Trademark Market Perspective for 12/28/17
Bonds made a move lower over the last couple of weeks most likely in response to the apparent inevitability of the new tax law lowering corporate tax rates. This development encouraged investors to believe that economic activity would be stronger in the future and that inflation would be higher. As a result, the yield curve’s flattening trend was broken. I’m not sure that this is a trade I would get behind at this point. The fact is, bond yields have a strong seasonal tendency to rise in December as investors expect economic conditions to improve in the coming year. In the last 9 years, only 2011 and 2014 have not seen bond yields rise in December.[1] For me to get really bearish on bonds I would need to see the 10-year note yield break above 2.65% amid yield curve steepening, and stocks would have to be performing reasonably well. This would tell me that investors were buying into a faster growth/higher inflation narrative, such that a healthy asset rotation was underway. Bottom line: resist the urge to dump your bonds until a new trend toward higher rates is more firmly established.
My feeling about the stock market is this: we are not trading on fundamentals, despite what all the 2018 Market Outlooks say. We are trading on sentiment. That sentiment has gone from mildly bullish to full-on greedy. How else to explain Bitcoin and all the other crypto currencies? If you ask enthusiasts it is about privacy and efficiency. If you give them a beer and ask them again it is about making a ton of money in a very short period. It has been my experience that get-rich-quick-trades like Bitcoin happen late in the economic cycle. Whether it is people quitting their jobs to day-trade tech stocks (1999), people buying multiple properties for a quick flip (2006), or today’s crypto mania, there is confidence that the world is full of greater fools with the means and desire to buy things at an ever-higher price. Such a cycle of emotionally driven investing never ends well. The eventual popping of the bubble creates a negative wealth effect that can spill over into other assets and possibly into the larger economy.
It is easy to suggest that stocks have moved up this year because the economy is improving, and corporate profits are going to get a boost from tax law changes. That isn’t wrong, but it isn’t the whole story. The stock market has not experienced a down month all year. That is highly unusual. That tells me that something in our collective belief system has changed. After all, stocks rose 37% in 2013 yet there were two down months. Gains topped 30% in 1997, but there were three down months.[3] Even when things were good, occasionally investors took profits. That’s how healthy markets work. The lack of even a three percent pull-back in 2017 tells me there is a certain “can’t lose” mentality at work.I fear that the end of this streak is going to result in a hard landing. Not immediately, but ultimately. As you recall, if you tried to buy the dip in 2001 or 2008, you got steamrolled. There are no good selling opportunities on the right side of a parabola.
Bottom line: I believe that it is a necessity to lighten up on stocks, and that also means to prepare yourself for the underperformance that results from lightening up early. If we are lucky, we will be selling into the long overdue minor correction that sets the stage for the next leg of the bull market and will get the opportunity to buy a lower price. Alternately, if the next leg down represents a structural shift in market sentiment we will be selling near the top of the latest parabolic stock move.
Commodities are the sector to watch. If the global economy is truly in a sustained growth cycle, the price of energy, base metals, and other commodities should benefit. If commodities don’t rally (and if interest rates cannot hold the recent rally), then economically we could be on shaky ground. Historically, technology, biotech, utilities, and staples are the classic weak economy scenario industries and they have been relatively out of favor since the tax bill became more likely than not in early December. Financial services, industrials, retail, and energy may currently be benefitting from the idea that 2018 may see a higher level of economic growth. I’m still skeptical that domestic economic growth will be higher in 2018. I expect that energy and real estate will perform well in the first quarter because they appear to be the biggest winners from tax reform. Since most technology stocks had a fairly low tax rate to begin with, they shouldn’t benefit as much from corporate taxes being lower (even with repatriation).
From our perspective, one of the better investment ideas this month has been frontier markets. From reformer Cyril Ramaphosa’s win in South Africa to the continuing turnaround story in Argentina, this is where most of the positive global surprises are coming from. My frontier markets preference is Ashmore (EFEIX/EFEAX).
-Mark Carlton, CFA
[1] Source: Telemet Orion
[2] John Mauldin’s Over My Shoulder, 12/18/17
[3] Source: Telemet Orion
[4] John Mauldin’s Over My Shoulder, 12/18/17