Kenneth Arrow, Nobel Prize-winning economist, and one of the most influential economists of the 20th century died in 2017 at the age of 95. While Dr. Arrow’s contributions are many, he is most quoted for his anecdotes about World War II. During the war, Dr. Arrow was assigned to be a weatherman and tasked with making long-range predictions about the weather. He soon realized these forecasts were no better than random guesses, but when Dr. Arrow pointed the problem out to his superiors, he received a quick reply, “The commanding general is well aware that the forecasts are no good. However, he needs them for planning purposes.”
As we begin the new year, the news is full of predictions and forecasts by great minds and famous investors. In this environment, it is important to remember that no one, not even those in the news can predict the market, and research shows that these forecasts are little better than random guesses. Remember the quotes from 2016 when experts like Gross, Icahn, Gundlach, Grantham, and others said that in 2016 the stock market was at a peak? Nonetheless, many, just like Dr. Arrows anecdotal general, still need these forecasts for planning purposes.
At Cedarstone we like to believe that, just like the weather, we cannot predict the market, but we can take the temperature. We admit that we cannot accurately predict what will happen in 2018, but instead seek to build portfolios that have the best opportunity to achieve our client’s goals. Given that approach, here is what we see as the temperature of the market today. Stock Market Highs We continue to hit stock market highs, and prices are somewhat expensive by historical standards. Stocks have quadrupled since the great recession’s stock market bottom in 2009, and 2017 showed tremendous gains, leading some to believe we're in a stock market bubble. However, a look at the underlying data shows that there are reasons for the market’s highs. Economic growth is surging both domestically and internationally, driving up corporate earnings. Oil is cheap, and the US Dollar is lower. The Federal Reserve is still accommodative. Inflation is tame (for now), and US consumer confidence is strong but still far from its historical peak. Let’s look at a few of those key areas.
Strong Earnings
We hold to a simple principle that earnings drive stock prices and earnings are strong. Profit margins for 2017 were 6.7%; healthy but far from historical peaks. Corporate investment has recovered and exports have significantly increased for US Corporations. Also, most analysts agree that the new tax law will add about 8% to the earnings of US Corporations. The tax bill has certainly pushed the market higher, but it is impossible to accurately determine how much of the recent increase is due to the new tax laws.
Federal Reserve Policy Accommodative
While the Federal Reserve has ended its quantitative easing and has begun to raise the Federal Funds rate, the overall policy is still very accommodative, and the Federal Reserve Bank is still cautious about raising rates. As we have said in the past, it is not the first hike in rates that matters. It is the last hike in rates. The first rate hike is only the beginning of the tightening cycle, and overall policy can be very accommodative for months or years after the Federal Reserve begins its tightening. Further, the European Central Bank has continued its quantitative easing program, holding down European rates and global rates through their continued intervention. Meanwhile, inflation is still tame at 2.2% giving the Federal Reserve room to allow the economy to grow.
Consumers are strong, but not irrational
Finally, consumers are in good shape with wage growth accelerating from 2.2% annually for the past eight years to 2.5% in 2017. Household net worth has fully recovered from the recession and consumer sentiment is strong but nowhere near the irrational levels seen during the tech bubble.
The Long Term
One of the more interesting milestones during 2017 is that the stock market caught up to its long-term trend line. In spite of the great recession, and all of the ups and downs of the last decade, those that held on were rewarded with simple, consistent returns over the long term. As we reach these market highs, it is important to remember that declines will come, but that those who think strategically and over the long-term are rewarded. Perhaps that is the best lesson we can take into 2018.
McDonough, Megan. "Kenneth Arrow, Nobel laureate and seminal economist with wide impact, dies at 95." The Washington Post. Feb. 21, 2017. https://www.washingtonpost.com/national/kenneth-arrow-nobel-laureate-and-seminal-economist-with-wide-impact-dies-at-95/2017/02/21/089c3888-f8aa-11e6-be05-1a3817ac21a5_story.html?utm_term=.3f62bb8dfd1e
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