Happy September! Now that the month is upon us, the kids back at school and the weekends filling up with tailgates or trail runs (or both, even better), it’s time to think about that possible rate hike a couple weeks away. Just kidding – we’re not thinking much about a September hike because we think that is well and truly baked into the cake already. We’re thinking more about that possible December hike, the year’s fourth, which is less fully priced into current asset markets but which we see as increasingly likely. Today’s job numbers add a resounding notch to our convictions.
Meet the New Data, Same As the Old Data
Sometimes it can seem like the world is changing in unimaginable ways every day. However, one just has to study macroeconomic trends over the past four-odd years to be reassured that, economically speaking at least, not much ever seems to change at all. We often use the chart below in client discussions to drive this point home: in terms of jobs, prices, sentiment and overall growth – the big headline data points – the story more or less remains the same.
In brief: monthly payroll gains have averaged 215,000 in 2018, including today’s release showing job creation of 201K in August (and also factoring in a downward revision to July’s numbers). Real GDP growth is above-trend, consumer confidence has not been higher for literally the entire millennium, and consumer prices are above the Fed’s 2 percent target for both core and headline readings. This composite view suggests a fundamentally stronger economy than the one we had in between the two recessions of the previous decade. What is inconsistent with this picture of strength is a Fed funds rate staying much longer at 2 percent. It was 2 percent at the end of 2004, on its way to a peak of 5.25 percent by the time that growth cycle peaked. With the caveat that nothing in life is ever certain, including economic data releases, the picture shown in the above chart tells us to plan on that fourth rate hike ringing out the old year come December.
As the US rate scenario settles into conventional wisdom, there is plenty of upside room for the dollar (a rising rate environment, all else being equal, is a bullish indicator for the national currency). While the greenback has traded strongly against the euro and other major developed market currencies this year, at $1.15 to €1.00 it is far from its late 2016 peak when it tested euro parity.
Where the dollar’s strength can do much more harm, though, is in emerging markets. Many of those currencies are at decades-long, if not all-time, lows versus the dollar already. The dollar is up 22 percent against the Brazilian real this year, and 12.6 percent versus the Indian rupee. If you hold emerging markets equities in your portfolio you are feeling this pain – when your equity price returns are translated from the local currency back into dollars you are directly exposed to those currency losses. For example, the MSCI Emerging Market index reached an all-time high in local currency terms back in February of this year. But in US dollar terms – shown in the chart below – the index has never recovered its pre-financial crisis peak reached in November 2007.
We’ve communicated our sentiments about emerging markets frequently on these pages – while important as an asset class given the size of these economies (and the wealth therein), emerging markets have underperformed domestic US stocks on both an absolute and risk adjusted basis over a very long time horizon. They enjoyed a sustained period of outperformance during the mid ‘00s in conjunction with the commodities supercycle – and again for about a year following the reversal of the ill-considered “Trump trade” fever after the 2016 election. During that latter growth spurt we elected to sit tight with our underweight position rather than try any fancy tactical footwork. We stand by that decision today.
We have yet to arrive at our conclusions for positioning in 2019, in EM or any other asset class. But from where we sit today the most convincing picture of the global landscape points to a continuation in the US up-cycle, with the attendant implications of a stronger dollar and further downside potential in other markets, particularly emerging ones. That does not necessarily imply blue skies ahead for US assets – there are some complicating factors at home as well, which will be themes for forthcoming commentaries. But we see little out there today arguing for a bigger move into emerging markets.
Is anyone else not quite ready for back to school season? Every year it seems that the calendar races by that much faster – which of course just means that we’re getting older and grayer. Anyway! Labor Day weekend is here and thus begins the critically important fall season for asset markets. Much of the time the going is great these last four months of the year, particularly if things look promising for retailers heading into Black Friday and the holiday season. But in October, the stock market reminds us of that old nursery rhyme about the little girl who had a little curl – “when she was good she was very, very good, but when she was bad she was horrid!”
Indeed. 1929, 1987, 2008 – investors need no reminding of just how horrid some of these fall seasons have been. From where we sit today, things don’t look particularly ominous. Which is not to say that we may not have some twists and turns ahead, but no one particular X-factor looms large. Here is a brief run-down of some of the events ahead that we’ll be keeping an eye on to make sure our prognosis stays intact.
The Never-ending Back Story
US stocks this year had a somewhat wilder ride than they did in 2017, but the back story really has not changed all that much. The two key propellers behind this slow and steady boat are (a) continued GDP growth with relatively modest inflation, and (b) strong corporate earnings and sales. Businesses are confident, consumers are spending at a decent pace, and all that trade war rhetoric seems to be on a back burner for now – at least the trade negotiators are fumbling along incoherently without actually choosing the worst possible outcomes. Now, at some point the music will stop – no expansion lasts forever. And the next downturn will have its own special set of problems, not least of which will be how much ammunition the Fed has on hand to fight back. But that is likely a problem for another day.
September and December…
“Wake me up when September ends” goes the Green Day song. By the time September ends we will know if the Fed funds rate is higher than it was at the beginning of the month. The likelihood is that it will be – a third 2018 rate hike is pretty well baked into current market yields for short term Treasuries. That leaves December, the final FOMC meeting that will include the whole carnival of press conference and dot-plots. Recent FOMC press releases have conveyed a generally more upbeat assessment of market conditions (see “never-ending back story” above). We sense the Powell Fed wants us to understand that a fourth rate hike is very much a possibility (and not subject to undue pressure from certain Executive Branch politicians with incurable Twitter habits).
But December is still a long way off. If little has changed in the economic story and holiday shoppers appear to be rocking their Santa hats all over the malls and cyberstores, then we should expect a rate hike (and also expect that it would not much faze markets). But, anything can happen between now and then.
…And Don’t Forget November
Oh, yes, and one of those “anythings,” of course, happens to be a midterm election likely to draw much more interest than these midterm decision days usually do. How much event risk might there be in the midterms – either because Democrats win big and the specter of impeachment rises front and center, or because the Republicans hang on to Congress and Trump announces the evisceration of the Mueller probe and the Justice Department on November 6 evening amid all the victory and concession speeches? Not much, in our opinion. Markets have been almost unrelentingly placid in the face of all the political squalls and brushfires of the past 19 months. There seems little reason to think this one will be any different.
Don’t Cry for Argentina – Or Ankara
We’ve had our eye on the various emerging markets woes that have been a drag on this asset class this year, including the meltdown of the Turkish lira a few weeks ago. This week it’s Argentina’s turn to fail at winning the battle against a freefalling currency. The monetary authorities there have pushed interest rates up to 60 percent to fight the peso’s plunge (remember those hundred year Argentine bonds that were in vogue a couple years ago? Ouch) and the reformist government of Mauricio Macri is fighting to retain credibility. Meanwhile, Argentina’s neighbor to the north, Brazil, has presidential elections this fall where the leading candidate is in jail and the second-place contender in the polls is a far-right populist with a flair for controversy. The good citizens of Brazil, like Queen Victoria, are not amused.
These random disruptions in developing markets could continue to stay mostly in isolation – witness that the S&P 500’s total return for the year to date is over 9 percent while the MSCI emerging markets index has moved in and out of bear market territory. Again – we don’t see event risk clouds of a dark enough hue to suggest a more systemic pullback across a broader swath of asset classes. But it’s the fall, and tricks & treats come with the territory.
This past Wednesday, apparently, was one of those red-letter special days in US stock market history. The current bull market, which began in 2009, became the longest on record, based on the daily closing price of the S&P 500. So said the chattering heads, not just on CNBC but on your friendly local news channel. Hooray! Or should we worry, perhaps, that the good times are coming to an end?
The right answer to that question and all others about the bull market’s record longevity is to ignore it, because technically it didn’t happen. Nope, this is not the longest bull market on record, not by a long shot. Now, some may quibble when we present the facts, arguing that we are splitting hairs. Well, sorry, but ours is supposed to be a precise business where performance measurements are concerned. And facts, surprisingly enough in this day and age, are still facts.
So, to be precise, the bull market that reached its peak on March 24, 2000 (the one we supposedly beat on Wednesday) did not in fact begin on October 11, 1990. That was a span of 3,452 days. The basis for “longest bull market ever” claims made this week is that 3,453 days elapsed from March 9, 2009 (the low point of the last bear market) to August 22, 2018. However! Based on the technical definition of bulls and bears, the bull that peaked in March 2000 actually began, not in 1990, but on December 4, 1987. That’s a total span of 4,494 days, or 1,041 days (about 2.8 years if you prefer) longer than our current bull market.
So why did the media spend so much energy this week talking about the “longest bull market?” Because (a) it’s more fun to talk about things grand and historical than about the daily grind of random market movements, and (b) on October 11, 1990 the S&P 500 closed down 19.9 percent from the previous record high set in July of that year, and, well, 19.9 percent is close enough to 20 percent, which is the commonly accepted technical threshold of a bear market.
Let the quibbling begin! 19.9 percent is close to 20 percent, certainly. But it never passed that threshold. More importantly, the stock market pullback of 1990 (which started with the recession of that year but had recovered before the recession was over) never spent a single day – not a single day! – in actual bear market territory. You can’t say that a bull market began the day after a bear market ended when that bear market never even began.
So, again sticking to the definition of a 20 percent pullback from the prior high, the last bear market before the dot-com crash of 2000 occurred after Black Monday in 1987. On December 4 of that year the S&P 500 had retreated 33.5 percent from the prior record high reached in August. That wasn’t a super-long bear, lasting less than a couple months from the breaching of 20 percent, but it was certainly impactful.
The Music of the Market
Here’s the more important reason why we’re not just splitting hairs over the 19.9 versus 20 percent, though. If you look at the way markets trend over a long enough period of time you notice a certain pattern – a tune, if you will, the music of the market. Every bull market experiences periodic pullbacks. These happen for a variety of reasons, some of which may seem frivolous and some of which may seem more serious at the time. Traders in the market are highly attuned to how far these pullbacks draw down from the previous bull market high. A 5 percent pullback is deemed significant. The 10 percent threshold has its own special name – correction. And the 20 percent level, as we noted above, is the event horizon for a bear market.
What tends to happen during the more severe bull market corrections is that they get ever so close to the 20 percent threshold without actually going over it. This happened in October 1990, as we showed above. It also happened in August 1998 with a 19.3 percent pullback (this coincided with the Russian debt default and subsequent meltdown of hedge fund LTCM). More recently, it happened in 2011 with a 19.4 percent pullback in the S&P 500 while the Eurozone crisis and US debt ceiling debacle played out simultaneously.
It’s not accidental that these pullbacks flirt with bear markets but refrain from going all the way. It’s how short term trading programs, which make up the lion’s share of day to day liquidity, are set up to work. A correction or bear market threshold is considered to be a technical support level. If prices approach, but don’t breach the support level it means that the net consensus of the market supports the status quo; in other words, that conditions continue to justify a bull market. These pullback-recovery movements happen frequently. Real bear markets are much rarer, and more durable when they do happen.
The chart below provides a good illustration of this “music” – it shows the price trend of the S&P 500 from 1987 to the present (lognormal scale to provide consistency in magnitude of returns over time).
This chart is instructive for another reason. To paraphrase Tolstoy, every pullback has its own dysfunctional story. What causes a pullback to become a full-on bear market? It’s not always a recession – witness 1990, when we had an economic downturn but only a limited market pullback. It’s not always a financial crisis – we had one of those in 1998 and again in 2011 but in both cases economic growth stayed positive. In 1987 financial markets came close to shutting down, but again the economy was still resilient and the drawdown, while intense, turned out to be brief. By contrast, in 2000-02 and again in 2007-09 we got a double-dose of financial crisis and recession in roughly the same time frame (the grey bands in the above chart signify recession periods). Both the magnitude and the duration of these drawdowns, of course, were more severe.
In any event, with all apologies to financial market pundits everywhere, there was nothing particularly historical about this week. Perhaps our good fortune will last another 1,039 (and counting) days and we will have a real, actual “longest bull” to celebrate. Or maybe not. Expect more pullbacks along the way in either case. Remember that most pullbacks do not end up in a real bear market, and also remember that while we humans have a need to read meaning into calendar events, markets themselves do not.
Pundits who follow financial markets are always ready to supply a narrative to the crisis of the day. “Stocks fell today because of X” is how the story usually goes, although “X,” whatever it may be, is likely only a strand of a larger fabric. These days market-watchers are focused on Turkey, and the “X” factor giving the story a human face is one Andrew Brunson, a North Carolina pastor who for the past two decades or so has lived in Turkey, ministering to a small flock of Turkish Protestants. Brunson was caught up in a 2016 political backlash following an attempted military coup, and has been detained on charges of collaboration (unfounded, he claims) against the Erdogan regime ever since.
Earlier this month the Trump administration anticipated Brunson’s release after protracted negotiations. Instead, the pastor was placed under arrest. The US responded with a new round of sanctions, including a 50 percent levy on imported steel. Team Erdogan dug its heels in. The currency collapsed and – voila! – the summer of 2018 now has its official crisis. For investors, the pressing question is whether this is an isolated event, or a larger peril with the potential to turn into a 1997-style contagion.
Shades of 1997
Once seen as the next likely candidate to join the European Union and pursue the traditional path to prosperity by linking in to the global economy, Turkey instead has become a dictatorship under Erdogan. Possessed of a less than perfect understanding of macroeconomics, Erdogan has doggedly refused to address the country’s currency crisis by raising interest rates, the normal course of action. Facing down external borrowing needs of $238 billion over the next twelve months, the regime improbably imagines relief coming from comrades-in-arms such as China, Russia and Qatar. These are Turkey-specific problems.
But currency woes are anything but local-only. Almost all major emerging markets currencies are having a terrible time of things in 2018. The chart below shows four of them, including the Turkish lira.
From this standpoint, the situation looks less like a simple tempest on the Bosphorus, and more like the summer of 1997. That was when Thailand, under speculative attack from foreign exchange traders, floated its currency and sparked a region-wide cataclysm of devaluations and stock market collapses. One of the issues contributing to the mess in 1997 was the vulnerability of countries with large amounts of dollar-denominated external debt – a falling currency makes it increasingly difficult to service interest and principal payments on this debt.
This is an issue of relevance today as well; indeed, countries with the largest non-local debt exposures have been hit hardest alongside the lira (see, for example, the South African rand in the above chart). Another theme of 1997 was current account deficits, a particularly important data point for countries where exports play a central role in growth strategies. That has been the driving force behind India’s currency woes this year (also shown above). High oil prices (a key import item) have raised India’s trade deficit to its highest level in five years. And, of course, the specter of a trade war looms over all countries active in global trade.
Sleepless in Shanghai
Arguably the biggest difference between 1997 and today is the role of China in the world’s economy. Back then the country was still in the early stages of the boom that spawned the great commodities supercycle of the 2000s. Now it is the world’s second-largest economy (and the largest when measured in purchasing power parity terms). China is currently dealing with its own growth challenges – very different from those facing trade deficit-challenged economies like India or near-basket cases like Turkey, but concerning nonetheless. The Shanghai and Shenzhen stock markets have been in bear market territory for much of the summer. China’s biggest challenge is managing the transition of its economy from the fixed investment and infrastructure strategy that powered those supercycle years into a more balanced, consumer-oriented market. That is the right thing to do – the infrastructure approach is not sustainable for the long term – but concerns about the transition persist even while the country putatively continues to hit its GDP growth targets.
So how much contagion risk is there? The main problem as we see it is not that the detention of a pastor in Turkey could bring down the global economy. It is that all these strands – debt exposures, trade deficits, growth concerns, trade war rhetoric – are percolating to the surface at the same time. The story is not as systemic as that of the ’97 currency crisis, where the same one or two problems could be ascribed to all the countries suffering the drawdowns. But with all of these strands front and center at the same time, we cannot rule out the potential for broader repercussions.
The ’97 crisis had only a limited impact on developed markets. US stocks paused only briefly before resuming their manically bullish late-1990s ways. So far, neither turmoil in Turkey nor sleepless nights in Shanghai are having much impact on things here at home. A little more volatility here and there, but stocks within striking distance of January’s record high for the S&P 500 (and still setting new highs when it comes to NASDAQ). But we’re closing in on the always-important fourth quarter, and need to be fully cognizant of all the different narratives, positive and negative, competing for attention as the lead theme.
The languid dog days of August are truly upon us. Risk asset markets would seem to be feeling the soul-draining humidity as much as runners and cyclists slogging through day after day of relentlessly damp blankets of heat while training for fall goal races. The S&P 500 hovers just below its January record high, while volatility has resumed last year’s deep slumber. The 10-year Treasury yield casts a sleepy glance every now and then at the 3 percent level, yawns and goes supine again somewhere around 2.95 percent.
Random headlines make a splash on these days where nothing much from macroeconomic or corporate earnings data releases manage to perk up investor attention. This week’s little diversion came – as seemingly all diversions in 2018 must come – from Twitter and specifically from the account of Elon Musk, founder of Tesla, as he mused about the likelihood of taking his $60 billion enterprise private. Now, once upon a time a major strategic undertaking like taking a public company private would have simmered under the radar in boardrooms and hushed discussions with bankers, lawyers and advisors before proceeding in an orderly fashion into the public domain. But such are the times in which we live.
Mind The (Listing) Gap
While Musk’s method of communication may have been unusual (and quite possibly illegal), the decision itself – to take a public company private – is anything but an anomaly. Our interest piqued, we went hunting for some data on the subject and came across a 2017 Credit Suisse paper entitled “The Incredible Shrinking Universe of U.S. Stocks” with some eye-opening facts and figures. The universe of publicly traded equities – i.e. shares of common stock traded on an accredited stock exchange, compliant with SEC disclosure and transparency regulations, and available for purchase by any institutional or retail investor – has radically diminished over the past several decades.
Here’s a good illustration of what this means in practical terms. How many stocks do you think make up the Wilshire 5000 Total Market Index? Ah – you were about to say “5,000, of course!” but then realized it must be a trick question if we’re asking it. Indeed, this bellwether index launched in 1970 to represent the “total US stock market” does not consist of 5,000 companies. It consists of 3,486 companies as of June 30, 2018. Why? Because that is roughly how many publicly traded companies exist in the United States. In 1976 there were about 4,800 companies with publicly traded stock, and in 1998 that number soared to more than 7,500. The Wilshire 5000 reached its peak holdings with 7,562 names on July 31 of that year.
Where Did They All Go?
Why are there so many fewer listed companies now, and how much does it actually matter from the standpoint of an investor seeking to capture as wide a swath of global wealth as possible through portfolio diversification? The answer to the first question is relatively straightforward. The second – not so much.
The main reason why there are fewer companies on stock exchanges in 2018 than there were in 1998 or 1978 is twofold. First, mergers & acquisitions (M&A) activity has gone gangbusters over this period, and has been the main driver for delisting (a company, when acquired, naturally retires its stock ticker at the signing ceremony). Second, initial public offering (IPO) activity has fallen. If M&A is the main way that a company falls off the stock exchange, then IPOs are the main source for new supply. According to the Credit Suisse report we noted above, the average number of IPOs every year from 1976 to 2000 was 282. From 2000 to the present the average annual number was a mere 114.
Long story short – M&A fever has raged while the IPO market has slumbered. This in itself is unusual. Historically, strong equity markets tended to encourage both M&A and IPOs. That makes sense – companies feeling flush look to bulk up by taking out competitors or to buy their way into new industries, while start-up founders want to cash in with the high valuations available in bull markets. But that positive correlation no longer holds. From 1976 to 2000 the correlation between M&A and IPO activity was 0.87 (1.0 being perfect positive correlation). From 2007 to 2016, the correlation is actually negative: minus 0.08. Those start-up founders apparently have other, more enticing options for cashing in.
The Changing Market For Private Capital
And indeed, those alternatives exist. Probably the most noteworthy, in terms of explaining the diminished attractiveness of IPOs, is the growth of late-stage venture capital / private equity. Venture capital used to be concentrated in the early years of a start-up company’s history, with the VCs motivated to get their investments through successive funding rounds and out the door into the public markets via IPO as fast as possible. Now there is a whole distinct asset class of late-stage private investors. This includes most of the major mutual fund families, like Fidelity and BlackRock, that operate dedicated late stage private equity funds. This asset class provides a level of liquidity that previously could be found only in public markets. For example, late stage private deals allow start-up founders and their employees to cash out some of their stock and options – again, reducing the natural pressure to go public.
The Implications for Asset Allocation
So the story about how we wound up with so many fewer public companies is relatively easy to understand. But that second question we posed a few paragraphs ago remains outstanding. Is the long term investor with a diversified portfolio missing out on a major asset class exposure by not being invested in private equity?
This is a question we take seriously: after all, our primary job is to construct portfolios with a prudent level of diversification aligned with each client’s specific investment objectives and risk considerations. The data thus far are somewhat inconclusive, with attendant benefits and costs.
For example, while there may be fewer publicly traded companies out there, the total market capitalization of the US stock market is more than 1.35 times the value of US real gross domestic product (GDP). By comparison, total market cap in 1976 was just 0.47 times GDP, and in the late 1990s, when the number of listed firms peaked, it was 1.05 times. The collective profits of all listed firms today is close to 9 percent of GDP versus 7 percent in 1976. And share volume – hence liquidity – is at record levels today.
For investors there are other potential downsides to owning private equity, including reduced transparency and less consistent, available data for performance benchmarking. On the other hand, it is not possible to simply dismiss the reality of a new structure to the US capital market and the existence of distinct new asset classes large enough to demand consideration, if not inclusion, for long term diversified portfolios. We will have more to say about this in the coming weeks and months.