An Autumn Review. Also, Stock Market Questions and Answers

It is hard to believe how quickly the year has marched on, but we are well on our way through autumn and the holidays are quickly approaching. With less than two months left in 2017, the investment world is already looking ahead to 2018. As we focus on finishing out this year strong, let’s look at some common questions that come up when it comes to the markets.

          

Why Does The Stock Market Continue To Trade Higher?

The stock market has risen to new highs through much of the fall, following the upward trend that began when President Trump was elected in November 2016. This unexpected increase has confounded the bears and frustrated traders.

Frustrations And Volatility

The bears are confused because they see dysfunction in Washington, the volatile situation in Korea, high market valuations, and the President's own bombastic personality as disruptive factors that should be negatively affecting the markets.Traders are frustrated by the disappearance of volatility and the lack of stock corrections that allow those with a trading mentality to profit from price declines. In fact, it has been months since the market corrected by over one percent.

                                                           

The disappearance of market volatility is a unique occurrence. This year is on track to be one of the least volatile on record, a trend that is unlikely to last forever.

Taxes And World Economic Growth

There seem to be two main reasons for much of this year's gains. One is a belief that we will see some type of tax reform in 2018. Regardless of where you stand politically, any significant reworking of the tax code should be good for corporate profits and theoretically good for economic growth. The other, and perhaps the most substantial reason for the advance, is that both the U.S. and world economies are finally seeing sustained economic expansion.

For years the U.S. economy limped along with subpar GDP growth, sitting at just 1.6% in 2016. To show the difference between then and now, preliminary reads of 2nd quarter U.S. GDP growth for 2017 were 3%. That number has long been pegged by economists as the magic number that creates jobs and grows wages, which definitely seems to be happening right now.

                                                           

Today in many places you see help wanted signs on windows and hear job ads on the radio and companies are raising wages in advance of minimum wage adjustments. Some of this reflects a changing view of how employees perform in the marketplace, but it also reflects a reality that the job market has become tighter, which is to be expected with unemployment under 5%.

                                                           

Higher economic growth means more money for consumers to spend and they're doing just that, even if it's not in traditional ways. Malls may be hurting for customers but online companies are growing like weeds. Amazon is growing so fast that it's scouring the continent looking for a location for a second headquarters. For now, higher economic growth and corresponding higher corporate earnings are trumping everything else that would normally be bringing the stock market down.

But Doesn’t This Situation Sometimes Lead To A Correction?

We know that stocks won’t grow at this rate forever, and even in a bull market stocks have periods when they correct or trade sideways. Also, the uncertainty with North Korea could escalate into something serious very quickly. But if things stay close to where they are currently at, then it looks like conditions are supportive of equities in the long-term.

Correction Vs. Bear Market

Let’s again clarify the difference between a correction and a bear market. A market correction is when the markets decline 10-20%, often to adjust for overvaluation (when the price of a stock is inflated) and usually lasts two to six months. A correction forces investors to be disciplined when they’ve become a little too aggressive in their portfolios and it allows valuations to adjust to levels where fundamental investors again become attracted to stocks. When economic conditions warrant it, the markets will eventually reset and stocks should go back to trading higher.

                                                           

Corrections can also occur by time instead of price when stocks trade in relatively tight ranges for longer periods of time until fundamentals and valuations again become aligned. This is the stair- step action one typically associates with a secular bull market. We saw this happen with the bull market in the 1980s and 90s (minus the 1987 crash).

                                                           

On the other hand, a secular bear market occurs when economic conditions deteriorate. They can last for years and take the stock market down by as much as 50%. Sometimes they are triggered by a sudden economic dislocation, but usually occur when the world’s economic situation falls apart. Currently, there is no evidence of a coordinated economic contraction around the globe.

                                                           

But to use the cliche of the canary in the coal mine, what emerging markets do could be an early warning sign for any changes. Emerging markets have been dormant for years but have come to life in 2017 with stellar market performance. This trend shows that worldwide economic growth is advancing. Yes, we'll have corrections, and yes, at some point volatility will return, but that does not necessarily mean a bear market has arrived.

The Media Says The Bull Market Has Run Its Course. 

What Happens Next?

Investors should have an asset allocation that fits into their unique goals and lets them sleep at night. Various factors go into this analysis, but the major one is how soon you will need access to the money you’ve invested. Many investors worry about having a repeat of the 2007-2009 bear markets where the average value loss was 50%. Since markets are cyclical, there will be a secular bear market again someday. Absent a sudden dislocation this will occur when worldwide economic conditions or geopolitical concerns bring about a severe adjustment to stock prices. But as we stand right now, it is unlikely that current conditions will result in this.

Let’s take a longer view by reviewing the total return chart of the S&P 500, focusing in particular on everything that comes after 1982, the start of the last great bull market. Since 1982, stocks have experienced five down years, averaging just a bit under a 17% decline. That’s just slightly above the long-term yearly volatility average for stocks, which is about 14%, meaning stocks will yearly experience a period where prices decline on average about 14%.

                                                           

Now, let’s imagine what would happen if that level of decline were to start now and carry forward over the next six months:

                                                           

The S&P 500 currently trades around 2,575. An average volatility decline would bring the index down to the point stocks traded at in November 2016. A 17% decline would take stocks back to October 2016. A 20% drawdown moves the averages back to the summer of 2016. If we imagine a repeat of 2008 when stocks declined 37%, then stocks would trade about the same levels as they did mid-2013. A 37% decline would sting, but given where we are in the current economic cycle, it would probably take a major, unexpected event for that type of drop to occur. Even if that were to happen, it is unlikely that conditions would deteriorate too fast for us to become defensive towards the markets. The good news is that even with that much of a decline, we still don’t lose those hard-fought gains since the lows of 2009 in the major averages. Instead, short of a catastrophe, we’d experience a normal correction followed by a period of backing and filling before stocks could advance again.

October Was The 30th Anniversary Of The 1987 Crash. 

What Can We Learn From This?

Although I was a barely minted young stockbroker at the time, the lesson I learned from that event is that risk can happen fast and it’s essential to ensure that your investment approach is aligned with client’s risk profiles. The broker that sat behind me sadly wiped out many of his clients because he’d been using an aggressive options strategy. That approach had netted him big returns in the proceeding years but was disastrous when the bottom fell out. I learned not to do that and I learned to only use margin in client accounts with caution if at all.

                                                           

The day after Black Monday, as prices started to rise again, one of the older brokers called me into his office and said, “You need to go out and make some calls to clients and buy something. Stocks are on sale and they’ll never be this cheap again!” So I made the calls. ETFs didn’t exist at the time, so I went out and told clients to buy the safest company I knew at the time, General Electric. Some took me up on the offer, some didn’t. Those that did made many times their money as the company ultimately went from a split-adjusted price of around $4.00 a share to near $60 in the summer of 2000.

                                                           

As hard as that period was to stomach, the day barely registers as a blip on a long-term chart. It took stocks some time to recover from the event and we managed to fight the first Gulf War not too long after it occurred, but when the economy found its footing, we experienced one of the greatest bull markets in history. As long as economic growth continues, stocks have the ability to recover from such events and, if history is a guide, these are better bought than sold in a panic.

What To Look For Next

I hope these answers shed some light on our markets, what history teaches us, and how to approach your investments. If you’re curious about my thoughts on what I believe to be the greatest engine for economic growth, stay tuned for an upcoming post! As always, if you have any other questions or just want an update on how your money is doing, you are welcome to call my office at 708.488.0115 or email us at lumencapital@hotmail.com.     

                                                           

*Amazon and General Electric are components of several different ETFs we own in personal and client accounts. Certain clients own individual shares of General Electric as well. We own ETFs related to the S&P 500 in client and personal accounts. Short S&P 500 in a personal account as part of a separate individual strategy. Positions can change at any time without notice on this blog or via any other form of electronic communication.

About Chris

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, developing customized portfolios that reflect a client’s unique risk/reward parameters. We also manage a private partnership currently closed to outside investors. Mr. English has over three decades of experience working with individuals, families, businesses, and foundations. Based in the greater Chicago area, he serves clients throughout Illinois, as well as Florida, Massachusetts, California, Indiana, and other states. To schedule a complimentary portfolio review, contact Chris today by calling 708.488.0115 or emailing him at lumencapital@hotmail.com.