It has been a while since we sent out an update because from an investment standpoint, not much has changed. There continues to be basically three scenarios for the market, and any individual security is a play on one, or at most two, of them:
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The lower-for-longer scenario. Some call this the Obama trade. Slow economic growth and low cost of capital means that companies experiencing real sales growth can borrow cheaply. They are going to be prized, no matter how expensive, because their growth rate can be projected into the distant future with little time value of money discount. Most technology fits this description, as does certain media, industrial services, and consumer stocks. Large cap growth is the best fit sector.
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The cyclical expansion scenario. Some call this the Trump trade. The idea is that economic stimulation via tax cuts and de-regulation will lead to a tradition cyclical growth phase, which will benefit companies more leveraged to the capital goods economy. Think transportation, industrial production, financial services, materials, mining, and energy. Small cap and value stocks may be the way to play this.
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The recession scenario. The economy fails due to excess debt and not enough demand. High quality bonds may be the best way to play this, although utilities, consumer staples, and certain high dividend telecom and energy stocks might also work out. Very large cap dividend stocks tend to lose the least in down markets.
Since the first quarter of 2016 money has shifted back and forth between scenarios 1 and 2. In other words, money didn’t leave the stock market, it was simply redeployed. Hillary Clinton was a scenario 1 candidate, so when she lost scenario 2 stocks surged. Since March the air has completely leaked out of the scenario 2 trade on the failure so far of the Trump administration to deliver on their promises. Interest rates are back down to the levels that existed before the election and small cap stocks have almost no gain in 2017. Yet markets are not pricing in Scenario 3. Slow growth, high dividend stocks are still not attracting a bid.
Until something changes, money is likely to continue to flow to large cap growth stocks. Capitalization has been the best predictor of return this quarter. Look for very large cap stocks funds (yes, the American Funds Group should do well in this environment). I am also using the iShares Morningstar Large Cap ETF (JKD), which has a ridiculously high average market cap of $126 billion.
Other Thoughts
In other matters, I’ve been watching gold lately and I am not impressed. Year to date, the dollar has dropped 11.1% and 14.6% versus the euro and Mexican peso, respectively. And gold can only gain 13%? It’s up just 5% this quarter in a dollar free-fall? See Chart 1. Many strategists such as Ray Dalio have been recommending gold recently due to economic and political dysfunction. Maybe that will work out, but our experience is that when your thesis plays out but your investments hardly move, you need to get out of that trade.
Chart 1
I would like to pass along one of the best articles I have ever read. Charles Gave did a brilliant job of explaining why low interest rates are not just no panacea for an economy, but over time a killer of entrepreneurship. Low interest rates were what we needed to escape a frightening contraction that gripped markets in 2008, but extending them past 2010 has brought on a set of circumstances that are de-stabilizing both to the economic and political world. I believe you will find it interesting. At the very least, you will understand why scenario 1 has been so successful in this “recovery”. You can access the article by clicking here.
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