Sections in this note:
- Comment on Performance
- High Stock Valuations
- Upcoming Test of Stock Market Strength
- Historical Precedents Support a Positive Outlook for Stocks
- Stocks Tend to Hold Value During Extended Inflationary Periods
- Corporate Earnings are Resuming a Positive Trend
Comment on Performance
The performance of our portfolios has been lower than our
target returns. While our losses have not been as great as the alternatives
that many investors use, we have not participated in the periodic gains of the
stock market. Please be patient through this period. Our strategy is to be
aggressive when the market is resilient and to be conservative when the market
is vulnerable to declines. Over the last few years, we have been better at
avoiding declines than capturing resilience.
In 2023, uncharacteristically ambiguous signals from our key
metrics and high stock valuations resulted in portfolios that were more
conservative than needed. For investors sensitive to losses, this may have been
appropriate. But we will need to be more aggressive to generate our target
returns. Our portfolios can be much more aggressive than they are now, and they
will be when we have stronger positive signals.
High Stock Valuations
Stock valuations for the DJIA continue to be high, hovering at
about the 90th percentile of levels since the late 1990s - a level they have been at for several quarters. As you may
recall from prior notes, our recent research indicates that during historical market
phases like the current phase, valuations have been significantly higher than
in other phases. This observation suggests that we need not be concerned about
valuations. However, disregarding higher valuations will be more prudent in a few
weeks, as discussed below.
Upcoming Test of Stock Market Strength
The stock market is coming to a test of its strength and the
extent to which it can support currently high valuations. Since late December
of last year, the stock market has been supported by two important drivers of
resilience: a) the Exceptional Macro Market Resilience Index, which over most
of the last 100 years has indicated a strong bull market, and b) a period of naturally-occurring
optimism. An important feature of naturally-occurring optimism is that we can forecast
how it will change over the coming several weeks, which we cannot do with the
MRI.
While still present, the Exceptional Macro is showing signs
of weakening. It is not appropriate to act on this alone because it may strengthen,
but it is worth noting, considering the upcoming end of the naturally-occurring optimism.
The naturally-occurring optimism will start to fade over the
next week or two. In that short period of time, we will see the strength of the
current bull market and its ability to support high stock valuations without
the tailwind of naturally-occurring optimism.
The next period of (long term) naturally-occurring optimism is likely to start in June (roughly). As we move through the weeks from now through May, it will become clearer if it is prudent to shift to a more aggressive model portfolio on page 2 of the weekly pdf.
We will make the portfolios more conservative if it looks like the market is failing the test. We will make the change outside of the regular trading schedule if needed.
Historical Precedents Support a Positive Long-Term Outlook for Stocks
Historical precedents support a positive outlook for the
stock market. Of the last 80+ years, 1989 is the year that has similar market dynamics
in terms of both MRI and naturally-occurring shifts in optimism. That year saw
strong returns. If the market follows
these precedents, we might expect a gain of over 5% over the next three months.
That said, the performance of the DJIA over the last three
months has been lower than the average of similar periods. This suggests that
the market is being weighed down by other factors, one of which may be high
valuations.
Stocks Tend to Hold Value During Extended Inflationary
Periods
Stocks tend to hold their value during inflationary periods. Figure 1 below shows the Consumer Price Index
over the last 100+ years in the lower panel.
The steeper the line, the higher the inflation rate. Periods of high inflation are indicated. The DJIA (log
scale) is in the upper panel.
Figure 1
Figure 1 shows that during the high-inflation periods the
DJIA had flat returns or gains. None of the periods has extended stock market
losses. Major losses occurred after the
1929 stock market crash. During this period, the CPI declined – a period of deflation.
The point for us today is that stocks tend to be reasonable
investments during inflationary periods. Companies can pass along to consumers the
higher prices they incur while doing business.
Corporate Earnings are Resuming a Positive Trend
Corporate earnings are moving higher, which supports the
view that companies can maintain earnings growth during inflationary periods. Figure 2 below shows the price of the DJIA (log scale) and the earnings of companies in the index (log scale) since 1997.
Figure 2
Figure 2 suggests that the recovery in corporate
earnings is underway. While consumers dislike inflation, corporate earnings
tend to be insulated from its effects.
The negative impacts of inflation tend to come from the battles to fight inflation. The Fed increases interest rates to slow economic growth. Slower growth reduces corporate earnings and may lead to economic recession. As of now, however, the Fed’s focus appears to be on when interest rates should be reduced to encourage growth as opposed to when to increase rates to slow economic growth. The threat of higher interest rates seems, at least for now, not to be a major threat.
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