Evaluating when to board your financial lifeboat
SS Bull Market isn’t listing yet, so stow vests for nowAugust 14th, 2014
If you’ve ever gone on a cruise or been aboard a vessel that’s going to be out at sea for a while, you’ll be familiar with this process. It’s basically done so that, if the situation calls for it, all the passengers will know what to do, how to do it, and where to go. By doing so, the ship’s company will help keep passenger safety concerns to a minimum.
For the last almost 5 1/2 years, we’ve been enjoying our trip on the SS Bull Market. We’ve had a few storms and some crew challenges along the way, but, all in all, it’s been a great trip.
I thought it would be good to forewarn now you of some potential market upheavals so that you too would know when and how to get into your financial lifeboat.
Good news is bad
Doesn’t it seem logical that more people working and being paid more for what they do is generally a good thing … especially if you’re one of them? Well, Wall Street has a unique way of interpreting financially-related information so that, many times, what normal people would think of as good news is turned into bad by the influence of the trading decision process.
My motivation for writing this came early this month, after a couple day sell-off that brought the market down more than 2 percent. The size of the drop was only unique in that there have been very few of that size so far this year. Matter of fact, according to FactSet, as of Jan. 23 of this year, “the S&P fell 2 percent or more in a day an average of once every 30 trading days in the thirty years from 1982–2013.”
What caused the drop was the perception by traders that, due to the Employment Cost Index having risen to its highest point since 2009, the Fed would now be thinking about letting interest rates move up “sooner than anticipated.” This would also bring inflation up with it, so the combination—according to conventional wisdom—would cause the market to crater.
This is particularly true if you happen to be of the opinion that most—if not all—of the growth we’ve seen has been due to Fed interventions. That logic goes that the market is doomed without the Fed’s policy support. I’m of the opinion that, while the Fed has been of some help to be sure—for instance, lower borrowing costs do help to reduce companies’ expenses—there are other drivers of the market. I guess we’ll find out at some point if it’s all been about the Fed, but I don’t buy it.
Before I get into why, the need for any fiscal lifeboat drill is directly related to the potential response by traders to increasing interest rates. I believe the market action in early August was kind of a preview of coming attractions. The (again) conventional wisdom holds that interest rates rising “must” equal stocks dropping.
To be sure, we’ve been operating with artificially low interest rates for some time. When the Fed indicates that it plans to take action to let the rates float up, it’s then that the lifeboats can be used. I imagine a lot of selling will be going on as traders and investors each try to anticipate “what’s next.”
Those who are mentally and emotionally prepared for near-term volatility around the Fed’s announcement will simply ride it out, i.e., in their lifeboat. Those whose investing is either completely market- and/or performance-focused, as opposed to having a personal strategy, will find themselves cast upon some very choppy waters.
What if interest rates do go up?
Okay. What if they do? Rising rates can also occur when an economy is growing and demands more money to do so. I can tell you that I’ve been through many market situations over my 40-plus years in this biz. The fact is that in many of those, we had both stocks and interest rates moving up … they aren’t mutually exclusive. Here’s Barry Ritholtz to demonstrate that my perceptions were actually pretty much accurate.
He offered this regarding interest rate movements relative to the S&P 500. “During the past century or so, on 86 occasions, interest rates changed significantly during the course of a calendar year. Almost three-fourths of the time when rates were rising, stocks tended to rise as well.
“During these periods of rising stocks and rates, we found that the 10-year (U.S. Treasury) note yield averaged 5.11 percent, the price-earnings ratio of the S&P 500 averaged about 15 and inflation, as measured by the consumer price index, was more than 4 percent. The average S&P 500 increase during these periods was almost 21 percent.”
The other side is that his study showed what happened when rates rose during the period. He added, “When rates rose from higher levels and stocks fell, the S&P dropped almost 16 percent, on average. The 10-year note averaged more than 6 percent, the PE ratio was a historically low 12.57 and inflation was high, averaging 6.8 percent.” We’re a loooong way from there.
And here’s a recent report from a Goldman Sachs team led by stock strategist David Kostin. In it, they said, “Stocks typically perform well in the months leading up to an initial rate increase. For instance, when the Fed first raised interest rates in 1994, 1999 and 2004, the S&P 500 rallied 11 percent, 21 percent and 18 percent, respectively, in the 12 months prior to those moves. The market then declined in each of those subsequent one- and three-month periods following a rate increase.”
It’s all about the fundamentals
To reiterate, I’m convinced that the bull market’s long rise hasn’t been due to the Fed. It certainly hasn’t been due to Congress or the administration. Simply, most of our growth has been—and continues to be—based on continuously growing corporate profits.
Contrary to all the talk of the Fed’s easing having been the driver, I believe that these profits have been, and continue to be, supported by real growth in U.S. manufacturing, exports and energy production. This applies to both trailing and forecasted profits. Most have been, and seem set to continue to be, at record levels. This trend of solid, growing economic reports, in my mind, will continue to support share price growth.
Since 2009, earnings led the rally off of those lows, multiple expansions took over in the middle, and—most recently—earnings have picked up. Higher revenues have certainly helped higher stock prices as well.
It’s true that Fed policy is still easy. The Fed is making a commitment to keep its balance sheet larger for longer and sees no real urgency to raise rates. I believe all of this will help create a boost for stocks and the economy over the next 12 to 24 months.
Let me offer these observations from noted market strategist Dr. Ed Yardeni. He says. “As long as the economy continues to grow, forward earnings should continue to provide a good tailwind for the stock market. S&P 500 forward earnings tend to be a good leading indicator of actual operating earnings over the coming year when the economy is growing.”
There’s certainly no need to be overly concerned now. Just think of planning for the use of your lifeboat as having your strategy for dealing with the potential market changes—which can certainly include maintaining your positions—in place before the economic storms and rough investing seas cause others to act against their best interests.
Michael Maehl is an independent financial adviser and Spokane-based senior vice president of Opus 111 Group LLC. He can be reached at 509.747.3323 or firstname.lastname@example.org.