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Investment Review/Outlook

Current Investment Outlook

Since the depths of the 2008 financial crisis, we have been steadfast in calling for rising stock market values. This forecast has been both rare and totally on the mark. Since the beginning of 2014, we also began calling for more volatility. And, since then, the market rise has had a more volatile character. The first quarter of 2018 gave us a real correction followed by a strong recovery through the end of September. And, then, on cue, we saw another correction. A rising market will always have periodic corrections and this, by itself, is healthy. The fundamentals underpinning the market remain very strong, but the drag of higher rates will continue to keep us on a more volatile path. We maintain our positive view on the market held consistently since the lows in late 2008 and early 2009 but tempered with increasing caution. Our views are explained below. This is not a market for amateur investors.

The uncertainty and the volatility we now see in the market comes from the re-pricing of risk with higher interest rates. Stocks tend to sell at lower valuations when there is more competition from income producing investments and when you need to earn more or have less risk when your borrowing costs rise. For now, there is not a recessionary risk unless rates rise significantly higher. It is just a matter of a lower ceiling on valuations.

The easiest part of our forecast is to observe that the economic fundamentals are strong and getting stronger, giving positive support for the market. This is due to reduced regulation, the positive effects of the tax cuts, and the repatriation of $300 billion of overseas cash, with significantly more to follow. Earnings growth for the S&P 500 in 2018 is expected to exceed 20%, with still strong gains of 10% in 2019. The outlook for corporations and consumers remains bright and improving.

Ten-year Treasury rates rose from 2.8% to over 3.2% (3.1% now), providing a more challenging environment for stocks. The most serious negative factors for the market are rising interest rates and the simple fact that there is way too much debt outstanding around the world. Rates are rising in the U.S. for fundamental economic reasons and the fact that the Federal Reserve has shifted from loose money policy to tight money policy. The rest of the world is beginning or about to follow suit. The process has been orderly so far, but we still have an extraordinary $247 trillion debt outstanding worldwide.

Despite criticism that they kept rates too low for too long, the Federal Reserve has now established its transition from providing liquidity to the markets (QE or Quantitative Easing I, II, and III) following the financial crisis to withdrawing liquidity (QT or Quantitative Tightening). The Fed Funds rate has now increased from 0% to 2.25% and the Fed has now raised its selling program to $50 billion a month. It is clear that the ten-year easing program helped drive the nine-year stock market expansion and encouraged investors to buy riskier assets. It is impossible to know how this unwinding of liquidity will affect markets, but we can trust that the Fed would like to roll out its program with a minimal negative impact on the economy and the markets. As a sobering side note, over the next 5 years, the U.S. will have some $7 trillion in Treasuries roll over from a 2% to at least a 4% cost of financing.

Not only is there way too much debt outstanding around the world, there is still a tremendous amount of zero and negative interest rate debt, as Central Banks look for ways to boost their local economies. Our Federal Reserve has led the world in making a shift from QE to QT, but it appears that the ECB and then Japan will eventually follow suit. We do not know how much this tightening will raise rates worldwide, or the impact it will have on their local economies and markets. We do know that there is too much debt worldwide and it will be paid or written off with a certain amount of pain or difficulty. China has been suffering a crushing bear market, and the European market has disappointed as well, perhaps due to their excessive amounts of debt.

Higher interest rates will offer wider spreads and may be good for banks, but the combination of less liquidity and higher rates will cause difficulty for marginal borrowers who may be unable to refinance or service debt at higher rates and wider spreads. The same is true for margin debt at new peak levels. With U.S. rates so low for so long, corporate debt has risen to past credit cycle peak levels, something that typically has only happened during recessions. Emerging markets will continue to be hurt by the combination of higher rates and a stronger dollar. China is particularly vulnerable because they have so much debt outstanding, even before considering their shadow banking activities. It is easy to build up debt when it costs very little. But, it can be very painful to unwind. The resulting pain will be quite unevenly shared.

The financial condition of individuals is a relative bright spot. Household net worth has almost doubled from its previous peak in 2007 and debt service for individuals is a significantly lower drain on income than it was then. Consumer confidence at 138 was above estimates and at an 18-year high. Wage growth has reached a 3.2% rate, and there are 7.1 million unfilled jobs outstanding.

As we have said before, we think the fears of trade wars are somewhat overblown. Mexico and Canada have come to terms and we think there is a possibility that China will do the same at the November G-20 meeting. In due time, we expect an agreement with China, and that would be viewed very positively by the market.

The economic data remains robust. Second quarter GDP was up 4.2% and the third quarter forecast is for a 3.3% increase. The jobs picture is very strong with all those unfilled positions. Housing prices have softened somewhat with an increase in mortgage rates and auto sales may take a pause. Crude oil prices have been working higher and now stand at around $70 per barrel. The inflation rate seems likely to rise above the 2% target set by the FED, but the risk of higher inflation is offset by softer demand overseas.

Overall, we remain optimistic, but with a heavy dose of caution and the expectation of more corrections from time to time. The market price-earnings ratio in January was over 18 and we now have a forward PE ratio of 16.8 times. The continued rapid growth in GDP and corporate earnings provide strong support for a rising market. Merger and acquisition activity is high, and companies are buying record amounts of their outstanding stock. After a period of unusual calm, market volatility has increased, and with rising interest rates, we should expect to see more corrections even if we continue to have a rising market. Regardless of the market direction, our view is that the proper focus should be on individual stock selection and that the market will reward discerning investors. Leading sectors have been healthcare, consumer discretionary, and industrials, and many attractive buying opportunities remain in these and other sectors.

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