Wednesday, August 8, 2018

Save the Date - Dow 45,000 in the Next Decade!

I always try to write a controversial title for the start of my blog to try to get you interested in the contents. However, the above title is neither controversial nor outrageous. We will almost surely see the Dow hit 45,000 in the next decade, and I will explain later why that is possible. Every day, I read the financial journals where someone is forecasting economic disaster for the U.S. and its equity markets. However, rarely has there been a time in our lifetime when the economy has been stronger or our dominance in worldwide trade more superior. I will explain all of this later. In addition, I want to share a few subjects that I’ve been thinking about.

Ava and Caroline at Cooking School
Ava in her new Astronaut Suit from the Air and Space Museum

However, before I get to the more interesting stuff I have to reflect upon the markets performance for the month of July. It was quite an excellent month for the financial markets, which have been very successful in 2018, contrary to popular opinion. The Standard and Poors Index of 500 stocks was up 3.7% during July, and up 6.5% for the year 2018, and up 16.2% for the one year period on July 31st 2018. The Dow Jones Industrial Average was up a robust 4.8% during July and is ahead 4.1% for 2018, and the one year period then ended up 18.7%. The Nasdaq Composite was the laggard in July, up a more modest 2.2%, however, it is up 11.8 % for the year 2018 and for the one year period it is up 22.2%. I always like to give you the comparison with the bond market to reemphasize the point I have written so many times , if you are a large holder in bonds you are likely to well underperform the equity markets. The Barclays Aggregate Bond Index was exactly flat for the month of July and is down 1.6% for the year 2018 and down 1% for the one year period that ended. As you can see, investing in bonds has been a losing proposition over the last one year period; exactly as I predicted.

I received a lot of comments over the last article I wrote regarding a few topics about my father. Some of the comments were reflective. Some clients I have serviced over the last 30 years exclaimed that they had no idea that my father was a Methodist Minister. I guess I did not do a very good job of telling this story.

One of the most interesting memorabilia I have in my office is the actual hospital bill from the day I was born. At that time my father was a Minister in Norton, Virginia, which was a small coal mining region in Southwest Virginia. That bill from the hospital, dated when my mother and I were sent home on September 3, 1949, reflected a total amount due of $50.64. It even set out the circumcision fee of $2 which was low since it “wasn’t that big of a deal.” What is interesting about this piece of memorabilia is that attached to it are the receipts from the church members who actually paid the bill, with one gentleman paying $5 and some of the others paying more. The note attached reads, “Because we love you we hand you herewith your hospital bill mark paid.”

What is interesting is that I had never seen this bill until after my father’s passing. I did know, however, my father was a beloved figure in Norton, Virginia, even though I was only a child. The church had very small memberships and could not afford many nice things. But I do remember that my father became the general contractor and actually built the sanctuary of the church during our stay in Norton, Virginia. I also remember as a child, going back there often for weddings and funerals long after he had left that particular church. This hospital bill was prior to the time of medical insurance and even though my mother was there for 3 days, the total bill was only $50.64. The important part was the show of kindness from the members of the church who actually paid the bill and the fact that my father was so touched by that kindness that he kept the bill and the receipts for the remainder of his lifetime. Hopefully this gives you some insight to what he considered the important things in his life.

I also wanted to give you a quick update on some of the items I wrote about in the last posting related to tariffs. It seems now less than a month later, the European Union has agreed to play nice with the U.S. and to reduce tariffs so that they are equal. It also appears that Mexico has jumped on board and has agreed to re-write NAFTA; Canada not so much. It didn’t take long for two of our largest trading partners to agree with President Trump that free trade means exactly that. Its free for both sides. As I forecasted in that last posting, it will not be long for the rest of the world to agree also. Frankly, they have no choice.

Many commentators are writing that the contentious trade negotiations with China would have catastrophic results in the equity markets. They just do not seem to understand that the only loser in this trade war will be China. Since they sell to us five times as much goods as we sell to them, the hit on their financial markets will be substantially greater than the minuscule change to our economy. Oh yes, I fully understand the issue of trade barriers creating inflation but the economy in the U.S. is so strong at the current time that we need to get this straight and if it means we must suffer some inflation to bring China into the 21st century, then so be it. As the President so correctly pointed out recently, the U.S. economy is playing with the house’s money and we can not allow this golden opportunity to go by without satisfying the problem with China when it comes to intellectual property and state supported enterprises. We have made great progress in only a few months and I expect to see the rest of the countries fall into line shortly.

You may wonder how I can express so much confidence in my headline that the Dow will reach 45,000 in the next decade. A lot of my optimism is reflective of the current, strong U.S. economy. Of the first 275 companies in the S&P 500 Index, 81% have already reported earnings that top estimates. If these numbers hold up for the rest of the reporting period, it will be the highest win rate on record since 1994. So I got to thinking the other night what exactly it would take to reach such a lofty number as 45,000 within the next decade. Simple arithmetic proves the point that even a 6% average annual yield on the S&P 500 would reach a number well in excess of 45,000 within the next decade. And, oh yes, for your doubters out there, I will give you some comparisons to reflect on this number.

Just so you don’t assume I picked some arbitrary number, I looked at the S&P 500 Index which is a much broader index than the Dow. The Dow only includes 30 stocks, while the S&P 500 includes 500 of the largest stocks in the U.S. I think this index is much more reflective because it includes a much broader group of individual companies. So how has this index performed over the last few years?

Through the end of 2017, the S&P 500 Index has had an annualized yield of 15.79% over the last 5 years. Over the last 10 years, which included the year 2008, where the S&P lost 38% the average return over that 10-year period was 8.49%. If you look at the 15-year annualized return, that number comes in at 9.92%. If you go back over the last 20 years, which included multiple recessions along with the meltdown of the dot-com era and of course 9/11, the annualized yield is 7.19 % and for the 25-year average return that number comes in at 9.69%.

If you look at all of these examples above you will note that all are substantially above the 6% hypothetical number I have proposed. And as you also will note, some of these average returns are significantly greater than my 6%. The one thing that investors just can not seem to get their heads around is that it is perfectly possible for the index to go down and go down significantly in a year. However, when you talk about average returns, you are averaging those negative returns yet you still get outstanding long-term results.

I think I am perfectly comfortable with assuming a 45,000 Dow within the next decade, since I have assumed a relatively low annual gain, and given the strength in the U.S. economy it does not appear that a recession is anywhere in sight for the next several years. Even though I have picked a decade as my benchmark, in all reality we are likely to reach that threshold if not years, then maybe months earlier. Save the date!

I guess there are just some things about the economy and the way it is reflected by the financial news that I cannot understand. It seems there are reams of paper written on the subject of the collusion between the U.S. and Russia. While this is a hot topic, we can rest assured that at least Russia does not pose an economic threat to the United States.

As I reported in my last post, we spent two weeks in the wonderful country of Italy. What is true of Italy is that no one really works that hard. It’s a country based upon reflecting on its beauty, drinking fine wine and eating delicious food. No one ever accused Italy of being an industrial giant and I suspect that there are not many Italians, if any, that die from being overworked. However, there is a parallel that you should recognize.

Did you realize that the GDP of Italy is greater than the GDP of Russia? Last year Italy posted a GDP number of $1.9 trillion. While Russia posted a GDP of $1.57 trillion. Who would have ever thought that a country like Italy not known for its industrial growth would actually have more GDP than Russia. I am a little baffled why the financial news makes such a big deal of the threat of Russia. Yes they have their nuclear weapons but their economy is weak and could easily be crushed by sanctions from major countries.

The U.S. had a GDP of $19.4 trillion in 2017, 10 times the size of the economy in Russia. Additionally, Russia has vast natural resources, but not the money or the capital to exploit them. Due to the harsh weather in Russia, their agriculture is weak and they almost export nothing other than natural resources to other countries. How anyone migh classify them as a financial threat ignores the actual facts.

Also, did you realize that the state of California GDP at $2.7 trillion is almost double the size of the economy in Russia. Even the states of Texas and New York have GDP greater than the entire country of Russia. Maybe we need to find another threat to our economy since Russia clearly does not measure up.

I continue to be very optimistic for the financial markets for the rest of the year, and in 2019. It looks like we are well on our way to meet our double digit returns for 2018. Many critics said I was out of my mind to propose such a huge increase in the markets after the S&P went up 21.83% in 2017. But my optimism is not based on sentiment or the alignment of the stars. Its based on the absolutely solid economic data that the U.S. is reporting.

For the S&P companies reporting so far this year sales are up 10% year-over-year. It is fairly remarkable that sales continue to go up in light of the so-called tariff battle ongoing. But the most important component is earnings are up 28% and are currently projected to go up 29% in the third quarter of 2018 and 25% in the fourth quarter of 2018. If we come close to making either one of those estimates for the remaining quarters of 2018, then the markets are significantly undervalued today.

GDP was reported at 4.1% for the second quarter, which was extraordinarily good. No one has any idea what the rest of the year will bring but most assuredly the GDP for 2018 will be above 3%, making it one of the best years in recent memory. The unemployment ratio continues at 3.9%, virtually an all-time low. There is no question inflation is making its way through payroll and employers are having a harder time finding qualified workers. From an employer’s standpoint that is certainly a negative, but from the employees standpoint it is a true positive. As employees make more and more money then consumer confidence goes up, more consumer goods are sold and the economy only gets stronger. How someone sees a negative in this positive ratio defies basic common sense.

And what is happening in residential real-estate is quite remarkable. There is a pronounced shortage of residential homes in America, and homes cannot be built to accommodate the rising demand. But there are certainly regions of the country where valuations are stretched - a large portion of the country is underutilized and can afford to build many more houses without increasing the inflation of the cost of housing.

Just so that you don’t think that I am oblivious to the negatives, I read them also. I know that at a certain point unemployment will create wage inflation and that’s an overall negative. I also understand that a demand for housing will increase the cost of housing which corresponds with a decrease in the demand. I understand that economic theory, but we are not there yet. I also understand the inverted bond-yield where short term interest rates are higher than long term rates. We are not there yet either, but history tells us even when we get there the effect is not negative in financial markets for 2 to 3 years. Why on earth would we be worried today about something that is not likely to happen for 2 to 3 years from now?

In summary, the positives so far outweigh the negatives and you cannot help but be totally optimistic. As I often mention, the three components of higher stock markets are firmly in place. Interest rates continue to be low, although higher than they were a few years ago, and earnings are extraordinarily high and only getting better. That’s the most positive of the positives. And as we sit here today, the economy is stronger than it has been in many years. Therefore, we still have in place the trifecta of the economic components that make markets higher. So as I read the negative financial headlines on a daily basis, all I can ask of you as investors is to sit back and enjoy it.

As always we encourage you to come in and visit with us and discuss your goals and financial plans. If you are interested in discussing your specific financial situation, please feel free to call or email. I had a client who came in the other day who expressed complete optimism regarding the equity markets. He emphasized to me his goal was to have S&P type results in his portfolio but the one thing was he never wanted to lose money. If you expect those types of financial results it is unlikely you are looking realistically at how markets work. Give me an opportunity to explain.

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

Best Regards,
Joe Rollins