Everyone who forecasted that the economy would turn into a death cycle this year and that the stock market would fall (for any number of reasons) has, thus far, been incorrect. Given the negative sentiment by the investing world and numerous world events that continue to keep the market in an uproar, the stock market has actually survived extraordinarily well. And despite it being difficult to find people to actually express it, this has been quite a satisfactory year financially.
I would like to cover several issues in this post, so bear with me. And because there is not a whole lot going on economically, I will be sharing a story that a client suggested I include in my blog: how I personally contributed to the fame of one of collegiate basketball’s best players of all time. I will also be addressing the end of the bull market, current economic news and other world events that I find most interesting.
Two of the most dangerous months of the year in the investing world are thought to be September and October. There are a lot of reasons for these particular months to perform below par, but principally it has to do with the lack of participation during the summer. As more and more people go on vacation, it takes less volatility to move the market in one direction or another. So if a certain group of investors tries to move the market, it does not take a lot of volume to make that happen, which in turn makes individual investors uneasy after summer’s end.
We are fortunate to have just ended the third quarter of 2016, and in all accounts, it was an excellent quarter. We survived the volatility of August and September and actually had a nice return for the third quarter. The year-to-date numbers for all the financial indexes have been very good, and contrary to the commentators’ words of doom, it appears we are in for a solid financial year in 2016. However, this is not the thinking of the average investor as there continues to be a record number of investors holding uninvested or underinvested cash. It is also true that interest rates are finally starting to move up, and the bond market that has performed so well over the last few years is now posting negative returns. All of this is interesting, but the reasons behind it are often hard to explain. I will try to cover some of these important points below.
Before analyzing the numbers for the third quarter, I thought I would share some pictures of Eddie Wilcox, partner at Rollins Financial, Inc., with his beautiful family.
Harper, Jennifer, Lucy & Eddie
Lucy (Age 5) & Harper (Age 7)
For the third quarter ended 2016, the major market indexes have performed admirably. The Standard and Poor’s index of 500 stocks is up 7.8% for the year 2016. The third quarter finished with a return of 3.8% and the one-year return for the S&P 500 is now 15.4%. These numbers are nothing short of excellent. The Dow Jones industrial average while negative for September is up 7.1% for 2016, up 2.8% for the three-month period ended September 30, 2016 and up 3.5% for the one year then ended. The NASDAQ Composite was up a cool 10% for the third quarter of 2016, up 16.5% for the one-year period and by far was the best performing index in the group. In contrast, the Barclays aggregate bond index was down 0.1% for the month of September, only up 0.5% for the three months ended September 30, 2016 and up 5% for the one-year period.
It is always interesting to look at the long-term returns for these indexes to get a better feel for the long-term returns. For instance, if you look at the 10-year returns, which include the negative year 2008, this shows you how strong the indexes performed despite the huge selloff in 2008. For a 10-year period, the returns are as follows: S&P 500 7.2%.; Dow Jones industrial average 7.4%; NASDAQ 10.1%, and Barclays aggregate bond index 4.4%. I think it is fairly clear and obvious from looking at the records, stock market investing should produce a return roughly double that of the bond index. Unquestionably, that comes with higher volatility and greater stress, but in investing, volatility brings long-term performance which is the most important goal of investing.
You would be surprised how many clients say to me, “The market has to go down because there have just been too many good years in a row.” I am not really sure where that philosophy was developed, but certainly the markets have no recollection of past events. The markets are controlled by earnings, interest rates and the economy. All three are excellent at the current time, and therefore there is no reason to assume that market would go down dramatically. Keep in mind that over the last 14 years, the S&P 500 has produced a positive rate of return in 13 of these years. There is no economic law that says there must be a down year since there have been so many good years.
One of the great investors of all time, Sir John Templeton, characterized the life cycle of market advances as follows: “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” I think that is a good roadmap to explain where the markets are today. If you characterize his statement, it is absolutely clear that these markets are not driven by optimism or euphoria. In fact, the absolute opposite is true. You cannot read a single financial update without some noted forecaster, investor or speculator forecasting a major market down cycle based on reasons that even they cannot define. Therefore, in my reading of John Templeton’s statement, I would say that we are in the skepticism stage. While the market continues to move up on a regular basis, the skepticism could not be higher. The general investing public is skeptical of the market’s ability to move higher, even though they do not need the money for years, if not decades, in the future. I am confronted everyday by investors who say “I will invest in the market when there is a major move down; I want to buy at the bottom.” Some of those investors have been waiting since 2008 and the market is up close to 300%.
The other argument that the skeptic investors like to point out is that the market is expensive. Expensive is a relative term in my way of thinking. If interest rates were higher and you could get a 5% rate of return on a CD, there is no question that billions of money would flow out of the stock market and into those CDs. But the fact is, it just ain’t so. When a five-year CD is paying a little over 1% and the rate of inflation is closer to 2, that money invested in the CD loses buying power in the economy year after year. Therefore, if you evaluate the stock market at a period when interest rates are 5% as compared to a period of time where interest rates are approaching zero, certainly the fundamentals of the market would be changed if interest rates increased.
It is absolutely true that the price earnings ratio of the S&P 500 has risen over the last couple years. In fact, the price earnings ratio has moved up from 18 to approximately 21 times earnings. The question you would have to evaluate is whether or not 21 times earnings with a zero interest rate is high. I would argue that it is, in fact, quite reasonable priced.
If you look back over time, Zacks Investment Research has forecasted the price earnings ratio in the last 6 bull markets, they top at 30. As mentioned above, the current is roughly 21. If the S&P 500 was trading at a 30 multiple rather than a 21 multiple as it is today, then the S&P index would be 2,935, or 36% higher than it is today. Based upon prior history, this would tell us that even if overvalued, in order to reach levels where other bull markets have ended, the market would still need to move up significantly higher. There is no question that if interest rates moved up dramatically, this higher level would have to be significantly reduced lower. That is why we evaluate the market on an ongoing and continuous basis so that we understand exactly where the economy stands in order to evaluate stock market performance.
The most important component that we see today is interest rates. With interest rates being at all-time lows, other types of investing compare more favorably than do investments with stated interest rates. It is interesting how technology is changing the environment of interest rates. Due to technology, everything has gotten quicker, faster and, more importantly, cheaper than it was in the past. I would be shocked to see inflation move up dramatically in the coming years. In fact, it is very interesting that technology companies produce more and more and their costs continue to decrease. You can purchase a computer today significantly cheaper than you could have purchased one three or four years ago. There is no inflation in technology and that is reducing the cost of everything we buy. And while new cars today do things that were unheard of in those produced only five years ago, they are cheaper today than they were then.
The entire world is adopting technology for the betterment of us all and our personal budgets. Given the advancements in technology and the computerization of the economy, I would not expect to see inflation in the U.S. economy within the next decade. And if I am correct, we would not see a major increase in interest rates over the same time period, and therefore equity investing would appear to be more favorable than debt and bond investing.
Recently, I was telling clients about when I played basketball at the University of Tennessee. Not a whole lot was memorable during that time frame, but one particular incident stood out. At the time I played, freshmen did not play with the varsity. We, as the freshmen, played a game preceding each varsity game, which was usually attended by few. In most cases, when we started the freshmen game, the janitorial staff would still be cleaning up from prior events. As an 18-year-old kid out of Tennessee playing in 20,000 seat arenas was exciting but generally we played before few fans.
However, one team was completely different. The famous “Pistol Pete” Maravich was at the same grade level in college as I was, despite him being a year older. For those of you that are not familiar with Pistol Pete, he may be one of the most famous college basketball players of all time. Even though college basketball did not have the 3-point shot or the 30 second shot clock back then, he has the highest average of any collegiate basketball player of all time. He averaged 44.2 points per game over his three-year college career. One season, he averaged 44.5 points for every game in the season. Pete played three years at LSU prior to having a very successful but less memorable pro career.
Being 18 and not knowing a lot about the rest of the world at that time, I was unfamiliar with Pistol Pete’s reputation when we played the freshmen game at LSU in the old field house on campus. Contrary to our normal playing crowd, when we showed up to the arena to play our freshmen game, every seat in the house was full to watch Pistol Pete. In fact, after the freshmen game, most of the crowd left and did not even watch the varsity game. That night, we played a box and one, which meant four of our players played a zone and guarded the interior of the lane in front of the basket. One player was picked to guard Pete Maravich and it was me. Essentially, I was designated to chase Pete around on the court and do the best I could while the rest of the team just attempted to keep the game in control.
Even though I worked very hard that night to keep Pete down, he was an incredible player and scored a whopping 66 points against our team. He scored 66, yet the entire team only scored 88 and we won the game. As a freshman game, it meant nothing in the long-term scheme of things, but it meant a lot to my basketball career. It proved once and for all that I did not have the skill set necessary to play at a level of the Pete Maravichs of the world. Fortunately, I realized that early enough that I was able to resign from the team a year later and move on to other higher aspirations.
I got to know Pete a little when he was playing for the Hawks in Atlanta. At that time, he was not married and was pretty much a wild man enjoying the sights and sounds of Hot Atlanta. Subsequently, he was traded and later became very religious. He dedicated the remainder of his life to religion and would go around the country giving religious basketball clinics. At age 40, Pete had a massive heart attack and died. Even though he had been a spectacular athlete for most of his life, he was born with a heart defect that no one discovered and he subsequently died on the basketball court during a scrimmage. It is very sad that someone that physically fit and devoted to physical activity would die at such a young age to a heart condition.
Therefore, in the annuals of the legend of “Pistol Pete” Maravich, I could exclaim that I was helpful in making him the ultimate star that he was. They always made fun of his droopy socks as pictured above. The only time I saw those socks when playing basketball against Pete was after he had already passed me and was doing a layup.
As we look forward to the end of the investing year, you should be somewhat optimistic. The best time for investing is said to be during the span from November through May. That is not a statistical outlier, but is based on true economic facts. The principal reason why this is likely true is that corporations fund their retirement accounts generally late in the year and as that money is put to work the market goes higher. We have already enjoyed a very successful year so far, and I would anticipate that it will go up even farther before the end of the year. But there is a major change I am noting which we are now investing to capture.
After many years of lagging the U.S. market, it now seems the emerging markets are starting to catch up. It looks like China will have a GDP in excess of 6% this year, and India may be even higher. The economies of Brazil and Russia have been in recession but appear now to be breaking into the positive. Throughout the entire world, the economy is bottoming and starting to move up. Not in a big dramatic way, but more positive than in the past. Over the last five or six years, the U.S. markets have led all world markets in performance. Therefore, the emerging markets have a long way to go to catch up. You will note that we have been moving into emerging markets, emerging Asia and other worldwide funds to capture this catch up phenomenon. With interest rates low, earnings improving and the economy stable, I would be shocked if the international markets did not outperform the U.S. market over the next couple years.
With the holiday season coming up, it would be a great time to visit with us and learn more about what we do so that we can learn more about how you want to invest. Most importantly, if you have not made IRA contributions for this year, you should do so now. Every week, someone says “I do not want to do an IRA contribution because it is not tax deductible.” In summary, everyone should do an IRA yearly, regardless of its deductibility- whenever you have the opportunity to make money on a tax deferred basis, you should do so.
Ava is getting ready to see the Rockettes in New York City!
As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.
Best Regards,
Joe Rollins
