November 2017 Update: Where the Market is Going Next by Jack Moller

“What do you think the market is going to do next?”

I can’t tell you how many times I’m asked to answer this unknowable question.  In thinking about it, I was reminded of an experience I had a few years back.  At that time, I was invited to participate on a panel at an investment conference.  The topic was the then relatively new fundamental indexing strategies (which are now more generally referred to as “smart beta”).  I was the sole advisor on the panel with one panelist being a Chief Investment Officer at Schwab and the other being one of the creators of the concept and actual architects of the fundamental index products.  The moderator was a CNBC reporter.  What struck me right away (not solely based on some stage fright) was that the IQ of the other panelists was not only higher than mine, but probably multiples of mine!  Then I realized a truth that helped calm my nerves and when asked how I use the fundamental indexes, I blurted out, “I try not to be too smart about it.”  Clearly, I wasn’t trying to impress anyone but hoped to get off the stage as fast as possible.  (Maybe I had watched too many Clint Eastwood “Dirty Harry” movies and had internalized Harry’s famous line, “Man’s got to know his limitations.”

I guess what ties this together in my mind is the importance of recognizing what we can know and what we cannot know.  As I’ll point out below, analyzing a market to discern its next move is clearly nothing I am capable of consistently doing, nor can anyone else.   What I can know is that there are disciplined investment strategies that, if followed, have a very high likelihood of achieving success.  I can’t tell you how freeing this is to know that I don’t have to “know the unknowable” to succeed in markets.  All I need is the big three – patience, discipline, and time.

What makes short-term predicting so hard is that there are just too many conflicting signals.  For example, here is a current brief list of seeming contradictions that can drive a short-term market prognosticator crazy.  In fact, before I start, I’ll point out that the market is the riskiest it has been in ten years, and we are in the midst of a kind of “Goldilocks economy” that continues to support this powerful bull run.  Go ahead and predict based on that.

Point 1: Twin Bull Markets Getting Old. 

The current bull market in U.S. stocks is now the second longest in modern history at over 8-1/2 years.  If the bull continues through August 2018, it will become the oldest.  On the other hand, the bond bull market is now an astounding 35 years old!  I almost don’t know what to say but will point out that almost no current investors remember what a bond bear market with rising interest rates feels like. 

Counterpoint 1: “Bull Markets Don’t Die of Old Age”. 

Historically, stock bull markets end when investors become greedy and feel euphoric.  This market keeps climbing the proverbial “wall of worry” and seems far from euphoric.  Often the end of a stock bull market is triggered by Federal Reserve monetary tightening.  Technically, they have begun to do this, though arguably they are doing it so slowly and from such low rates that it is hard to see the current Fed moves harming this bull.

Point 2: Weakest Post-War Expansion. 

While we are now in the third longest economic expansion since World War 2, the growth rate has been the weakest.  In fact, as has been the pattern for decades, each recessionary bear market has ended when the Fed came to the rescue by lowering interest rates, providing ample liquidity.  While this has generally worked to jumpstart the economy, unfortunately, the net result of this pattern has been more and more debt fueling less and less growth with each recovery.

Counterpoint 2: Synchronized Global Economic Expansion Accelerating. 

After years of flying solo, the U.S. economy’s expansion has been joined by most major international developed and emerging market economies.  This has pepped up our growth to the 3% area and no doubt will provide a tailwind for corporate earnings around the world.  Furthermore, markets generally respond well to slow-but-positive growth, ample liquidity, and rock-bottom interest rates.  A modest bump in earnings will likely provide an economic and market tailwind. 

Point 3: U.S. Stocks and Bonds Are Historically Expensive. 

Yale economics professor and Nobel Prize winner, Robert Schiller who coined the phrase “irrational exuberance” in the 1990s tech boom, developed a market valuation measure based on average, inflation-adjusted earnings.  Currently, this indicator is flashing “red” with the only higher readings having occurred in 1929 and 2000.  While that sounds quite ominous, it is important to note that some “experts” believe this indicator is not as meaningful today as it has been in the past.

On the bond side, in the depths of the last bear market, prices were so low that interest rates in the mid-teen were available.  That was cheap!  Currently, 10-year treasury notes are priced to yield less than 2-1/2% interest.  That is not cheap.

Counterpoint 3: Valuation Is Not a Good Timing Tool. 

Many valuation measures can be fairly predictive over longer periods, i.e. expensive markets tend to have lower returns over horizons of 7-12 years while cheaper ones tend to have higher returns.  However, most experts agree that valuation measures tend to be useless in predicting shorter term market returns.

Point 4: Record low volatility may indicate dangerous complacency. 

The current low volatility in markets (not just U.S. stocks) has been nearly unprecedented (and is interesting in light of all the perceived geopolitical risks).  Many argue that this indicates investors are very complacent with low fear levels driven by the ingrained belief that the Federal Reserve will always come to the rescue as it pretty much has ever since the Stock Market Crash of 1987.  The concern is that the Fed with its bloated balance sheet and still super-low interest rates doesn’t have the bullets anymore to come to the rescue.  If investors suddenly realize the Fed’s limitations, it may trigger suddenly shifting from calm complacency to panic quickly.

Counterpoint 4: The S&P 500 “averages” one 14% correction every year. 

Since we have had so little volatility, a good-sized selloff might trigger outsized emotional reactions.  Yet, the flipside is whenever we do finally have a meaningful decline this outsized reaction might quickly take away the complacency and put healthy fear in the market before anything approaching panic ensues.

Point 5:  I don’t know or care what the market does next.  Isn’t that great!?!? 

I could go on and on with different arguments. There are certainly reasons for concern as well as reasons for optimism.  Fortunately, we don’t really have to know which point/counterpoint is accurate.  In a nutshell, here is the simple yet sometimes quite challenging approach that works:

• Have and follow a plan that has high likelihood of achieving financial success however you define it.

   

• Prepare emotionally for the challenging times whether corrections or bear markets, high or low volatility.

   

• Most importantly, continue to rigorously follow your personal plan, especially during those most difficult periods when it doesn’t seem to be working.