Paul Volcker Taught Us How to Tame Inflation

I started writing a monthly investment update for the investment firm I was with in 1975. I didn't know what I was doing at first, so the older people in the firm would feed me what to say, and I would write the update.  This was just a few years after the OPEC oil embargo and inflation had shot higher. As the months rolled on and inflation continued to rise, I found fewer and fewer of the old-timers were stepping up to tell me what to say, so I became a student of the Federal Reserve in order to have something halfway intelligent to say. That was no help for several years.  Inflation remained persistently high. At times, prices changed on grocery shelves and gas pumps while I was standing in front of them, ready to make a purchase.  Interest rates kept going higher and higher, and none of the Federal Reserve's rate hikes seemed to make any difference.  

An inflation mentality set in on Wall Street, Main Street, and Ivy Street. Inflation became a way of life. We had silly government programs such as Whip Inflation Now (WIN) and a lot of other kinds of cute sloganeering that was not rooted in any economic truth because very few people really understood inflation and how it worked. 

We all became followers of the money supply.  M1, M2, and M3 discussions went on at social gatherings like somebody somewhere knew what it all meant.  "Too many dollars chasing too few goods" became the wink and a nod answer to all things inflation.

There was one man who did understand what drove inflation and how to control it. His name was Paul Volcker. Volcker was promoted to chair of the Federal Reserve in 1979. He immediately began a series of rate hikes that would drive the Fed Funds rate up from around 11% in September 1979 to 20% in March 1981. The 6’7”, cigar-chopping man taught us all that in dealing with inflation, the right course of action was to use a leading interest rate strategy instead of a lagging strategy.  In effect, Volcker made it clear verbally and by his actions that wherever inflation went, he would push interest rates even higher. His leading strategy was truly remarkable, and it broke the back of the inflation panic that had been raging through the economy for years. Inflation peaked at 14.8% in March of 1980 and by 1983 had fallen below to near 3 %. 

Today, we face another inflation crisis and the same 'we got this thing under control' illusion that I watched play out for years in the late 1970s.  Modern Monetary Theorists, who spoke so boldly of 'we got this economic thing' and advocated dumping huge quantities of dollars onto anyone who could breathe, have become silent. They should have done so much sooner.

Inflation is as much of a psychological phenomenon as it is a monetary phenomenon. The present Fed has been saying 'we got this thing' for too long.  They are losing both the psychological battle as well as the monetary battle. They must come out of today's meeting with two huge changes in what they say and what they do.  First,  they must say "Paul Volcker taught how to tame inflation, and we are now following his playbook." Second, they must raise Fed Funds by at least 1% and promise even more 1% hikes in the future. Jerome Powell must ignore the politicians, jump straddle inflation, and fight it with tools history shows us have worked.  If he continues to bow down to the politicians and make small interest rate hikes, we may be fighting inflation four years from now.

I believe the stock market understands what needs to be done and will soon find a bottom if the Fed takes a tougher stance. If the Fed keeps nickleing and diming us along, stocks will likely keep falling because big investors know that the longer we allow the current lagging interest rate strategy to prevail, the worse will be the ultimate recession.

The illusion of 'we got this thing" should end today."         

Dividend Watch: The Financial Media Are Barking Up The Wrong Tree

• The financial media are howling about all the companies cutting, suspending, or omitting dividends; but among S&P 500 companies, they are barking up the wrong tree.  
• Since March 1, only 28 of the S&P 500 have officially cut or omitted their dividends.
• That number of cuts pales compared to the 212 companies that have paid dividends and is blown away by the 103 companies that have raised their dividends.
• The financial media might be guilty of looking so hard for the bad news that they are ignoring the good news.
• Since March 1, nearly 50% of the 212 companies announcing or paying dividends have hiked them compared with just 13% that have cut them.  We expect more good news in the weeks ahead. 

The media are missing the powerful message that most major U.S. corporations are broadcasting:  "The coronavirus is devastating and creates much uncertainty, but we believe it will pass sooner than most headlines are stating"
         As I mentioned in a previous Dividend Watch, in 2008-2009 we noticed that apart from the banks, few U.S. companies were cutting their dividends in the face of the recession.  Indeed, much as today, many companies were hiking dividends.  That was one reason we became more optimistic that the credit crisis would be shorter and more shallow than was the consensus of the day.              The coronavirus pandemic is unlike anything we have ever seen, but the greatest corporations in the world are telling us, at least for the present, that tomorrow is coming and it will be much brighter than most of us now believe.
        You may argue with the point I'm making, but I believe the stock market has zeroed in on the net positive dividend actions of major corporations, and that is one of the reasons stocks are nearly 20% above their recent lows.

The following are the 28 S&P 500 companies that have cut or omitted their dividends.  We will have a list early next week of companies whose dividend may be in jeopardy.

S&P 500 Companies Cutting Their Dividends

 From March 1-April 24  

Alaska Air ALK	Darden Inc. DRI	Invesco Corp IVZ	MGM Corp MGM
Apache Energy APA	Estee Lauder Co EL	Nordstrom JWN	Noble Energy NBL
Aptiv PLC APTV	Ford Motors F	Kohl's Corp. KSS	Occidental Pete OXY
Boeing Corp BA	Freeport-McMoRan FCX	L Brands Inc. LB	PVH Corp PVH
Carnival Cruise CCL	Gap Inc. GPS	Las Vegas Sands LVS	Schlumberger Int'l SLB
CenterPoint Energy CNP	Hilton Worldwide HLT	Macy's Inc. M	TJ Maxx TJX
Delta Air DAL	Helmerich &Payne HP	Marriott Int'l MAR	Tapestry Inc. TPR

Volatility Will Continue, But Stocks Are Going Higher

After an historic January run, the S&P finished the first full week of February in what looks to be a consolidation phase.  As we thought might be the case, the S&P 500's 200-day moving average has proven to be a level of resistance for the market with a sharp pullback off the moving average in the middle of the week.  Still, an impressive intraday rally took hold on Friday to see the market close well off its morning lows.  Late Friday rallies have been a good sign during the last couple of years and continue to suggest that buyers abound at these levels.  So while stocks may face a battle as they try to work through the 200-day moving average, the outlook is constructive for the longer-term and there are decent levels of technical support close by.  This is born out by the surge in the percentage of stocks above their 50-day moving averages, which typically results in strong returns over the next 6 to 12 month time frame.  Importantly, strong  stock gains in January's tend to beget strong full-year performance. 

Economy and Bonds

From a macro standpoint, the economic data continue to be more mixed, but that is probably the best case scenario for stocks grinding higher.  US economic data softened significantly at the tail end of 2018, but a small rebound in the Mfg. PMI and last week’s stellar jobs report have tempered the recession talk.  Still, consumer confidence has taken a hit, and business investment is rolling over a bit.  With the recent mix of data and little inflation in sight, the Fed is probably on hold, and the cacophony of economic naysayers has been quieted.  On that note, credit spreads have stabilized and more of a risk-on attitude has been evident.  What is perhaps most striking in the recent upleg in stocks has been the behavior of US 10-year bond yields.  One might think that a more lax Fed would allow inflation and growth expectations to creep higher, taking interest rates with them; but global economic woes are keeping inflation expectations and bond yields in the US well anchored.  The US's expected GDP growth in the 2%-3% range for the year ahead looks downright rosy compared to much of the rest of the developed world.  We believe this realization has not been lost on foreign investors.

Trade

Trade remains an issue as gamesmanship has once again emerged between the US and China as tariff deadlines draw near.  Of great concern is the February 17^th deadline with the Eurozone that could lead to the imposition of tariffs on European autos.  These tariffs have the potential to wipe out a good deal of the incremental tax cuts in 2019.  This is an area to watch as well.   

Earnings

Here's a quick update on fourth quarter earnings: With 66% of companies reporting, earnings have surprised by an average of around 3%.  Revenue growth of 6.5% has contributed to earnings growth of 14% year over year.  Fourth quarter earnings continues to look better than expected; however, expectations for Q1 earnings growth have softened.  This is likely a symptom of the slower global growth.  Still, there are pockets of strength that are relatively immune to the global slowdown. In our next blog we will discuss a few of the superior operators.  

Finally, our overall valuation model says stocks are still in a sweet spot and should end the year higher than they closed on Friday.

Preston May, Certified Business Economist

Research Analyst

Donaldson Capital Management, LLC.

Editor Greg Donaldson

The Great P/E Debate: A Stopped Clock and Other Wild Eyed Guesses

We have shown in previous blogs that much of what academia and Wall Street tell us about how to calculate the most foolproof price-to-earnings ratio for the S&P 500 at any point in time is . . .well, foolish.

1. Professor Robert Shiller, the creator of the CAPE method of valuing stocks, which has many academic adherents, says that stocks are wildly overvalued.  The only problem is he has been saying that for nearly six years, and in interviews, he cautions that CAPE is not a good metric for timing.  But, professor, what good is a valuation metric if it is correct only once every decade, or so?  That sounds a bit like the accuracy of a dead clock: it's correct twice a day but fails at telling time during the other 23 hours 59 minutes and 58 seconds of the day.  CAPE currently suggests that the S&P 500 P/E is approximately 80% above it fair value.  

2. There is another crowd of soothsayers who hold to the idea that the long-term average P/E of the S&P 500 is the correct metric to determine its fair value.  These folks argue that a P/E of 16x is the right multiplier, and, that being the case, at 21.3x, stocks are currently about 33% overvalued.  History shows us that if you would have bought every year when the S&P 500 was below a 16x P/E and sold or shorted every year above that level you would have crashed and burned a long time ago.

3. Many on Wall Street believe that the best way to calculate the normal P/E for the S&P 500 is to subtract the rate of inflation from 20.  In our judgement, this crowd has had a better track record over the last 50 years than Dr. Shiller or the 16x crowd, but we have previously shown, there is a more statistically significant way to determine the right P/E at any point in time.  That methodology is what we call the earnings yield to inflation' ratio.  

Our work shows that since the 1960s, earnings yield (the inverse of P/E) minus core inflation has averaged 3.35% with a correlation coefficient of .70.  For our calculations, we use earnings before extraordinary additions or subtractions and the core personal consumption deflator inflation (PCD, the data most favored by the Fed.)  The current reading for these two data points are as follows.  PCD is 1.6% and the trailing 12 month earnings yield is 4.70%, or a P/E of 21.3.  

To determine where the model says the current earnings yield, (P/E) ought to be, we add the current PCD rate of 1.6% to the long-term constant of 3.35%, or 4.95%. Converting this back to P/E, we find the model predicts the correct P/E is now 20.2x.  With the S&P 500 now trading at 21.3 times earnings, that would suggest that stocks might be about five percent overvalued.  But there's more.  The stock market is a discounting mechanism.  That is, it is always looking ahead and pricing in where it believes current financial and economic data will be in the future.  Currently the consensus view of analysts and economists is that the PCD inflation rate will climb to 2% by year end and S&P 500 earnings will grow to approximately 160.  If these estimates come to pass, that would put the fair value of the S&P 500 at about 3200 by year end.  

With the S&P 500 currently sitting at 2727, that would mean it is about 17% undervalued.  That's my best guess and I'm sticking with it no matter how much volatility we see over the next few months. I'll update the model in the coming months. 

Earlier, I said the correlation coefficient on our P/E model is approximately .70.  Being less than 1.00 means that it has not perfectly predicted annual stock market moves (surprise, surprise).  I offer it here because the model is simple and has done a reasonably good job of predicting stock market action over the last few years.  We have another model that has more complexity and with an even higher correlation coefficient that also predicts stocks are undervalued by double digits.  I'll show it in a future blog.
  

3 Headwinds for Dividend Stocks: Will They Continue?

This blog was written prior to today's news about Greece. Based upon everything we see thus far, the Greece situation has short-term implications, but not long-term. Investors and financial institutions have had seven years to get used to the prospects of a Greek default. Furthermore, Greece represents only 2% of the European Union, which is a fraction of the global economy. We will have more to say on this over the next few months.

Dividend investors have had a difficult time so far this year.  While the S&P 500 Index has risen 3.0% on a total return basis, the Dow Jones Dividend Index is down 2.2% and the Vanguard Dividend Achievers Index is down 0.4%.  As usual, the nay-sayers are neighing that dividend investing is dead. But whoa Nellie, there have been three disparate forces that have pulled in the reins on stocks with higher than average dividend yields:

1.       Rising long-term interest rates

2.       Sharply appreciating U.S. Dollar versus most world currencies

3.       Collapsing energy prices

In many ways, the confluence of these three forces is unusual and not likely to last.  Over the last 20 years, long-term interest rates have been negatively correlated with oil prices and oil prices have been negatively correlated with the dollar.  One or two of these economic measures would be rising in a "normal" environment, but not all three at the same time.  It would be highly unusual if these three price trends continue in the same direction for much longer.

As strange as this time has been, the result has been clear. The current trend of these three economic measures has had a negative impact on many of the most important stock market sectors for dividend investors:

• The rise in interest rates has hit the prices of the utilities, REITs, and telecoms sectors in much the same way as it has bonds.  
• The rise in the dollar has significantly lowered multinational companies’ earnings and dividend growth, along with their stock prices.  
• The collapse in oil prices has sent big oil and pipeline stocks down by as much as 30%.

The only sector with higher than average dividend yields to escape the adverse prevailing forces has been the financials, whose net interest margins and profits normally improve with rising interest rates.

As dividend investors, we have been facing all three headwinds for the last six months.  The question most of us are asking is, “How much longer can the headwinds last?”

Here is our view of these trends over the short and intermediate-term trends:

Interest rates:  With Greece teetering on the edge of default, we expect money will be in a flight-to-safety over the near-term.  This will push U.S. Treasury yields lower and allow for a modest rally in interest-sensitive stocks such as utilities and REITs.  How long the rally prevails will depend on how long it takes for the markets to digest the final outcome of Greece.  Regardless, we expect long-term interest rates will slowly move higher once the crisis is over. 

Oil prices:  The supply and demand of oil is nearing equilibrium. If that is the case, oil prices may have seen their lows.  Despite their rally in recent months, they are still 40% lower than a year ago. We have difficulty believing that a rally in oil stocks is near.  The Greek tragedy is a deflationary event. If it lasts very long, we would expect oil prices to trend lower. Furthermore, we will likely see some negative surprises from those oil and pipeline companies with high debt loads.  The companies in our portfolio are of the highest quality in the industry, which means they are in better shape to handle sustained low oil prices than their peers.

U.S. Dollar:  The flight-to-safety we spoke of would benefit U.S Treasury bonds and should also push the U.S. dollar higher.  The Greece concerns may not be a long-term occurrence, but will continue to produce near-term headwinds to most big multinational companies’ earnings and dividend growth.

Our analysis of the headwinds that have held back the performances of many great dividend stocks in the first six months of the year suggests that the second half will be modestly better than the first. However, we don’t see big moves in interest rates, oil prices, or the value of the dollar.

Companies that can produce double digit earnings and dividend growth in this environment will be highly prized.  We will continue to favor higher dividend growth versus higher dividend yield in the coming months.  We particularly like companies that derive more than 60% of their earnings in the United States. These kinds of companies are not as sensitive to the movements of the dollar as are the multinational stocks.  In addition, their higher growth can trump changes in interest rates.

In addition, most of them are benefactors of lower oil prices.  As long as these companies can produce above average earnings and dividend growth, we believe investors will continue to push their stock prices higher. We'll talk about some of our favorites in future blogs.

Finally, a near-term modest fall in interest rates would seem to be a negative for the financials.  In addition, they have all experienced strong price growth year to date.  With the trouble in Greece filling the headlines, we would not be surprised to see the financials tread water for a few weeks to months.

The Greek tragedy seems to be a never ending story that will lead surely to a catastrophic ending, but investors have had five years to get out of the way of a doomsday scenario for Greece.  We doubt the effects will be long lasting.

The 4 Drivers of Stock Market Prices

We have found that very few investors understand what really drives the stock market.  In our view, the four primary drivers of market valuations are earnings, dividends, interest rates and inflation.  If you can quantify what is going on with those four variables, our models indicate that you can predict about 90% of the annual movement of stock prices.

Last time, we talked about the Barnyard Forecast which is a model that signals the probable direction of the market.  While the Barnyard Forecast does correctly predict the market’s direction 6 to 18 months from now with about 80% accuracy, it is not a short-term predictor nor does it have any valuation component.  Therefore, we use select valuation models to ascertain the relative attractiveness of stocks.

Almost all of these models use some component of the above mentioned variables.  Within those four variables, there are two that stand out above the others as being the most important drivers.  We’ll take a look at each factor and then conclude with what it means for stocks.

Earnings

Most investors look to earnings as the primary guide of what a company is worth.  In theory, that makes sense.  If Company A is earning $500 and Company B is earning $1,000 - wouldn’t you rather own Company B?

The problem with earnings is that they can be engineered by creative corporate executives.  In times of recession, earnings are particularly volatile. Earnings can be calculated in a variety of different ways, which adds additional complexity.  We don’t think earnings should be completely discounted in valuing companies or the stock market as a whole.  However, the unpredictable nature of earnings often gives very bad signals at turning points in the market.

Dividends

We have found dividends to work much better than earnings.  Over the past 50+ years, dividends have had approximately three times more predictive power than earnings.

Let’s say you own two rental properties.  One rents for $100 per month and the other rents for $200.  If both rents are increasing at 3% per year and both will continue to rent for the next 20 years, which rental property would be worth more to you?  The one that will pay you the most in rental income over its useful life… right?  

John Burr Williams was the first to apply this theory to stocks.  He said the value of a stock today is the sum of all future dividend payments discounted back at some required rate of return.  In other words, the more a company pays out to its owners in the future, the more valuable that company is to its owners today.  

Not only does that theory make “real world” sense, but it also holds up statistically.  In our models, we’ve found that dividends are the most important driver of stock prices by a wide margin.

Interest Rates

Interest rates are a primary concern for most stock investors.  The general level of interest rates essentially represents the “opportunity cost” of investing in stocks.

If your bank account were to start offering 10% per year on your savings account, you would probably prefer to “invest” in your savings account rather than in the stock market.  If your bank account is only paying 0.1%, however, the attractiveness of investing in stocks increases.

Many investors would be surprised, however, that interest rates are not the most important factor in determining long-term stock prices.  

Inflation

Inflation is actually a much more significant predictor.  How can that be? There are several reasons for this.

Interest rates can be artificially set by the Federal Reserve.  Inflation can be influenced by Fed policy, however, it is primarily a result of real world economic activity.

Inflation is also one of the primary drivers of interest rates.  If inflation is rising, it has the effect of diminishing the real rate of return for a bond investor.  In that environment, a bond buyer will demand a higher rate of interest to compensate for the loss of purchasing power.

In addition, inflation is impacted to a large degree by economic growth. When the economy is growing at a faster rate, the Federal Reserve will generally tighten monetary policy, which raises interest rates.

The importance of inflation is also reflected in several of our models.  We have a price-to-earnings (or “P/E”) Finder model that we use to determine the appropriate P/E ratio for stocks.  In that model, inflation has been a much better predictor of P/E than interest rates, GDP growth or earnings growth expectations.

Outlook for Stocks

If you can understand these four variables, you can get a fairly accurate gauge of the valuation of the market.  At this moment, all of these variables are very positive for stocks.

• Dividend growth for the S&P 500 has been over 10% year-to-date.  We believe this will continue to be strong in 2015.  Companies are beginning to understand how valuable their dividend checks are to shareholders and have begun to emphasize dividend growth as a priority.

• Earnings are expected to grow by over 10% in 2015.  Time will tell whether that will come true or not.  If it does, we anticipate the market will reward the companies for their continued strong performance.
• Inflation remains very low.  With little capacity pressure from either employment or plant and equipment, we don’t see much of a chance that inflation gets higher than the Fed’s target of 2.5%.  The economy is simply not growing fast enough.
• With inflation low and the Fed continuing their stimulative monetary policy, interest rates are likely to remain low.  The 10-year Treasury continues to trade at the low end of our 2013 prediction of between 2.5% and 3.0%.  We don’t anticipate that rates will get much higher than that over the near term.

As we talked about last week in our Barnyard Forecast, monetary policy conditions are very favorable.  Aside from a major geopolitical shock, stocks don’t face any major red flags going into 2015.

The most current reading from our S&P 500 valuation model indicates that the fair value of the market is about 1,950.  As this is being written, the S&P 500 is trading at about 1,952.  From both a directional perspective and a valuation perspective, our models are saying that stocks are still the place to be.

Barnyard Forecast: More Bull to Come or Is the Bear Growling?

Our last published Barnyard analysis appeared approximately 1 year ago in September of 2013.  At that time, the Barnyard Forecast resulted in 6 out of 8 points, indicating that the market would be favorable over the next 6-18 months.  That has come true, with the S&P 500 up nearly 20% since then.  We expect many will be surprised by the latest Barnyard Forecast.

During this week’s Investment Policy Committee meeting, we updated our “Barnyard Forecast” model.  The Barnyard Forecast is a basic model we use to determine whether the current environment is accommodative, neutral or restrictive towards stock market growth. Since 1990, the Barnyard model has correctly predicted the general direction of the market over the next 6 to 18 months with approximately 80% accuracy.

The Forecast gets its name from the acronym of its components: economy, inflation, earnings, and interest rates = opportunity for stock market appreciation (E+I+E+I=O).  Each factor is rated as positive (2 points), neutral (1 point), or negative (0 points) for stocks based upon historical relationships between that component's economic data and its likely effect on the Federal Reserve's monetary policy and market reactions.  The total points are then added up to arrive at a score between 0 and 8.  A score above 4 indicates a positive environment for stocks.  

Economy - 2 Points

When the economy is growing slowly, the Federal Reserve's projected actions over the next 12 months should favor stocks.  The Forecast score is positive when economic growth is less than the optimal, non-inflationary rate of economic growth of 3%.

Economic growth has improved significantly since the 1Q 2014 numbers.  However, year-over-year GDP growth remains below the 3.0% mark.  At this moment, we’re at about 2.5% with the 3-5 year range between 1.5% and 3.0%.  Economic growth would need to be at least 3.0% before the Federal Reserve would start taking any action to raise rates.  In our view, even 3.0% might be too low in light of the other data coming from the economy.  The bottom line: the economy is still not growing fast enough to warrant monetary policy tightening.  Positive for stocks – 2 points. 

Interest Rates - 2 points

Historically, the yield curve spread (difference between long-term and short-term interest rates) has been a predictor of economic performance.  As long as the spread remains positive, stock markets tend to rise.  When it turns negative, that is a danger signal for stocks.  

Spreads between long-term and short-term rates are currently very positive.  The 2-year U.S. Treasury is yielding around 0.5% versus nearly approximately 2.5% on the U.S. Treasury, a positive spread of 2.0%.  Since we are nowhere near a negative yield curve, this component of the model strongly suggests a favorable environment for stocks.  2 points.

Earnings - 2 points

Earnings growth is a statistically significant driver of stock market prices.  Over the long-term, earnings growth for U.S. corporations has been 7%.  The Forecast scores growth greater than 7% as being positive for stocks.  

In September 2013, the 2^nd quarter earnings were only 3% - well under the 7% level.  This time around, earnings growth is markedly improved.  Last quarter’s earnings growth was close to 9%.  Earnings growth projections are for even better grow over the next 12 months.  Companies have continued to grow despite the lackluster economy.  Positive for stocks - 2 points.

Inflation - 2 points

The Federal Reserve's optimal level for core inflation is approximately 2% to 2.5% year-over-year.  Core inflation under 2% allows the Fed to stimulate the economy without creating inflationary problems and is positive for stocks.  Inflation greater than 2% is negative for stocks.

Mr. and Mrs. America tend to watch the Consumer Price Index (CPI) and core CPI (excludes energy and food).  However, the Federal Reserve pays more attention to the Personal Consumption Deflator, which tends to run about 0.5% less than CPI.  At the moment, CPI is about 2.0% and the Personal Consumption Deflator is around 1.5%.  Unless inflation ticks up at least another 0.5%, we don’t anticipate the Fed is going to raise rates.  Positive for stocks - 2 points.

= Opportunity for Stocks - 8 out of 8 (Positive)

Adding each of the 4 factors totals a perfect score of 8, which indicates conditions are very favorable for stocks.  Our Barnyard Forecast has historically done a good job of indicating the general trend of the market.  While there are many unknowns surrounding the Federal Reserve's next moves, our Investment Policy Committee agrees with the Forecast's projection of continued positive returns for the market over the next 6 to 18 months.

This B-U-L-L Market Is Getting L-O-U-D

Throughout the history of the U.S. stock market, there have been many bull and bear markets. Studying these market cycles can teach investors a great deal about how the market behaves and the underlying reasons behind it.  If you can identify the driving forces of a bull or bear market, you can make more intelligent decisions to either protect yourself against a looming bear market or take advantage of a bull market.

In the 20-year history of our firm, we’ve seen several of these market cycles and have studied countless others.  While no bull or bear market looks exactly the same, the past provides us with useful insights about the future.  In the words of Mark Twain, “History doesn’t repeat itself, but it does rhyme.”

Today, we are going to see how the current bull market “rhymes” with years prior and what information we can gather from its historical patterns.

Anatomy of a Bull Market

The anatomy of almost all bull markets can be broadly defined by four primary characteristics that make up the acronym B-U-L-L, which you can read more about here.

1. Breadth

2. Unrelenting

3. Leadership Rotation

4. Loud

The “Loud” part of the equation is of particular interest in today’s market.    Bull markets attract a lot of attention from media and Wall Street.  Everywhere you turn, it seems like you hear about the stock market.  The local newspaper, CNBC, Wall Street, and even outings with family and friends can turn into investment discussions.

That’s typical of bull markets.  They grab you and force you to pay attention.  For all of those investors who have been out of the market since 2009, the run-up in stocks over the past five years has shown them just how wrong they have been.

Bull markets attract their fair share of commentators on both sides of the fence.  Some say the bull market will keep going, while others continually predict it’s demise.  The longer the bull market goes, the louder the shouting on both sides become.  Amongst all of the noise, it’s difficult to discern between what is truly relevant information and what is just that - noise.  

A lot of the chatter lately has been speculation about when the current bull market will end.  If you look back on nearly every bull market we have ever had in the United States, you will find that the vast majority of them don’t die of old age, they are killed.  There are two primary killers of bull markets:

(1) Recessions

Pullbacks and corrections can occur at any time, but it is really difficult to have a real bear market unless there is an economic recession that negatively impacts company fundamentals.  Remember, prices will always follow valuation in the long-term.  So if long-term values are increasing, the long-term trajectory of the stock market should also be increasing.

The majority of the data we see coming out of the economy have been very positive.  We thought the Q1 economic data were mostly weather-related, which turned out to be correct.  Employment numbers have improved significantly.  The economy has now added at least 200,000 jobs for the past five consecutive months.

As the economy starts to heat up, we should see increased activity from consumers and better sales growth for U.S. corporations.  Unless there is an unforeseen major geopolitical issue or natural disaster that disturbs the global economy, neither our Macroeconomic Team or the economists we follow foresee any recessions on the horizon.

That leads us to the second major killer of bull markets...    

(2) The Federal Reserve  

In the absence of any major economic shocks, the Fed is the primary suspect in the death of most Bull Markets.  

When interest rates are low, investors look outside the safety of U.S. Treasuries and into more traditionally risky assets such as stocks.  As the stock market increases from the inflow of funds, people begin to experience the “wealth effect” from watch their account values go up.  As consumers feel more wealthy, they increase their spending, which puts upward pressure on capacity.  To meet the rising demand, businesses hire more people and invest in new factories and technology to push up supply. When the Fed raises interest rates, the opposite tends to occur.

Even when the Fed raises rates, however, the stock market has historically been very slow to respond. Looking back to previous bull markets, it has taken several months of interest rate increases before the stock market has had any meaningful reaction.  This is not to say that this time will be the same - but it does contradict the widely held belief that the stock market will be hurt by the Fed raising short-term rates in the coming year or two.  Using history as our guide, that just doesn’t seem to be the case.

Furthermore, the small body of evidence we have about Federal Reserve Chair Janet Yellen suggests that she isn’t going to be quick to raise interest rates. Yellen believes wholeheartedly in the Fed’s dual mandate of both maintaining price level control (inflation) and in promoting employment.  As long as the economy continues to have above average unemployment, it is very likely that Yellen will push the Fed to keep rates low.  And as long as rates stay low, there is nowhere for investors to go but stocks.

When Is The End?

While we would consider ourselves to continue to be optimistic about the future of stocks, we certainly are not raging bulls.  We know that all bull markets must come to an end at some point, we just don’t believe that will happen in the near-term.  

While no one can know for sure when the bull market will end, there are often signs that start show up ahead of time.  One of the things we look for are the “one percent days.”  If stocks start moving up rapidly with a series of these large increases, that is likely a sign that Mr. and Mrs. America are starting to get tired of sitting in cash.  As they pour into the market, the buyers dry up and leave nothing but sellers.  On the flip side, a long string of negative one percent days typically indicates that the market is going through more than just a batch of profit taking.

We get a lot of questions about what we would do if we sense weakness in the market.  When we see potential trouble on the horizon, we don’t just immediately move to cash or try to time the market. We find it in our clients’ long-term interests to “take air out of the ball.”  

If things were to get rowdy, we would strategically reduce more volatile positions (“A” stocks) and look to add more “Royal Blue (RB)” stocks to stabilize our portfolio.  This does two things: (1) it reduces the volatility of our portfolio and (2) provides solid earnings growth and dividends to get our clients through the worst of the storm.  In bad markets, the RB stocks become defensive strongholds.  They are so big and strong that they can absorb huge amounts of shock without damaging the intrinsic value of their businesses.

Current Outlook

At this moment, we don’t see much sign of weakness. Despite the geo-political issues in Russia, the market has continued to move higher.  If shooting planes out of the sky doesn’t spark even a small pullback, that’s a pretty strong indicator that the market can continue to drive north.

Valuations for some companies are getting frothy, but the overall market is about fairly valued and well within its normal statistical range.  With interest rates so low, even higher valuation multiples than we are currently seeing would not be out of the question. While that’s a possibility, we don’t anticipate getting any additional return from valuation multiple expansion.  

In our opinion, stocks are likely to return what they generate in net earnings and dividend growth over the next 6-12 months.  If Q2 earnings are any indication, growth is starting to accelerate along with the economy.  As long as the companies continue to be the stars that they have been, this bull market still has strength to keep charging on.