Keep Emotions in Check

by Albert Meyer

The first quarter of 2017 has been the least volatile in recent memory. The S&P 500 and the Dow each saw only a single -1% daily decline, which occurred on March 21. Both the S&P 500 and the Dow gained on average +0.3% per day, which was the smallest average daily move since the mid-to late-1960s. Since the November election, the market has experienced a series of all-time highs. Invariably, the media, playing on our emotions, have rolled out the scaremongers predicting a major crash.

Granted, this lack of volatility won’t last. Donald Trump and Paul Ryan seem to have conflicting ideas about how much and where to cut taxes. Ryan, the consummate politician, knows that the tax code provides ample opportunity for pandering to special interests. “Cut the corporate tax rate to 15% and be done with it” is far too simplistic. Ryan’s border adjustment tax pits the likes of GE (in favor) against the likes of Wal-Mart (opposes). Think: campaign contributions. The spoils go to the highest bidder. So, while the tax circus is in progress, the market will get antsy. Based on past experience, a market correction cannot be too far off.

It is natural to fear temporary selloffs. However, market corrections present an excellent buying opportunity, if one can keep one’s emotions in check. Sure, the market is not currently offering us stocks at bargain basement prices. There is no way of knowing for certain whether the current exuberance may not spark a further rally as those who missed out, join the party. After all, prices are determined by buyers and sellers. An influx of buyers will propel prices higher. That said, the probability of a correction before the end of summer is perhaps more than 50%.

A recent BlackRock report observes that, “Volatility is often the catalyst for poor decisions at inopportune times. Amidst difficult financial times, emotional instincts often drive investors to take actions that make no rational sense but make perfect emotional sense.”

The report highlights the fact that long-term investors build up large unrealized gains in their portfolios, which ensures that their initial capital investment is adequately protected against market corrections. The market gives and then it takes some away, only to recover. Over the long-term, the market is a giver. Corrections outlast themselves, and then the upward trajectory continues.

In this context, Salil Mehta, a statistician and former director of analytics for the Treasury Department told MarketWatch that there was a 13% chance of a short-term bear market, or fall of at least -20% from a recent peak. He sees a more than one-in-three chance of a downturn of at least -10% or better, and a nearly three-out-of-four likelihood of a -5% drop.

It ultimately boils down to market tolerance. Those who can’t handle the occasional downdraft ought not to be in stocks. The mistake these investors regularly make is to resort to panic selling in an effort “to protect capital.” On the contrary, the worst time to panic is during a correction.

Professor Robert Shiller, Nobel Laureate and an economics professor at Yale, has always had a bearish bent. He receives most, if not all, of his publicity when he voices his market concerns. It would have been highly disadvantageous in the past for investors to have acted on these concerns by either selling out or remaining on the sidelines. Shiller is also famous for his CAPE ratio, a measure by which he assesses the intrinsic value of the S&P 500. It would not be disrespectful to say that based on the CAPE ratio at almost any point in time, the market seems to have been overvalued. Hence, the wrong conclusion would be to sell when the CAPE ratio appears too high to one’s liking. Such a decision would have caused many an investor to miss huge market rallies.

Professor Shiller, in article in the New York Times, admits, perhaps prompted by criticism, that his CAPE Ratio does not tell us “where the market is going tomorrow, but it suggests that some caution is advisable, and that returns over the next decade or so are likely to be constrained.”

Professor Shiller concludes the said article with this advice: “Long-term investors shouldn’t be alarmed and shouldn’t avoid stocks altogether. But my bottom line is that the high pricing of the market — and the public perception that the market is indeed highly priced — are the most important factors for the current market outlook. And those factors are negative.”

Clearly, buying stocks today is not as an attractive proposition as it was in February last year, but that does not mean one should liquidate today and wait for better days. It merely implies that one should be cautious. Even during periods when the market peaked, investors could have discovered stocks that had compelling value and bucked the down trend, or recovered really quickly after a market correction.

Of course, if the slowpokes in Congress surprise us all and cut the corporate tax rate to 15% any time soon, even the likes of Professor Shiller would look back at the current apparently overvalued market and admit that in retrospect it was fairly- to under-valued.


What has this got to do with the Price of Cheese?

by Albert Meyer

Lower consumption of cheese in 2016 caused inventories to increase. Producers responded by cutting prices. This action had the desired result. Consumers, enticed by lower prices, bought more cheese and inventories fell back to normalized levels. In fact, the increased demand for cheese at lower prices caused milk prices to go up. This dynamic interaction between supply and demand for cheese and milk all took place in an orderly fashion without interference from the “Federal Cheese Reserve.”

In a free market for capital, borrowers and lenders agree on price in response to the forces of supply and demand. Interest rates reflect the price or cost of capital. When there is excess demand for capital, interest rates rise and vice versa when demand dries up.

Unfortunately, in our capital markets, a big gorilla in the form of the Federal Reserve Bank interposes itself under the false assumption that we need a hairy and invisible hand to help us regulate the supply and demand of capital, so as to avoid excess inflation and unacceptable levels of unemployment. They make it sound ever so reasonable.

Evidently, we can be trusted to operate cheese exchanges, but when it comes to capital exchanges, we had better defer to the Fed. After all, one of the biggest players in the capital markets is the government, a menacing accumulator of enormous debt. It is no coincidence that with the help of the Fed, we had record low interest rates during a period of fifteen years when the national debt ballooned from $5 trillion to $20 trillion. If we did not know any better, we might argue that taxpayers, responsible for the servicing of this debt burden, owe the Fed a token of gratitude.

March 15, 2017, the Fed raised its target for the federal-funds rate by 25 basis points to a range of 0.75% to 1.00%. The S&P 500 surged +0.84% on the day, bringing the index within fifty basis points of its March 1 record close of 2,395.96. The first interest rate increase that followed years of rate cuts came in December 2015. Since then, the S&P 500 has climbed +15%. The market curmudgeons warned of a stock market crash once the Fed changed course.

From June 30, 2004 to June 29, 2006, the Fed raised its fed funds target on seventeen consecutive occasions. The rate increased from 1.00% to 5.25%. The S&P 500 rose +12% over the same period. The Fed began cutting rates on September 18, 2007 down to zero by December 16, 2008, during which period the stock market plunged -40%. (Reminder: history teaches us that a market recovery occurs 100% of the time. All market crashes are temporary phenomena.) From 1987 through 1989, the Fed hiked rates 27 times over 28 months, but stocks soared +26% during that time, which included the 1987 crash – case in point. From 1994 to 1995, there was a three-percentage point increase over 12 months. Stocks advanced +20% over the following six months.

Rate increases are not going to derail the market in the short to medium term. Economic data, as well as soft indicators such as confidence indices, all point to a more robust economy. Perhaps we need to hear it from a trucker, at the coal face so to speak. Here is a comment posted online, “You can feel it here in Detroit. I’m a truck driver, run auto parts, hit them all, I am dedicated to none. I hit the plants and the suppliers throughout Michigan, Indiana and Ohio. The air is different in the plants, it actually feels good to be in many of them. Prior to Trump, you could cut the air with a KNIFE. It was anger and hopelessness, that is what I felt, and I am being very serious about that. Now, things have changed, the feeling I get is a 180 from what it was just a matter of a few months ago. The guys on the dock are much more polite. The guys and gals cutting the paperwork are now actually helpful, and POLITE! I have had none of them snap at me…”

The state of the economy will drive the stock market despite the Fed’s gratuitous attempts to influence the capital markets. This is not to say that rate increases come without consequences. Those with credit card debt will feel the impact immediately. A quick Google search confirms a troubling statistic. On average, US households carry $16,000 in credit card debt. A 25-basis point increase translates into an additional interest cost of $40 over 12 months. As banks collect more income from borrowers, the frugal among us should begin to see higher rates on our savings, which currently earn us next to zero.

As the economy warms up, the demand for capital will increase. In response, the cost of capital will increase to a point where demand will taper off. The Fed, driven by fears of economic growth stalling will, as in the past, announce a cut in the federal-funds rate, which in itself becomes a self-fulfilling prophecy of economic doom. The “logical” conclusion in the media and among the intellectual elite would be that the Fed, in its infinite wisdom, obviously foresees an impending recession. Hence the need to lower rates in an effort to perk up borrowing demand – a futile exercise that distorts the natural course of economic cycles. When that happens, we can expect a major market correction. No fear, these, on average, do not last more than three to nine months.

As for now, the current bull market, albeit fairly pricey, has room to run. Time to sit down and enjoy a cheese omelet.