BWC Market Update - February 14, 2017
“There are known knowns, … there are known unknowns, … but there are also unknown unknowns.”
Well, the sugar rush from the holidays is over and the blare of New Year’s horns is but a distant ringing in our ears. In 2016, the U.S. equity market extended its string of non-down years to eight, matching the longest such streak since 1960 (namely, the ’82 - ’89 bull market). A year ago we thought the Fed was too bullish on short-term rates for 2016 (with a 1.375% year-end target that proved 62.5 basis points high), that bonds were probably at the end of their third-of-a-century-long bull market (the ten-year bond fell over 4% year-over-year and considerably more after yields rose over 100 basis points from their lows last spring), and that the equity market looked to be “boring”. Count us right, right, partly right, and very lucky. What of 2017? The market so far also seems to be over its own election-induced sugar high and appears to be in a “wait and let’s see” mode.
There are clearly anticipated positives for the market with the change in presidential administration, and they were quickly “priced in” after the election. They include a reduction in onerous business regulations, lower corporate tax rates, a more constructive approach to health care reform, and a more business-friendly way of dealing with climate change, among other things. But it is easy to tally the negatives also: a very strong dollar curbing exports, trade frictions, if not outright wars, weakness in Europe, and an exploding deficit (tax cuts reduce revenue quickly, but the attendant economic growth they are designed to spur takes longer to come on line). Then there’s always the potential for the manifestation of an “unknown unknown”, which could be geopolitical (revolution, war, etc.), terror related, or a natural disaster (case in point: on January 9, a building-size asteroid that hadn’t even been noticed whizzed by the Earth well inside the orbit of the Moon, an eyelash-width miss in astronomical terms. A hit in a place like NY or Tokyo would be an unprecedented disaster in human history).
That cheery thought aside, as we asked, so what of 2017? The known knowns are just that, and they are the positives we listed above. The known unknowns are the degree to which the listed negatives come into play. The unknown unknowns … we won’t even go there! That said, we feel the Fed is probably once again over-optimistic on short-term rates. For example, weakness in something like auto sales (which reached a record high last year) could quickly trim the Fed’s own sails. We made the case last year that longer-term rates can’t rise too fast given the refinancing needs of governments at all levels and the harm such increases would do to pension and insurance portfolios that hold a lot of long-term debt. That thesis is still firmly in place. Nevertheless, longer-term bonds should be at historic low weightings given their longer-term richness. The equity market once again looks to be mostly boring. If we’re right, that’s not a bad thing! Given the rate situation and a recent uptick in inflation expectations (as reflected in the yields of TIPS, or Treasury Inflation-Protected Bonds), the secular case argues for equities. That said, on an earnings valuation basis (which, we addressed several times last year) the market is over-valued and, as mentioned at the outset, this bull market is getting long in the tooth. A correction (down 10%) or even a bear market (down 20% or more) this year is a known unknown, and should be taken in stride, if it happens. IF the market turns down, once firmly in correction territory or worse, investors should be looking to put money to work for the longer term. That wouldn’t be a bad thing either! Tricky, huh? If the market is flat, we’re right; if there’s a correction or bear market, we’re right; and if we’re wrong and the market rallies strongly this year we’re pleasantly surprised! Happy New Year and steady investing to all.