Happy Anniversary: 1987, 2007, and 2017

Posted:
Monday, October 30, 2017

What is it about years that end in seven? Thirty years ago, in October 1987, the stock market as measured by the Dow Jones Industrial Average plunged over 20 percent in a day. Ten years ago, the market hit what was then a peak before declining 35 percent over the next twelve months.

Two major market corrections had vastly different subsequent events. In 1987, there was no noticeable impact on the economy from the stock market’s rapid decline, which was subsequently blamed on computers and program trading. In fact, stock prices in the aggregate recovered in less than two years.

A decade ago, the pell-mell extension of credit, especially in the housing area, led to a subsequent collapse in housing prices which triggered the greatest economic contraction since 1929. Quick action by the Federal Reserve to supply funds to a financial system that had seized up led to a stock market boom, which has persisted to this day. At issue: when the next stock market correction comes, will it be more like 1987 or 2007?

First, it is important to note just how these corrections came about. In both cases, there was a fair amount of complacency prior to the downturns. Markets had become narrower in terms of stocks and industries carrying the advancing averages. At some point, an extraneous event (an effort to stabilize the dollar in 1987, the marking up of marginal credit borrowers as more credit worthy in 2007) kicked off the slide in stock prices.

So, can this happen today? Like prior events, there is a concentration of a small number of advancing stocks, specifically the so-called FANG group (Facebook, Amazon, Netflix, and Google). Google has since changed its name to Alphabet from the time the acronym was first decreed. Cutting edge technology, which has no history and thus no comparative valuation, is the leader of the favored sectors. In a twist, people who think they are diversifying by buying index funds are contributing to the inflation in the top names, as they make up a material amount of the index by market value. 

Another factor which is often overlooked is the role of low interest rates. When returns on “safe” investments like cash, certificates of deposit, and bonds are miniscule, investors are forced to look to avenues like the stock market for returns. When interest rates rise, especially if that rise is in excess of inflation, more risk-adverse investors will switch back to less risky investments. This implies that higher interest rates will help to cap the demand and price of stocks.

Somewhat offsetting the effect of rising interest rates is the international demand for US investment assets for retirement purposes. Around the world, literally billions of people are being ushered into the middle-class life. Among other trappings, these people are looking at how to invest for their own retirement. The US financial markets remain the largest in the world for this purpose. To a foreigner, an international mutual fund would hold names like Microsoft, Coca-Cola, McDonalds, etc. All of these companies are domiciled in the US and benefit from foreign purchase of their shares.

Finally, while the total value of the US stock markets is advancing, the number of stocks available for investment is shrinking. This is the result of the purchase of entire companies by private equity firms, who manage a portfolio of companies under their ownership for the benefit of third party investors.

Private equity returns are a function of leverage, which is to say bank borrowing. Since the typical firm purchased by private equity is a generator of cash, its purchase works so long as interest rates remain subdued. As interest rates rise, (and the loans are typically floating rate and rise in tandem) such firms may find their leveraged capital structure to be a liability in terms of both absorbing the higher interest rates as well as providing cash for capital expenditures. If this thesis is correct, expect to see a number of companies go public as interest rates go up, in an effort to cash out of the investments before the IPO market gets too crowded. The popularity of private equity has chiefly grown since the last stock market decline in 2007. No one knows how well private equity will do in a down cycle. 

As part of the tax reforms being proposed, corporate tax rates will be cut from 35 to 20 percent. In part, this could be offset by the prevention of interest expense deductions. Whether this is an advantageous trade-off depends on how much debt a firm has on its balance sheet. If this provision were to pass, it would put even more pressure to make companies public by using the stock proceeds to pay down debt. Such a provision would reduce the amount of debt issued, as presumably companies would issue stock at a low or no dividend rate in place of debt, whose cost could be rising. While this may increase stock prices in the short run, an inevitable fall in the earnings of a company could trigger the next decline in stock prices in general.

To put this all together, the market has to fear most a sustained rise in interest rates, which would at best cause the market to stall out and might even be the impetus for a decline. Such a rise in interest rates could come from a contraction in Treasury assets, a demand for higher yields to compensate for inflation, or a larger federal deficit. While there is great argument as to when interest rates will rise, there is no valid case for them to decline further. 

A rise in interest rates will not affect all stocks equally. It will have its greatest impact on investments that are supported by borrowed money at adjustable interest rates, excessive valuation (i.e. high Price/Earnings ratios), and which pay no dividends or whose dividend policy does not keep up with inflation going forward.

The Economy

 In spite of natural disasters of near biblical proportions, the US economy was estimated to have grown at a three percent annualized rate in the third quarter ending September 30. This was far better than many economists had predicted, given the amount of disruption caused by fires and hurricanes recently.

Looking ahead, it would appear that the domestic economy is in good shape for the next six to nine months. However, higher wages due in part to the country’s immigration policies will serve to stoke inflation, which will erode the purchasing power of a given volume of funds. 

Interest Rates

The combination of disaster recovery, Federal Reserve balance sheet liquidation, and possible tax cuts will all conspire to raise interest rates over the next year or so. The key question is how high will interest rates go? 

Historically, short-term interest rates should be around one percent above the inflation rate, with long term rates to be two to three percent above the inflation rate. Since most of the inflation experienced of late has been in asset prices in the stock market, it has escaped official scrutiny. With the tightening of the labor market, that is set to change. 

Inflation

Inflation is set to take off back to its historical average of 2-3 percent per year. While this is not a high number, it is higher than has been experienced in the past decade.

In order to keep inflation in check, interest rates will need to rise to a level higher than prevailing inflation. This will be the driver of many of the market’s threats and opportunities going forward.

The Stock Market

Stock prices are trending at record levels. However, progress from here will require either a further expansion of corporate profit margins (which are also at record highs), a corporate tax cut, a surge of exports, and/or significant economic demand in excess of that which can be demanded domestically. 

At this stage of the economic cycle, the operating profit leverage from incremental revenues has about run its course. Whereas a few years ago we saw that a five percent increase in revenues would generate, say, a ten or fifteen percent increase in corporate profits due to increased capacity utilization, a falling cost of inputs, or steady labor costs, we now see the same five percent increase in revenues generate a five percent increase in profits, if that. 

While there are still industries that have operating leverage, they are more the exception than the rule. Thus for most of the market, profits are set to slow down, especially as higher cost labor and the cost of borrowing exceeds the increase in revenues.

                        Warren M. Barnett, CFA

                        October 30, 2017

Warren Barnett, Founder & President, CFA - Barnett & Company

Warren Barnett

Warren Barnett is the founder and President, and Portfolio Manager for Barnett & Company. He was associated with the investment banking firm of Kidder, Peabody & Company and the investment counseling firm of Davidge & Company in Washington before returning to Chattanooga to accept a position in the trust department of a local bank. Perceiving the local need for the type of firms with which he was associated in Washington, he established Barnett & Company in 1983. He obtained the Chartered Financial Analyst professional designation from the Institute of Chartered Financial Analysts, Charlottesville, Virginia in 1986. Mr. Barnett graduated from The McCallie School in Chattanooga. He received his Bachelor of Science degree in Accounting from the University of Tennessee at Knoxville and his Master of Business Administration degree in Finance from the Owen School of Management at Vanderbilt University.

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Barnett & Company is a fee-only registered investment advisory firm registered with the Securities & Exchange Commission working with the investment and financial planning needs of individuals and organizations. For a brochure on the company and its available services, please call Mary Chastain at 423-756-0125 ext. 1006.