After multi-year gains in the stock market, investors are looking beyond easy money for signs of continued momentum.
When we began working in portfolio management, we were excited by the idea that everything happening in the world was reflected in the prices that went by on the ticker tape - economic data, war, peace, elections, and the anticipation of an almost infinite number of factors. The past several months have been astonishing to watch. Beginning with a major surprise in the presidential election and a massive rally in the stock market, we have tried to understand the behavior of participants. We think it is fair to say the country has seen events unfold in ways that would have previously been hard to imagine.
Can this market really be factoring in all of the things that have occurred - possible Russian meddling in the election, charges of wiretapping of the president, North Korea, border walls, threats of trade disputes, intemperate tweets? Or have emotions overtaken logic? This grand bull market began during the depths of despair in the economy. With an economic recovery seemingly improving, it is fair to wonder whether a market that is, at best, fully valued can continue its rapid advance.
Then and now
Prior to the election, economic recovery and stock market gains were aided, and maybe even caused, by ultra-low interest rates and easy credit. From 2009-2015, dividend yields on stocks exceeded the interest rates available on low risk bonds for the first time since the 1950s.
Then came the election and an abrupt turnaround in the mindset of investors, as the focus turned to the prospects for much stronger economic growth and higher corporate earnings. The thinking became that the combination of fewer regulations, sharply lower taxes, repatriation of foreign profits, and massive infrastructure spending would justify the higher valuations being placed on stocks.
In a rather bizarre turn of events, the attempt to repeal and replace the Affordable Care Act was beaten down. A program that few understand fully was being offered to replace a program that while equally confusing, had put more people under health care coverage.
The question now becomes what happens to factors that kept the markets bubbling?
Valuations in focus
Over the past eight years, price-to-earnings (P/E) ratios have almost doubled from the nadir of 2009. Just since the election, P/E ratios have expanded by several percentage points. Though economic activity had begun to improve, the bet by participants has been that the factors listed above would give a huge boost to earnings that would be more than enough to offset the likely rise in interest rates.
With the collapse of the health care bill, a huge question mark will hang over an expensive market. No one can be sure now that promised tax reform will be passed, or infrastructure spending will be approved. The large Republican majority clearly is not going to be bullied by the president. While Congressional gridlock was favored by many over the past decade, expectations for movement on tax cuts and reform have gotten very high.
Valuations for most stocks seem rich compared to historical levels. Very low interest rates have abetted those valuations. We simply don’t know how long investors will drink the Kool-Aid of the grand benefits of potential changes in entrenched political positions. If stocks were trading at depressed levels it would be a non-issue. But the bull market that fed on easy money is likely to demand proof now that a potential smooth ride through Congress has turned bumpy.
The dividend train rolls on
In the meantime, the dividend train keeps rolling, as so many companies have continued to do right by investors. Though the rate of dividend increases has slowed a bit, we are confident in continued increases going forward.
We are trying to make sense of the astounding events occurring almost daily. Thus far, investors have not shown an interest in aggressive stock selling. We will continue to hold our best companies, understanding that the results of the first three months of the year are unlikely to be translated into an annual rate of return. It has been a great run in the market for several years; a rest or pullback would not be surprising. Interest rates, though up from pre-election levels, remain at rates that are not likely to draw money from stocks, or threaten economic recovery. We have lived through multiple stock cycles and believe firmly that patience, balanced by good research, is a winning formula. In the current rapidly changing environment, we continue our preference for those companies providing a measure of stability in cash flows and dividends.