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First Quarter 2020 Newsletter

INVESTMENT QUARTERLY

PRICED TO PERFECTION

The term “priced to perfection” refers to an investment or market that is at a price level that will sustain itself only if the investment or market performs to high expectations in the future with no missteps or disappointments. This is likely the condition of the current stock market after the Fed driven rally of 2019. Now that we have breached 29,000 on the Dow, and appear to be on our way to 30,000, it is reasonable to examine whether any future disappointments could upset the perfection and accompanying complacency of the market.

Recent studies by Charles Schwab and Goldman Sachs highlighted the conditions of 6 valuation models for the market versus historical averages. The results were three very expensive valuations, one expensive valuation, one fairly-valued case and one inexpensive valuation. The very expensive valuations were Market Cap to Gross Domestic Product at 203%; the S&P 500 Forward Price/Earnings Ratio at 19 times; and the ratio of Enterprise Value to Sales at 2.6 times. The S&P 500 Price to its Book Value Ratio is considered merely expensive at 3.7 times. These valuations are market facts, based on current conditions, and not forecasts or hopes.

The old Rule of 20 results in a fairly-valued calculation. This rule says that if the total of the S&P 500 forward P/E and the inflation rate equals 20 the market is fairly-valued. Historically this rule reflected low price earnings ratios when inflation was high and led to expectations of stock gains as inflation ebbed. With current expectations for rising inflation rates in the future it would imply that future price earnings ratios could decline. Unless earnings pick up enough to offset a potential drop in the P/E ratio, this could result in a lower market. The one inexpensive valuation model is the yield gap versus the 10-year Treasury. At 3.4% this spread is favorable for stocks but could change if, and when, the Fed begins to raise short term interest rates. Although the Fed is currently on hold regarding interest rates, conditions could change rapidly.

Liz Ann Sonders, Schwab’s investment strategist, pointed out that the 31% performance of the market in 2019 was due almost entirely to expansion of the market’s price earnings ratio. This reflects the “risk on” approach of investors last year. Risk on leads to a momentum market as investors succumb to the fear of missing out. A prime example of this P/E expansion is a stock that shall remain nameless as we are not recommending stocks in this letter. The stock was up 90% in 2019 with a small sales decline and a real earnings decline of 3%. But, because of the company’s share buy-back program, they were able to report an increase in earnings per share. Despite this mediocre earnings performance the price earnings ratio went from 13 (near its historical average for the last 10 years) to 24, resulting in a new high for the company’s stock. In a nutshell this picture explains the 2019 market.

The background for this market environment is sponsored by the Fed and company stock buy-backs and mergers. The Fed has exploded the money supply since 2009 and, after a little bit of tightening, went back to an annualized rate of increase over 30% in the latter part of 2019. So, we have again pumped extra money into the economy which still has not led to increased investment in plant and equipment. These funds have found their way into the stock market for lack of better investment opportunity. At the same time, stock buy-backs and mergers have reduced the shares of stock in the US market by close to 50 percent. So we have more money coming into the market and fewer stocks available for purchase. It sure looks like the Fed has helped create an inflationary environment for stock prices.

The problem with a priced to perfection environment is that it requires continually perfect events to sustain itself. This can lead to complacency, greed, and fear of missing out. The shock of an unexpected event can bring a sudden change of the market psyche and lead to a nerve-wracking decline. The potential for shocks in this election year are more significant than in the recent past. The threat of impeachment is one of the largest challenges this market will face. A second, but no less significant, issue is the struggle between capitalism and socialism taking place in the Democrat primaries. Lest we assume our economic system is safe, be aware that a recent survey among millennials showed that they favored a socialist economic system over capitalism by 51% to 49%. We also must face the unexpected threat of the coronavirus which is projected to have a negative impact on the Chinese economy. At this stage it is impossible to project whether the threat will spread to pandemic proportions and leapfrog to other countries. In addition to these front-page threats we also face the issues of Iran and the middle east, a consensus that world-wide economic growth is slowing, and continuing forecasts by some that interest rates will increase. There are plenty of black swan opportunities in 2020. Hopefully they will not find a place to land and shock our markets. At this point a two-handed economist might say that, on the other hand, a failure to impeach and a continuing ease in the trade and tariff wars could send the markets even higher. These differing opinions are not what one would expect to see as the background for a priced to perfection market.

Recently Congress passed, and the President signed, a bill called The Secure Act. Among its provisions is a change in the ability to stretch an inherited IRA over the beneficiary’s life. After January 1, 2020, any new inherited IRA can only be stretched for 10 years. This means the tax shelter that was available until last year no longer exists. A 10-year limit to the inherited distribution life means that the IRA will result in potentially larger income tax payments.

For the year the DJIA returned 25.34%; the S&P 500 31.49% and the Russell 3000 31.01%. The Bloomberg 1-5 -year Corp/Govt index returned 5.01%. Please keep the standard industry disclosure in mind, “Past performance is not a guarantee of future returns.”

Robert B. Needham, CFA