Recent Letter to Clients {Part II}

Below is Part II of our most recent letter to clients.  We are again using a question and answer format.

The market sold off last winter on fears of slower economic growth so why then did it rally this spring?  

A prime reason for the rally was at last winter’s lower prices stocks became attractive to investors.  Markets had by then discounted the fear that the economy was slowing down.  Since then we’ve seen that while economic growth has been anemic, there is still growth.  Right now estimates peg our GDP in 2016 around 2%.  Unemployment is also low and while we can argue about the quality of the jobs being created, more people are working now than at any time since the end of the last recession.   Also last winter the Federal Reserve had just raised interest rates and there was talk of perhaps a series of three or four more increases in 2016.  Stocks volatility and fears back then of slowing global growth led to diminished worries over further rate increases this year.  Recently commentary from “Fed” members has started to suggest rates could rise sooner this year than the market thought.  Not unexpectedly, markets have again become volatile.  However, we will likely now only see 1-2 more interest rate increases this year.  I think a small rise in interest rates would help savers and be a sign that the economy continues on the track to a more sound footing.  If we can't handle the US going from 'basically free" money to "a little less free" money then we're in worse economic shape then we thought.

But I’ve heard on TV because the market is expensive that we could possibly have a really bad decline, maybe even like we saw in 2008.  Does that worry you?

Nobody knows whether we’ll have a large decline or maybe trade higher because nobody knows what the future will bring.  The media darlings and investment folks that emphatically tell you they have all the answers are basically "Show Men".  They are there to provide entertainment.  Those that think they know for sure what's going to happen tomorrow or six months from now are either trying to deceive us or deceiving themselves.  When it comes to the markets there is a debate on whether stocks are expensive or cheap.  There is always that debate.   Nobody knows the answer.  You can outright guess or use probability.  We as a firm prefer probability analysis because it allows us to define odds of what might happen as certain events unfold.  Historically speaking a rapid decline in markets, something akin to 2008, occurs when an unexpected event occurs that catches most investors “off sides” in their risk/reward profiles.  In 2008 for example, the event that pushed the market over the brink was the government’s unexpected decisions to let the investment firm Lehman Brothers fail.  These sorts of things don’t have to be related to finance.  Markets for example rapidly lost about 15% in 1990 after Iraq invaded Kuwait.  Remember these were unexpected events.  These sorts of things may happen tomorrow or never.  That’s why understanding your risk/reward criteria is important.   

What do you think stocks need in order to break out of this current range?

Stocks may need nothing in order to move higher.  It’s impossible to know when the herd mentality takes over and pushes prices above the range.   What I think stocks will need in order to mount a sustained advance is either better corporate earnings or a continuation of the current range until earnings catch-up with valuations on stocks.  What could help on both fronts would be better economic growth.  An economy growing at 1-2% simply doesn’t have the same jets to propel growth the way it would if we were growing around 3%.  3% used to be the default US growth rate.  We now seem to be in an era where economic growth can’t consistently sustain that level.  There are all sorts of reasons being put forward as to why that may be and they are beyond the scope of this update.  I personally believe that technology and productivity advances are changing the economy in ways that are hard to quantify.  The reason for this I think is that we’re still mostly using statistics invented when we were more of a manufacturing based society.  I think economic growth may be a bit better than the statistic suggest.  How that ultimately shows up in both earnings and income is harder to quantify. 

Part III will be published Tuesday.

*Long ETFs related to the S&P 500 in client and personal accounts.  Please note these positions can change at anytime.