Q4 Quarterly Letter

“If you want to catch beasts you don't see every day,
You have to go places quite out of the way,
You have to go places no others can get to.
You have to get cold and you have to get wet, too.”

- Dr. Seuss

As we enter 2017 and the beginning of the Trump presidency, the US equity bull market is almost eight years old. In fact, the eight years since the “great recession” has been a bull market not just in domestic equities, but in almost every global financial asset class. This is particularly interesting given how weak actual economic growth has been over the same timeframe.

Writing in July 2016, Kevin Kliesen of the Federal Reserve Bank of St. Louis commented:

“Although the current expansion keeps plugging along, the U.S. economy's pace of growth during the past seven years has been extraordinarily weak. Since the second quarter of 2009 (when the Great Recession officially ended), real growth in gross domestic product (GDP) has averaged 2.1 percent per year. By contrast, growth in the previous three expansions (1982-90, 1991-2001 and 2001-2007) averaged 4.2 percent, 3.6 percent and 2.7 percent, respectively.”1

Despite the bull market’s age and weak economic growth, the coordinated central bank interventions in February of 2016 seem to have (once again) successfully quelled any threat of a global recession that appeared possible as commodity prices collapsed and industrial production shrunk for well over a year. Further, as far as markets are concerned, President Trump’s economic proposals are bullish for real growth and risk taking.2 Credit spreads have been narrowing for almost a year now and the trend continues.

Yet whether or not President Trump’s agenda is successful at reinvigorating economic growth, financial assets and domestic equities in particular are priced to provide poor returns going forward. As of January 30, 2017 Research Affiliates projects an average annual real return over the next 10-years of just 0.8% for the S&P 500.3 Even more pessimistic, GMO’s 7-year forecast published on December 31, 2016 estimates a -3.1% annual real return for large capitalization US equities over that period.

No Real Growth? There’s Always Financial Engineering

While the economic expansion has been weak, for the largest corporations, the last three years have been even worse. S&P 500 sales are up just 3.2% from 2013 to 2016. Earnings are DOWN 1%. Yet dividend distributions are up 30% and the price to earnings multiple is up 22.4% driving the S&P 500 Index up 21.1%.