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Investment Review/Outlook

Current Investment Outlook

In the first quarter of 2018, the stock market encountered its first significant correction in two years. The 10-year Treasury broke out of a 24-year downtrend in rates (and but for the brief increases in 1994, a 37-year downtrend). We think there is a good chance that the second longest stock market expansion in modern history continues. But, it will do so with much more volatility, as the positive of strong fundamentals is offset by the negative of rising interest rates. While we have consistently predicted a rising market since the lows of late 2008 and early 2009, we now expect the market to drift higher with increased volatility and more corrections along the way. We discuss the competing positive and negative forces below.

The economic fundamentals today are strong and improving. The economic expansion following the 2008 recession continues, and it has been strengthened by reduced regulation, the recent tax cuts, and repatriation of overseas cash. Each of these is powerful and together they give real support to the economy going forward. Earnings growth for the S&P 500 companies in 2018 is expected to be 16%, with nearly half of that coming from the tax cuts. Consumers will see more take-home pay, and the combination of higher earnings for individuals and corporations is quite powerful.

Offsetting the benefits of stronger GDP growth is the pain of higher interest rates and the fact that there is too much debt outstanding worldwide (now an astounding $233 trillion). Rates have bottomed and will continue to rise for fundamental and policy reasons. The only question today is how fast rates will rise. We expect the Federal Reserve to encourage more rapid inflation but seek to avoid sending the economy back into recession. In any case, individuals, corporations - and federal, state, and local governments - will be paying much more on their borrowed funds. It almost seems foolish to note that higher rates always cost more than zero percent or even negative interest rates. But, that is the circumstance in which we have been. Higher rates also mean lower price-earnings multiples for the valuation of stocks. Interestingly, it was news of a higher rate of wage inflation that seemed to trigger the recent market selloff.

Over the past ten years, the Federal Reserve has done all it could to push the markets higher, with rate cuts and Quantitative Easements I, II, and III. Making money “free” has pushed investors into riskier assets, and this has helped drive the nine-year stock market expansion. Now, however, the Fed represents a headwind of sorts, as it plans four rate hikes this year and three hikes next year. The Fed seeks to undo the $4 trillion QE borrowings with reductions to the Fed balance sheet of $30 billion a month this quarter, $40 billion a month next quarter, and $50 billion a month in the fourth quarter. This process will take time and it will have a cost as it pulls liquidity out of the system. How much and how long, we can only guess.

As the U.S. shifts from Quantitative Easing to Quantitative Tightening, the Central Banks in Europe and Japan are still easing. This will change in September and it seems likely that this will give us higher interest rates on a worldwide basis. And this, in turn, highlights the fact that the growth in worldwide sovereign debt is a gigantic problem. For many countries, the problem is insurmountable (think Greece). For the U.S., we face a huge challenge with record debt and unfunded liabilities. But, we have prospects for growth and the rule of law – and these will make a real difference. The U.S. debt-to-GDP ratio is a too-high 100% (without unfunded liabilities), but China stands at 300% (or more) and Japan at 600%. The overall worldwide ratio is 318%, reflecting a decline of three percentage points in the last quarter.

The financial condition for individuals is generally good, with household net worth up to $100 trillion versus $68 trillion in 2006. But there is cause for some concern. Today, we find that some individual investors are borrowing record amounts to invest in equities. Margin debt stands at some $680 billion, versus two previous highs near $500 billion. And, today, there is also four times the amount of BBB corporate debt outstanding than we had in 2008. These are not healthy circumstances.

There has been increased worry in recent months about the risk of major trade wars. Investors can’t seem to decide whether they want Free Trade or Fair Trade – or what they are willing to fight for. But, recent signs have actually been encouraging, as President Xi indicated that China will stop (or soften) its policy of demanding joint ventures with non-Chinese entities. This is a huge positive, and it comes as Trump has suggested that he will reconsider joining the TPP (Trans Pacific Partnership). We feel very good about the newest member of the Trump economic team, as we know Larry Kudlow very well and consider him to be a sound and pragmatic economist.

As described earlier, the U.S. economy is expanding at a rapid and possibly accelerating pace. Wage growth is growing at a more rapid 2.4% pace. Unemployment is low at 4.1%, though underemployment remains high at 8% and labor participation is still too low at 62.9%. Housing starts are back up to a normal 1.3 million rate, auto sales have slipped somewhat to 17.4 million units, and consumer confidence remains in a steady uptrend. As the positive effects of the Tax Bill begin to kick in, the outlook is very strong for most domestic industries. Surprises will probably continue to be on the upside. Worldwide economic growth is generally positive, as well, and the IMF projects 3.8% growth for both 2018 and 2019.

There is always international uncertainty, and that is certainly true today. However, the behavior in trade talks is quite encouraging, as our counter parties recognize that they have a lot to lose by taking too tough a stance. And, the latest news on North Korea gives cause for more hope than at any time in the last thirty years. They haven’t taken us seriously in previous negotiations, but perhaps they are coming to the table with a more constructive purpose today. We shall see!

With an expanding GDP and strengthening corporate earnings, there is good support for a higher market. Mergers and acquisitions are up 42% year-over-year to an impressive $1.3 trillion. Market volatility will clearly be higher than it has been, with rising rates and compared to abnormally low levels. Leading sectors have been technology, consumer discretionary, and financials.

Following the first quarter correction, the valuation of the market is much more reasonable. Previously, we had a price-earnings ratio of 18.5, but post-correction it is now down to 16.3 times. That makes the market a lot more reasonably valued and with an expectation of strong earnings at least somewhat attractive. With rising interest rates, however, we expect corrections from time to time. We believe individual stock selection is likely to be more important than ever, so that will be our primary focus.

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