Wall of Worry

There are a lot of economic negatives to worry about these days. Slow growth, annual GDP rising at only 2.1% on average since the '08 recession. Stagnation. Low inflation. Burgeoning government debt relative to GDP. One third of global government bonds at negative yields (and a few corporate bonds now too). Corporate earnings per share declining for 6 consecutive quarters, even after historically high share buybacks. High share prices from relatively high earnings multiples—the S&P 500 at 17x forward earnings. Falling worker productivity for the third consecutive quarter. Flat retail sales, likely as a result of an over indebted consumer. High inventories relative to sales. The U.S. government putting the kibosh on several potential deals. Corporate insider buying at only one third of their selling—a poor ratio. General uncertainty, much stemming from an election year with two controversial candidates espousing controversial policies.

Though the anticipated dire consequences of Brexit may not materialize when implemented, other issues, including a potential bailout of Deutsche Bank, whose shares just fell to a record low, have negative implications for Germany and the Eurozone. China, the world’s second largest economy, continues to grow, albeit at a slower pace. And growth worldwide is sluggish with growth for 2016 expected to be 2.9%, the slowest since '09.

Stocks the Lesser Worry

Stocks may be the only game in town. Well, certainly the best game. The yield of 1.7% on U.S. 10-year treasuries is less attractive than the 2.1% dividend on the S&P 500 and an earnings yield of 6%, making stocks preferable, especially for taxable accounts which can enjoy a lower capital gains tax rate on equity sales compared to the tax on bond income. Moreover, the risk of bond yields rising and creating short-term losses on fixed income securities is likely greater than the potential loss on equities in the near term, even if a rate-hike driven correction were to hit the stock market.

Household net worth has improved almost 30% since the '08 recession, and, in the current low rate environment consumers are taking advantage of their spending power in the housing sector. U.S. new home sales were up 12.4% in July, the highest since October '07. Sales of previously owned homes were down 3.2% in July after 4 months of gains, with supply falling and prices higher. Foreclosures were at an all-time low. With the current low interest rates, household debt payments as a percentage of disposable income are at a 35-year low. U.S. auto sales should also continue to rise over the next year.

U.S. consumer confidence in September was at its highest level in 9 years so spending should pick up. Central banks want inflation, which should boost prices of goods in general. Look for energy and materials earnings to improve from rising commodity prices. Although energy earnings declined 25%, about 70% of U.S. companies beat earnings expectations last quarter.U.S. Q2 GDP rose 1.4%. New orders for durable goods rebounded in July but were little changedin August. The unemployment rate is a low 4.8% with rising average hourly earnings of 0.3% in

Avoiding the stock market during a recession is typically a good idea. We still aren’t seeing the normal signs of a pending recession—oil prices are clearly not spiking, unemployment isn’t rising, bank losses are contained, and most importantly, the yield curve is not only not inverted, it’s actually steepening. Our own Economic Composite (TEC™), designed to alert us to recessions in various regions around the world, is not forecasting a peak in the business cycle. Even though equities are trading at fair value in our work, bear markets rarely occur without a recession. Our TRIM™ stock market indicators, which warned earlier in the year, are back on buy in most regions. So, while the stock market can suffer a correction at any time, we believe a decline in the near term will likely be modest and that growth and equity prices should continue higher, although perhaps at a tepid pace. Meanwhile, this doesn’t feel like a market top—where typically everyone’s optimistic, fully invested and buzzing about stocks.

The Fed says it is getting close to raising rates, likely in December, as the economy is reaching its growth and inflation goals. Better news for stocks than for bonds. Though rates are not likely to rise dramatically as further economic stimulus is still required. Look for continued monetary easing. The market is generally at all-time highs, clearly climbing a “wall of worry.” If not the only, then the best, game in town.

© Trapeze Asset Management


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