"A sad tale's best for winter: I have one
of sprites and goblins.”
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{"The
Winter’s Tale” by William Shakespear, Act 2, scene 1, lines 25-26}
I have
always thought of the end of January as the rump of winter. Now I find out that in the vast realm of fake
science {right up there I guess with fake news} is the concept of “Blue
Monday”, a day supposedly calculated to be the third Monday of January as the
worst day of the year. Whether we define
this time as a set period or a single day, there is no doubt by mid-January;
winter can certainly weigh on the soul.
That is especially true for those of us who reside in the northern half
of the United States as we are usually beset by our worst winter weather by
now. Chicago usually finds this time
with sub-zero temperatures and often snow.
This year we have been largely spared the artic blasts and tundra but
the sun seems to have gone south on vacation and I think we’ve seen sunshine
about three days in the past three weeks.
Instead, the days have been dark and damp, perhaps reflecting the
nation’s mood as Donald Trump is sworn in as our 45th
President. For the millions who did not
vote for him, his ascendancy to the nation’s top office has been viewed in
almost apocalyptic terms. For many of
his supporters, it is not hard to imagine some anxiety as even they might
wonder what they purchased with their vote.
Yet whatever our individual views on the election we must now deal with
the new reality. My mandate is to view
the new administration through the investment matrix and that is what I intend
to do in a question and answer format.
Why did the stock market rally after the election?
Markets
rallied after the election in a way that was opposite of the nearly 10% decline
that occurred at the beginning of 2016.
Then investors decided that the economic projections were too
optimistic. Stocks rallied in November because political uncertainty had been removed
from the system. Whether investors
supported President Trump or not, you then had an idea of the general direction
of economic policy over the next few years.
Benjamin Graham, the famous value investor once said of the markets in
the short run it is a voting machine but in the long run it is a weighing
machine. In this instance it seems to me
the market both voted and weighed in favor of what it perceives as strategies
likely to be employed by the new administration that favors domestic growth and
pro-business policies. After our results
came in investors assumed their views on the future had been too negative given
the new reality and markets rallied.
How did the markets do last year?
The
S&P 500 returned 9.5% plus dividends and the Nasdaq Composite returned
7.5%.* Overseas, developed markets returned
1.5% and emerging markets rebounded from a disastrous 2015 with a return in
excess of 11%. A diversified portfolio of assets returned 8.3% last year.** It is
easy now to forget how volatile markets were at the beginning of 2016. Last year’s 10% market decline in January was
the worst start to a year since 1930. US
markets advanced in the spring on better economic numbers and an uptick in the
price of oil. Globally, markets
surprised investors by rallying after Great Britain voted to leave the European
Union despite an initial sell-off after the results were announced. The same pattern repeated itself after Mr.
Trump was elected President in November.
Markets were initially down by better than 3% on news of the Trump
victory but quickly righted themselves to post a substantial rally by
year-end. The S&P 500 gained nearly
5% after the election, almost half of its return came between November 9th
and December 13th. Last year is a wonderful argument for staying the
course in one’s investment plan. There
were plenty of times last year when pundits and commentators offered well
thought out reasons to get out of the markets.
Investors that listened to that advice were likely regretting it by
year-end.
So what comes next?
Stocks
have rallied on what is believed to be the new economic environment. Now comes the hard part for the new
Administration of actually making policy into law. Investors will want progress from President
Trump on economic policy, job growth, immigration reform, tax reform, and
cutting government red tape. Progress on
those fronts could mean the optimism we have seen in the past few months could
continue. On the other hand an early
stumble in implementing these policies or a wavering from these goals could
lead to market turmoil at some point.
Early on, the new Administration seems the most vulnerable to a major
foreign policy crisis. We will have to
watch how President Trump deals with Russia, China, Mexico and the Middle East
as well as our nervous allies. Assuming
we avoid foreign policy mistakes and also see some progression on the economic
front then stocks have the potential for positive performance in 2017.
We are currently using an earnings range of $130-133 with
a mid-point of $131.50 on the S&P 500 for 2017. The index currently trades
with a price to earnings ratio between 17.50 and 18 by that analysis. At these levels the earnings yield on the
S&P 500 is still north of 5.5% and the dividend yield of the S&P 500
carries a yield slightly better than 2%.
Valuations may seem elevated by historical standards but seem more
reasonable with longer term interest rates such as the US government 10-year
treasury bond still below 3%. I use a
system called the Cone of Probability {COP} when calculating a possible range
for the S&P 500 in a given period.
Current inputs give us a COP between 1,950 and 2,500 with a midpoint of
2,400. That is approximately a 6% price
appreciation potential to the midpoint from current writing. Add on a 2% dividend and domestic US equities
have the potential to see a total return for 2017 between 6-9%. For sake of comparison, last year I used an
initial COP of 1,700 to 2,150 on the S&P 500. The index traded as low as 1,807 in February,
put in a year high of 2278 on December 13th and closed the year at
2,239.
The Cone of Probability is our current probabilistic assessment
of the trading range within which we think stocks have the potential to trade
during a described time period. Our analysis is based on many factors.
Some of these include: Earnings estimates and whether those estimates are
rising or falling, dividend yield, earnings yield and the current yield on the
US 10-year Treasury bond. The COP is used solely for analytical purposes.
It will fluctuate with market conditions and changes to our data inputs.
Equity prices can and have traded outside of these ranges. The data supplied here is for informational use only.
There should be no expectation that this price range will be accurate and
there are no guarantees that this information is correct.
What worries you?
Here are some of the areas where I think investors should be
paying attention. First, while I believe
stocks have the potential for appreciation, valuations are not cheap. An event that causes investor into risk off
mode could leave stocks with more of a decline than many have become accustomed
to. I understand investors hate volatility. However, it is
the price investors pay for liquidity.
It is the reset mechanism that often caps the financial excesses that
sometimes can lead to larger market declines. Investors should expect some
volatility and should accept that sometimes prices will correct. Last year we began the
year with nearly a 10% correction in the markets. Historical volatility suggests that
correction usually fall between 10-20% with the historical average around 14%
decline. It’s been awhile since we’ve
seen a decline of that magnitude. There was
about a 14% decline in 2015 but then you have to go all the way back to 2011 to
find a similar event. A 15% decline from
current prices would take us to around 1,900 on the S&P.
The
first event that I think could lead to that higher volatility would be a faster increase in
interest rates versus investors expectations.
Paradoxically this could also be a positive as it could make fixed
income investments more attractive for portfolios, but it would also be
competition for stocks. The 2nd
would be a foreign crisis or some other unexpected event. The 3rd
could be a stumbling of the Trump economic agenda.
Regarding the 2nd issue if somebody asked me to look
for an unforeseen event that could be a problem over the next few years I would
keep a watch on Mexico. Mexico relies
heavily on four sources of income as it struggles for economic growth and each
is in trouble. One of its major
resources is oil. But Mexico’s oil
production has fallen precipitously in the past few years due to declining
reserves and inadequate infrastructure investment. Lower prices for oil also haven’t helped.
Another source of revenue coming into Mexico has been from the sale of illegal
drugs into the rest of North America.
While the majority of these profits go to the cartels some of that money
gets dispersed into Mexico’s economy.
However, the other side of that is that the Mexican Government has waged
war against the cartels since 2006 to staggering costs. Through 2013 it is estimated that Mexico has
spent over $172 billion dollars in combating the trade and an estimated 100,000
Mexicans have lost their lives to the violence.
It is anybody’s guess what happens to these cartels as drugs, especially
marijuana are decriminalized in the United States.
Another major source of revenue for Mexico is tourism. Unsurprisingly the fear of violence has seen
the number of tourists and their desired foreign cash reserves into the country
decline. Finally, perhaps the major
source of foreign cash coming into the country comes from the Mexican immigrant
communities in the United States and to a lesser extent in Canada. Not only has this been a major source of
money but immigration has also been a pressure relief valve on the Mexican economy. Mexico simply cannot create enough jobs for
its population. Now, demand for
immigrant labor in the United States is declining and has been doing so for
years. Illegal immigration into the US
is therefore down as well. All of that
is before President Trump builds his wall.
Now maybe Mexico will make it through these problems but it is the one
foreign area I think bears watching that perhaps others are not regarding at
this time.
Finally markets may become more volatile if investors become
concerned whether President Trump can get a large portion of his economic
agenda passed. It is early in the new
Administration so this will likely be months in the making. For those wanting a truer picture of the
Trump Administration’s plans as it goes along I would caution you to pay less
attention to the regular press or pundits.
Trump spent nearly two years making them look bad and they have a vested
interest in seeing his presidency fail.
Business oriented media like the Wall Street Journal, Investors,
Business Daily or the Economist may be a better judge of his economic policies
than even CNBC, the New York Times or the Washington Post. However, the best arbiter of his policies
will likely be the markets.
A Few Final Thoughts
There are always worries when investing and often it’s the event
that nobody pays attention to that harms us the most. That being said the current weight of the
evidence seems to suggest that the underlying foundations for a positive market
environment are in place. There will be
volatility this year as there always is but we have an administration that at
its onset has a pro-growth agenda. If
they can execute the majority of that plan then it has the potential to be good
for our economy and ultimately good for the markets. As such I think a major change has occurred
where buyers will be found when volatility returns. In that scenario investors will likely be
rewarded for picking good solid ETFs that have appreciation potential as well
as pay dividends and using cash reserves to pick at bargains.
Very truly yours,
Christopher R. English
Enclosures.
Christopher R. English is the President and founder of Lumen Capital Management, LLC.-a Registered Investment Advisor regulated by
the State of Illinois. A copy of our ADV Part II is available upon request. We
manage portfolios for investors and also manage a private investment
partnership. The information contained here is taken from sources deemed
reliable but cannot be guaranteed. Mr. English may, from time to time, write
about stocks or other assets in which he or other family members has an
investment. In such cases appropriate discloser is made. Lumen Capital Management, LLC provides
investment advice or recommendations only for its clients. As such the
information contained herein is designed solely for the clients or contacts of
Lumen Capital Management, LLC and is not meant to be considered general
investment advice. Mr. English may be reached at Lumencapital@hotmail.com.
Long ETFs related to the
S&P 500 in client and personal accounts.
Footnotes:
**Asset class returns taken for this report can be found at JP
Morgan “Guide to the Markets”, published quarterly J.P. Morgan Asset Management.com.
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Go here if you want to see some of the astounding statistics for
Mexico’s war on drugs and the narcotics trade into the United States..