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ACM Journal - Investment Management
22 Jan

Current Thinking – Q4 2017 Newsletter

With the exception of Donald Trump and Bitcoin, stock market valuations seem to be making the most headlines these days.

Bubble Territory?

Sure, by some measures the stock market is as expensive as it has ever been, with the exception of 1929 and 1999. I’m sure you know how things turned out then. However, we have written many times that past is not necessarily prologue. Unlike those prior periods, there is not the same speculative excess in the markets today, with the possible exception of Bitcoin.

Indeed, while today’s stocks may be highly valued, they are all real companies. Back in the late 1990s, stocks weren’t priced on earnings, since they didn’t have any, but rather on sales figures. Then, late in the boom, some companies came public without any sales. We had to value them on a “price to clicks” basis, counting the number of hits they received on their web sites. Today’s environment is staid by comparison. Even high-flying tech stocks generally have relatively sound financials and solid business plans.

Admittedly, there are a couple similarities to the 1990s. Lately, we’ve noticed that stocks can score significant run ups just by announcing that they are entering the cybercurrency space. An iced tea maker recently did so, boosting its stock by over 300%. Eastman Kodak did the same. In the two days since it announced the coming launch of KODAKcoin, the stock also increased by over 300%. This is similar to the early days of the internet, when stocks would shoot higher after announcements that the companies would be launching new websites. In fact, I remember when Zapata Corp, a purveyor of fish meal products, announced it was launching a web site and changing its name to The stock soared, despite the fact that its underlying business remained the same. However, the world was forever changed, as you could now buy your fishmeal over the internet. Lookout Amazon.

Today’s boomtime environment will naturally have some parallels to earlier times when money was fast and loose, but otherwise, the economic environment appears quite robust. Historically low interest rates, tame inflation, and the prospect of higher corporate earnings have propped up stock returns. From the chart on page 2, you can see that 2017 was a very strong year for stocks, across all sectors. The S&P 500 earned over 20%, besting all but international stocks. Mid-cap and small-cap stocks lagged somewhat, though still with very solid gains.

A Global Expansion

The returns of international and emerging market stocks show that the current economic expansion is a global phenomenon. Despite political tensions seemingly everywhere in the world, there is still money to be made in virtually all corners of the globe.

Can the good times continue to roll? Probably. Corporate earnings could continue to grow, particularly as after-tax earnings recently received a boost from the passage of the new tax law. The rollback of Obama-era regulations also will likely lead to stronger earnings, at least in the near term. This could all lead to more capital spending by corporations, which have largely hunkered down the past ten years. Capital spending by one corporation leads to increased profits at another corporation, which could set up a virtuous cycle of increasing profits, economic growth, and stock market gains.

Look Out Below?

Of course, this can’t go on forever. What happens when the music stops is anyone’s guess. It largely depends on how the music stops. A gradual rise in interest rates could start to cool the economic engine, and bring us to a soft landing over several years with flat stock market returns. That’s probably the best-case scenario. The worst-case scenario would look a lot like 2008. We’re not forecasting either of those just yet, but there are always risks.

In fact, while we don’t expect to see a major drop in the stock market, there likely will be more volatility in the coming year. That is a pretty easy forecast to make since the stock market has been unusually tranquil of late. Don’t be surprised by a 10% to 15% drop in stocks at some point in 2018. This may be driven by higher interest rates, the threat of renewed inflation, the crash of cryptocurrencies, or any number of exogenous events (remember who our leaders are). Still, this type of decline is very normal, not cause for concern, and very healthy for an expanding market. In early 2016, the stock market declined over 11% from prior November highs. Yet, for the full year stocks earned almost 12%.

A periodic decline in stock prices, while not comfortable to endure, is actually positive for many investors. For younger investors who are still saving for retirement, a market correction is an opportunity to buy stocks on sale. For those already retired, a market decline can be a chance to realize tax losses, rebalance the portfolio, and get rid of low-basis legacy stocks that might have been too costly to sell previously.

This may sound overly optimistic, but periodic losses are part of investing. We either need to accept them and make the best of it, or we shouldn’t be in the markets. We suspect we won’t have to worry about deep losses for at least another couple years, but the threat is always there.

To Download the complete 2017 Q4 Newsletter please click below.