Q1 Market ReviewSubmitted by Karstens Investments on May 15th, 2017
By Michael D. Karstens, CFP®, AIFA®
After a brief pause in December, most U.S. stock indexes recorded solid gains in the quarter, with some even hitting record highs. After trailing in 2016, the tech-heavy NASDAQ performed the best, gaining 9.82% for the quarter. Large cap stocks also performed strongly with the DJIA up 5.19% and the S&P 500 up 6.07%. After small cap stocks outperformed in 2016 the Russell 2000 was a laggard but still gained 2.47%. In our opinion, small stocks continue to be expensive when compared to historical valuations and also compared to their large cap U.S. counterparts.On the opposite side of the valuation spectrum are international stocks and emerging markets. We have written that these markets had under performed for an extended period of time and were relatively cheap compared to U.S. stocks. Some may argue that the relative value of the international stocks should be less due to political and economic factors overseas. That may be true but in the rst quarter owning “cheaper” stocks paid off as the MSCI EAFE gained 7.39%. Emerging markets were even better with the MSCI Emerging Market Index posting a gain of 11.49%.
On March 15th, the Federal Reserve announced that it was increasing interest rates for the second time in three months. Interestingly, stock markets rallied on the news and the interest rate on longer term bonds actually fell. With interest rates at extremely low levels and the fear of rising rates going forward, corporations issued investment-grade bonds at a record rate. Lower quality bonds, both corporate and municipal, continued to do well as investors scraped for yield wherever they could nd it. Many would agree that most of these gains were driven by hopes for regulatory reform and economic stimulus under the Trump Administration. This optimism is reflected by the fact that the Conference Boards consumer con dence index hit its best level since 2000 and The National Federation of Independent Business gage of small business attitudes remained near all-time highs. Looking ahead, our biggest concerns remain global debt levels, government money printing (easy money) and valuations. From a valuation perspective, most of our managers are telling us that they believe stock prices are fairly expensive but in many ways deserve to be due to ultra low interest rates. March actually marked the eighth anniversary of the 2009 stock market low. Since that time, total returns on the S&P 500 are just over 300%, while earnings per share have only advanced 80%. This disconnect has caused its index’s average P/E ratio to expand to 21.9x earnings from its 2009 low of 11.2x. Some stocks are trading at very high levels based on extreme optimism. Net ix, for example, trades with a P/E of 338x earnings. Tesla is another market favorite. In late March, Tesla’s market value of $48 billion topped that of Ford’s $44.8 billion. For the record, Tesla sells about 80,000 cars a year and is unpro table, Ford sells around 6.5 million cars and makes money. Obviously the market is betting heavily on Tesla’s long-term success and innovation.
Lastly, many people believe that corporate insiders are a good gauge for future stock returns based on the knowledge they have regarding their companies. Last month one service stated that the ratio of company insiders buying vs. selling had declined to the lowest levels in 30 years. Clearly, corporate insiders see their stocks as expensive. We have voiced concern about debt levels for quite some time. These concerns include not only U.S. debt levels but also global debt levels. Total global debt at the end of the 3rd Quarter of 2016 was more than triple its level at the end of 1999. It is estimated that approximately $20 trillion of debt in the U.S. will reset in the next two years. Interest rates are up approximately 1% from the lows of last year. Unless rates reverse, the annual interest costs will jump by $200 billion a year and move steadily higher as more debt matures. In addition, a few top economists have raised concerns about how much more debt it takes today to generate growth in GDP. Domestic non nancial debt rose by $2.6 trillion in the past four quarters, or $5.00 for each $1.00 of GDP generated. For comparison, from 1952 to 1999, $1.70 of domestic non nancial debt generated $1.00 of GDP, and from 2000 to 2015, the gure was $3.30. Total debt gained $3.1 trillion in the past four quarters or $5.70 for each $1.00 of GDP growth. From 1870 to 2015, $1.90 of total debt generated $1.00 of GDP. It is clearly taking more and more debt to keep the economy growing. Perhaps this is one of the rea- sons that the current expansion has been so weak compared to the past (see chart). By pursuing policies in which debts are accumulated worldwide, spending from the future is brought to light today. Thus, credit (debt) “booms” are commonly followed by an economic “bust” and this indeed has been the case for many countries.
In the U.S. the easy money policies seem to have ended, at least temporarily. The ending of QE 3 in 2015 and the Feds three interest rate hikes is clear evidence of this. Behind the scenes, the Fed has taken some less obvious steps to drain reserves and unwind some of the huge increases in its balance sheet stemming from the 2007-2009 financial crisis. The big question is will this tightening slow the economy as has happened in the past or will it serve to somewhat dampen the anticipated growth initiatives of President Trump. How this plays out is anyone’s guess. Should the growth initiatives by President Trump prove successful, world wide growth would likely accelerate and stock and real estate prices could continue to grow. If global debt does prove to be a huge growth deterrent, stock prices are probably too high.