September 2018 has seen a plethora of stories regarding the tenth anniversary of the fall of Lehman Brothers, an investment firm that had been around for over 100 years before being caught with insufficient capital to weather a financial market panic. The value of the collateral of real estate securities they had loaned against was called into question. In the eyes of some, this was the beginning of the Great Recession, which continued until the stock market bottomed out in March of 2009.
History is illuminating but is not a predictor of the future. For those who went through this time, it was a searing experience. For those who got out, it was possibly an expensive one. Many who cashed out early could not bring themselves to get back into investing until the markets had recovered, if then. To this day, there are still investors who speak of those times as being traumatic.
Since that time, there has been a new generation of investors who have not experienced a downturn firsthand. Many invest through packaged products such as mutual funds and exchange-traded funds (ETFs). What these investors will do in a downturn is anyone’s guess, although inexperience is not considered an attribute in an environment where television talking heads are trying to outdo each other with an end of the earth prognosis, as they did ten years ago.
That there will be a downturn is a given. As always, no one can say when. If a downturn could be predicted with confidence, the risk would be removed from investing, and such an investor with such predictive powers would eventually hold the world’s wealth. A few make great calls, such as the managers who foresaw the collapse in real estate values and its impact on the financial markets. Fewer make consecutive great calls, which is why following someone who has made a great call so seldom works out.
The investors who earn significant returns over time, stay invested over time. They learn how to take the thunder with the sunshine. They accept that markets are volatile and that the way to win the investing game is not necessarily to have to win every inning, because this game has a lot more than nine innings.
To stay invested means to accept volatility in prices. Too many investors let the price of a security dictate its value. Value comes not from stock moves, but from the company associated with the stock. Digging into financial statements is a lot more work than trying to read stock charts like they were some Rorschach test.
So what do the next ten years hold in store for financial markets? First, there will in all likelihood be lower annual returns, on average; this is first the result of valuation. The higher the current price/earnings (P/E) ratio for the market, the lower the future returns over a five and ten year period. Currently, broad market indices have trailing indexes of 20-21 times earnings. Some of this is the factoring in of the lower corporate tax rates, passed last year. However, such tax adjustments are one-time events. Earnings are expected to decelerate sharply next year and thereafter. At the bottom of the market in 2009, the average P/E ratio was less than eleven times. In the past year, the market as a whole has gone up over three times the rate of corporate profits. Some parts have gone up more, some less.
The treasury is borrowing more money to fund the government to finance those tax reductions. The expectation is that, before 2022, the amount the U.S. Government spends on interest will exceed the spending on defense. With apologies to Arthur Laffer and his believers, lower taxes are not generating sufficient receipts to pay for the deficits.
This issue of larger borrowing amounts and higher rates of interest will collide sometime in 2020 or 2021. The result will be some combination of lower government spending and higher taxes. There are those who believe that this situation will set up a way to reduce Social Security and Medicare coverage. That is doubtful. If the Kavanaugh hearings were about the different perceptions of men and women, the future financial crisis would be between the haves and have-nots. With more have-nots than haves, expect taxes to increase before the reduction of spending.
If the issues are not addressed, beyond 2020, the United States will be grappling with the consequences of low birth rate and restrictive immigration. As stated before, low or no population growth leads to stagnant economic growth. The lack of workers needs to be resolved in a manner that satisfies employers and the general population at the same time. Both political parties benefit from the issue being dragged on, as a fundraising issue and a rallying cry to their bases. It is time to cut the theatrics and get something done about this.
Europe has endured no population growth for years. But many European countries have former colonies, which can provide markets for goods to growing populations. The U.S. is reducing both the influence and scope of future markets for U.S. goods and services with the “go it alone” attitude of the current administration. The logical end of the trade wars is that the rest of the world will not want to trade with us. That will hardly be considered a victory for the United States.
Economic activity continues apace. The optimism of small businesses is at a record high.
At the same time, businesses are having increasing problems in finding workers. Most are looking to raise prices to offset the higher level of compensation.
Housing is showing some signs of cooling off, as homebuilders have a harder time finding land cheap enough to build starter homes on, the category in highest demand. Also, due to more restrictive immigration policies, there are 20 percent fewer construction workers than a decade ago.
Recently Ford Motor Company announced that tariffs on metals reduced profits by $1 billion per year from higher steel and aluminum costs. And the same factors cited above are supposed to add 20-30 percent to the cost of reconstruction in the Carolinas after the recent hurricanes there.
Interest rates are going up. The ten-year treasury was above three percent and headed higher while writing this. The Federal Reserve all but promised another quarter-point rate hike in December.
As interest rates go up for money market accounts, Certificates of Deposit, etc. expect some investors who have less tolerance for volatility to be attracted to the rates offered. Such competition from cash-equivalent investment has not existed since the last market downturn a decade ago.
Inflation is ratcheting up. The trade tariffs have come in time to increase the price of Chinese toys at Christmas. Higher interest rates will make the cost of homeownership more expensive.
While the tariff program aims to increase the supply of domestic goods to substitute for imports, the lack of workers makes this goal a bit problematic. Also, by applying tariffs both to raw materials as well as finished goods, much of the advantage of producing in this country is dissipated in the higher cost of steel, aluminum, etc.
The Stock Market
The stock market, facing mounting obstacles, continues to bull its way through. For many, the performance of the stock market is not rational. However, there is an old Wall Street quote attributed to John Maynard Keynes, “the market can remain irrational longer than you can stay solvent.”
Historical data can tell a lot about future market potential and financial relationships. It cannot tell us precisely when a market will react one way or another. Thus timing the market needs to be replaced by faith in the relationships between market forces. Faith comes from knowledge. Timing comes from luck, which is sometimes mistaken for skill. They are not the same thing.
Warren M. Barnett, CFA
September 28, 2018