From the January swoon, to the BREXIT vote in June, to the surprising presidential election in November, stocks rode a wave of volatility with generally an upward bias in 2016. Now that 2016 is over, we would like to reflect on a few events that we believe will impact markets in 2017 and, in some cases, beyond.
Despite a very rough beginning to 2016 (The index’s 8% decline in the first 10 trading days represented the worst start to a year on record), equity markets ended the year at all-time highs. The rally, much of which took place in the second half of the year, was so strong that many forgot about how severe the decline was in January and February. But, with each tick above the 2015 all-time high, all the business channels broke out the party hats to declare a “new record for the Dow.” The celebratory tone did little to inform investors of what was really happening inside the market.
The BREXIT vote was surprising to many, including us. The “smart money” bet was for the U.K. would remain in the EU and markets would remain calm. The vote went the other way on a wave of populist dissatisfaction that foreshadowed what was to occur here in the U.S. a few months later. The rally that followed the BREXIT vote also foreshadowed what would happen after the presidential election.
The outcome of both the BREXIT and U.S. presidential vote highlighted the public’s growing dissatisfaction with the status quo and deepened their distrust of various polling data and opinion any “expert” deemed to be part of the “establishment’s” view. This extreme reading on the meter of sentiment is an important development to us because it is clear evidence of the public’s exhaustion and frustration with the status-quo. A common indicator found at the beginning of every 17-year growth cycle is this type of exhaustion on the part of investors.
While we correctly predicted a Trump victory back in July, we were caught a bit off-guard by the strength of the rally that followed it. Despite being a bit underinvested, our managed accounts did keep pace with the market’s performance. While it is fun to say that we predicted the outcome of the election earlier than many, what matters is how this outcome will affect markets going forward. This is a critical exercise for us here at KIG as our research suggests the markets are on the cusp of a protracted growth period that will resemble 1914-1932, 1948-1965 and 1982-1999. To get a sense of how likely it is that the beginning of the next 17-year growth cycle is upon us, let us look at history for some clues.
To begin, identifying similarities to the most recent cycle is most helpful as it is a personal memory of many investors today and easily researched by those who were too young at the time. Our focus will be on comparing President Reagan and President Trump, Fed Chairman Volker, Bernanke and Yellen along with a few economic and investor sentiment indicators.
In the cases of Reagan and Trump, both were swept into office on a wave of voter discontent. Much of this discontent was directed at “establishment” politicians and the result of a languishing economy. Both presidents had backgrounds in entertainment and were considered political outsiders, notwithstanding Reagan’s stint as Governor of California. They both made the economy their primary policy focus. They both have tax cuts as a centerpiece of their economic plan. Both also entered office at a time when the Federal Reserve was on the cusp of a protracted string of interest rate increases (time will tell if we are correct about the current Fed.) Maybe most importantly, both presidents entered office at the end of a 17-year period of lackluster stock market performance. More on that later.
During the 17-year period leading up to Reagan’s election, both political parties tried to deliver economic growth but failed. A similar failure occurred during the last 17-years as the Republicans and Democrats failed to deliver on sustained economic growth.
Our view is it might not have been their fault despite how easy it is to pin it on the president. Consumer and investor behavior, influenced by the previous 17-year cycle, overwhelmed any effort by the President to invigorate the economy with policy. Following the market peak of 1965, the next 17-years were characterized by slow growth and stock market swoons. What led to this was the fact that investors were heavily invested in stocks by 1965 (due to strong performance) and, thusly, stocks had no incremental buyer to lift prices. In other words, everyone who wanted to invest was invested. Furthermore, economic expansion had gotten ahead of fundamentals and led to a cyclical downturn in the economy. The OPEC crisis, Watergate, the Vietnam War and other geo-political and social matters took center stage at the expense of the economy during this period, too.
It took more than a decade for the economy to steal back the spotlight from social and geo-political issues. Simply put, it takes time for the pendulum of public opinion and political will to swing from economic to social concerns and vice versa. It is during this 17-year period that investors and consumers change their behaviors. At economic peaks, public attention (and therefore political attention), turns to social issues that have been brushed aside during the economic expansion. At the peak of social considerations, attention turns to the economy which has been brushed aside. We believe we are transitioning from a period where social policies are front and center to one where economic policies rule the day. This is what happened with each of the presidents who came to office at the beginning of a 17-year growth cycle. In 1914 it was Woodrow Wilson who created the Federal Reserve Bank. In 1948 Truman signed the Marshall Plan which put returning GI’s to work rebuilding post-war Europe. It is also worth noting that Eisenhower launched the Interstate Highway System which had a dramatic effect on economic growth in a similar way to the intercontinental railway and internet. In 1982, Reagan signed tax reform which reduced the highest tax rate from 70% to 50% and continued to lower it to 38.5% by 1987. In each example, the president launched significant economic policies in response to protracted periods of economic sluggishness.
As we enter 2017, it is safe to say that neither political party had much success propelling the economy to toward the healthy growth rate of 3-4% experienced during the last 17-year growth cycle. Geopolitical and social concerns, such as the Gulf War and ObamaCare, took center stage. The “Financial Crisis” of 2008-09 had a similar effect on the stock market as the 1973-74 recession. The main difference between the two is that the Financial Crisis of 2008-09 saw credit dry up while the 1973-74 crisis was characterized by expensive (higher interest rates) credit. However, the equity market dropped by 50% in both cases.
In both cases, the dramatic drop in equity prices “set the hook” for investors, who had already grown weary of owing stocks, and led to a cyclical outflow of money from equities. In a reflection of this broad sentiment, a famous headline from the August 13, 1979 edition of Business Week read, “The Death of Equities: How Inflation is destroying the stock market”. When sentiment reaches such an extreme, history suggests a turn in stock prices is nearing. Therefore, we try hard to identify when extremes in sentiment line up with the 17-year cycle. Inevitably when public sentiment turns extreme (positive or negative) it creates an opportunity for investors. Thusly, we are looking for opportunities, on behalf of our clients, that could deliver significant appreciation over the next decade and beyond.
To further draw a comparison between the recent 17-year stagnant cycle to that of the period 1965- 1982 (the last stagnant cycle) we note that both periods saw a 50% decline in stock prices. Interestingly, the amount of time between the 50% decline in stock prices in 1974 and the beginning of the next 17- year cycle, which began in 1982, was 8 years. Likewise, it has been 8 years since the March 2009 low of the Financial Crisis when equity prices dropped 50%. Both declines reached “generational lows” that marked the lowest prices for stocks from that time forward. While the jury is still out on whether the 2009 low will be a once-in-a-lifetime event, we believe it will. The 34-years that separate these two generational lows lines up precisely with the alternating 17-year cycle. This suggests the next “generational low” is sill 26 years down the road. Of course, healthy and normal declines are ahead, but we believe a major decline in equity prices, such as those in 2008 and 1974 are well down the road.
Another “clue” that we are at the beginning of the next 17-year growth cycle lies with tax reform. During his first term in office, Reagan was successful at pushing for legislation that effectively cut the highest marginal tax bracket 70% to 50%. There is much debate about the long-term effect of this tax cut but our focus, as an investment manager, is on its impact on investor behavior. Of those who benefited from this dramatic tax cut, most were business owners. At a 70% tax rate, these business owners had little incentive to earn an extra dollar as 70 cents of it went to the federal government. The tax cut helped to incentivize business owners to earn more money which led to job growth as they expanded their businesses. This is a simplistic view of the tax cut’s effect but very much a real one.
While many Republicans continue to clamor for lower tax rates, today’s rates are already lower than they were after Reagan’s tax cut went into effect. So, any reform of individual tax rates will have limited impact on economic growth. However, U.S. corporate tax rates remain high as compared to other countries. The decision by many large companies to move their headquarters overseas was driven by this disparity. Bringing the tax rate in line with other competing countries might not only stem such moves, it could encourage foreign companies to move to the U.S. Additionally, the amount of corporate cash sitting overseas has grown to record levels. Repatriating this corporate cash, via a lower tax rate, would not only increase tax revenue for the U.S. it could very well invigorate corporate spending on growth. The President has started the conversation to tackle tax reform. We will be paying close attention to action on this critical issue.
Our view on Fed policy is key to our forecast for stocks in 2017. We expect the Fed to raise interest rates at least three times this year. More importantly, we believe there will be a “fear” of further rate hikes. This “fear” will remind investors of the adage, “Don’t fight the Fed.” The 1994 Fed cycle, which included 6 consecutive interest rate increases, is called to mind when contemplating what might be in store for the equity market in 2017.
In 1994, equity prices were volatile and ended the year lower than at the beginning of the year. However, because of short-term interest rates rising, bonds suffered mightily. Investors in bond mutual funds found out how bond prices are affected by a change in interest rates. As interest rates rise, bond prices go down. However, in the case of bond mutual funds, the effect is more pronounced due to investors moving funds out of the fund as prices drop. Ultimately, a lot of the money that was in bond funds moved into stock funds which helped to propel equity prices higher. However, there was a painful transition period that happened beforehand.
The Fed raised interest rates in December of 2015 and again in December of 2016. These two rate increases have not had a dramatic effect on equity markets, which is good, as they are important steps toward “normalizing” interest rates without the need to do so rapidly as we saw in 1994. We will be focused on any change to this measured approach to raising rates. If we sense that rates are accelerating higher, it could weigh on equity prices as investors fear it will slow the economy and, therefore, profit growth. If the Fed does not raise rates multiple times this year, it will be because the data suggests to them that the economy is still not ready for normalization. The point, is we anticipate equity markets will be looking for direction throughout the year.
There is nothing about the nascent Trump Presidency that changes the central assumption, guiding our outlook for the remainder of 2017. We still believe that we will see the transition from a long-term, sideways, low-growth cycle, which started in 2000, into a 17-year growth cycle ahead. That is not to say that this transition will be quiet and orderly. There will very likely be more volatility or bigger moves in stock and bond prices than we have experienced the past two years.
We cannot fixate on the exact timing of this “transition”. Too sharp a focus on being “correct” may lead us to miss information and trends that would benefit our decision-making process. So our process will be to “feather” into and out of our exposure to the equity market at points when our indicators suggest the market is “overbought” or “oversold” in the short-term.
There are a few items in the political realm that could give a boost to or be a drag upon stock prices. There are a critical number of powerful parties interested in corporate tax reform. The optimism seen in the market since the election has been due, in some part, to a belief that this will be a priority for the new administration. A significant delay in taking this up may be a cause for concern for investors. Business leaders are encouraged by an Executive Order to drastically reduce the regulatory burden on their businesses. The details of implementation are important if we are to assume that a reduced regulatory burden is a rationale for higher stock prices. Finally, with regard to political levers, the fate of the Affordable Care Act or Obamacare likely matters to stock prices in the health care sector. It does not appear that a quick repeal and replace agenda will carry through. This will prolong the contentious debate on health care and a host of complicated issues that will likely keep a lid on the prices of health care stocks. These are all factors that could cause the overall stock market to stumble in the short run, despite the long-term macro transition upon us. To put a number on “stumble”, we’ll define it as 4% to 7% decline from the all time highs we are currently hovering around. A much larger decline into bear market territory would require a move of 20% or more. It would be reasonable to expect a big move down, if for no other reason than we are overdue. This possibility is always present. However, currently it doesn’t appear imminent.
This will be a period of time where discernment is particularly valuable. The overall market may appear to be relatively still while billions of dollars are rotating from one S&P 500 sector to another. By keeping a focus on the sector level analysis, we are more likely to see opportunities to grow and preserve capital for our clients.
Kessler Investment Group, LLC