23 Jun 2017 Where Do We Go From Here?
With summertime upon us, complete with tropical storm Cindy soaking the South, and nearly half of 2017 in the books, this might be a good time to review the progress and condition of the capital markets. While forecasting the direction of the markets is not one of our value-adds, better understanding what could be ahead encourages us to keep our ‘financial umbrellas’ at the ready.
Stock investors remain confident that President Trump and the Republican-majority Congress will improve US economic growth by fixing health care, lowering taxes on corporations and small businesses, and increasing military and infrastructure-spending, despite their plodding progress. Stock prices so far this year are up from 9.2% to 9.8% as measured by the Dow Jones Industrials and the S&P 500 indexes, respectively. Our US Treasury allocation of 7-10 years is up 3.5% for the year, despite two Federal Reserve interest rate hikes this year and three going back to December of 2016.
The Fed wants short-term borrowing rates it lends to banks to range between 1% and 1.25%. They target inflation at 2%, but their near-term and 12-month forecasts are below that level, causing some to wonder if this month’s rate increase might be too early. The benign inflation outlook and slower-than-expected economic stimulus measures from Congress have buoyed bond and Treasury prices, keeping rates low.
Stock prices have been strong and well-supported since the elections of Mr. Trump and the Republican majorities in the House and Senate as investors hope that expected policy and regulatory changes will result in a healthier economy and improved corporate earnings. Note in the chart to the right, the near-tripling of the volume of stock buyers starting in mid-December of last year.
But expectations that are driving stocks higher must eventually be met by the reality of rising corporate earnings. Today the Senate is deliberating their version of healthcare reform. Whether Mitch McConnell can get the bill passed and a compromise between House and Senate can be worked out in committee remains to be seen, but legislators are far ahead of where most critics expected.
Once (if) healthcare is passed, congress can move onto legislation that is more directly impactful on corporate earnings, like reduced taxes and expanded government spending on infrastructure and military. But, what if these do not happen? Are stock prices too high?
The most widely used measure of stock valuations is the price-earnings ratio. The P/E ratio for a specific company is calculated by dividing the company’s earnings per share of stock by the stock’s price. To determine the P/E ratio of an index or a collection of companies, like the 500 corporations in the S&P 500 index, the earnings per share for each company are added together and the sum is divided by the index’s price.
Today’s S&P 500 P/E ratio sits at 25.75, exactly the average of the past 19 years. If, however, we remove the spike to 70 caused by low stock prices during the Great Recession, we see get an average of 23.5, making today’s 25.75 appear a bit on the high side. But, remember expectations for earnings growth are higher than usual as well. The big questions are whether the Congress can enact the promised policy changes and whether the economy and corporations will respond in kind.
The US economy has been growing at about two thirds of its presumed potential for more than a decade. Most recently first quarter 2017 growth has been pegged at 1.2%, decidedly down from the fourth quarter’s 2.1%. A problem with slow growth is that jobs are not created in sufficient quality or numbers to stimulate consumer spending, which represents some 70% of our economy. A more subtle, but significant problem of slow growth is that it takes less of a shock to the system to halt, even reverse the economy’s momentum. If economic improvement doesn’t materialize in the next quarter or two, investors may ultimately find that stock prices too high.
We are not predicting or even suggesting that a stock market correction is near. That said, it always makes sense to be prepared for stormy weather, by ensuring that you are not taking more investment risk than is required to meet your goals and that your portfolio is carefully designed to meet the volatility of occasional market/economic uncertainty.
For example, if your stress-tested financial plan indicated sufficient confidence with a portfolio return of 5%, our most conservative Beacon 30 portfolio would do the trick. Its 10- year gross return of 5.8% before fees has been delivered with very low volatility, suffering only a 2.6% decline during 2008, when the the stock market was down 40%. By the way, the all-stock indexes, as measured by the Dow Jones Industrials and the S&P 500 have averaged only 7.2% and 7% respectively by comparison to the 5.8% of our Beacon 30, containing only 30% stocks.
Now here’s the most important part: Without a financial plan, the information shared so far is meaningless and, therefore, worthless. When it comes to understanding appropriate risk, determining best financial options, recognizing opportunities, and avoiding mistakes, facing life’s uncertainties without a financial plan is like floating on the ocean in a small boat completely at the mercy of winds, currents, and storms. One may wash ashore on the island of his or her dreams, another may sink, but most will wind up in a large non-descript harbor with a lot of other boats that drifted in without aim or purpose.
A life plan like a sea chart, compass and sextant at sea, inform us of when corrections are needed, identifies favorable tides and winds, and enables u to avoid the worst of storms that will surely come. Let us help you bring purpose and direction to your financial life to meet and exceed your highest aspirations.
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