Written by: Jonathan V. Bever
Typically, a dollar today is worth more today than tomorrow (inflation), but what if a dollar is worth more tomorrow (deflation)?
Around the holidays it’s nice to sit around the fireplace and reflect on the past year. Coincidentally, it is common for people to ask what kind of return we expect from the stock market in 2020. Investors instinctively know the market is expensive, so they are cautious. To a contrarian, the skepticism of investors is a good sign; likewise, we find our analysis to be more optimistic than some.
Regarding this year’s market expected performance, let’s look at the attributes of the market return in 2019. (Please note, in this blog, we will give a summary in one paragraph, then offer a more complex answer in the following paragraphs).
First the summary: the 2019 stock market had a good year of performance after starting off rather ugly. The performance was mainly driven by an expansion of the price to earnings ratio or P/E, and not because of outstanding earnings growth, which is cause for concern. So, the market is expensive based on its historical valuation of price to earnings or P/E. The good news: the reasons for it being expensive are not expected to change any time soon. As we consider the market is priced for perfection and there are real concerns that could affect earnings, we still expect the market to end the year up about 10%. The bad news: we would be ready for corrections of 10%-15% due to a high P/E ratio, headlines concerning the Coronavirus, the Presidential Election, recession rhetoric, national deficits, and the Federal Reserve policy statements.
Now the more complex longer answer:
In a prior blog we argued that the S&P historically has a lower Price to Earnings Ratio and while the Fed is on a rate hike cycle it was inevitable so see a compression of the P/E; for a low-interest-rate environment allows for a higher P/E multiple and conversely a high-interest rate environment a lower than average P/E ratio. However, the Fed was not only raising rates; they were reducing their balance sheet during 2017-2018 thereby causing compression and volatility more than most expected.
With the volatility of 2018 being so severe, we argued the Fed would cut interest rates and begin another round of Quantitate Easing or QE; QE, we argue is an expansion of the Fed balance sheet, and Quantitative Tightening is the reduction of the Fed balance sheet or QT. We were pleased to see our forecast come true as essentially this is exactly what happened. Some are dubious about the economic health of money printing much less understand it. We just call QE, “ magic money” done by means of extreme leverage. As long as there is confidence in the Fed narrative it works.
Please see the chart: the top line the Fed balance sheet, the second is the Fed target rate, and the third is the S&P 500 Index.
We have a simple view of money printing: it is the division of purchasing power of the money that already exists. There isn’t much resistance to QE, we believe, is that it hasn’t caused a spike in monetary inflation as stated by CPI. QE has elevated investment or risk assets such as real estate, 401Ks via the stock market, so why complain? Further, we believe there hasn’t been a spike in inflation from money printing because the velocity of money has gone down. Money velocity is the rate at which money is exchanged in an economy. In other words, the number of times it changes hands.
M2 money supply velocity in red, CPI in yellow, and the commodity index in the green.
You may already be thinking, what if the velocity of money goes up? At that point, we will have a lot to worry about. It will mean there is inflation and it will have to be dealt with. Historically, the Federal Reserve will fight inflation by raising rates.
A very current example of money printing and velocity of money, we can look to China dealing with the Coronavirus. One consequence of the quarantine is their velocity of money has gone down. China’s quick response was to inject 1.2 Trillion Yuan ($175 billion). This injection was necessary to maintain the balance of currency exchange. The Chinese are very smart regarding economics and long-term planning.
Our thesis: if the velocity of money goes up, so will inflation. If there is a spike in the velocity of money, then the likely response would be a reduction in the money supply and higher interest rates. Just as you would expect this could wreak havoc on the market. Hence, we are vigilant regarding the velocity of money and other inflationary pressures.
We see the minds of smart people spin as we try to understand QE or money printing. So, we are injecting some humor going back to 330BC. Aristotle’s book called Economics has a fun example of money printing.
Aristotle: Economics: The tyrant Dionysius of Syracuse wanting money convinced his subject to lend him money. “Also having borrowed money from the citizens under a promise of repayment, when they demanded it back, he ordered them to bring him whatever money any of them possessed, threatening them with death as the penalty if they failed to do so. When the money had been brought, he issued it again after stamping it afresh so that each drachma had the value of two drachmae and paid back the original debt and money which they brought him on this occasion.” Economics 1349: -28-32 Jonathan Barnes.
At the last Fed meeting, Powel indicated a continuance of their overnight purchase. This overnight purchase is not officially called QE; however, as it increases their balance sheet we do. So, what is not called QE we will call “magic money.” Perhaps a magic marker is all we really need to help Jerome Powel with magic money! A pause in QE, or “magic money,” we will call: MMP- “magic money pause.” We believe a pause in QE may not be as much of a cause for concern as an unwinding of QE known as Quantitative Tightening.
Our message: Rates will remain low for a long time. Therefore, in order to grow our net- worth, we are forced into risk assets. However, bubbles can form, and the amount of risk accumulating can be treacherous. Think “Nifty Fifty”. Let’s review some history. Not long ago there was a list of stocks called the nifty-fifty where investors were not concerned with valuation and were willing to pay for growth at any price. Ultimately, they became overvalued and investors got burned. In short, the risk associated with money going into popular investments and ignoring undervalued stocks may not realize the results investors expect. We will write more about the Nifty Fifty in a future blog.
Lastly, in prior blogs, we were looking for a potential recession to give the flattening of the yield curve. Specifically, we were concerned about the Fed target rate getting about the 5-year treasury yield. This did occur, and we were concerned with the significant risk of a recession. The Fed cut rates as you can see in this chart. Ultimately, we expect additional rate cuts to further reduce the risk of a recession. In fact, we argue avoiding a recession is almost necessary. In a recession, the government will receive less tax revenue, and as the government has a hard time cutting their spending, lowering rates and QE is the easier choice.
Please see the chart: the red line is the 5-year treasury yield. The black line is the Fed Target Rate.
Looking back at 2019, what we didn’t anticipate was such a bifurcated market. Owning an index or the top few stocks which drove performance in many cases was the better performance choice (ignoring the risk). Further, many individual stocks failed to meet their expected revenues or earnings estimates; hence, the label “earnings recession”. Stocks that disappointed in quarterly reports were heavily penalized. Money invested in passive indexes and performance was driven by P/E ratio expansion and not necessarily because of the robust growth of the underlying fundaments. This is cause for concern, as the reason investors pay attention to P/E is they want to know if it is a good value for their money or not. Any time there is a lack of caution, is a cause for concern. Fundamentals matter, and if not today then one day, they no doubt will.
Further, in time prices tend to revert to their mean. So, if earnings grow modestly while the P/E ratio is high, then the market will go down to revert to the mean. Last year's valuation didn’t matter, and the P/E soared back to over 20 which in some cases outperformed many investment styles; especially the very thoughtful hedge fund managers. So, in 2019 being a passive index or ETF investor may have been the best place to be. So, where does this leave us while we look ahead in 2020?
We believe risk management on the one hand, and not overpaying for stocks on the other, will ultimately give the investor a better experience. The earning recession for stocks may not be completely over, and companies that are growing may not grow quite as fast as expected. These disappointments could provide an excellent opportunity to accumulate a position for the long-term investor. This year we expect volatility to be your friend as it provides an opportunity to buy good companies at a good price. The Federal Reserve's current monetary policy should provide support for the market and corrections will be short-lived. To sum: an accommodating money policy doesn’t last forever, don’t forget risk management, and try not to pay too much for growth. We care about what is in your portfolio. What is in your portfolio?
The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change with or without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not consider the effects of inflation and the fees and expenses associated with investing. Investment advisor representative of, and securities and investment advisory services offered through Cetera Advisor Networks LLC, member FINRA/SIPC, a broker/dealer and Registered Investment Advisor. Cetera is under separate ownership from any other named entity. Some Investment advisory services are offered through Fulcrum Wealth Advisors, LLC. Fulcrum Wealth Advisors, LLC is a registered investment advisor in the State of Washington. Branch Address: 10940 NE 33rd PL., #210 Bellevue, WA 98004 Branch Phone: 877-400-0260
FDTR Index: The federal funds rate is the short-term interest rate targeted by the Federal Reserve's Federal Open Market Committee (FOMC) as part of its monetary policy. In December 2008, the target "fed funds" level was replaced by a target range, and this ticker represents the upper bound of that range.
FARBAST: Federal Reserve Banks Total Assets.
BCOM Index: Bloomberg Commodity Index (BCOM) is calculated on an excess return basis and reflects commodity futures price movements. The index is rebalanced annually weighted 2/3 by trading volume and 1/3 by world production and weight-caps are applied at the commodity, sector and group level for diversification. Roll period typically occurs from the 6th-10th business day based on the roll schedule.
CPI Index: Consumer prices (CPI) are a measure of prices paid by consumers for a market basket of consumer goods and services. The yearly (or monthly) growth rates represent the inflation rate.
VELOM2: The average number of times a unit of money (as measured, for instance, by a monetary aggregate) turns over during a specified period of time. The income velocity of circulation is typically calculated as the ratio of a monetary aggregate to nominal GDP.
USGG5YR: US Generic Government 5-year yield.