Tuesday, October 10, 2017

Is this a great country or what?

We have just ended what is historically the worst month of the year for stock market performance. Not surprisingly, given the very strong markets that we have had for all of 2017, the S&P 500 was up a sterling 2.1% for the month of September - so much for this being the worst month of the year. In fact, it was the best September since 2013. The economy continues to grow, earnings continue to increase and interest rates continue to stay low. The components for future positive stock market performance are all in place.

I would like to talk to you about various aspects of the stock market performance and why I do not see a large downward shift coming anytime soon. I will illustrate what happens when the “Wealth Effect” starts to take over the higher end of the economy. We are now seeing this in the U.S. economy, and more importantly around the world, which should lift stock markets around the world higher. However, before I begin all of that terribly interesting information, I need to cover the performance of the markets through the first nine months of 2017.

Ava horseback riding in the mountains and building sandcastles at the beach - all in the same month!

As mentioned, the Standard and Poor’s index of 500 stocks was up 2.1% for the month of September and is up a very respectable 14.2% for the year 2017. For the one-year period ended September 30, 2017, that index is up double digits at 18.6%. The Dow Jones industrial average was up 2.2% for September, up 15.5% for 2017 and up 25.4% for the one-year period ended September 30th. The NASDAQ Composite index was up 1.1% for the month of September, 21.7% for 2017 and up 23.7% for the one-year period ended September 30th. For all of those forecasters that continue to forecast gloom and doom for the equity markets, they must be truly amazed to see close to 20% performance for all of the major market indexes for the one-year period. As the above numbers indicate, we have been correct in our insistence that one be fully invested during this highly profitable time.

I always like to illustrate what the bond index reflects given our projections that you are not likely to make money in a bond index portfolio. For the month of September the aggregate bond index was down 0.5%, for the year 2017 it was up 2.9%, and for the one-year period it was down 0.2%. Therefore, if you have been invested in bonds over the last 12 months, you have actually had a negative rate of return as compared to an almost 20% gain on any of the other major market equity indexes. Not much explanation is needed to see why we forecasted negative returns in bonds and positive returns in stocks.

Last month I wrote about how much happier my life has been since I quit watching the news. Don’t get me wrong – I keep up with current events, I just do not watch the editorials that try to explain them. The one thing that I do is make a concerted effort to look at what is going on around me rather than what people are telling me. I am convinced that a lot of commentators believe that they can influence the thinking of the population by slanting the news in a fashion that meets their agenda. I decided I would rather make those decisions on my own, and I feel much better about the world since doing so.

You have to admit though, when disaster strikes, this country steps up. Over the last couple months, we have had hurricanes in Texas, Florida and Puerto Rico along with mass murders and other shocking news developments. However, this country rallies at the time of disaster, and the response is overwhelming. Who would have ever believed that a defensive end for the Houston Texans would raise $20 million for hurricane relief by simply asking for it? When the federal government gets into disaster mode, the relief is overwhelming. They move in with housing, clothing, support and take care of thousands. Not to say there is not human suffering and, of course, financial loss, but the attempts to alleviate the basic discomforts of the disaster were in full exhibit over the last two months. What other country can you think of that has done so much to help the average person? We continue to help Puerto Rico due to the tremendous issues its government and infrastructure currently face.

While the financial news has been quite positive, the doomsayers still want to argue that the price earnings ratio of the markets continues to be at an unsustainable level. However, perhaps they missed that earnings have been so strong that the price of the S&P 500 has actually fallen lately. How is it possible that the price earnings ratio could fall when stock prices have increased almost every month in 2017? The simple explanation is that corporate earnings have gone up higher than the index has. As a basic example, the S&P 500 price index has risen 15.4% over the last one-year period ended in June, however the earnings during that period grew at an even faster rate of 18.1%. Therefore, if the index grew 15% and earnings grew 18%, based on simple arithmetic, the price earnings ratio would fall rather than go up.

Every day, we are confronted by forecasters who say the stock market cannot sustain a continued increase. I would agree with them to the extent to say that if earnings cannot keep up with the increase, then it is true that the markets cannot sustain this valuation. However, to this point, earnings have not only kept up with the index, they have exceeded it! I am always amused by those who like to report statistics to support their forecast that the earnings are going to go into free fall. They often point out that sales to earnings are declining. They also point out that book value is a multiple of valuation and our revenue per employees has fallen and that the dividend yield per stock is falling, rather than going up.

If you have read our posts over the years, I hope that you have learned a very important point. Stock valuation is very much like real estate. As it is said in real estate, the three most important aspects are location, location, location. In stock market performance, the three most important components of valuing a stock are earnings, earnings, earnings. Yes, in both sectors interest rates are important and the economy is important, however, the MOST important aspect of valuation is earnings, and earnings continue to move up nicely at the current time.

Yes, it is important to look at prior earnings, but the most important component of stock market valuation is future earnings. Just like the last 12 months ended June 30th saw an 18% increase in earnings for the S&P 500, forecasters now project an increase in earnings of an additional 18% over the next year. As long as earnings are moving up, it is highly unlikely that any one event (other than a geopolitical disaster) could move the markets down.

We are also seeing an all too obvious economy that continues to strengthen. Unemployment is now at a multi-year low at 4.2%. Literally, anyone who wants to work can get a job – it is just a matter of finding a job that suits his or her skill set. There is no shortage of jobs as “help needed” ads continue to pop up for unfilled positions. Now that we are operating at essentially full employment, the flow down of wealth is occurring at all levels. Each person that has a job supports other people in his or her household as well as their community with their income and spending. The compounded effect is that you are seeing all aspects of the economy grow in some respect. The strengthening of employment is by far the most important component to keeping the economy strong. At the current time, we are in a “Goldilocks environment” as it relates to employment since the unemployment rate is extremely low but not so low as to create a strain on the labor markets.

In addition to the good news on the economy, the tax cut policy is going to bring further economic growth soon. I even have to quote the famous Warren Buffett, who is clearly a democrat when it comes to economic terms, as he admits, “I think they can get it done (commenting on Congress). It is not a tax reform act, it is a tax cut act. Any politician that cannot pass a tax cut is probably in the wrong line of business.” I believe he is exactly right on this subject. How could any congressman not vote for a tax cut with the general election coming up next year?

The natural outrage of the progressive wing of Congress was that the tax cut would benefit the rich. First off, the rules are very basic – 50% of the population pays no income taxes whatsoever. You cannot cut income taxes on people who pay no income taxes. If you are to have a tax cut, it must (by definition) cut the taxes of the people that actually pay taxes – the higher paid 50%. The other explanation was almost laughable. The progressive wing of Congress expressed outrage that the tax cut would explode the deficit. Lest we forget, this is the same progressive wing of government that over the last eight years has accumulated deficits greater than each and every president in this country up until the last. So, if you need experts on deficit producing economics, the current progressive wing are your experts.

But I also see an opportunity for enlightening that is going to change America going forward. Even the most liberal of commentators realize that what the progressive wing of the party has been doing is a mistake. When it comes to progressive agendas, Bill Maher may be one of the most progressive. Recently, it was a shock to hear him say, “We need to get some Democrats elected, and that is hard when the movement to childproof the world has made the Republicans a party of freedom and the Democrats a party of poopers.” I think it is fairly clear what he is saying. You cannot overregulate Americans, as U.S. citizens will not tolerate it. All of us were wringing our hands about the Obamacare disaster, but the reality was a lot simpler. At its maximum, Obamacare only covered 13 million Americans out of a total of 330 million people in the U.S. Therefore, the coverage of Obamacare was 4% of the population. However, the rules and regulations that controlled Obamacare affected 100% of the policyholders of medical insurance. This type of regulation is not only nonproductive, but also a waste of economic resources. Finally, we have an administration today that is cutting needless regulations which will clearly benefit the economy going forward. Good news for the economy!

Also, for the first time in many years, I see the “wealth effect” taking place. The wealth effect is when the consumer feels confident enough about their job that they will use their gains in wealth to buy consumer goods. Every day you see investors taking money out of the markets to buy new houses, new cars, new boats and other assets. As the markets move higher and the confidence of the average investor is secure, there is a slippage in investing and a tilt toward consuming. I do not need to illustrate to you how useful this wealth effect will be in making the market higher. When profits from investing slip out into the economy, it puts more people to work, creates higher tax dollars for the government, and it makes the economy better. With gains now up over 20% for the last 12 months, the wealth effect will very much be a positive going forward over the next year. The evidence is as overwhelming as it is remarkable that more people do not see it. If you will notice, restaurants are full on Friday nights, construction cranes are everywhere and consumers are buying all types of goods at record levels. Those who do not see the positive economics of the current economy clearly have blinders on, but it is not just in the United States. Growth is occurring in Europe, Asia and around the world.

Recently, I read an interesting statistic that illustrated this point. Basically, it was a boring article on corporations’ dividends but it said that dividends would grow this year from the S&P 500 by 7.7%. That was interesting considering they grew the prior year at 4.8%, and therefore have grown 10% over the last two years. But the number that struck me was that the actual number of dividends paid by the S&P 500 companies was $436 billion in actual dividends. That is up from last year’s $404 billion. As most of you know, dividends are used by many investors as their income stream. If their income stream grew at 7.7% this year, and pumped $436 billion into the economy, the wealth effect will only further increase going forward. Just for reference, the GDP of Puerto Rico was $101 billion in 2012 – 25% of the dividends paid in the U.S.

In summary, things are great in the U.S. at the current time. There is no question that there are terrible events occurring around us, but the good is definitely out there. Those who think the economy is faltering clearly do not see what is going on around them. Until this changes or a geopolitical event that is unexpected knocks it down, I see nothing but further gains over the next 18 months. Yes, they may be muted to the prior gains but up is always better than down.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins