Zeller Kern’s Investment Monitor

Great Market Returns, Record Low Volatility.
What’s Next?

January 10, 2018

By Steve Zeller

The beginning of 2018 kicked off with strong momentum within the equity markets. What’s even better is that this is occurring on the heels of a fantastic year of 2017 that finished off with a spectacular month of December. The year-end performance data posted favorably, with the NASDAQ leading the way, up 28.24%, the Dow Jones Industrial Average up 25.08%, the S&P 500 up 19.42%, and the Russell 2000 Small Company Index up 13.4%. International equity markets did well too, with Emerging Markets producing a strong performance at year end. This is all backed by what appears to be favorable data for the economy, favorable outlook moving forward into 2018, and an accelerating momentum within the current market rally.

All is good. We haven’t seen this kind of confidence and optimism since the dot com era, especially within the technology sector. Asset prices are up in several areas, including stocks, real estate, bitcoin, art, etc. We have gone through a period that should be celebrated, and it brings us to the question, “will this continue?” Well, for the time being, it looks like it will do so. A basic indication of this, at least within the economy, is that employment is strengthening – companies are hiring because companies are confident which is expansionary. When companies hire, consumer spending should rise, and when more people get onto the payrolls, confidence remains strong. However, consumer confidence pulled back slightly last month as did business confidence, according to some reports. Was that the peak? We’ll just have to see.

There are a number of things that will play out in 2018, including the effects of the recent passage of the tax reform, the situation in North Korea, Europe, and the upcoming mid-term elections in November. Our expectations, for most of last year were very favorable for the markets, and we have been of a favorable viewpoint for the markets into 2018, and perhaps through the first quarter, at least.

However, from a contrarian standpoint, there are many things now existing, as we have discussed in recent issues of the “Investment Monitor” that causes us to at least keep an eye on the situation. Indicators, such as investor confidence, market valuations, investor margin debt, consumer debt, consumer confidence, low unemployment, etc., are all at record positive extremes, which cause the contrarian to be concerned. What do we mean by that? When stocks become historically expensive along with investor confidence rising to record levels, and margin debt reaches all-time highs, it becomes increasingly difficult for the market to rise significantly further.

As we have discussed in the past, the Shiller P/E ratio, which is a tool to measure how expensive the stock market really is, is now at a level that exceeds the levels at the height of the market in 1929. The only other time that this measurement has reached these levels, other than in 1929, was the 2000 tech bubble. According to the chart from www.gurufocus.com, the Shiller P/E ratio is at 33.4, which is 98.8% higher than the historical average. (Click chart to expand)

What this suggests is that positive market returns will be increasingly difficult without first experiencing a significant downturn. But how much further this ratio will rise before it does so is the big question in this. Granted, there are strong arguments that refute the validity of this ratio, such as the recent tax reform and the potential repatriation of cash assets from overseas will expand corporate earnings and make equities continue to be attractive. There is also included in the argument that, this time is different and that we are not in a typical cycle in that, this current environment will support unusually high ratios due to structural reasons including increased monopoly, political, low interest rates, and a lowering of the tax rates.

That may be true, but more likely will have a positive effect in the shorter term, in our view. Historically, this ratio always reverts back to the mean. The calm before the storm – 2017 was the year that broke all records for years with the lowest volatility on record. According to some reports, the S&P 500 did not experience a single decline of five percent or more, during the whole year, which is the longest stretch on record. Also, the last time the S&P 500 experienced a decline of at least 2% was in September of 2016. Another measurement worth noting is investor sentiment, which by several indications, has reached record levels. The Investors Intelligence Advisors Survey has recently posted the highest 13-week average in 40 years. The National Association of Active Investment Managers Equity Exposure Index hit a record high of 109.4, during the week of December 11th. The American Association of Individual Investors asset allocation survey reveals that small investors are now allocating 72% of their portfolios to stocks, and just 13% to cash, which is the widest spread since the tech mania in March of 2000.

Also, the level of margin debt is now at record levels. According to an article published by the Business Insider, back on November 30th, 2017, margin debt hit another record, totaling $561 billion at the end of October, up 16% from a year earlier. (Click chart to expand)

As this article reminds the reader, stock market leverage (margin debt) is the big accelerator on the way up. Leverage, or margin debt, is money being created by the lender in a borrowed fashion. When stocks sink, leverage also becomes the big accelerator on the way down. The article also points out that when stocks are dumped to pay down margin debt, the money from those stock sales doesn’t go into another asset and doesn’t sit around as cash ready to be deployed and it just disappears.

What happens to the stock market going forward remains to be seen, but, let’s hope that the economy really begins to expand. Even though there is a high level of optimism, there are still a lot of challenges within the system.  Much of the American working population continues to owe more and is saving less. According to a recent article, posted by Mish Shedlock, a greater share of Americans has more debt than money in the bank than at any point since 1962, according to the Deutsche Bank. 30.4% of U.S. families have negative not worth despite the recovery in the housing market and the stock market. Additionally, Median net worth is below where it was in 1989. More alarmingly, inflation adjusted net worth may be the lowest in history.(Click chart to expand)

As we have pointed out before, a major issue facing us in the future is the level of debt that we have accumulated and what the risks are and potential consequences of accumulating all of that debt. The St. Louis Fed, back in 2016, discontinued reporting and updating their chart that reflected total U.S. debt including Federal, corporate, consumer, and municipal debt. At that time, total debt accumulated was approximately $63 trillion. It has surely climbed further, since then. The charts below illustrate that corporate debt is at an all-time high, student loan debt is now in-excess of $1.4 trillion, and of course, Federal debt now exceeds $20 trillion.(Click all charts to expand)

One way for this condition to keep or postpone serious negative consequences from coming to fruition, significant economic growth has to happen. We greatly look forward to the GDP data and other indicators to come out later this year and beyond. Let’s hope that it is significantly in the positive.

As this week gets going, on Monday we will have consumer credit. However, the big numbers will not come out until Thursday with jobless claims and the producer price index which are expected to come out year-over-year at 3.1. On Friday, we will see CPI which is expected at 2.2% and retail sales also to be released. Most of the fundamentals that are being released will have very little impact on the markets this week. Most of the action will continue to be driven by market sentiment which is likely to continue to be positive.

Best Wishes,

Zeller Kern Investment Committee