Every Little Thing is Going to be Alright

One of my two year old son’s favorite songs of the moment is Bob Marley’s hit “Three Little Birds,” whose chorus line states, “don’t worry about a thing… ‘cause every little thing… is gonna be alright…” Considering the rather tumultuous time we live in, this seems like sound stress management advice, and it is made all the better when sung by a verbally challenged two year old. This time of year is often a bit stressful for asset managers as it is a popular time for everyone to put out their market forecasts for the coming year. This usually includes what they think will happen or won’t happen; and by the end of the year they are almost inevitably at least half wrong. Here at CWM we try not to make market forecasts (though it does happen), but we do look at the probabilities of outcomes to determine the likelihood of negative future events. If risks are perceived to be higher, we take prudent steps to diminish the impact ahead of a negative market event actually occurring. Nothing is guaranteed of course. Currently, there is plenty of geopolitical risk and market valuations are relatively high, but that doesn’t mean the rally is over as there are also any number of things that might keep the market rally going in the near term.

Things to Worry About (in case you didn’t have enough already…)

The global political status quo is in complete upheaval after the surprise anti-establishment outcomes of 2016 and the continued potential for similar anti-establishment outcomes in Europe this year. These types of issues are what we call “headline risk.” This type of risk is characterized by an ability to cause extreme bouts of market volatility, typically for short periods of time and markets often move in the opposite direction of what was expected. Take the United Kingdom’s “Brexit” vote or our own presidential election for examples. Both events caused significant swings in market valuation in the following days, but neither ended up being the market calamity many assumed. Had investors sold in either case, they would have been on the wrong side of the market shortly after both events. We caution anyone away from making portfolio changes on headline risk fears. In most cases, these issues are usually well known, analyzed, and traded well in advance of the actual event date. More often than not the anticipation of such events is much scarier than the reality, if the event even happens at all. Low probability events with highly uncertain market affects should not greatly influence long-term portfolio management strategies. If you must worry, below is a list of the greatest geopolitical risks of 2017 according to Deutsche Bank. I stress again, most of these probably won’t happen or won’t really matter to markets in the long-term if they do.

<sub>Source: Folkerts-Landau, D. et. al. (January 9th, 2017). Deutsche Bank Research Outlook
2017. Deutsche Bank.</sub>

One item not on the list above is the coming return of the debt ceiling bogeyman in March. A violation of our nation’s, mandated by law, debt ceiling hasn’t been a concern for some time, but we are quickly approaching the $20.1 trillion (that’s $20,100,000,000,000) current debt ceiling. With Republican control of both houses of congress and the presidency, it is expected that the ceiling will be easily raised or perhaps even eliminated altogether. This issue always has the possibility of political theater/fireworks and it should not be dismissed out of hand, especially considering the current US political climate.

_{Source: Slok, T. (January 2017). US Economy: Animal Spirits are Back. Deutsche Bank.}

The above items are all known risks at this point and markets are forward looking mechanisms. This means that, to some degree, asset managers and private investors have analyzed these events, made portfolio changes if they were going to, and these events are therefore priced into the market’s current value. That is why in most years, the event that ends up being the big market mover is something no one was thinking about at the beginning of the year; another reason not to make forecasts.

Those who have followed our monthly articles know that our primary concern is always around valuations of the overall market. Markets continue to be slightly expensive, but not extremely.

However, some of my favorite market metrics over a longer timeframe, unlike the chart above, show markets are well above their long-term average and are sounding the alarm.

_{Source: Murphy, M. (January 2017). Global Income Chartbook. Eaton Vance Investment Management. Used with permission.}

The current rally, coming off of the 2009 low, has become 2nd longest in months duration and in total price gain, beating out the 1980s. This leaves only the 90s dot-com rally ahead of it. Perhaps the current rally has room yet to run, but it is difficult to qualify the current economic/business environment as greater than the 90s (or 80s even) and deserving of a comparable duration/value run in the market. Statistical data, based on the below table, tells us that there is less than 10% probability of a longer duration rally. Looking at the performance data, there is statistically a 23.6% chance we continue higher from here. Can the market rally continue? Yes. Does statistical analysis show a rising probability of the rally ending and turning into a bear market? Yes. Does that mean we should be more cautious in our portfolio positioning? Yes.

_{Source: Kelly, P. et. al. (December 31st, 2016). Guide to the
Markets. J.P. Morgan Asset Management.}

Taking a different look at overall market valuation via 5-year annualized returns, the S&Ps current level is in the 90th percentile according to Goldman Sachs. This level historically has around a 60% probability of a future positive 5-year outcome. If a positive outcome does occur, it will likely be in the low single digits (4-6%). Put differently, investors in the broader market are currently risking a 40% chance of future, perhaps significant, loss for the potential that they eke out a small 4-6% gain. It should be noted that if market price does increase from here, the probability of a future loss also increases. Because of the current increased risk of a negative outcome in the overall market and the probability of low upside potential, we continue to recommend conservative and diversified portfolio allocations.

_{Source: Market Know-How. (Q1 2017). Goldman Sachs Asset Management.}

There is always something to worry about if one looks hard enough. The challenge is discerning what actually matters, what has a relatively high probability of occurring, and what the potential fallout might be in the occurrence of that event. Of the above listed issues, market valuations represent the most significant risk in our opinion, but it is possible for the markets continue to move a bit higher for a bit longer yet. Assuming markets do continue higher, patience with conservative methods will be tested, as no one likes to miss out on gains. However, we believe patience will be the key determiner of success in coming years as it remains our belief that defense wins championships.

But on the Brightside…

There is some potential for a continued market rise, so it is worth considering what might propel markets higher. From a political standpoint, there is the potential for significant bipartisan effort to reform corporate taxes. As it stands, the US has the highest corporate tax rate in the world as many other developed nations have cut their rates since 2006. The current US rate of 39% is now well above the developed world average of 28%. The potential tax savings from a competitive tax restructuring could be huge for the bottom line of US companies. Higher revenues typically result in higher stock valuations.

_{Source: Kelly, P. et. al. (December 31st, 2016). Guide to the Markets. J.P. Morgan Asset Management.}

The US consumer also remains a potential source of economic growth, as spending is still a major part of US GDP and the balance sheet of the average American family generally looks fantastic. Household net worth is at all-time highs thanks in part to the long stock market rally, but also to the recovering housing markets, the growing trend to eschew personal debt, and rising wages.

_{Source: Kelly, P. et. al. (December 31st, 2016). Guide to the Markets. J.P. Morgan Asset Management.}

Since the 2008 economic crisis there has been a large movement towards debt-free or a reduced debt lifestyle. The amount of personal income necessary for debt repayment (the debt service ratio) has dropped from 13% to under 10% and the debt to disposable income ratio has dropped from roughly 125% to 75%. This represents the potential for consumer spending to pick up considerably, assuming the American public decides to return to their former higher spending ways. The chart below shows that the declining rate of debt use since the last crisis has slowed or stopped all together. Either we have seen a major paradigm shift where debt use does not return back to more normal levels or the American consumer may be about ready to get out their credit card again, which of course helps company bottom lines and their stock valuations.

_{Source: Mathias, A. (January 2017). Global Macro Briefing. Guggenheim.}

Another potential driver of consumer spending is rising wages. After almost a decade, we are finally starting to see wages rise at over 4% per year. Economically, this is a bit of a mixed bag statistic as the rising wages are good for consumer balance sheets and potential spending, but not for the balance sheets and valuations of companies that must shoulder the additional labor cost.

_{Source: Slok, T. (January 2017). US Economy: Animal Spirits are Back. Deutsche Bank.}

Though there is potential for markets to move higher still, relatively high valuations remain the primary focus for us. Current valuations reflect a high and rising probability of a negative outcome, which we are hoping to mitigate for our clients when it occurs. CWM PTS™ models continue to be invested conservatively, as they have been for some time. Your CWM team will continue to be disciplined in our efforts to provide the best risk adjusted returns possible.

Please pass this article on to any one you know who may be interested in or might benefit from the information. We are always looking for more great clients just like you and would welcome any opportunity to assist them.

If you have questions or comments about the above subjects or other investment topics, I would love to have a conversation with you! Feel free to email me at MorganA@CWMnw.com or if you are interested in more regular financial tidbits, follow me on Twitter.

Morgan Arford
Chief Investment Officer, Principal
MorganA@CWMnw.com

P.S. On a lighter note, my recent favorite memory is when the youngest Arford (10 months) met the oldest (93 years).