2018 will mark the 10th anniversary of the global financial crisis. Since then, the economy has been on a record long expansion and the stock market has roughly tripled from its bottom. Unfortunately, fear of further pain and a completely new economic environment have kept many people cynical and out of the markets.
As markets continue to rally into the New Year, many younger investors have caught a case of FOMO — fear of missing out. Is it at just the wrong time? Are they making the same mistakes of the past. The answer is probably, they just don’t know it yet.
In this year’s letter, I take some time to talk about the continuing “slow growth forever” global economy, President Trump, a new Fed Chief, rising tension in the Middle East and some factors that could play out very badly. All that though is up against a global economy that is growing, record profits at corporations, near full employment in the United States and a rising standards of living for the tiny Xer generation and the huge Millennial generation.
Grab a tall glass of water, this is “must read” material.
The Markets Are Topping, But Where’s THE Top?
If you read my most recent article The 12 Sells Of Christmas, then you saw the charts I put up showing the similarity between the current bull market and the one from just before the financial crisis. You also saw the CAPE ratio chart.
Here are some more scary charts. And, if you don’t find them scary, you don’t scare easy enough, so pay attention and have a little respect and fear of what these charts are implying.
Here is one of the best pages for keeping track of things economic and market related by charts. These might be the most stolen charts in the financial advisory industry: dshort — Advisor Perspectives
What you should think there are two things. First, “dang, that’s the third highest valuation for the stock market in history.” Second, “hmmm, I wonder if it could become the highest?”
Notice, we are approaching the 3rd standard deviation. What does that mean? It means, reversion to, or beyond, the mean is coming. Understand what I mean? Because I mean it.
I’ve mentioned Crestmont before. I love me some Crestmont. There’s more in the linked article. Here’s one to ponder, it’s left incomplete:
The chart shows that we were undervalued in 2009, but not that much compared to following other crashes. Does this imply more pain ahead? Could be, it could be. For more, read: Validating the S&P Composite Stock Price Index — dshort — Advisor Perspectives.
Once again, it’s not hard to see that the stock markets are overvalued.
Warren Buffett cites the low interest rates as the reason we are seeing higher valuations. Jeremy Grantham this summer talked about the possibility that we see valuations stay higher for a long time. I don’t argue with either point.
However, the clear overvaluation on stocks adds an element of risk for investors because of the unknown element of whether or not valuations can stay this high. That in and of itself makes investing harder.
It is more important than ever to build our own little mini-indexes vs. using the big broad indexes. By having our own 20–30 stock portfolios with a small handful of ETFs, we can use both smart stock selections with asset allocation to protect ourselves and take advantage of investment opportunities.
Reinforcing Some Lessons In 2017
Peter Lynch’s idea that a few big winners can propel a portfolio certainly does play out. That’s why it is important to have a big dose of growth stocks in a portfolio. Our substantial outperformance in 2017 was largely due to just a few stocks and an ETF.
I know that it is popular to load up on dividends in portfolios, however, most investors do that wrong. They imagine that high dividends are a sign that a company is doing great. Often, that is a sign that something went wrong and the dividend shot up as the stock price fell. We have seen that play out in hundreds of “safe dividend stocks” over the years.
“Dividend growth” investors often forget to focus on that second word: growth. If a company is not growing, but is constantly raising its dividend, at some point they will run into a problem. Revenue and earnings might fall or expenses might rise. As we enter an era of higher interest rates and rising commodity costs, we should be wary of companies that raise their dividends without growth or with use of financial engineering.
Overall, 2017 was a very, very good year for most investors. However, investors who glom onto media and financial industry narratives only did about as well as the markets. Why, because whether they intended to or not, they largely indexed to the market.
I do not care much for asset allocation strategies that include somehow mirroring indexes — even if inadvertently. To me that completely defeats the point of intelligent asset allocation that I have talked about.
When I take equity risk, I am looking for absolute returns. I am not looking to somehow beat the index by a point or two — which is how many dividend growth investors [DGI] seem to think of things now.
If I am going to take equity risk, which let’s be very clear here, is to accept that you can wake up 50% down on any given day, then I want anything I own to have enough upside.
My demand for taking individual stock risk is that I want a very high level of confidence I will double money on a position within 5–7 years (so, 10–15% minimum return) with a good chance the double will actually occur within 2–4 years (18–36%), and that there is a chance the stock triples within 5–7 years (16–23% returns or better). To me, if I can’t shoot for those numbers, what is the point of equities?
Take A Look At The Big Picture
Macroeconomic analysis, or top down, has largely become a futile form of analysis for many investors who have been foiled by an inability to forecast well. Lackluster returns have led many to abandon even trying to develop investment thesis based on macroeconomic data and analysis.
John Curran, formerly a partner and head of commodities at Caxton Associates, and chief investment officer at Tigris Financial Group, discussed the decline of macro investing in an article on Barron’s where he postulated about The Coming Renaissance of Macro Investing.
In meetings with fund managers, asset allocators, and analysts, I have found a virtually universal view that macro investing — investing based on global macroeconomic and political, not security — specific trends — is dead, fueled by investor money exiting the space due to poor returns and historically high fees in relation to performance. This is what traders refer to as capitulation. It occurs when most market participants can’t take advantage of a promising opportunity due to losses, lack of dry powder, or a psychological inability to proceed because of recency bias.
Curran believes that the coming decline of the petrodollar “will lead to a renaissance in macro investing” though. I agree. I have written extensively about oil the past seven years and more recently about the decline of the petrodollar at MarketWatch and here on Seeking Alpha:
- The ‘Last Great Secular Oil Bull Market’ Has Begun
- Is This ‘The Calm Before The Storm’ On Iran And Oil?
- The Coming ‘Peak Oil Plateau’ And Higher Oil Prices
I believe much of the disappointment with macro analysis for developing investment ideas is that it is used by most in isolation from other methods of analysis. Another clear factor is a lack of talent and unbreachable biases by many of the analysts.
Instead of using macro analysis on its own, I have developed a repeatable process I call the “Core 4 Investing Method”. This approach incorporates four key pillars to developing an investment thesis. A more complete analysis can be found in:
Before closing out this long introduction, I want to return to Curran who made another point that I agree with. He believes that now is an opportune time to embrace macro investing ideas:
I regard this as an extraordinarily opportune moment for those able to shed timeworn, archaic assumptions of market behavior and boldly return to the roots of macro investing.
The opportunity is reminiscent of the story told by Stanley Druckenmiller, who was promoted early in his investment career to head equity research at a time when his co-workers had vastly more experience than he did. His director of investments informed him that his promotion owed to the same reason they send 18-year-olds to war; they are too dumb to know not to charge. The “winners” under the paradigm now unfolding will be market participants able to disregard stale, anomalous concepts, and charge.
He moved onto a discussion of challenges facing “trend following.” I believe that the trend followers left are about as likely to avoid what I think will be a sudden major correction in equity markets as the indexers who will figure it out around the third or fourth wave down in prices.
In response to my belief that trend following has become compromised in recent years by the supercomputers and algos, I have embraced finding trend reversals on a “just in time” basis as a safer and more profitable, as well as frequently holding extra cash. Curren had this to say:
…THERE IS a running debate as to whether trend-following is a dying strategy. There is plenty of anecdotal evidence that short-term and mean-reversion trading is more in vogue in today’s markets (think quant funds and “prop” shops). Additionally, the popularity of passive investing signals an unwillingness to invest in “idea generation,” or alpha. These developments represent a full capitulation of trend following and macro trading.
Ironically, many market players who wrongly anticipated a turn in recent years to a more positive environment for macro and trend-following are throwing in the towel. The key difference is that now there is a clear catalyst to trigger the start of the pendulum swinging back to a fertile macro/trend-following trading environment.
As my mentor, Bruce Kovner [the founder of Caxton Associates] used to say, “Nobody rings a bell at key turning points.” The ability to properly anticipate change is predicated upon detached analysis of fundamental information, applying that information to imagine a plausible world different from today’s, understanding how new data points fit (or don’t fit) into that world, and adjusting accordingly. Ideally, this process leads to an “aha!” moment, and the idea crystallizes into a clear vision. The thesis proposed here is one such vision.
Now that I have gotten some preliminaries out of the way and before I move onto my sure to be wrong forecast for 2018, let’s take a look at a handful of forecasts for 2017 that were, let’s say, pretty par for the course.
2017 — The Year That Wasn’t
Macro forecasts abound near the end and beginning of each year. Here are some of the pronouncements that I found which were often repeated. I’ll include sources to expose the guilty and validate the prescient.
“As Trump launches his policies… the Fed is likely to tighten its monetary policy more than it had planned before the inauguration, not less, as the markets still expect. More important, as Trump’s policies boost both real economic activity and inflation, long-term interest rates, which influence the world economy more than the overnight rates set by central banks, are likely to rise steeply.” - Anatole Kaletsky Chief Economist, Institute for New Economic Thinking from: Three predictions for the economy in 2017
- The Fed actually did about exactly what it said it would and long-term interest rates haven’t changed much.
“After seven years in recovery mode, the beginning is over and the real expansion is underway…As the atmosphere morphs into a cyclical upturn, consider value stocks, financials, and other cyclical assets that we expect will benefit from the upturn.” - Principal Global Investors
“After a lackluster outturn in 2016, economic activity is projected to pick up pace in 2017 and 2018, especially in emerging market and developing economies. However, there is a wide dispersion of possible outcomes around the projections, given uncertainty surrounding the policy stance of the incoming U.S. administration and its global ramifications. The assumptions underpinning the forecast should be more specific by the time of the April 2017 World Economic Outlook, as more clarity emerges on U.S. policies and their implications for the global economy.” - IMF World Economic Outlook January 2017
- Translation: “we don’t know.” At least that was honest in a long hand sort of way. Their growth estimates were quite a bit light for 2017, so they proved they didn’t know.
“Crude oil prices are forecast to rise to $55 per barrel in 2017 from an average of $43/bbl this year as the market continues to rebalance and OPEC is likely to limit output.” - World Bank October 2016 Commodity Markets Outlook
- Hey, that one is pretty darn good. Yeaaa!!!
“If, as assumed in the projections, the incoming US Administration implements a significant and effective fiscal initiative that boosts domestic investment and consumption, global growth could increase by 0.1 percentage point in 2017 and 0.3percentage point in 2018.” OECD Economic Outlook, Volume 2016 Issue 2
- Of course there has been no fiscal initiative in the United States and a tax cut bill for next year just passed, but growth has continued in America and has expanded more than expected globally despite no U.S. stimulus.
|Firm||S&P 500 Forecast||EPS Forecast|
|Credit Suisse (CS)||2300||123.9|
|Deutsche Bank (DB)||2350||130|
|Goldman Sachs (GS)||2300||123|
|JP Morgan (JPM)||2400||128|
|Morgan Stanley (MS)||2300||128.70|
|Societe Generale (OTCPK:SCGLY)||2400||-|
- The S&P 500 is of course at about 2,682 right now. Earnings are set to clock in at about $144 according to FactSet.
So, RBC takes the prize. Now of course, everybody is revising 2018 forecasts up. This is I presume to make up for being so wrong in 2017. Here’s another link to see how crummy analysts were in 2017.
My own S&P 500 forecast was 2,600 in a couple places, but this was the most fun regurgitation of it from an article titled: Value Traps Are Par For The Course
- That’s not the original S&P 500 estimate as the main one was behind a paywall. I’ll go public for 2018 below. I went on with Mark in this exchange, which will lead us to our next section.
I’ve had some great talks with market big shots over the years. I’m curious to see if I’m right that we’ll get some early year volatility followed by a rally. We’ll see.
My Wrong Forecast For 2018
Let’s start right off with the S&P 500. If you have been following along and read The 12 Sells Of Christmas, then you saw my case for the S&P 500 being overvalued. Here’s I think the best chart:
Here you see that the stock market is somewhere between a 2nd and 3rd standard deviation away from mean. What does that mean? It means that we should expect some reversion to the mean. It does not mean that mean reversion has to happen right now though. Know what I mean? It could mean that we see a little correction, which isn’t so mean, and then a move into La La Land past the 3rd standard deviation which will mean look out below, things are going to get mean. While Yusko sees euphoria now, I only see as coming soon. I did mean to have some mean fun with the word mean there by the way.
How do I know euphoria isn’t here quite yet? Well, I have the luck of knowing a lot of Millennials due to having been involved with men’s baseball in Milwaukee, I travel, I join their groups and the fact that I still will go to a bar from time to time. Here’s what I know. Most Millennials don’t have the experience to know that things are expensive.
In short, the Millennials have not gotten their humbling from the markets yet. There is a great humbling coming. The set-up is going to be a doozy though.
Here’s how I think the S&P 500 could play out in 2018. First off, there will be some profit taking early in the year and a small correction, maybe 5%, maybe 10%, maybe as much as 19%, but not 20%, because that would be an official “bear market” and we can’t have that so says the “Gods of Algo.”
The “Gods of Algo” are of course all the money that can be moved quickly via radar waves and fibre optic hot links to the markets that have a .001 second advantage on the rest of us schmucks.
I also don’t see much benefit of the tax cuts or a future infrastructure bill in 2018. The benefits will come in 2019 as money is repatriated and some spending actually occurs. The thing is, we know that most of the “found money” will not be invested, it will go to pay down debts and be paid to shareholders. Sure, the half of the population that spends every dime they have will spend it, but who cares, it ain’t that much and is a one off event that will get eaten by inflation down the road.
I also don’t think a tightening Fed and slowly slowing China bode well for global economic growth. Sure, there is still a lot of debt driven QE loot floating around, but we’re getting close finally to a “recognition” of either inflation or that the economy just isn’t really all that good organically. Maybe both. We’ll see. I don’t think the “Big One” comes until 2020, which followers will get to read about. Subscribers are already getting hints as I plan a trip to Japan (hmmm, a hint maybe? Ask Kyle Bass).
Ultimately, I see an earnings disappointment towards the end of 2018, maybe Q3. That will wipe out any rebound from the early year correction. By year-end, I see an S&P 500 with earnings at about 130 and trading at 2,500. Multiples won’t respond to that.
So, I see a small loss for 2018 on the S&P 500. Ah, but remember, I also see the S&P 500 going to 3,000 by late 2019, so, get ready to be a buyer on the small correction that’s coming.
Of course, I’m probably wrong and I know it. So, I’m keeping 25% in cash, writing a lot of cash-secured puts on companies I like from lower entries and have some limit orders placed for the PowerShares QQQ (QQQ) if support levels are reached. Ultimately, I like the stocks I buy, so I’m not worried about being heavy in cash. Smart tactical asset allocation is a good thing. I have been able to beat the market despite high cash levels in 2017. I’ll share that composite chart as soon as I have year-end numbers.
What Else Do I Think?
Well, I think we’re getting closer to balance in the oil markets, so I think oil is going to $80. I talked about that here:
That will lead energy companies and the SPDR Energy Select ETF (XLE) to be among the leaders next year, although I like the SPDR S&P Oil & Gas Exploration &Production ETF (XOP) better as detailed here:
I think there will be more gunfire and missiles in the Middle East and that we might even see Iran have a bit of an uprising soon that is supported by strange bedfellows:
I think that GDP will disappoint and come in closer to 2% than 3%. So the over and under is 2.5%, and I’m taking the under.
More people will realize that climate change is real and that burning coal and oil is really bad for the planet and us.
I think the Packers go 15–1 next season finally get home field advantage in the playoffs and win the Superbowl (yeah, that’s early 2019, but so what).
I also think my Milwaukee Brewers will narrowly get into the playoffs in 2018 after narrowly missing in 2017. Domingo Santana will be NL MVP! (Homerism? Sure, but again, so what.)
The Milwaukee Bucks are going to be a surprise team at the end of the 2017–18 season winning a playoff series and looking very good moving into next year with LeBron out in L.A.
I might even win a World Series of Poker bracelet.
I’ll be safer than the markets as usual and probably still beat the index returns (again), especially if I’m right about an early year correction.
HAPPY NEW YEAR!!! THE WORLD IS GETTING BETTER! BELIEVE IT! EVEN IF THERE ARE BUMPS IN THE ROAD.