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ACM Journal - Investment Management
12 Apr

Economic and Investment Overview – Q1 2019 Newsletter

Lately, the stock market has been a lot like the weather in Rochester, NY. If you don’t like it, you only have to wait three months for things to radically change. The fourth quarter of last year was one of the worst since the Great Depression. But we didn’t have to wait long for redemption. It arrived early this year, with a 13.6% gain in the first quarter (see market segment returns in the nearby graph).

However uncomfortable this sort of volatility can be, it is a lesson that stocks don’t only rise. In order to reap long-term returns, we have to suffer the slings and arrows of occasional short-term downturns. Unfortunately, this late into an economic cycle and bull market, it is likely we have not seen the last of the volatility.

We have been making the case for the past couple years that the stock market is feeling a lot like the late 1990s. That is because of the dominance of large-cap growth stocks, particularly the largest technology stocks. Anecdotally, the drawdown last December makes the comparison even stronger. Stocks declined sharply from February to April 1997 at the onset of the Asian Contagion.

Economic problems in Asia in 1997, many thought, would drag down economic growth around the world. Similarly, the stock market drop last December was largely because of concerns that global economic growth was declining.

Despite more lasting turmoil in the Asian markets, the U.S. stock market went on to return 33% in 1997, 28% in 1998, and 21% in 1999, before starting a three-year decline in the early 2000s. Despite those strong full-year returns, the Asian Contagion was not the only speed bump.

Mega-hedge fund, Long-Term Capital Management, imploded in 1998. The event sent shock waves through the financial markets. Unwinding this fund, and the complex derivatives in which it invested, caused much uncertainly and required intervention by the Federal Reserve and many of the largest Wall Street investment banks. The stock market declined 18% during the turmoil, but as mentioned above, went on to generate strong returns for the full year.

We expect further parallels to the late 1990s to unfold in the years to come, particularly as IPO activity picks up. However, that doesn’t imply that this bull market will end the way the Dot-Com Bubble ended. At least for now, the largest technology stocks are real companies with solid assets and earnings. The late 1990s were marked by far more speculation, when internet companies were going public with few prospects of ever marking money.

The lesson today is more that markets rise and fall, even during strong bull markets. A downturn will eventually come, but we won’t be able to predict the timing, duration, or magnitude of that event. In order to reap the impressive long-term returns of the stock market, we have to stick to a disciplined plan, no matter how uncomfortable that can be at times.

That said, another lesson from the 1990s is that economic expansions and bull markets can last longer than anyone expects. An extension of the current bull run wouldn’t be surprising. The economy remains fairly healthy, even if growth is slowing somewhat. There are also strong vested interests in keeping the good times rolling. With an important election less than two years away, and economic success a large part of our incumbent’s platform, it would not be surprising to see the government pull out all the stops to juice the economy.

Already, the Fed has reversed course and indicated it will not raise interest rates further in the foreseeable future. Whether this is because of pressure from the Oval Office remains a matter of debate. However, the capital markets have responded. Stocks rallied and 10-year Treasury bond yields fell from 3.23% last November to 2.41% at the end of last quarter. Low interest rates can be strong fuel for stock market growth.

Also of note, is that traditionally riskier corners of the stock market are showing signs of life. Small-cap value stocks rose strongly in the first quarter, after what seemed like a very long drought. It remains to be seen if this is a blip or a trend, but smaller stocks generally perform best at the beginning of bull markets, so renewed strength could indicate a renewed bull market phase.

We wrote previously that despite the duration of the current economic recovery, the rate of economic growth has been tepid at best. Historically, severe economic downturns have been followed by strong economic recoveries. It may be that we’ll see a strong recovery, just stretched over a longer-than-expected period. If we are to achieve average economic growth during this cycle, the expansion could last for another three years. If we experience a recovery similar to those that have followed severe downturns, the recovery could go on for another 8 years.

Even if this proves to be correct, it bears repeating that it likely will not be a smooth ride. There will be more volatility in the stock market. Just as we endure the ups and downs of rollercoasters for the overall fun they provide, there is a reason to be invested in stocks. Building long-term wealth requires fortitude and patience. So, buckle up and enjoy the ride.

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