First Quarter 2018 Newsletter
SIX FLAGS OVER WALL STREET
The stock market’s sleepy complacency, after a Rip van Winkle-like period of calm, awoke with a sudden volatility matching the wild ride on Six Flags’ “Bizzaro” roller coaster. Investors had to hang on for dear life, with some becoming nauseated, before the market’s ride slowed and gradually came to a stop after a long overdue 10% price drop. The surprise and speed of the correction startled many investors and left them wondering if this was the start of “The Big One”. Now that the dust has cleared it looks like this was caused by a failed market bet that virtually cleaned out the speculators. During the wild ride, the markets managed to hold at their 200 day moving average and the US Treasury market remained stable. Generally money flows into Treasuries in a market crisis. The performance of these two indicators supported the conclusion that this was not going to be a market melt-down. While there has been continuing volatility, this shock has at least brought a temporary halt to the parabolic price rise we experienced in late December and early January. Since the drop in February, the market has continued its roller coaster ride based on the daily news from Washington and around the world. The market’s rebound after a continuing diet of potential black swan news items shows that there is still enough support for the market in some quarters to avert a major decline at this time.
Market support likely comes from the realization that the economy is doing reasonably well and that earnings reports for the year 2018 will likely be up 16%. In fact, many companies are reporting earnings well in excess of forecast for the first quarter. This earnings increase is primarily the result of the Trump tax act although the lower US dollar has undoubtedly helped improve earnings of the large international companies as well. The Federal Reserve is projecting that unemployment will drop below 4% both this year and next and therefore they conclude that continuing to increase interest rates is the proper policy to keep inflation from overheating. Despite these rosy predictions, first quarter GDP estimates from GDPNow at 2% and NowCast of 2.9% are down significantly from projections earlier in the quarter. We’ll get a preliminary look at official first quarter GDP estimates on April 27th but unless the results are significantly above forecasts I doubt if it will have much of an effect on the market. It does appear, however, that the US economy has made some improvement over the last few years. The big question is whether it can stand the double whammy of the Fed reducing liquidity and raising rates at the same time. We will have to wait to see how that plays out. Real estate would likely be one of the earliest sectors to suffer as mortgage rates play off the 10 year Treasury rate which is nearing 3%. This is the result of expectations for four, rather than three, rate increases this year and next year as well. While the 10 year and shorter end of the yield curve has moved up substantially, the 20 and 30 year maturities have hardly blinked. In fact the 10 and 20 year are just slightly below the yield of the 30 year bond. We are getting close to an inverted yield curve where short term bond yields exceed those of longer term bonds. Generally this type of formation precedes a recession. Most forecasters don’t see this as likely in the near term. As the correction in February showed, however, all market declines don’t need a recession to get them started. And it is generally thought that market action precedes economic events by six to twelve months.
Longer term the major threat to our economic stability is debt. I’m not talking yours or mine but the Federal government’s debt. While individuals have significantly deleveraged since the 2008-2009 period, the government has bulked up on bond steroids. The new tax plan will create additional debt of $1.5 trillion over the life of the plan. In the short term, however, we will see yearly budget deficits of $1 trillion and will need significant cash inflows to offset the revenue decreases in the early years. Maybe the stimulation of the tax plan will offset some of this but I wouldn’t hold my breath. Increased government borrowings could likely push up interest rates as well as crowding out corporate, state, and municipal fundraising via debt. A significant black hole exists in state and municipal pension funds. Despite the strong equity markets and continuation of the bond rally, pension plans are still dramatically underfunded. The situation in California is so bad that the government is looking to pass a law that will allow them to reduce promised retirement benefits if the markets have another significant correction. The problem is past promises that weren’t or can’t be funded. None of this is a problem until it is. And when it becomes a problem there are no easy or non-harmful solutions. Hopefully we will not have frittered away our national debt capacity before we really need it.
The caution I have expressed over the last few years has resulted in a number of readers calling me bearish. I prefer to use the term prematurely pessimistic. In my opinion it is better to give up the last 5 or even 10 percent of the market rise to protect your assets from a much larger decline. If only someone would ring a bell when it is time to be cautious. Sometimes we win by not losing.
For the first quarter the Dow Jones Industrial Average returned a negative 1.97%; the S&P 500 a negative 0.76%; and the Bloomberg/Barclays 1-5 year Government/Corporate index a negative 0.50%. Not what most expected after the parabolic start to the year.
Robert B. Needham, CFA April 24, 2018