January, 2019
IS THE SKY FALLING? COULD WE PUT HUMPTY DUMPTY BACK TOGETHER?
Humpty Dumpty has obviously fallen over the past few months but he is not yet broken. We gave back most of the 2018 profits but our economy is still healthy and the US dollar remains the safest currency. Our economy is slowing but still growing and both market sentiment and momentum for stocks changed in the last few months but is now improving again. Volatility increased with program trading and algorithms by hedge funds, along with individuals selling for tax reasons and to protect profits in case the decline continues. The unanswered question is whether the bull market ended or if it’s just a bear market rally within a continuing bull market? The answer is not yet known but the next several weeks will provide more clarity.
We believe that the storm clouds are temporary and that the markets will recover but there are many other opinions, both negative and positive. At times like this, we rely most on the market fundamentals and try to understand the reasons for the decline. If everyone agreed, we would take comfort in the belief that such a consensus is usually wrong. Nobody knows the future. Historically, the market climbs a wall of worry. Today, there is much to worry about.
Why am I cautiously optimistic while others are negative?
I try to first understand the past before forming an opinion about the future. My biggest worries are as follows:
The market expansion since 2009 was the longest in history and could last longer. Bull markets don’t last forever but they don’t die solely of old age. There is usually a catalyst such as a recession. Our economy as measured by the GDP (gross domestic product) was growing by 3-4% in early 2018 because of the boost from the new tax act. That growth was unsustainable. Growth slowed to 2.8% in the third quarter and may slow a little more but there appear to be no great negatives. Housing and auto sales are weak, the price of oil declined but unemployment is low and wage growth is at 2.8%, inflation is under control at slightly over 2%. Rising short term interest rates have temporarily inverted the yield curve but not to the extent of foretelling an immanent recession.
The recent market decline erased most of the 2018 gains but stock valuations are now at very attractive levels. The average price is at a multiple of approximately 14.5 times earnings, down from about an average PE (price to earnings ratio) of 17. By most standards, stocks are reasonably priced today.
The Federal Reserve: The Fed has a legal mandate to maintain stable employment and stable prices to keep inflation within an acceptable range. Several years ago they set a target of 2% inflation and just recently achieved that goal. Their primary tool is to increase rates to avoid high inflation by discouraging borrowing and to slow economic growth, or decrease rates to stimulate the economy and recover from recessions. The last increase in December came at a time when the market was declining and economic growth slowing. Unfortunately President Trump was publicly challenging the Fed not to increase rates and threatening to fire the Fed Chairman if he did so. In my opinion, Chairman Powell raised rates in hopes of maintaining the independence of the Fed and not appearing to be a Trump puppet, thereby causing a predictable market decline. On the bright side, on January 4, Powell publicly clarified the Feds intention is to be patient in paying attention to the market and not follow a pre-set path for interest rates by noting that they are willing to shift their goals and policy as necessary. Too little, too late? Maybe it is but it is encouraging. Potentially, it may mean that either we won’t see another rate hike soon or that a rate decline is possible if economic fundamentals change.
Tariffs: Most economists disagreed with the bold unilateral U.S. policy of tariffs and predicted that it would cause major global problems. It could be argued that the motives were appropriate because of the inherent unfairness in the balance of trade with other countries, especially China. The public challenge instead of the past preliminary diplomatic approach of negotiations was unprecedented. The stated deadline is March 1st. A positive resolution of current negotiations with China will probably stimulate huge market gains. Failure to agree on a resolution may result in substantial pain to both economies. Large multi-national companies will be affected the most.
Government shutdown: Our country has now operated for several weeks without a budget deal. Congress and the president are both inflexible. Both sides want a budget but the Democrats refuse to agree to fund $5+ billion to build a wall and the Republicans won’t agree to a budget while President Trump refuses to sign the deal. Really? The entire country is in limbo, services aren’t being provided, and employees aren’t working or being paid because of a wall? Can’t a compromise be negotiated on a short-term basis in the interest of Americans? If all government employees were treated equally, and Customs were also not being paid, the result might be that everyone from other countries could illegally and casually walk across our border because no guards would be paid to keep them out. Do we need an adult in the room?
Actions we have taken: Portfolio changes
With respect for current market declines and uncertainty about the future market direction, we used our discretion to reduce portfolio risk by selling some equities and increasing fixed income. Risk is the only thing we can control, so all client portfolios from aggressive to conservative were rebalanced more conservatively. Depending upon future events, our plan is to either reduce equities further, or hopefully to rebalance back to our prior asset allocations.
A few gratuitous thoughts
Our forefathers wisely created three equal branches of government concentration of power in one person, such as the King of England. Unfortunately, they assumed a level of individual maturity and didn’t foresee the power of the parties to control their members so they vote as a bloc in exchange for financial and other support during elections. Money and power often overcomes the desire to vote one’s conscience. Is there a solution? I submit that a fiduciary standard might diminish the party’s power but enhance the citizens’ rights. As registered investment advisors, we have a legal duty to place our clients’ interest first. As a past LA County Retirement Board trustee, I was legally required to be a fiduciary in representing the interests of all employees, retirees, and the County of Los Angeles, regardless who elected or appointed me. Shouldn’t all elected members of Congress and the President of the United States be held to the same standard? I believe that such a requirement would lead to more collegiality, discussions and compromise across the aisle in Congress, and less concentrated control by both branches of government. We expect our elected representatives to vote based on their individually considered opinions, not based on instructions from the party or lobbyists. A fiduciary standard, properly monitored and enforced, would help to achieve more independence and honesty.
These thoughts do not favor either party. I believe both parties have legitimate values and concerns. My concern is that too much power results in extreme results, both left and right, with unintended consequences. For the best long-term solutions that benefit the greatest number of Americans, open discussions and compromise leads to lasting policies. There are no perfect agreements but progress toward perfection beats dissention, dysfunction, and gridlock.
Marv Kaye, J.D., CFP®
President and CEO
Kaye Capital Management
