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End of Year Market Summary from Beirne Wealth Consulting

Friday, January 8, 2016

“The cause is hidden, but the result is known”,  Ovid (1st century A.D.)

Were Rip Van Winkle to awaken today from his 20-year sleep, he might be as disturbed as he was upon awakening in post-Revolutionary America, the picture in his favorite inn now George Washington and not George III.  Now Yellen I (and her comrade across the pond, Draghi the Terrible) reign over a Central Bank-ruled world of negative short-term interest rates (once considered impossible by economists) and a stock market near all-time highs despite a sub-par economy.  Hopefully, we’ll try to make sense of this looking-glass world, shedding some light on Ovid’s “hidden causes”.

The U.S. economy has grown at an annual rate of only 2% for the past six years.  This contrasts with a post WWII average (aka “trend line” growth) of 3.24%.  This difference is more significant than is commonly portrayed.  The difference between 2% growth and just 3% growth over six years is a cumulative 6.8%, amounting to $1 trillion in today’s $16.5 trillion dollar economy.  That’s a lot of “missing” income!  The depth of the “Great Recession” in the wake of the 2008 crisis is often cited as the cause of this anemic growth.  This is disingenuous.  We have had other recessions equally or more severe than the “Great” one.  The double-dip 1980-81 recessionary environment was significantly worse, with both unemployment and inflation at double-digit levels (Remember those 18% 30-year mortgage rates?).  Yet, the economy rebounded and experienced 4.8% growth per year from 1982 to 1986 in the wake of tax cuts and deregulation (in airlines, telecommunications, trucking, and railroads among others).  A more likely cause of the recent malaise is the unprecedented amount of deficit spending and a huge and growing regulatory burden.  Since the crisis, over 21,000 new rules and regulations (taking up almost 500,000 pages) have been added to the Federal register.  If you own or run a business, you know this; if you don’t, seriously, ask someone who does.  Certainly some of these regulations are good and necessary, and reflect rules regarding new areas of the economy (social media, for example), but a more conscious cost-benefit approach is needed to minimize the drag on economic growth imposed by so many regulations and the attendant bureaucracy that feeds off of them.

The stock market ended 2015 essentially flat (down 0.73% as measured by the S&P 500).  This brings us to seven years without a significant down market (2011 was also flat, almost exactly in fact).  The only better stretch since 1960 is the eight-year bull market from 1982 to 1989.  That market, however, accompanied near unprecedented economic growth and job creation, while the current market has increased over 200% from the 2009 lows amidst the aforementioned tepid growth.  We feel that three factors explain much of the market’s recent buoyancy.  One, low interest rates have more or less forced investors into equities.  Big pension funds, endowments, trusts, and the like pretty much invest in stocks and bonds, and hold some cash.  While some funds dabble in “alternative” investments (hedge funds, real estate, private equity, etc.) the amounts committed to these are relatively small (to non-existent for most large public pension plans).  With actuarial return targets of 6-8.5%, a world of 10-year bond yields of around 2% drives them out of fixed income.  Even risky “high yield” corporate bonds have hovered in the mid-single digits for most of this decade.  So it’s equities or bust.

Two, corporate buybacks of their own shares have reached historically unheard of levels in the past decade, amounting to approximately $7 trillion dollars!  This in a market with a total capitalization of about $20 trillion.  For one example, as of September 30, 2015, ExxonMobil had $229 billion in (bought back) Treasury Stock vs. total assets of $341 billion.  Some of these buybacks are in lieu of cash pidends and some are offset by new shares (often the result of corporate officers exercising vested options), but this huge structural buying has nonetheless propped up the market.  

Both of these factors have been cited by many pundits and publications, but there is a third factor that we feel has gone relatively unnoticed and may be the most important in explaining the market’s recent behavior.  In the mid-1970s, there were approximately 5000 investable stocks in the U.S. market.  In 1974, Wilshire & Associates created the Wilshire 5000 Index, meant to be the most comprehensive measure of the U.S. market and named for the number of stocks available at that time.  GDP in 1974 was only $1.5 trillion.  As the economy expanded in the 1980s so did the number of firms in the market.  The Wilshire 5000 grew to 7562 names by mid-1998, with GDP then at $9 trillion.  Now, with GDP at $16.5 trillion, the number of stocks in the Wilshire 5000 is only 3691, over a 50% decrease in the new millennium!  This is astonishing.  The ever-growing pool of pension, endowment, and trust money is chasing an evaporating pool of stocks, forcing valuations up beyond where they would be with more choices.  Where are the “missing” companies?  No doubt some firms have remained private, largely to minimize the impact of regulation (such as Sarbanes-Oxley), but the number and size of privately-held firms does not near match the “gap” between 3691 companies and an expected 9000 or so.  This same factor goes a long way in explaining the sluggishness in the economy, the shrinking of the number of people in the workforce, wage stagnation, etc.  While many factors are at play here, it is hard to escape the conclusion that excessive regulation and the developed world’s highest corporate tax rates have significantly impeded new business formation in the U.S. and have driven much of it offshore.

Before concluding, we’ll venture into the dangerous land known as forecasting, mostly because it seems de rigueur in pieces such as this.  That said, it’s good to remember the great physicist Neils Bohr’s contention that “prediction is difficult, especially about the future”!  We’ll start with interest rates.  Despite the Federal Reserve increasing the Fed Funds target (for the first time since 2006) to 0.50%, we don’t see rates increasing much in the next two years.  We think that even the Fed’s own target of 1.375% for Fed Funds next year looks too aggressive.  Rates are going the other way in Europe and the dollar is already the strongest it’s been in a decade.  The economy is not nearly as robust as it has been at the beginning of prior tightening cycles.  And 2016 is a Presidential election year.  In our next piece we will further address the constraints binding the Fed from being very aggressive on rates.

As regards the U.S. stock market, we see 2016 playing out much as 2015, namely, boring.  While a 10-20% decline wouldn’t be a shock, or even a bad thing, the aforementioned three factors are still in play and declines will be seen as a chance to put new and idle cash to work.  The bears will most likely remain in their extended hibernation.  That said, significant upside seems capped also.  The market goes up for only two reasons:  either earning increase and/or the market values a given dollar of earnings at a greater multiple.  With respect to earnings, at 9.9% of GDP (as of September 30) they are over 50% higher than the long-term average of 6.5% and near an all-time high.  Given the strength of the dollar and the other structural factors weakening the economy, no burst in earnings is in the offing; more likely we will see tepid growth, mirroring the economy as a whole.  As for valuations, theoretically there is no limit, but as measured by the Case-Shiller CAPE (cyclically-averaged price earnings ratio) at 26, the market (on its way up) has only been valued higher twice, inauspiciously in 1929 and 1999, both just before major market corrections.  So it doesn’t appear that higher valuations are going to drive the market much higher, and if they do, then care be taken!   We will discuss the prospects for oil and gold in a subsequent piece.  Happy New Year!

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