September Investment Comments


“Is there anything left to be made in the stock market?”  “Everything seems so overpriced.”  “The market is so high.”  “Stock prices are ahead of earnings.”  All of these are actual quotes I’ve recently heard from clients and friends.  Investors have spoken the latter three a majority of the time over the past couple of decades.  Stock prices usually seem high.  The market is a discounting mechanism.  It compresses expected future events into one present value.  If economic conditions are pretty good, the market should be somewhat high.

Bear markets are almost always accompanied by recessions, so the economic outlook over the near- and medium-term is important.  Gross Domestic Product in the U.S.  grew at an annualized rate of 2.6% in the second quarter.  Personal income is trending higher, as is consumer spending.  These are solid underpinnings for future economic growth.  The unemployment rate in July was 4.3%, approaching the lows of the past two economic cycles.  Job growth has consistently run in the vicinity of 200,000 a month, although we remain concerned that too many of the new jobs remain of the low-wage variety.  Despite slightly improving economic growth, inflation remains almost nonexistent at just 1.7%.

These trends are similar to what we’re seeing from Europe and Japan.  Other major economies like China and India are growing even faster.  These countries collectively are the engines of sales and profit growth for American and global companies.  We’re hopeful that economic growth might move above its post-recession trend of 1.5%-2.0%.  Some signs suggest this is possible.

Bear markets in equities can be preceded by investor complacency that allows stock prices to rise too far before coming down with a thud following an economic, monetary, or geopolitical shock.  We saw that in 1987 and 2000, with unpleasant consequences.  Reaching all-time highs in stock prices certainly indicates confidence on the part of investors, but does it also imply complacency?

Actually, facts suggest the opposite.  I’ve been keeping data on fund flows for mutual funds and exchange traded funds for almost 11 years, dating back to the beginning of 2007.  Investors have withdrawn more than they’ve put in to mutual funds and ETFs focused on U.S. stocks for 10 of those 11 years.  The exception was 2013.  The worst year of those 11?  That has to be 2008, when investors were justifiably scared out of their britches, right?  No, 2016 was the year of biggest withdrawals from equity markets.  This year is shaping up to come in second place.  Investors wouldn’t likely sell equity funds if they were greedy and complacent.

One popular theoretic measure of complacency suggests otherwise.  It’s called the CBOE Volatility Index, better known as the VIX or the “fear gauge.”  The VIX had been surprisingly low for an extended time.  Investors were shaken out of their calm on August 10 following increasingly hostile rhetoric between President Trump and North Korean dictator Kim Jong Un.  Stock markets dropped sharply across the world.  In the busiest trading day ever for options tied to the VIX, that index shot up 44% in one day to its highest level since the November election.  It was like pouring cold water on the face of a person taking a nap.  Oh, we’re awake now!

The abrupt rise in the VIX could be taken as a sign that investors had been too complacent.  If they were complacent, the evidence suggests investors weren’t acting on it by buying stock.  I tend to put more weight on what people do (mutual fund flows) than point-in-time indicators (the VIX) or opinion polls.  Watch what people do with their money rather than listening to what they tell pollsters.

The long-term rise in stock prices tracks growth in corporate profits.  Earnings growth for the companies making up the S&P 500 rose 11% in the second quarter, following 15% growth in the first.  These are better numbers than we’ve seen in several years.  Coupled with economic growth at or above recent trends, the outlook for profit growth is encouraging.  Recent softness in the value of the dollar may provide additional help to U.S. exports while rendering imports less competitive, further aiding the profit outlook of U.S. businesses.

Stock prices are high, but the outlook for economic and profit growth is improving.  Investors occasionally become overconfident, but continued flows out of domestic equity mutual funds and ETFs suggest no “irrational exuberance” on the part of stock investors.  However, it is easy for investors to conclude that there is “nothing to buy” at these lofty market levels.  Every bit of evidence I’ve seen shows that investors who remain consistently invested tend to have much better results than those who “time the market.”  It takes courage to remain invested when values are lofty, but evidence shows that “hanging in there pays off.”

Scott D. Horsburgh, CFA