Investment Commentary

photoSep­tem­ber 7, 2017

How wise is it to be invested in today’s stock market?

Robert Brooke Zevin, Chair­man, Senior Port­fo­lio Manager

Many peo­ple, includ­ing a num­ber of our clients, have been con­cerned in recent weeks that the long stock mar­ket rise since 2009 has finally reached unsus­tain­able heights that will soon lead to a crash. Our first pri­or­ity has always been to avoid or min­i­mize losses in bad mar­kets. Finan­cial mar­kets are always more or less unpre­dictable and sub­ject to sud­den declines. How­ever, we believe the like­li­hood and poten­tial mag­ni­tude of such set­backs can be esti­mated with some degree of accu­racy before they hap­pen. Use of such esti­mates is an impor­tant part of our invest­ment process. At the moment, we esti­mate that the prob­a­bil­ity of a major stock mar­ket set­back is low for the next 12 months or longer, and that prop­erly diver­si­fied port­fo­lios may reduce to a greater extent than usual the net dam­age from most of the poten­tial declines.

As long-​term investors, we are focused on pro­tect­ing against mar­ket losses that are large and long-​lasting, rather than trad­ing in and out of stocks around small and brief fluc­tu­a­tions. Bear mar­kets rep­re­sent exactly the type of major invest­ment pot­holes we aim to avoid. A bear mar­ket is defined as a decline in value of more than 20 per­cent. After bear mar­kets occur it usu­ally takes at least a year, some­times many years, before the pre­vi­ous peak price level is regained. The most fre­quent cause of bear mar­kets is an eco­nomic reces­sion or depres­sion. In fact, every reces­sion or depres­sion through­out the his­tory of cap­i­tal­ism has been accom­pa­nied by a bear mar­ket. Other bear mar­kets have occurred because of extreme over­val­u­a­tion or a finan­cial cri­sis in which peo­ple and busi­nesses are scram­bling to sell assets in order to pay their debt oblig­a­tions. These two causes are closely related since most peri­ods of irra­tionally high prices, or stock mar­ket “bub­bles,” are fueled with increased debt used to buy stocks and other assets that con­tribute to the bub­ble. In fact, all three causes are related and inter-​related. The increased debt that leads to finan­cial crises is also typ­i­cally a dri­ver of the eco­nomic expan­sion that pre­cedes a reces­sion or depres­sion. And declines in the stock mar­ket can them­selves be not only the signs but also the causes of recessions.

The Good News

With this in mind, here is our assess­ment of poten­tial causes of a bear mar­ket in the near future. Although the cur­rent eco­nomic recov­ery is old by his­tor­i­cal stan­dards it has also been weak and slow com­pared to ear­lier recov­er­ies. The weak­ness has extended to both real eco­nomic growth and price infla­tion. We con­tinue to believe, as we have for some time, that the U.S. (along with many other coun­tries) is in the midst of a pro­longed period of slow growth and low infla­tion. It seems para­dox­i­cal at first glance, but weak expan­sions typ­i­cally last longer than strong ones. Reces­sions usu­ally start with the col­lapse of a mar­ket in which there has been rapidly expand­ing activity—internet infra­struc­ture invest­ing in 19982001 or home con­struc­tion and resales in 20062008. At the moment almost every cat­e­gory of invest­ment spend­ing is already quite weak, so there is not much fur­ther for them to fall. New home con­struc­tion has been very strong but is cur­rently stalled for lack of resources, includ­ing land to build on. How­ever, it is now too small a por­tion of the Amer­i­can econ­omy to cause a reces­sion if it col­lapses. The same is true of the decline that has been under­way for some time in U.S. auto sales although not in the rest of the world.

Mean­while, the global econ­omy is expe­ri­enc­ing an unusual coin­ci­dence of expand­ing economies in almost every coun­try. This means that each coun­try is able to grow faster and is less likely to expe­ri­ence a reces­sion. Thus, for both global and domes­tic rea­sons even a mild reces­sion in the U.S. is highly unlikely for the next year or more. There­fore, the recession/​depression cause of a bear mar­ket can pretty much be ruled out for at least the next year.

What about a finan­cial cri­sis? The enor­mous level of debt in the finan­cial sec­tor of the Amer­i­can econ­omy has been cut in half since 2007. Mort­gage debt has also been dra­mat­i­cally reduced. Inter­est rates remain extremely low. Infla­tion is also low, sug­gest­ing that inter­est rates will not rise steeply in the next few years. One major excep­tion to this benign out­look is that stu­dent loans are approach­ing the one tril­lion dol­lar level while default rates con­tinue to increase. Like many of the finan­cial debts that con­tributed to the finan­cial cri­sis of 20089, these government-​guaranteed pri­vate loans are often scams cre­ated by the gov­ern­ment to ben­e­fit banks and other pri­vate lenders at the expense of lower-​income stu­dents seek­ing their way to higher incomes. The inevitable high rate of defaults on these loans has been harm­ful to banks and oth­ers, but banks also are now sig­nif­i­cantly less lever­aged and bet­ter cap­i­tal­ized than they were at the end of 2007. In sum, cor­po­rate Amer­ica has accu­mu­lated enor­mous amounts of new cash since the 2008 finan­cial cri­sis, and house­holds have about 20 per­cent less debt and more assets rel­a­tive to income than they had at the end of 2007, mak­ing a new finan­cial cri­sis very unlikely at this time.

A Ques­tion of Value

Even with­out a reces­sion, aren’t stocks still just too expen­sive? Of course this is pos­si­ble and by some well-​established mea­sures even prob­a­ble. U.S. stock mar­ket aggre­gate prices are at his­tor­i­cally high mul­ti­ples of earn­ings and trade at a high level rel­a­tive to the replace­ment cost for all cor­po­rate assets. In fact the lev­els are as high as or higher than the start­ing point for vir­tu­ally all the bear mar­kets of the past.

But there is a catch. The aver­age ratio of price to earn­ings (P/​E ratio) appears to have been increas­ing for a very long time, although fluc­tu­at­ing wildly along the way. This could reflect the grow­ing por­tion of national prod­uct for which pub­licly traded com­pa­nies are respon­si­ble or grow­ing monop­oly power and polit­i­cal influ­ence. A sec­ond catch is that we are now in a period of slow growth, low infla­tion, and low inter­est rates. If a 10-​year U.S. gov­ern­ment bond pro­vides a guar­an­teed return of about two per­cent today, com­pared to an aver­age of around five per­cent for the lat­ter half of the twen­ti­eth cen­tury, then pric­ing stocks to pro­vide a sim­i­lar three per­cent excess return above bonds would imply earn­ing eight per­cent on your stock invest­ments in the past and five per­cent today. In the long run, the earn­ings of your stock in a com­pany are indeed what you earn (or should earn, absent cor­po­rate skull­dug­gery). When earn­ings are eight per­cent of the price of a stock, the mul­ti­ple of price to earn­ings is 12.5, which is below the long-​term aver­age. When earn­ings are five per­cent of the price, the mul­ti­ple of price to earn­ings is 20, close to the present situation.

Catch num­ber three: the mod­ern cor­po­ra­tion has become increas­ingly asset-​light. Some com­pa­nies own lit­tle besides patents, trade­marks, office fur­ni­ture, and desk­tops con­nected to the cloud. Any nec­es­sary man­u­fac­tur­ing, trans­port­ing, ware­hous­ing, and sell­ing is sub­con­tracted to oth­ers. The value of such com­pa­nies often will be enor­mously larger than the replace­ment cost of its assets, while the sub­con­tract­ing com­pa­nies may often be over­seas or not owned by pub­lic share­hold­ers. Gen­er­ally, brand names and monop­oly power are not included in most com­pa­nies account­ing of their assets. Since both monop­oly power and asset-​light busi­ness mod­els have grown over time, it makes sense that the ratio of stock mar­ket value to mea­sured assets should also increase. Indeed, the one time this mea­sure peaked higher than today’s level was the top of the dot-​com bub­ble, which in ret­ro­spect may not have been as irra­tionally exu­ber­ant as many of us thought at the time.

But What About Trump?

So far Pres­i­dent Trump has mostly suc­ceeded in alien­at­ing the rest of the world and much of Amer­ica with bombs, mis­siles, and words. The courts and many Repub­li­cans in Con­gress have dead­locked almost all of Trump’s agenda, to an even greater extent than they did Obama’s. Fail­ure to raise the debt ceil­ing or pass a bud­get might go fur­ther and cause more dis­tress than sim­i­lar fail­ures have in the past, but those ear­lier expe­ri­ences sug­gest that they will not cause cat­a­strophic or irrepara­ble harm to the Amer­i­can or global economies, nor to stock markets.

If the pres­i­dent were able to imple­ment any of his pro­posed poli­cies, the eco­nomic dam­age would likely be focused in only a few places. Cut­ting off immi­gra­tion or imports would hurt the U.S. econ­omy more than any­where else, with impor­tant neg­a­tive effects out­side the U.S. lim­ited to a hand­ful of coun­tries like Mex­ico, Guatemala, and the Philip­pines. Imple­men­ta­tion of var­i­ous other threats would typ­i­cally also do most of their dam­age in spe­cific regions or to spe­cific indus­tries. One plau­si­ble inter­pre­ta­tion of the recent turnover in the White House staff is that cor­po­rate Amer­ica has regained some of its cus­tom­ary influ­ence over the U.S. gov­ern­ment. As much as many of us might con­sider this trad­ing one bad thing for another, it will surely not be viewed that way by the stock market.

In this envi­ron­ment, and remem­ber­ing that coun­tries all over the world are expe­ri­enc­ing healthy recov­er­ies, inter­na­tional diver­si­fi­ca­tion of invest­ments is a more effec­tive pro­tec­tion against risk of loss than is nor­mally the case, as some regions and types of economies are likely to con­tinue doing quite well even if oth­ers suf­fer. In addi­tion, the for­eign recov­er­ies are mostly younger than the recov­ery here, with more room for profit recov­ery and stock mar­ket appre­ci­a­tion. We con­tinue to favor invest­ments in Europe, Japan, and Emerg­ing Mar­kets, as well as in e-​commerce. At the same time, we think that more tra­di­tional cycli­cal stocks are likely to do well in the younger over­seas recov­er­ies. For­eign stocks are still less expen­sive than U.S. stocks despite the gains they have already made, but in Europe the strong appre­ci­a­tion of the euro adds an addi­tional obsta­cle to future prof­its for an Amer­i­can investor.

From cur­rent lev­els we expect quite mod­est returns from most of the world’s stock mar­kets over the next 12 months, but still sat­is­fac­tory and bet­ter than bonds.

Robert has been a leader in socially respon­si­ble invest­ing since his pio­neer­ing work in SRI forty six years ago. He is cur­rently Chair­man of Zevin Asset Man­age­ment and has held var­i­ous senior posi­tions at the for­mer United States Trust Com­pany of Boston. In the 1960s Robert was also a pio­neer in the use of Mod­ern Port­fo­lio The­ory and com­puter tech­nol­ogy applied to invest­ment deci­sion making.