A new client writes, “So . . . why should I not sell all the stocks I still have a profit in?”
That is a reasonable question. From the September 20th all-time high, the major averages have taken quite a pounding.
Major Market Returns through 11/23/2018
As of Friday US Markets were unchanged on the year, and just 2.0% above the lows for the year set on February 8th.
How can this be, when the US economy is doing so well? For example, Consumer Confidence is at the highest level since right before the 9/11 terrorist attack, and at the second highest level since measurements began in 1967:
Source: Bloomberg, Conference Board
Business confidence is at the highest level since 1983:
Source: Bloomberg, National Federation of Independent Business
The US Unemployment rate is at the lowest level since 1968, with a record 157 million
Source: Bloomberg, Bureau of Labor Statistics
Americans employed full-time. The participation rate, at 62.9%, remains below the record level of 67.2%, which prevailed around 2000, which means that at least 10 million additional Americans could be working, but are not. Despite relatively stagnant wage gains, US Real Median Household income is at a record $62K/year.
Company earnings for Q3 2018 were up 25.6% on an 8.4% increase of revenues (a record level.) 79% of companies beat estimates. Thanks to the tax cut, US corporations are swamped with cash and have already used $1 trillion to buy back stock.
So nothing but good news, right? Yet this is the second time this year we’ve seen a 10% or more sell off. What do stock traders know that average Americans don’t know?
The stock market has been less healthy over the last year than the successive record highs would indicate. We have often talked about the FAANG stocks – Facebook, Amazon, Apple, Netflix and Google. For much of the last 4 years, owning these stocks became a one-direction trade, with gains of 115-600%. By this summer, both Amazon and Apple exceeded $1 trillion in market capitalization, and the FAANG stocks totaled 13% of the S&P 500 and 32% of the NASDAQ 100. Most stock market indices are market cap weighted, so a handful of ultra-cap stocks can drag the averages higher even if most stocks are not budging.
When those stocks break (as we have seen in recent months,) market indexes drop faster than
the average stock. We own Amazon, Apple and Google in our client accounts, but we have been net sellers (scaling back positions to less than 5%, preferably 2.0-2.5%) of these companies for the last five years. When a stock price is going straight up, it is very hard to keep to the discipline of position management. We are rewarded in moments like this where we sold high in a popular stock, used the proceeds to buy low in an unpopular stock or sector. For example, we have been net buyers of Emerging Market Index funds all year. We have yet to be rewarded for that decision, but don’t worry, time is on our side.
The bigger problem is investor worries about next year. About half of the record earnings US companies received in 2018 resulted from the giant transfer of cash from average Americans to corporations. Wait, how can that be – didn’t Americans get a reduction in the amount of income taxes withheld from their pay checks. Well yes, but the most optimistic study we’ve seen so far shows that the cut works out to an average of $1,400 for the average household, or $2,917 for a family of four. In other words, most people wouldn’t notice the benefit in their take-home pay. Compare your January to February pay stubs to see if you can see the difference.
Meanwhile, taxpayers in high tax states like California, New Jersey, Massachusetts and New York will actually face a higher net tax bill since state and local taxes, particularly real estate taxes, are no longer deductible. The increased tax burden will be a drag on consumer spending starting in 2019.
Here’s another problem with the tax bill – an exploding deficit. The projected increases of revenues from the “stimulative” effect of the tax cut were largely fictitious. As a result, the original budget deficit for Federal Fiscal Year 2018, at $526 billion, has now doubled to $1,085 trillion. So in return for an extra $1,400/year in payroll savings, the average household will be responsible for an extra $4,400/year in debt (currently totaling $852K/household.)
By the end of World War II, US Federal Debt was 120% of US GDP. By the start of the Reagan Administration, the ratio was down to 32%. The Reagan tax cuts set the deficit expanding again. Under Bill Clinton, the US budget was as close to balanced as at any other time in the last 100 years, so the debt to GDP ratio declined. That trend reversed with the George W. Bush tax cuts, and then soared under the massive borrowing under Obama necessitated to head off the Great Recession.
At the tail end of the Obama administration growth in tax revenues exceeded growth in spending, so the deficit began shrinking. However, with the doubling of deficit under the Trump-Ryan tax cuts, the US is now in a very precarious position with total debt greater than annual GDP. In the next financial crisis, the US would not be able to issue additional debt without ending up like Japan (223.8% debt ratio,) Greece (180.0%,) Italy (131.2%) or Portugal (127.7%.)
The next area of concern is the damage to US businesses and farmers caused by escalation of trade tariffs. So far, farmers who produce soybeans, wheat and dairy products are taking the brunt of the pain as China turns to other suppliers, causing US agricultural prices to plummet. However, manufacturers large and small are suffering from the 25% tariffs on imported steel and aluminum. The Mid-Continent Steel & Wire company lost 70% of sales and 200 jobs since those tariffs took affect June 1st. The fastener company can’t compete with imported nails, which are not subject to tariffs. Survival may depend on moving the factory (and 500 jobs) to Mexico.
Bloomberg News is tracking the effects of the tariffs based on company announcements. 62 so far have announced negative impacts, though 7 companies have announced positive effects. Unfortunately, the positive effects are the result of steel and metal processors raising price for domestic consumers; Saudi Aramco raising natural gas prices to China as China cuts imports from the US; the CSX Railroad system raising prices to accommodate increased shipments of iron ore, which raises the cost of everything else shipped by rail. China does not pay tariffs; American consumers pay tariffs.
The damage caused by the Trumpian tax and trade policies are not obvious to the average Trump voter, but the executives of major US companies appear deeply worried about the next couple of years. We measure executive confidence by insider stock sales (highest levels since 2008,) Manhattan real estate sales (prices of luxury apartments are down 12% over the last quarter while inventory is up 27%) and East Hampton vacation home sales (sales down 12.8%, prices down 5.3%.)
So if this is all bad news, should we be dumping stocks? No. The stock market is a wonderful discounting mechanism. All this bad news is already reflected in market levels. We wondered back in July when (not if) the stock market would sell off. We raised cash for clients who had needs coming up in the next 6-12 months, and went slow on investing new cash.
For sure, we expected a 10% correction (which is where we are now.) We’re not worried about a 20% bear market, because so many stocks in the Telecommunications, Materials, Consumer Staples and Industrial sectors have already experienced declines of 20% or more. At this point the stock market is undervalued by 7%, which gives some margin of safety. The CNN Fear & Greed Index, our favorite contrary indicator, is now at “Extreme Fear.” Lastly, while S&P 500 earnings won’t touch this year’s growth , the forecasts for 2019 are still respectable at 8.8%.
So getting back to our client’s question: “So . . . why should I not sell all the stocks I still have a profit in?” We replied, “Your stocks are ‘5 year money.’ You won’t be drawing on their value for at least ten years. Selling now means that you won’t have the means to retire then.”
Remember, if you can, how grim things looked in March 2009. The financial sector was de facto bankrupt, the auto industry was close behind, and millions of Americans were about to lose their jobs and their homes. Six client families fired us, sold off their stocks and went to cash. That was our signal to go fully invested with the clients that still trusted us. Their reward? Participation in a stock market that gained 345% over the next decade.
For all the new families who came on board with our firm this year, and who are still 50% or more in cash, we’ll move further into the markets in December. For the families who have been with us 5, 10, 20 years, yes, you have seen this before and yes, you will be fine.
As always, reach out to us with comments and questions.
David Edwards, President