October 14, 2016

Market Summary – 3^rd Quarter, 2016

“There is only one redeeming thing about this whole election. It will be over at sundown, and let everybody pray that it’s not a tie, for we couldn’t go through with this thing again.”

-Will Rogers              

It is clear from what the American people have told pollsters (see chart) that they are generally disheartened about their choices for president in 2016. The incessant coverage of this unusual election and the uncertainty associated with having a new occupant in the White House next year has proven to be a distraction for the markets. It isn’t surprising that some voters have expressed a desire to move to Canada if the wrong candidate wins. The generally sour attitude of the electorate could be spilling over to investor sentiment as well. Some may question if they should keep their money invested in stocks in the event of the “wrong” outcome.

Source: Pew Research Center. Survey conducted Aug. 23 to Sep. 2, 2016. Surveys in previous years occurred at comparable periods in the campaign cycle.

Investors may be letting distractions get the best of them. We are skeptical that the election’s outcome will be a key determinant of the investment environment in the years to come. Yet fear is a powerful motivator for investors. We know that most people are hardwired to avoid pain (such as a stock market decline) more so than pursue pleasure (such as a market rally). In times like these, investors’ ears may be attuned to the most fearful proclamations.

A new outlet for the fear industry
In many ways, the campaigns of fear associated with this election are an extension of something we’ve become accustomed to in the investment markets. Purveyors of fear thrive in the internet age. You regularly see “paid” links (a.k.a., advertising) for websites that will happily detail the “coming economic collapse” or some other disaster just around the corner. These sages are ready to share their exclusive solutions in newsletters that will save your financial life . . . for as little as just $9 a month!¹ These fear-based “vultures” are well positioned to exploit the uncertainty of the times. Yet they are little more than snake oil salesmen. We’ve seen it all before.

One of the modern-day “masters of disaster” was Howard Ruff, who came to fame in the mid-1970s. He built a huge following with his newsletter (which had over 600,000 subscribers at one point), and then followed it up in November 1978 with a book titled “How to Prosper During the Coming Bad Years.” He forecasted a hyperinflationary-driven depression, warning readers to get out of stocks and bonds and to put their money into gold and other hard assets. This was published on the cusp of what turned out to be two of the most prosperous decades for the U.S. economy, the 1980s and 1990s. Since its publication, the Dow Jones has increased from about 800 at the end of November 1978 to over 18,300 through September 2016, nearly a 23x increase. His missed predictions didn’t deter Ruff. He updated the book in 1984 and again as recently as 2008. Ruff finally retired in 2013².

The New York Times bestseller, “The Great Depression Ahead,” by Harry Dent was released at the tail-end of the Great Recession in early 2009, as investor fear and skepticism was soaring. Since then we’ve had over seven years (and counting) of economic growth and a stock market that has nearly tripled in value. This isn’t the first time Mr. Dent exploited the emotions of the investing public. During the strong stock markets of 2004 to 2006, he said the Dow would rise as high at 40,000 by 2009. The Dow bottomed out at 6,547 in early 2009 and even at today’s lofty level of 18,000 is not even halfway to Mr. Dent’s prediction at the time³.

Another in the long line of fear-mongers is Porter Stansberry, founder of Stansberry Research, who in the fall of 2010 released a video, “The End of America,” predicting the collapse of the U.S. He promoted the video saying, “I believe that we as Americans are about to see a major collapse of our national monetary system, and our normal way of life.” The U.S. economy is about 11% larger today than it was at the end of 2010. That is not spectacular growth, but it is steady. Meanwhile the S&P 500 is more than 70% higher from the end of 2010 through September 2016.

One of the newest entries to the “doom and gloom” club, regaining prominence after many decades, is David Stockman. He was the one time budget director for President Ronald Reagan in the early days of Reaganomics. After serving four years in that post, he left the administration and, in 1986, wrote a book with a subtitle of “Why the Reagan Revolution Failed.” He specifically attacked the political shortcomings of Congress that failed to match Reagan’s tax cuts with comparable budget cuts. Although deficits exploded, this was an era where the economy (and markets) took off. The Dow Jones Industrial Average stood at 1,784 (April 30, 1986) around the time of the book’s publication. It was about 25% higher when Reagan left office about 2½ years later, and is more than 10 times higher now. Today, Stockman is back on the bookshelves, predicting pending disaster for investors in a new book, “Trumped! A Nation on the Brink of Ruin…And How to Bring it Back.”

There is nothing new in predictions that the economy or the country itself will be “destroyed” if Candidate A or B wins. The 2016 election is unique in many ways, but is hardly groundbreaking when it comes to promoting pending disaster. It has been marketed for decades, and the worst fears of these doomsayers, even in the darkest days of 2008, have never come to fruition. Sadly, they have succeeded in scaring investors from sharing in the wealth of growing and successful publicly traded businesses.

Fundamentals still matter
Will this election result in a material change to the country, the global economy, and the private sector that could upset financial markets in a permanent way? We are skeptical that this could occur. A typical omen of a pending downturn is the formation of a “bubble” in the economy. However, financial bubbles are most often created by excessive prices of assets that are enabled by tremendous amounts of debt – something largely absent in today’s equity market. Furthermore, stocks (based on the S&P 500) are currently valued at about 16 times 2017 projected earnings. While this is slightly above the historical average of the S&P, it is not a “fully priced” market when you put this in perspective. Consider the findings of Wharton University Professor Jeremy Siegel, twice the featured guest of our MPMG Speaker Series. His research indicates that when the interest rate on the 10-year Treasury note is below 8% (it was 1.6% on September 30, 2016), the average price-to-earnings (P/E) ratio for the S&P 500 is 19 times earnings. When looked at from a historical perspective, it would seem that this market has room to grow.

Beyond that, investors can find an array of diverse and unique businesses that are growing and increasing profits in a way that no politician can derail. It is difficult to believe, for example, that FedEx (FDX) will see a dramatic change in the number of deliveries it makes based on the election outcome, or that a company like 3M (MMM) will stop innovating after the polls close on November 8th. Demand for internet service is not likely to reverse course, meaning that companies like Cisco Systems (CSCO) will continue to be called on to meet a growing demand for networking equipment. You can look at any period in history where less than savory politicians took charge of some arm of government, and still find dozens of companies that experienced exceptional growth, drove innovation, entered new markets, and created wealth. We believe that companies like FedEx, 3M and Cisco will continue to do so regardless of politics. An investor’s job is to boldly search for opportunities like these rather than shrink away from them amidst an environment of uncertainty.

Profiting from Uncertainty
It may be reasonable to expect some volatility leading up to and in the immediate aftermath of the election. Regardless of who the winner is, we know there will be a new occupant in the White House in 2017. Those who have followed our newsletters know that volatility (the short-term ups-and-downs of the market) is not the same as risk (the permanent loss of capital). We believe that change is nothing to fear. In fact, change is virtually the only constant we can rely on, and it often leads to investment opportunity.

It is change – technological revolutions currently in the minds of engineers and innovators – that will create solutions to meet the challenges of our world. The opportunities are numerous – feeding a growing world population, having enough clean water, designing products to make processes more efficient, curing disease and illness with new drugs, and ultimately, creating wealth. We still live in a capitalistic society that encourages leading companies to pursue world-changing solutions, backed by investors who can profit from those advancements.

As our MPMG Speaker Series guest, P.J. O’Rourke, noted at this year’s event, “Investment defines humanity. Animals don’t invest. If a dog has a surplus, he’ll eat it all and vomit it up. Investment defines civilization. Barbarians don’t raise money with debt and equity, but by stealing. If not for investing, all of the inventors and innovators, manufacturers and business people who brought decent living standards to the four corners of the globe would have to get their money as I do, by asking my wife.”

Even though we are in the eighth year of our economic recovery, there are reasons for continued optimism. To date, much of Gross Domestic Product (GDP) growth in this recovery can be attributed to consumer spending. Yet one of the key pillars of economic growth, business spending, has been largely absent. A return of business spending, however, should have a far-reaching impact. Unlike consumer spending, whose benefits to GDP are limited to the year in which they occur, investment spending benefits both current and future years. This is because many of these investments lead to increased productivity that improves future GDP. Further, business investment also often leads to job creation, which in turn supports greater consumer spending.

The Fed serves as an added distraction
When the media isn’t focusing its attention on the presidential candidates, they are speculating about the next moves by the Federal Reserve. The wait for the second Fed rate hike (the first in this cycle happened last December) continues. Nobody knows the timing of the Fed’s next actions. But we find the incessant obsession with the Fed to be interestingly unimportant. It distracts people from focusing on their primary objective – making money.

The Fed’s policies since 2007 have resulted in widespread asset reflation that led to a broad-based rally in stocks. This virtually indiscriminate rally for the stocks of both good businesses and bad has resulted in the price discovery process in the market being practically eliminated. A less interventionist Fed will likely bring the value of price discovery back as we begin to see a greater divergence in performance between winners and losers in the stock market. Bonds and bond-like equities will likely be under pressure. Higher interest rates could reverse the recent popularity of utility stocks and other equities that pay higher dividends. Many of these stocks have become overvalued and are at risk if market conditions should turn against them. The benefits of active management, a necessity to identify value and quality, will be more clearly recognized.

Protecting against an unsatisfying election outcome
In the world of politics, everybody, no matter what their party affiliation or political leanings, can agree that you win some and you lose some, usually in the same year. It’s important to remember that we have a process of checks and balances in place that limits the power of one person or one party over the direction of policy. History has proven through good presidencies and bad that the free market system keeps functioning, and wealth is continually created. The success or failure of the vast majority of companies is driven by factors that go well beyond the qualifications of the person who holds the nation’s top office or even which party is in control of Congress.

Politically speaking, no matter who is in control, it is important to remember that this too shall pass. Investors can choose to sit on the sidelines as companies continue to grow their businesses. But the lost opportunities may be painful.

We recommend a more productive investment approach. Ours is focused on identifying stocks of successful companies run by effective managers that can be bought at the right price. The key in today’s environment is to invest in companies that not only are outstanding businesses with unique products and strong balance sheets, but that are also poised to withstand a changing economy. As the Federal Reserve normalizes its interest rate policy, assets with interest rate sensitivity, including fixed income, real estate and bond-like equities, will be in a disadvantageous position. The best protection against an uncertain future is a diversified portfolio made up of attractively priced stocks representing quality companies with bright futures…a much better option than moving to Canada.

~MPMG

^{1Listed price of Stansberry Research’s “DailyWealth Premium” email newsletter.
2Doug Eberhardt, “Why the Predictions of Hyperinflation and Economic Collapse Were Wrong,” June 7, 2015.
3Allan Roth, “The Great Depression Ahead? Don’t Be So Sure,” CBS MoneyWatch, Apr. 3, 2009.}

_{Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted. Market returns discussed in this letter are total returns (including reinvestment of dividends) unless otherwise noted.}

_{The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.}