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Predicting The Future Is Hard

“Conditions for a hard economic landing — like slack in the labor market and weak balance sheets — are still largely absent.”

If the case for U.S. stocks is built on global growth and lower interest rates, other factors, too, suggest that the market is heading higher. For one, Washington is determined to avert a financial disaster, particularly in an election year….

Bull markets rarely end when the earnings yield on stocks — now around 6% — is higher than benchmark bond yields.

While some fear this year’s peak profit margins will wane, __________ says “margins will prove sticky at a high level” after years of cost-cutting. A 35% decline in leverage in the past five to seven years has made for healthier balance sheets, and continued stock buybacks are likely to keep boosting earnings per share.

Then there’s the market’s modest valuation. The S&P 500 trades today at just 15.6 times average estimated earnings — well below the average P/E of 18.6 times earnings during periods when inflation was at similarly muted levels in the past 57 years…

Stocks are “screamingly cheap relative to bonds.”

“The right time to get more aggressive [about the stock market] is closer to the end of the Fed’s easing cycle,”

“While the first half may look like death, second-half earnings will improve….

“The consumer is not dead!”

What’s more, the richest 20% of Americans drive 40% of the country’s consumer spending, and their outlays are less restrained by rising gasoline prices and higher mortgage rates.

All of those quotes above are from a late 2007 article by Kopin Tan in Barron’s headlined A Bullish Call. I’ve left out the names of the people saying what in retrospect were ridiculous things about the outlook for stocks in 2008. I’ve gotten plenty wrong in my career and my point here is not to pick on others who have trouble predicting the future course of the stock market or anything else for that matter. The most important character trait of a good investor – and one that is largely lacking on Wall Street – is humility. Realizing that you don’t know what the future holds and that even the things you are most sure about may not be, will make you a better investor.

It is quite eerie to read some of those quotes from just a few months before the biggest financial disaster since the Great Depression. Some of the same arguments are being used today by Wall Street’s soothsayers to justify staying bullish on a stock market that has surpassed even the most bullish expectations. Job growth and strong corporate balance sheets – neither of which I think are as good as the bulls think – are still being touted as reasons to stay bullish. The fact that it is an election year – mid-terms this time – is seen as a reason to be bullish. High profit margins – which plunged in the recession – are expected to continue. Valuations based on expected – predicted – earnings are not outrageous. Stocks are cheap relative to bonds based on earnings yields. The end of an easing cycle – expected in 2007 but obviously a bit early – is not seen as a reason to worry. And of course, things will get better in the second half of the year. That has become a perennial prediction during recent years.

So does that mean we will get the same outcome as 2008? That hardly seems likely. History does not repeat exactly and there are some significant differences between today and 2008. The next recession and bear market may not look anything like 2008; it could be worse, it could be better but I’m pretty darn sure it will be different. Investors are always looking for that period in the past that will inform them of the future. It is a fruitless search, a waste of time and will probably yield poor investment results. In important respects, it is always different this time. That certainly doesn’t mean you should ignore history. There are some universal truths; greed and fear always move markets but the exact nature of the events that lead to them often differ in the details.

I think most investors have the wrong idea about what it means to be bullish or bearish about an asset class such as stocks. Being bullish or bearish is not an all or none decision. Believing that the US stock market is richly priced does not mean that all US stocks are richly priced. It just means that the market, taken as a whole, is priced at a level that involves an above average level of risk. That risk, as last year so amply demonstrated, may not be realized in the short run or even what some might consider the long run. But the risk still exists and investors should take it into account when allocating their assets.

Peter Bernstein, one of the greatest investors who ever lived, once said: Survival is the only road to riches. What that means to me is that, in a world where the future is unpredictable (that would be the one we live in), one must take into account the worst case scenario as an investor. What you shouldn’t do, as the quotes above prove, is take conditions as they exist today and assume they will continue into the future. Profit margins are always high when the economy is expanding and they always fall in a recession. You may not know when a recession will come but you know it will. Survival investing dictates that you take into account what happens to margins in a recession. Stock buybacks – at least since tax reform made them preferable – are always high when things are good and always disappear when the market needs them most.

You don’t have to know exactly how things will change just that they will. In any scenario with multiple potential outcomes you have to at least consider all the alternatives. No matter what you expect, you have to assign some probability to the opposite outcome. If you believe the economy will accelerate in the second half of the year, what are the consequences of being wrong? In a highly priced market, being wrong about future growth could prove quite costly. It is the consequences of being wrong that reveal your true risk level.

At Alhambra we see a lot not to like about the current economy. In fact, we see a lot about the economy of the last few decades not to like. But we don’t know any more than anyone else when the next recession will come. What we do know is that this expansion, based on history, is pretty long in the tooth and we are likely closer to its end than its beginning. We know that the US will have another recession and when we do, profit margins will contract and stock buybacks will whither away. Stocks that appear cheap based on current estimates of future earnings will suddenly look quite expensive when the estimates prove too optimistic. At present valuations it is quite possible that the S&P 500 could fall 50% or more before finding a bottom in a recession. Every investor needs to consider how their portfolio is structured and whether they could survive that kind of drawdown without blinking and selling at the bottom as so many did in 2008.

We don’t need a crystal ball to invest. We just need some common sense and a sense of self-preservation. Own less of the things that are expensive and more of the things that are cheap. When the market is rising and the bulls are running the show, think like a bear. When the bears are growling, think like a bull. There are times and conditions when it makes sense to invest for maximum returns but they are rare and very, very hard to act on. The rest of the time, an investor’s focus should be on survival and living to fight another day. Predicting the future is hard – and unnecessary.

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“Wealth preservation and accumulation through thoughtful investing.”

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@alhambrapartners.com or   786-249-3773. You can also book an appointment using our contact form.

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