term trend of the market. Traders, the media and Wall Street might see each election, the Korean War, the assassination of President Kennedy and even 911 in the graph below. ⁽³⁾ As long term investors we see the Great Depression and the bursting Tech and then Real Estate Bubbles. The rest of the 130 years seem to move pretty much up and to the right. (For those interested in old “box scores”, see the performance of the US stock market during each of the Presidential terms following the creation of the Standard & Poor’s stock index at the back of this note) ⁽⁴⁾

Economic Growth: A Real Challenge

The Fed concluded their September open-market meeting by once again lowering GDP projections, down to 1.8%, for the fourth quarter. ⁽⁵⁾ Why does the economy continue to sputter along at about one-half of the historical growth rate? ⁽⁶⁾ Consider three prodigious sources of economic growth in the U.S. since World War II.

1. Women in the Workforce: Women (the green line) started entering the work force after World War II, helping improve GDP per capita. Men (the blue line) started dropping out of the work force once Social Security Benefits started kicking in for the baby boomers. ⁽⁹⁾
2. Debt Binge: U.S. debt ran between 30-40% of GDP for 40 years until 1984. Since then, US presidents, Congress, and Federal Reserve Board chairs have overseen expansion of domestic debt so that it now hovers near 100% of GDP. ⁽⁸⁾ Collateralized mortgage obligations (CMOs) helped drive the real estate bubble.
3. China: In 1980 Chinese GDP was a bit higher than that of Canada, not even one-half the size of Germany and around 10% that of the U.S. By 2015 China successfully morphed their agrarian economy into the world’s largest exporting machine. China, with nearly 20% of the world population grew into the second largest economy in the world, more than three times the size of Germany. ⁽⁷⁾

The common denominator? None seem likely to repeat. U.S. debt, at 100% of GDP, can no longer be expanded without restricting future growth prospects even further. Women are already fully represented in the work force and population growth in the U.S. has slowed to less than 1% per year since 2000. ⁽¹⁰⁾

Government Capabilities: Real or Memorex?

Despite absolute polarity ⁽¹¹⁾ and the cold facts regarding the budget deficit, both Presidential candidates seem likely to push for fiscal stimulus. ⁽¹²⁾ Infrastructure, already outperforming this year, seems like a reasonable spending target.

Janet Yellen’s term as Fed Chair does not expire until 2018, leaving her expansion policies likely unaffected by the election. Consider the impact of rock bottom interest rates:

• Allowed corporate America to refinance debt at lower rates and facilitate the buyback of stock, boosting earnings per share without necessitating an improvement in financial performance.
• Expedited the rebirth of the beaten down housing market.
• Forced investors out of C.D.s and Treasury Bills and into riskier assets.

No wonder the financial markets cower whenever the Fed meets to discuss the possibility of raising rates. Paradoxically, low interest rates, pushing down investment returns, have caused individuals to save more for retirement, and to spend less, restricting economic activity. ⁽¹³⁾

Real Expectations

Near term, expect more volatility in advance of the election, reflecting the market’s disdain for uncertainty. Longer term, curtail expectations. Between 1973 and 2015 large cap U.S. stocks returned about 10%, of which about 3% came from dividends and about 7% from growth. ⁽¹⁴⁾ We see lower contributions from each component on the basis of:

• The dividend yield is only 2.1% today vs. 3.0% historical.
• Appreciation tracks economic growth, which, as noted above, we expect to remain slower than recent history going forward. ⁽¹⁵⁾
• Valuations, as measured by the price to earnings ratio, are elevated (by yield hungry investors seeking returns). We expect their eventual migration back to historical norms, once interest rates normalize. ⁽¹⁶⁾

The combination of slower growth and lower multiples should culminate in lower equity returns than the historical norm. How much lower depends on a multitude of variables.

Real Returns

Investment returns mean nothing in isolation. Subtract inflation from reported returns and an investor (ignoring taxes and expenses), can determine their “real rate of return”. The feel good 10% returns, between 1973 and 2015 were accompanied by 4% annual inflation. ⁽¹⁷⁾ Annual real returns were therefore 6% (10% minus 4%).

Over the past 10 years, a period that included the infamous 2008 meltdown, the S & P 500 returned only 7.3% per year. However, inflation of only 1.9% per year brought a still respectable 5.4% “real return”. Seen through the prism of the current inflation projection of 1.5% per year, respectable real returns could be achieved with reported returns of around 6.5 – 7.0%. ⁽¹⁸⁾

Real Advice

Some of you may recall the less famous, but equally effective Memorex commercial captured in the picture below.

The recorded music sounds so real, it “blows away” the listener. During this election, the 35th such since the beginning of the market graph noted above, we will do our best to keep you from getting blown away. Our long game strategy includes:

• Maintaining aligned interests with you. We are saddened to see giant Wall St. firms in the news for insider trading, opening fake accounts, betting against their clients and charging high fees to do so. Remember that our money is invested alongside yours.
• Staying disciplined in our investment process so that you do capture gains when they occur. When interest rates finally rise we will not have to react, as your portfolios have been positioned to minimize the risks.
• Being sensitive to the friction from unnecessary income taxes.
• Seeking and pursuing diversification opportunities. We have made a serious commitment to real estate and continue to explore other options.
• Keeping your portfolio within the context of your bigger financial picture.

Instead of risking your capital on who makes the first fumble, we remain firmly focused on bringing you home the trophy – keeping you on track, with a suitably comfortable ride, to reach your financial destination.

1. Technically the slogan referred to “live” rather than “real” so please accept our use of poetic license.
2. Paraphrased from Jonathan Golub, market strategist at RBC Capital in speech given at IMCA conference we attended on September 29, 2016 in Chicago.
3. Using data provided by Standard & Poor’s
4. The Leuthold Group; 2012
5. Bloomberg; September 21, 2016. GDP is gross domestic product, a measure of total economic activity.
6. GDP is published by the Bureau of Economic Analysis. Calculations by WCF.
7. All GDP data sourced from Int’l Monetary Fund.
8. Federal Reserve Bank of St. Louis
9. Department of Labor
10. Worldbank.org
11. A technical recording term describing a clean reproduction of music. Obvious double meaning.
12. The current budget deficit, by the government’s own estimates, is projected to grow from $438 million this year to $1.2 trillion by 2026. Congressional Budget Office. CBO.COM. Report dated August 2016
13. From speech by Vikram Mansharamani of Yale University given at IMCA conference we attended on September 29, 2016 in Chicago.
14. Using data provided by Standard & Poor’s.
15. Federal Reserve Bank of St. Louis citing Bureau of Economic Analysis (www.bea.gov/national) This Time is Different by Carmen M. Reinhardt & Kenneth S. Rogoff; 2009 accurately predicted slower GDP growth that has failed to reach even 5% per year in the past 10 years.
16. According to FactSet, the S & P 500 trades for 16.7 times the forward 12 month earnings estimates and that compares to a historical multiple of 14.3.
17. Using Consumer Price Index, US Bureau of Labor Statistics; Thompson Data
18. The current yield on 10-Year Treasury Notes (1.54%) minus the current yield on 10-Year TIPs (Treasury Inflation Protected Securities) (.08%) leaves an implied 1.46% rate of inflation according to the financial markets. This has historically been a good source of inflation projections.

S&P 500 Performance By Presidential Term, 1928 To Date 

* Return measured from inauguration days, except for those ended by death or resignation