June 2018 Commentary

June 2018 Commentary

The Dow Jones Industrial Average (DOW) is back over 25,000 and is back to its normal ebb and flow after a very profitable, yet complacent 2017.  The broad stock market is up 2-4% (depending on the index being used) on a year-to-date basis through June 12, 2018 and volatility is now back to its normal range.  The S&P 500 Index’s price-to-earnings (P/E) ratio is now 16.6x down from 18.0x in January 2018.  Historically, the stock market has sold in the 12.0-18.0x range so it is now close to being back in the middle of the range rather than at the high end. So, with a P/E multiple at 16.6x and a strong corporate earnings outlook, I believe the stock market should continue to rise with earnings this year pushing the Dow over 26,400 and the S&P 500 Index over 2,900; implying an 8% stock market gain for 2018.  This estimate is based on the market discounting or “pricing-in” 2019 corporate earnings.

THE ECONOMY AND CORPORATE EARNINGS GROWTH.

As we are reading in the media, U.S. economic growth remains solid with business and consumer confidence at a 14-year high and businesses continue to hire new workers. The unemployment rate is currently 3.8% which is an 18 year low!  The Conference Board estimates US economic growth of 2.9% and 3.0% for 2018 and 2019, respectively.  Global economic growth is rising as well. The World Bank recently raised its Global economic growth estimate to 3.0% for 2018, up from its previous 2.9%.  S&P 500 corporate earnings are expected to rise 23% in 2018 and 9% in 2019.  The recently enacted corporate tax rate reduction contributes approximately 1/3 of the earnings growth in 2018.  I believe the stock market has already “priced-in” 2018 earnings, and any stock market gains in 2018 should reflect the markets’ confidence in the 2019 9% earnings growth being realized. 

TRADE AND GEOPOLITICAL ISSUES

Trade tensions remain an issue and causing uncertainty in the business community.  The Trump Administration continues to push forward to have our major trading partners remove trade barriers to reduce our $600 billion trade deficit. The U.S. has a $400 Billion trade deficit with China.  Did you know??  If a car manufactured in the U.S. is sold in China, a 25% tariff is imposed, and if a car manufactured in China and ships to the U.S., only a 2.5% tariff is imposed.  All apparel imports into China were assessed a 22% tariff, which is now being reduced to 10%. Even ice cream is assessed a 30% tariff!   If a U.S. manufacturer wants to bypass Chinese tariffs, they can build a factory in China.  However, in doing so, the U.S. company investing in the Chinese factory is required to forfeit 51% ownership and transfer its technology to China.  Many companies have acquiesced to these policies to gain a cost advantage and access to the Chinese market. Now let’s “Follow The Money”……  Each year China receives $400 billion of U.S. currency which it can use in several ways.  China has purchased billions of dollars of U.S Treasuries and, in essence, has helped fund our federal deficit.  Our politicians benefit because they can spend the funds and provide “goodies” to their constituents to get re-elected and maintain their power.  The result is that our children and grandchildren will be saddled with high debt and will be taxed at higher rates than would be the case if our Federal government did not run secular deficits.  China is also purchasing companies and real estate here in the U.S. Plain and simple, the trade deficit is a wealth transfer to China!

CONCERNS…WHAT COULD GO WRONG?

All eyes are on The Federal Reserve Board (FED) and interest rates.  Will the FED make a monetary policy mistake? Or will it be able to reduce its balance sheet and increase interest rates without damaging consumer demand and business investment?  The FED, with a $4 trillion balance sheet, is in uncharted territory after many years of implementing an “easy money” policy and infusing substantial liquidity into the financial system.  Time will tell how it will do, but I believe this is an important risk about which investors should be aware.

The U.S. Deficit is swelling again and is expected to be $800 billion to $1 trillion in 2018.  Congress recently passed, and the President signed (after a veto threat), a $1.3 trillion Omnibus Spending Bill that will keep the Government running through September 2018.  This budget, along with “non-discretionary- entitlements” spending, will push annual spending well over $4 trillion for 2018.   This is risky and irresponsible, in my opinion, when unemployment is at 3.8%! 

THIS IS THE PERFECT TIME TO REVIEW INVESTMENT STRATEGY AND AFFIRM PORTFOLIO POSITIONS.

 An investment portfolio’s allocation to stocks, real estate, commodities, bonds, and cash determines more than 90% of a portfolio’s potential return and risk.  We added “long short” funds to many client portfolios during the past two years to add to client portfolios equity investments with a measure of downside protection.  These funds have managed to capture much of the markets’ upside return while having approximately half the volatility or risk of the market.

Thank you … And as always … “FOLLOW THE MONEY”

Rich Lawrence, CFA

Disclosure:

This market update includes data we believe to be accurate. However, Lawrence Wealth Management (LWM) does not warrant or guarantee its accuracy.  Opinions about the future are not predictions, guarantees or forecasts. Investing in stock and bond markets have risk that could lead to investors losing money. 

January 2018 Commentary

2017: A year for the record books for the global stock market!! Global stock markets were up 13-25% depending on the index/market.  The combination of steady economic growth, low inflation and accommodating monetary policy all contributed to stock markets around the world rising substantially in 2017.  Stock market valuation is high, but can remain so if corporate earnings and dividends continue to rise with modest inflation. Ed Hyman, the well-respected wall street economist, notes that he does not see a recession developing in the next year or two and that corporate earnings should continue to grow 8-10% annually. Ed Hyman also reminds us that markets decline when earnings and dividends decline not when they are rising.  While I highly respect Ed Hyman’s views there is a limit to what an economist can forecast.  Most studies show that economists and the stock market are good predictors of the economy, but only for the ensuing six months.

2018 Outlook: We expect another positive year for the stock market, but returns may be more subdued and in line or slightly less than earnings growth. I believe a 6-9% rise in the S&P 500 Index is reasonable; based on current conditions. The S&P 500 Index price-to-earnings (P/E) ratio is 18.2x versus 15.0-16.0x historical average. History shows that 18.0x P/E ratios can be maintained with economic and corporate earnings growth.

Tax reform was finally signed into law at the end of 2017.  The central component of the tax reform legislation is the reduction of the corporate tax rate from 35% to 21%.  This component of the legislation is structurally imperative, in my opinion, for the U.S. to be competitive with other major economies around the world.  The average tax rate for the 35 OECD country members is 22%.  This new rate should encourage companies to invest capital here in the U.S. During the past several years many global US companies moved from the U.S. to lower tax jurisdictions. The new 21% U.S. corporate rate removes this incentive.

URGENT: review, change or affirm your investment strategy when markets are rising, not when they are declining.  We are conducting annual client reviews and confirming that our clients’ investment portfolios have the appropriate level of risk and growth prospects for their situation. As we all know, this “feel good” market environment is most welcome, but markets do go down when one least expects it. 

PLAN FOR LONG TERM GROWTH

PREPARE FOR PERIODIC STOCK MARKET DECLINES!

Rich Lawrence, CFA Managing Director

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3rd Quarter Commentary

October 2017 Commentary

Global economic growth is on the rise which has led to an increase in the MSCI World Stock Market Index by 15% on a year-to-date basis.   Global GDP growth is currently 3.2%, up from 2.5% last year.  The U.S. stock markets are up 11-15%, depending upon the index.   U.S. companies’ earnings should be up 10%+ in 2017 due to the rise in global economic activity, especially outside the U.S., and to the decline of the U.S. dollar. At the current time, US companies’ earnings are expected to rise 12% in 2018. For the most part, markets have not reacted to the political sparring in Washington D.C. and geo-political rhetoric between the U.S. and North Korea. The bull market appears intact for the time being. 

Are we due for a stock market decline of 5-10% (1,100-2,200 Dow Jones Industrial Average points)? The U.S stock markets’ valuation, as measured by P/E (price divided by earnings), continues to be high at 17.7x earnings compared to the 15-16x historical average.  This has been a continual theme for the past two years, while the market has climbed the proverbial “wall-of-worry”. The U.S. stock market periodically declines by 5-10% during most bull markets, but has not experienced a sharp decline since January 2016 when oil prices collapsed to $29 a barrel.  I believe the stock market is setting itself up for a correction considering investor optimism, high valuations, and low interest rates. Typically, when a negative surprise occurs with this backdrop, a correction is likely. 

Primary risks to our economy and stock markets: the reduction of the $4.5 trillion Federal Reserve balance sheet, and a tight labor market. The Federal Reserve (FED) built up a $4.5 trillion balance sheet of US Treasury and mortgage-backed securities as it was providing cash into the economy to stimulate growth. The FED is now planning to reduce the size of its portfolio to “normalize” its balance sheet.  In doing so, if interest rates rise more than expected the stock market may decline in anticipation of economic growth being constrained.

I continue to advise clients to invest in the stock market for the long term, while having sufficient cash and bonds in one’s portfolio to ride through the next bear market.  Although both optimism and complacency are in the air, we can expect to have a bear market and recession at some point in the future.  During the past 18 months, LWM has been adding “long short” investments to most of our clients’ portfolios.  These investments are designed to capture most of the market’s upside returns, while being exposed to only approximately half the risk of the market.

Rich Lawrence, CFA Managing Director

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Is Economic Growth On The Verge of Rising?

I ask if economic growth is on the verge of rising for a very specific reason. The stock market in 2016 is up 10% as measured by the S&P 500 Index, led by materials, industrials, financial and telecommunications stocks; and with health care and consumer staple stocks being the two worst performing sectors. In addition, gold and bond prices are on the decline. Please note: when bond prices decline interest rates are rising. This market behavior is classically associated with rising economic activity and certainly not indicative of the latter stage of an economic cycle.

1-2% Real GDP Growth

This market behavior may cause confusion to many, especially after nine years of economic expansion. Although the U.S. economy has been expanding, it has done so anemically with 1-2% real GDP growth. This compares to 6-8% annual GDP growth immediately after the deep recession of 1981 when the unemployment rate hit almost 10%. Then in the 1980s and 1990s GDP growth was 2-5% annually.

After eight years of so-so economic growth, corporate and consumer balance sheets are in good shape and not overextended as is usually the case when the economic cycle is nearing a peak. The U.S. government however continues to run deficits, and its share of GDP has expanded from 19 to 21%. Obviously our government has not had the will to curtail expenses, and its balance sheet poses risk to our economy and taxpayers.

A Republican President and a Republican Congress

What should we expect with a Republican President and a Republican Congress? The Trump campaign and policy initiatives were straight forward: reduce regulations; cut corporate taxes; increase infrastructure spending; renegotiate trade agreements, rebuild the military; and border control. These initiatives are pro-economic growth and the markets responded swiftly.
Some observers (pre-election) opined that the federal deficit would expand regardless of the election outcome. However Mitch McConnell (Senate Majority leader) stated last week that any corporate tax reduction must be matched with budget cuts to fully offset the revenue decline. So let the bargaining begin!

Higher Economic Activity

The stock market is an excellent economic predictor for six months, but that is about all. The market is expecting solid low-teen earnings growth in 2017, along with rising inflation and interest rates. If our government enacts policies of lower taxes and regulation the “animal spirits” of our country may finally be ignited resulting with capital investment and business formation. The result: higher economic activity.

Primary Market Risks

I envision two primary market risks as 2017 unfolds: saber rattling as we attempt to slow the transfer of U.S. wealth to China, and to a lesser extent a strengthening dollar.

As we all know we are in a $400 billion trade deficit annually with China. Why does this matter? Let’s “follow the money”. We sell China plenty of products, especially high technology and complex industrial products. China sells us a wide variety of products from low to high tech, most of which have a high labor content. There is a well know economic theory called comparative advantage that supports free trade. Essentially, comparative advantage stipulates that trading partners all win when each country produces that which they can produce most efficiently. And if trade balances are equal both trading partners win through sharing higher productivity.

Wealth Transfer to China

Our trading situation with China is far different. The regulatory environment of the U.S. and China could not be more different in term of labor laws, environment and market access. Our trade deficit with China has been running between $300 and $400 billion annually for the past few years, and is literally a wealth transfer to China. These deficits provide China with $300 to $400 billion of U.S. dollar currency which can be used to buy U.S. Treasury bonds, businesses or real estate around the globe including back here in the U.S. If this trade imbalance goes unchecked, we will see a slow but continued wealth transfer to China.

President-Elect Trump brought this issue to the fore and it is at the cornerstone of Trumps economic policy. I expect both countries will be pushing back against each other providing uncertainty and potentially stock market corrections. The good news is that both countries are economically dependent upon one another, so both economies will benefit greatly if trading activity remains brisk but moving back into balance.

Is economic growth on the verge of rising? Most indicators suggest our economy is gaining momentum. If you have questions about economic growth, financial planning, or would like to learn more about investment management advice offered on a fee-only basis, contact me Richard Lawrence at Lawrence Wealth Management LLC, a small, private investment firm. Phone 215-540-0896; email rich@lawrencewealthmanagement.com.