A new year, a new economic course…now what?
January 27, 2017
Market Summary – 4th Quarter, 2016
“Status quo, you know, is Latin for ‘the mess we’re in.”
America experienced a presidential election outcome that few thought possible, and that polls showed was highly unlikely. Many analysts anticipated that such an outcome could throw markets into a tailspin as investors grappled with the uncertainty of what was to come. In the waning hours of election night, futures markets reacted exactly that way.
The atmosphere changed by the time the markets opened the next morning. As investors began to comprehend that the government was headed in an entirely different direction, stocks suddenly raced ahead. The election outcome and subsequent market rally led to many questions, such as “What happened?,” “Can this bull market trend be sustained?,” and perhaps most importantly, “Does this new president, an unapologetic capitalist with his party holding a majority in Congress, create a compelling opportunity for investors?”.
The election result and its ramifications may not simply be a run-of-the-mill macroeconomic event or an interestingly unimportant distraction like those we’ve cautioned investors about in the past. Instead, we believe that it is possible that our markets and economy may benefit from a seismic shift in both government policy and positive investor sentiment unlike anything we’ve seen in a generation.
A 1980s Replay?
At MPMG, we do not let personal political views cloud our judgement. We are investors, focused on policy and the laws of economics. Few people would suggest similarities between the personalities of Donald Trump and Ronald Reagan. Yet, there are some parallels between the two men in terms of fiscal policy (namely, lower taxes, deregulation, and increased infrastructure and defense spending). This creates opportunity for us and our clients.
President Reagan’s policies encouraged those who thrived in free markets to pursue business opportunities with less interference from government regulation. Few investors old enough to have been in the market during the 1980s could ever forget it; the Dow Jones Industrial Average nearly tripled during that decade.
It has been said that history doesn’t repeat itself, but it often rhymes. Reagan inherited a different environment . . . one with high unemployment, and double digit inflation and interest rates (the Fed Funds rate when Reagan took office was 19% compared to approximately 0.50% now).1 Furthermore, the United States and other nations are more heavily indebted today than they were back in the Reagan era. Consider that in 1980, the U.S. federal debt was equal to about 30% of Gross Domestic Product (GDP); today, that ratio is approximately 105%.2 Debt at these levels could temper future economic growth. However, we believe that the new administration’s fiscal policies will still serve as a powerful tailwind supporting economic expansion. History shows that properly crafted tax and spending plans can contribute greatly to increased economic growth, greater tax revenues, and even lower debt to GDP levels.3
Unleashing “animal spirits”
Look for the term “animal spirits” to become more commonplace in 2017. Economist John Maynard Keynes popularized the phrase in the 1930s. It refers to what Keynes called “a spontaneous urge to action rather than inaction.” This is propelled less by a data-driven decision-making process than by the force of optimism to make something happen. This has the potential to generate significant economic activity. The Trump administration and Republican Congress certainly seem poised to be very active in the early months of 2017.
The prospect of an economy boosted by fiscal policy represents a significant change from what we’ve seen since the end of the Great Recession. One of the signature characteristics of the recovery that began in 2009 is its frustratingly slow pace. Outside of a stimulus package passed in 2009, fiscal policy has generally been non-existent. Instead, the recovery has been heavily reliant on monetary policy.
The Federal Reserve lowered its target for the Fed Funds rate from 5.25% to 0.00% in less than a year-and-a-half beginning in mid-2007. The Fed also added significant liquidity to the market, primarily through its unprecedented Quantitative Easing program. Assets on the Fed’s balance sheet ballooned from less than $1 trillion in the fall of 2008 to more than $4 trillion on 12/31/2016.
Few will dispute the important role the Fed’s intervention played in helping to move the economy out of the Great Recession. Yet monetary stimulus is considered less effective in spurring economic growth than fiscal stimulus (such as increased government spending or tax cuts). Perhaps most noteworthy is that even at this mature stage of the economic recovery, the Fed’s balance sheet remains near record levels. As the Fed keeps stoking the flames of economic recovery, Congress and the new president may be ready to pour lighter fluid on it with significant fiscal stimulus. The result could be what investors have been seeking for a long time – fiscal and monetary policy working in tandem with the potential to unleash extraordinary economic growth. This would ultimately lead to an upturn in what’s referred to as the “velocity of money,” the speed at which money passes from one holder to the next. The expectation is that as the velocity increases, the rate of economic growth improves. That should bode well for the stock market.
The goal of fiscal policy is to spur action to promote broad economic growth. In the coming months and years, we expect to see a series of developments that likely will be well received by the markets:
- Tax reform that will reduce individual income and corporate tax rates, as well as estate taxes.
- Repatriation of corporate profits as a way to invest cash that has been parked overseas into the U.S. economy.
- Immediate expensing for businesses to deduct costs in the same year they are incurred.
- Change in status of pass-through income for “S” Corporations, partnerships and sole proprietorships so it is taxed at the more favorable corporate tax rate.
These actions, particularly working in combination, should promote an acceleration of economic growth.
Furthermore, a renewed emphasis on deregulation could promote even more robust growth. Regulation is, in our judgement, necessary and important. However, we believe that some regulation could be modified and hope that our decision makers can find a productive middle ground between protecting consumers and promoting economic growth. We expect details of specific reform measures to emerge in the coming months. A prime industry that stands to benefit is the financial sector, as we’re likely to see a rollback of the Dodd-Frank regulations and other reforms that should help mitigate some costs and encourage business growth. The energy sector is also poised to see a loosening up of laws that restricted development of natural resources, a potential boon for oil, gas, coal and pipeline companies. Ultimately, easing of existing regulations could promote capital investment across a range of industries.
These pro-business policies and others like them could propel the economy and the stocks of select businesses that are beneficiaries of these policies significantly higher.
Consider that just a 1% decline in the corporate tax rate could drive an additional $1.50 of S&P 500 earnings.4 Proposals being discussed to drop the top corporate tax rate from 35% to 15% could drive earnings growth of more than 10%. Stock analysts are often hesitant to alter their estimates until proposals become law, so the lower tax rate has, in many cases, not been reflected in earnings estimates for 2017 and beyond. That also means it may not be fully reflected in stock prices.
In addition, proposals to encourage repatriation of corporate profits accumulated by U.S. companies could fuel further economic growth. It is estimated that $2.5 trillion in cash is stashed overseas.5 If a large portion of that money finds its way back into the U.S. economy due to a “tax holiday”, it could create a huge infusion of capital. That $2.5 trillion represents 13% of the market capitalization valuation of the Standard & Poor’s 500 Index, which currently stands at about $19 trillion. The last time this occurred, in 2005, the impact was miniscule by comparison, as only $300 billion in profits were repatriated.6 It is difficult to fully comprehend the potential benefits of such a large scale repatriation of cash back to the United States, given that it could be 3-6 times as large as the one that came before it. Suffice it to say, the impact could, in the words of a recently elected figure, be HUGE.
How we got here
In the years following the Great Recession, battle-scarred investors experienced two severe bear markets in less than a decade and an unprecedented (for most) loss of value in their real estate holdings beginning in 2007. Caution was reflected in their wary approach to the market. With persistently low interest rates and modest economic growth, money flowed into what many perceived as safer assets, namely bonds and bond-like stocks. We documented this in our newsletters, but even throughout 2016, we noted that the landscape was changing and implored investors to remain committed to a disciplined, value-based investment approach:
- In our first quarter letter (“Show Me the…Cash Flow!”), we pointed out that investors were sensitive to a volatile start to the year. Too many of them mistook volatility for risk. We explained then that paying the right price for a business from the start, not seeking to avoid volatility, was the best way to manage risk. In particular, we emphasized the benefits of owning businesses with positive cash flow, a factor that tends to offer a number of advantages for shareholders. Favorable cash flow often results in higher dividends, share buybacks or the company’s re-investment in future growth.
- Our second quarter letter (“U.K. Votes to Leave EU,” and other ‘bad news’ headlines) came on the heels of the most surprising development of the year up to that point – the decision by British voters to exit the European Union. That news initially sent markets in a downward spiral, but in a little more than two weeks, markets (in the U.S.) had recovered their lost ground. We noted that a number of other unexpected developments across the world in recent years also created temporary ripples, but we emphasized that markets have proven to be resilient to outside influences. History shows that it is a loser’s game to make investment decisions on the basis of today’s headlines. Short-term swings may come and go, but patience, and paying the right price for businesses will be rewarded.
- In the third quarter (“Don’t Move to Canada…Yet”), we focused on the topic of fear and how many times the so-called “experts” have been wrong in their dire predictions for the markets. With a heated election coming down to the wire, we reminded ourselves that through good presidencies and bad, unique and special businesses continue to demonstrate an ability to generate outsized profits.
2016 was clearly a year that set the stage for what is likely to be more profound change in 2017.
The more things change, the more they stay the same
The market as a whole may benefit from renewed economic vigor, but we still expect to be in an environment that will reward select businesses more than others. Regardless of what happens, we believe that an important tenet remains the same – investing in good businesses at the right price is the best way to capitalize on opportunities that are created, while also protecting your money from risk of permanent loss. Other strategies have had their proverbial “15 minutes of fame.” We’ve seen it before. Whether it is the run on tulip bulbs in Holland in the 1600s, the boom in strip malls in the 1980s, Beanie Babies or dot-com stocks in the 1990s, popular fads don’t last.
Investors in the previously listed fads have learned that trying to ride momentum is a matter of timing. If you are late to the game, you subject yourself to significant risk. Likewise, seeking to avoid market volatility by choosing sectors like utilities and consumer staples resulted in these positions becoming significantly overvalued. For investors who relied on index funds and ETFs, a significant trend in recent years, the ability to capitalize on market leadership by the biggest names in the index will, in our opinion, only be temporary.
Given that we’re headed into the 8th year of a bull market, we believe paying the right price is as critical as ever. The stock market has reached new heights. It parallels the environment we saw at the beginning of the millennium, at which time MPMG’s All-Cap Value portfolio outperformed the S&P 500 Index. This was achieved not simply by owning stocks in the general market, but, in our view, by prudently identifying good businesses whose good value was generally unrecognized by the market. We believe that our research and selective approach to investing will, as then, be critical to fully capitalizing on what the markets have to offer.
Considering the stock market’s current valuations, the fact that the economic landscape is changing, and that interest rates may be headed higher, it is important to invest with your eyes wide open. Active management – choosing the right businesses at the right price in the market – is essential.
We believe that we’ve positioned our portfolio to benefit from the trends that are taking shape as the rare confluence of fiscal and monetary policy unleashes animal spirits in our economy. Our investment focus today emphasizes energy, industrial, infrastructure, financial and technology companies. Along with choosing what we think are the right industries, we’re identifying within those sectors the businesses that we believe offer true upside potential because of their favorable pricing and strong underlying fundamentals. 2017 marks the beginning of what could be unique opportunity for investors. If new and appropriate fiscal policies are put in place, we are optimistic that there will be broad based economic growth. However, we see a different scenario playing out in the stock market. Some parts of the market are expensive, and thereby risky. Paying the right price for businesses that are positioned for the greatest benefit will separate extraordinary investment results from disappointing outcomes. It is a time to be invested, but it is also a time when selectivity and on-target, active management will position investors to prosper in our changing times.
1 Federal Reserve Bank of St. Louis.
2 Federal Reserve Bank of St. Louis, “Federal Debt: Total Public Debt as Percent of Gross Domestic Product,” updated Dec. 22, 2016.
3 Both the United States and the United Kingdom (UK) saw their tax revenues grow following tax cuts in the 1980s, while the UK also saw their debt to GDP ratio fall during this period.
4 Matthew Heimer, “The Best Investing Advice for 2017 from Fortune’s Experts,” Fortune, December 5, 2016.
5 Jeff Cox, “U.S. Companies are hoarding $2.5 trillion in cash overseas,” CNBC, Sep. 20, 2016.
6 Joseph Ciolli, “Whether Clinton or Trump, Multinationals Set to Win the Election,” Bloomberg, Oct. 19, 2016.
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.