Second Quarter 2017 Client Newsletter

Partying like it’s 1999 1997?

This mid‐year update is designed to bring clients and friends in on the current state of the market.  We will discuss the potential implications of monetary policy, exuberant tech stocks, as well as broad‐based economic/earnings related expectations.  The brief outline below teases each individual topic included in this newsletter. 

• US Markets continue record run – Bubble about to pop or Euphoria about to take hold?  
  • FAANGS might = 1999?
  • Slow and steady expansion that has yet to overheat might = 1997
• Length of post WW‐II US Economic Expansions – Time and Magnitude
• Monetary policy ‐‐ Not your father’s tightening cycle: Volcker & Greenspan slammed the brakes, Yellen expected to tap them 
• Do we need an acceleration in US GDP Growth? 
  • S&P500 Earnings vs US GDP – Which matters more to markets?

Much has been made in the financial press about the market leadership of mega‐cap information technology stocks.   Companies that fit this description are organized into the acronym FAANG, which stands for: Facebook, Amazon.com, Apple, Netflix and Google (Microsoft too).  These 6 massive stocks represent 2.9 trillion in market capitalization.  On a year‐to‐date basis, they are credited with nearly 40% of the markets gains.

This dominant and relatively narrow leadership in ‘cheerleader’ or ‘momentum’ type stocks is causing flashbacks for market veterans of the irrational exuberance days of the late 1990’s.  So the logical question must be addressed… Is this the dot com bubble all over again?

The short answer is, probably not. Macroeconomist and Market Strategist Ed Yardeni expanded on the ‘is this time different’ question earlier this week.  A few of his comparative statistics are below:

The takeaway is twofold: 1) The tech sector today has the earnings to support current valuations and     2) In order for this ‘party’ to continue or accelerate, the market will need to sustain its expectations for rapid fundamental growth at these bellwether companies.

Collectively this sector’s market capitalization makes up roughly ¼ of the S&P 500; so their next leg, (be it up, or down) will surely be felt across the entire market.

US Economic Expansions – Due for a Recession?

The recovery and expansion that we are currently in began at the depths of the financial crisis, early in 2009.  Since then, 31 quarters have passed and the US economy has grown a total of 32.7%.  That equates to about a 4% annual growth rate.  After inflation, you’re looking at a roughly 2% real growth rate per year.  

Based on length of time since our last recession, we are past due. The average expansion since 1954 lasted just 24.5 quarters, 3/31/2017 marked the 31st quarter of our current expansion.  

In terms of magnitude, the average expansion came in at an astounding 52.1%.  In order for our current expansion to reach the 52.1% mark, it would take another roughly 5 years (2022) before our next recession.  

The expansions of the past were hallmarked by rapid cycles of boom and then bust.  The current expansion (since 2009) is more akin to a slightly upward sloping escalator; you’re not always sure that you’re still ascending, but the ride is smooth and consistent.  The implications of this ‘low and slow’ economic growth is discussed in greater detail in a section to come.  

Monetary Policy ‐‐ Not your Father’s Tightening Cycle

The Federal Reserve’s oft mentioned “dual mandate” is to foster full employment and maintain price stability. Their primary tool for achieving both is through indirect control of overnight bank lending rates, known as the federal funds rate. When economic and employment conditions weaken, rates can be lowered to spur growth. Rates can subsequently be raised during an expansion to keep inflation from getting out of hand.

We are currently in the midst of the first tightening cycle since the Great Recession, but Fed Chair Janet Yellen is taking a more conservative approach than her predecessors. The chart below depicts the target federal funds rate since 1984. Previous tightening cycles are highlighted in blue, and the current cycle is in red. The last 5 tightening cycles averaged a rate increase of 3.2% over 1.6 years, while the current cycle features a mere 1% increase over a similar timeframe. Where previous chairmen slammed the brakes on expansion, it appears Yellen is content to just tap them.

Does the market need an acceleration in US GDP Growth?

Below is a chart of US Real GDP growth since World War II.  Since the 2008 Financial Crisis, US Real GDP has hovered at roughly 2% annually.  In contrast, between the conclusion of World War II and the Financial Crisis, US Real GDP grew at approximately 3% annually.  

As the population of the US ages, the productive capacity of the domestic economy will be reduced, resulting in downward pressure on US Real GDP. Additionally, improvements in capital equipment may continue to increase the pace of automation, rendering some occupations economically unviable and suppressing wages.  

Despite sluggish US Real GDP and wage gains relative to historical norms, corporate profits have continued to improve.   What does all this mean?  Maybe substantial economic growth is not a prerequisite for a domestic stock market that keeps chugging along.

The old cliché goes something like this: The market is not the economy.  Corporate earnings are the key, and they are expanding at or above the long‐term average growth rate.  There is however, very little doubt that if the current expansion falters, the end of the bull market won’t be far behind.

Conclusion

On balance, we view the developments discussed above as positive.  Although damaged in the last week, the momentum stocks that spurred the market to new highs continue to lead.  GDP growth, while subpar, is likely good enough to support a positive backdrop. If we never get into a euphoric boom, it stands to reason that a deep and sharp recession doesn’t have to occur solely due to age. Finally, while the Federal Reserve is beginning to tighten, it appears that they will do so within a very accommodative framework.

All of these positive tilting variables are of course subject to rapid change.  For that reason, we find ourselves cautiously optimistic, yet unwilling to expose our clients to the entirety of the potential downside that a significant shift in growth expectations, or interest rates could cause.

We hope you have enjoyed the content in this presentation.  If you have any questions about the topics, or about your portfolio in general, please do not hesitate to reach out.