Broker Check

Thoughts on the Market High

 

March 17, 2017

 

As the market hits new all-time highs over the last month, I can’t help but reflect on what got us to this point, where we could be headed, what if any investment adjustments we should make because of it.

The story begins in February 2015 – almost two years prior to November’s election. From that time until election day, the stock market as represented by most indices was basically flat. There were a few times where the market dropped or rose markedly on some sort of news, but reverted back within a few months. As election day approached, most market participants thought that the election of Hillary Clinton was a foregone conclusion. As a result, the market priced in the results of that contingency and after doing so, many thought most risk was to the downside. If Clinton won, the market would stay flat since the win was already reflected in market prices; if Donald Trump won, the surprise and resulting uncertainty would cause a market selloff in a “flight to safety”. So, quite a few money managers took precautions by selling some of their equity positions and overweighting cash in their portfolios.

Of course, we all know what happened. Trump won the election and the overnight futures market dropped almost 10% as I went to bed. As expected, his victory initially panicked the markets (time to get out the checkbook and buy while things are on sale). However, when I woke up the next morning, something unexpected had happened – the futures market had recovered most of that loss.

As the market digested the Trump victory, the thesis changed: along with a pro-business Congress, Trump was going to cut taxes and lower regulations that hinder business profits. As it always does, the market started to price in that new information even though none of it had yet taken place. Now the money managers who were overweight cash had a problem: the equity market was taking off and they weren’t fully in it. Since being out of a hot market – no matter how well intentioned – is rarely forgiven by investors, the managers started buying in. Add to that shorts getting squeezed, and the market continues to march higher (to short is to borrow and sell an unowned stock in hopes of buying it back at a cheaper price in the future).

Here is my current concern: if the market is pricing in tax cuts and other business friendly incentives that haven’t happened yet, what will be the effect on the market if they are delayed or don’t happen at all? My thesis is that the market is overextended and will correct in some form. The fundamentals underlying the economy are good, but growth is still weak as judged by current GDP versus the historical norm. The country is at “full employment” which eventually should cause wages to increase as businesses fight for talent. Increased wages and the inflation that tends to follow both hurt the bottom line if those costs cannot be passed on to consumers.

Judging by these and other indicators, I do believe we are in the “late upswing” stage of the business cycle which is one step away from a slowdown – often followed by a recession. The problem is that the length of the late upswing stage is variable and so predicting the end of it and the resulting downturn in the stock market is very tricky and entails a high degree of luck. For the few people who “get it right”, there are multitudes more you don’t see on TV who guess wrong.

This reminds me of a story of two hedge fund managers that I read about during my CFA studies. Recall that leading up to the crash of 2000, technology stocks were severely overvalued and crashed with major losses that year and the next. Both hedge fund managers lost their jobs due to poor performance, but for very different reasons. Manager A was fully invested in technology stocks during the crash even though he knew they were overvalued. When asked why he didn’t get out, he said he thought the run wasn’t over yet. So, you might think that one should obviously sell out or not invest when one thinks the market is too high. Manager B agreed with that sentiment and so didn’t invest in technology stocks in 1998 and 1999 as he correctly felt they were overvalued even then. Unfortunately for him, that was at the beginning of the bubble and since his fund underperformed by not being invested in tech stocks like everybody else, the fund was dissolved and the manager resigned before the 2000 crash even happened. (CFA Program Curriculum Level III, 2017, Reading 7, Exhibit 12)

The moral of this story is that trying to call a top on which to sell out (or pick a bottom on which to buy in) is next to an impossible task more akin to winning the lottery than to investing. Plus, if you stayed invested throughout the 2000 and 2008 crash, you are doing well.

Unlike the hedge funds previously mentioned, DFS Advisors, founded in 1992, survived both crashes, I believe for two reasons. First, unlike most hedge funds and many other financial advisors, we are not selling over-performance – we don’t promise our investors market-beating returns, and thereby build in unreasonable expectations. Second, we don’t build our portfolios with market timing in mind. Our strategy is designed to weather the full business cycle, regardless of what happens in the short term. We plan to continue doing what we have always done: stick to an investment plan that is tailored to each client. Invest in a diversified portfolio of good companies and mutual funds that we feel are undervalued with good growth prospects or that pay good dividends/income (optimally both!). Sell to take profits on occasion, when an investment becomes overvalued, or we have better use for those funds. And always, in up markets and down, be on the lookout for tactical opportunities to exploit when the market overreacts to a bit of news.

As always, feel free to reach out to your advisor with any questions or comments you may have. Also, since we rely on our understanding of your individual situation and risk tolerance to guide us in how we invest for you, please let us know if something in your life changes that would require us to adjust the plan. Communication is critical to reaching investment goals.

Sincerely,

Aaron Anderson *

Investment Analyst

 

 

* Aaron Anderson does not currently offer securities or investment advisory services.

 

The opinions expressed in this article are those of the author and do not necessarily reflect the views of LPL Financial.  This is not intended to provide investment advice for any individual investor.  You should discuss any choices or decisions with your financial advisor before implementing any changes to your investments. All performance referenced is historical and is no guarantee of future results.