The Perfect Calm
Economic growth continues, and although this cycle has been the slowest recovery in post-war history, the slower growth has allowed for a prolonged cycle. Inflation remains low—since peaking in 1980, the U.S. has experienced consistent disinflation. The latest PCE price index figures showed a 1.6% rate, leaving inflation below the Fed’s preferred 2% level since '08, so stimulus continues, keeping interest rates at low levels. The 10-year U.S. Treasury bond hovers around 2.3% and rates in other developed nations are even lower. Unemployment in the U.S. has fallen to 4.1%, near full employment for the economy.
And the variation in these statistics has been minimal. At the same time, the prolonged steady growth has allowed for record corporate profits, led by record high profit margins. No wonder that the stock market is at all-time highs and volatility is at all-time lows. If December is yet another positive month for the S&P 500, it will have been the first time in history that all 12 calendar months were up. Perhaps just a quirk of the calendar, but it’s already noteworthy that there have been 13 up months in a row, exceeding the former 11-month record stretch ending in January 1959. The S&P 500 has also set a record for number of days (over 280 and counting) without a 3% intraday decline. In 2017 there have been only 4 days with 1% or more declines, the least in over 50 years. And the average daily absolute change has been a mere 0.3%, the lowest in over 30 years. This steadiness seems almost too good—the opposite of a perfect storm. A perfect calm.
But investments are made looking to the future, not in the rearview mirror. So it’s our task to determine whether the road forward is up, down or flat, and just how bumpy it may be along the way. We first look to our macro overlays, which are designed to alert us to a recession and bear market, respectively, to gauge the urgency to exit positions in order to limit the impact of a significant market decline.
Today’s market is a tricky one for value investors. Our macro models remain bullish; therefore, we need to continue to scour our investment universe for undervalued positions in an attempt to be fully invested. However, valuations appear full—markets are fairly priced or overvalued—so it’s not easy to find a mix of undervalued stock holdings. And we are most certainly not willing to alter our strict requirements for attractive absolute values—stocks trading 20% or more below our estimated appraised values—unlike many investors currently trying to simply find "relatively" attractive opportunities. The lack of volatility isn’t helping. Normally we see many more opportunities driven by the typical ups and downs. In a study we did early this year, we found that for the 20 largest S&P 500 companies, in the last several years the normal annual drawdown, from peak to trough, was around 17%. Smaller companies tend to be more volatile. In normal periods we should witness our fair share of potential opportunities. But, as noted, this period has been unusually steady, providing fewer opportunities. 2
This study was a good reminder of how and why our process is designed to work. We wait for bargains. They tend to come often, so usually we don’t have to wait too long. We sell when positions rise to FMV (fair market value), especially when they coincide with ceilings in our TRAC™ work because we then become fearful of a potential double-digit decline. Not all stocks bottom at the same time. Individual stocks often march to their own time line. Therefore, we need to fully embrace a bottom-up mentality when our macro tools aren’t flashing negatively. This study was also a reminder that we could potentially do better trading with our TRAC™ break points rather than being subject to the inherent volatility of a buy and hold strategy. Most stocks trade between undervaluation and fair value. Once a stock reaches fair value, since its best case is to then track its growth rate, the stock becomes vulnerable to a decline until its undervaluation is again sufficient to attract enough buying power to offset selling pressure.
We are always on the lookout for companies with consistent growing earnings streams. Those whose steady businesses have FMVs that are persistently growing up and to the right but where for any number of reasons, due to a temporary operational setback, the share price has fallen sufficiently below our estimate of FMV.
Our preference is to own companies with competitive advantages where we expect those virtues to allow for continued growth. As well as being undervalued, we want those companies to possess strong operations and financials, all with a view to mitigate losses too. A few of our recent selections were made when they corrected to floors in our work and were sufficiently undervalued, in our view, to warrant a position. There are a number of others where our due diligence is complete and we are merely awaiting a slightly lower price to justify a purchase.
Our Economic Composite (TEC™) is not alerting us to a recession. Similarly, our market momentum indicator (TRIM™) is not suggesting an imminent bear market. Since our alerts have not triggered, nor do we see them triggering in the near term, we’re more confident about being fully invested. Because there are still few excesses, the potential for central bank led quelling of growth, and the global recession that accompanies, remains unlikely.
In our large cap only portfolios we have held an outsized cash position, while we scour for value opportunities, which has restrained our returns. Because of the calm environment, and all-time market highs, we are certainly seeing fewer opportunities that meet our criteria. In our All Cap mandates, with the ability to cast a wider net, we have been able to find enough positions to be fully invested in equity accounts.
The markets could keep rising as long as interest rates remain at today’s levels or lower, corporate tax rates head lower (as appears to now be the case with the tax bill about to pass) and the current rate of economic growth remains intact.
Central banks are becoming more restrictive. The Fed is shrinking its balance sheet and is considering further tightening. Interest rates have begun to rise, though still remain historically low. The balance sheets of many governments have ballooned. Therefore, we continue to diligently monitor some key economic statistics along with our macro tools to make sure we aren’t 3
caught off guard when risk again rises to levels that can cause a substantial selloff. With the U.S. GDP growth rate just upticking to 3.3% for the 3rd quarter, fears of an imminent economic decline should wane. Leading economic indicators are strong and U.S. GDP growth in Q4 could reach 3.5%. Notwithstanding, growth could downtick in the latter half of '18 as the normal U.S. and global inventory cycle causes a slackening. This inventory correction should not lead to a recession as long as it’s met with easing by the authorities. Meanwhile, this quarter should be the third consecutive quarter of over 3% U.S. growth, which hasn’t occurred since '04. Hurricane related rebuilding should help too. And the tax cuts, though phased in, should also bolster the growth outlook.
With stock market valuations so elevated, the medium-term outlook for stocks in general is not favourable. It’s at this point in the cycle that we feel that bottom-up stock picking is essential to help lessen the risk of holding positions that might succumb to negative revaluations.
As the economic cycle continues and unemployment shrinks, it portends the spectre of rising inflation. Though demographics, technological advances, the Internet and sluggish growth have all conspired to keep inflation low, at some point wage pressures should become a factor. This may even be exacerbated by demographic changes as the ratio of workers to consumers is believed to have peaked, even in places like China. Higher inflation could pressure interest rates higher which would be anything but calming for the stock market.
© Trapeze Asset Management