Stocks rocketed to all-time highs between October 1990 and March of 2000 to register the longest bull market ever (9 years, 5 months). No matter how ridiculous the price-per-stock share – no matter the mindlessness associated with owning U.S. tech stocks at 65 times trailing profits (rather than 15) – the popular view had been that the Internet’s “New Economy” had changed the rules of the game.
Unfortunately, it hadn’t.
The NASDAQ 100 ETF (PowerShares QQQ Trust Series 1 (NASDAQ:QQQ)) gave up 80% of its value over the course of the 2000-2002 bear. Investors who had placed too much faith in the so-called long-term never accounted for the mathematical reality of severe loss. The 80% decline for QQQ required 13-plus years to break even on a nominal basis, yet it still HAS NOT recovered when adjusted for real purchasing power (inflation).
Risk is the possibility of suffering severe losses like those that occurred in the 2000-2002 bear. It is not defined by how much money you place in stocks. It is not characterized by how optimistic the financial media are about corporate tax cuts and/or job-creating infrastructure spending.
Why is it important to rediscover risk now? In essence, when everyone around you is feeling triumphant about high water marks in real estate and/or stock assets, it is critical to safeguard your fortress and to minimize the extent of financial harm.
Historically speaking, different things have contributed to bearish environments where overexposed investors suffered severe losses. Recessions emanating from deteriorating economic cycles. Extreme asset valuations. Tighter borrowing costs. Inflation. Political and/or financial instability. A combination of one or more of the above-mentioned perils.
Here at the start of 2017, then, are any of these perils (threats) emerging? Let’s consider the economic cycle. Simply put, the current recovery’s length is already long in the proverbial tooth. The incoming administration may be able to improve the economic growth rate (GDP) and extend its duration. On the other hand, we may be closer to the end than the beginning.
In a similar vein, job growth is slowing and labor market conditions across the Federal Reserve’s 19 labor market indicators are weakening. (See charts below.) Maybe the President-elect will be able to alter the present course, but one would be hard-pressed to deny the potential for deterioration and/or breakdown in the current economic cycle.
And what about the bull-bear cycle for stocks themselves? The longest bull market in history (10/90-3/00), at nine years and five months, ended with one of the most devastating bears (3/00-9/02) on record. The second longest (8/21-9/29) hit the eight year mark before culminating in near total wipe-out (-86%) between 1929 and 1932. Few crashes have ever had the kind of impact on the collective psyche of the American public.
Today, the third longest bullish stretch (7 years, 10 months) from March of 2009 to January of 2017 looks set to eclipse 1921-1929. Is it actually the case that the age of stock market bulls are irrelevant? Or might one at least recognize the extreme prices that investors were willing to pay for stock assets at the 1929 and 2000 peaks as a reason for caution in 2017?
One way to value corporations is to incorporate both stock shares and debt obligations (bonds), then compare them to a dollar value for the amount of goods and services produced in an economy (less input costs). The latter is known as Gross Value Added (GVA). In Jesse Felder’s comprehensive view of asset valuations, stock and bond, one could say that we are back to the outlandish days of dot-com mania in 2000.
Even looking at stocks alone, and comparing the market capitalization to gross domestic product (GDP), a premier valuation tool with remarkable predictive value, suggests wariness. The “Warren Buffett Indicator” implies that U.S. stocks today are extremely overvalued, not bargains.
So let’s return to the list of perils that often lead to severe loss for those who ignore the warning signs. Do we have deteriorating economic fundamentals? Quite possibly. Do we have extreme asset valuations? In more ways than one.
What about tighter borrowing costs? On an absolute basis, one might continue to argue that rates are still attractive and accommodating. Yet monetary policy-makers are talking about three hikes to the overnight lending rate in 2017. The 10-year yield has catapulted 100 basis points from its 1.36% low to 2.36% today. And the jump in 30-year mortgages from the 3.5% level to the 4.3% level may be adversely impacting home sales in critical real estate markets like California.
Inflation that is associated with sharply rising interest rates has never been particularly friendly to stocks either. Economists polled by the Wall Street Journal believe that inflation will rise at a faster clip, as well as borrowing costs tied to the 10-year yield.
What about political and/or financial instability? This one may a bit tougher to gauge. The “Brexit” still threatens to destabilize the eurozone. China still uses massive amounts of financial reserves to defend its currency (yuan). A wide number of European banks remain close to the breaking point on requiring bailouts. And what may have seemed like political pandemonium just a few short months ago, pundits have now shifted to a more favorable view on the stability of a Trump presidency.
Bottom line? The very things that have led to painful financial loss in the past – deterioration in the economic cycle potentially leading to recession, asset valuation extremes, tighter borrowing costs, accelerating inflation, political and/or financial instability – are noticeably present at the start of 2017. The fact that these perils are largely present DOES NOT mean that a bear market or severe losses are imminent. On the flip side, the fact that these perils are largely present convey the sensibility of lowering one’s exposure to the risk of severe loss.
Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients June hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.