Ten years ago this month, the stock and bond markets collapsed after Lehman Brothers filed bankruptcy. For one day, 10 years ago, AT&T could not issue commercial paper that matured the next day. Investors were too afraid to lend AT&T money for one day. The S&P 500 declined over 55% from its highs during this period. The following companies either went bankrupt or were forced to restructure, Fannie Mae, Freddie Mac, General Motors, Chrysler, AIG, Wachovia, Merrill Lynch, Citicorp and Lehman Brothers. It was a scary time to be an investor. Local banks called in loans trying to raise money to help with their balance sheets. Virtually all future building projects were stopped. For an investor, it was a horrible time psychologically to live through. We want to congratulate all of you for making it through that period. Your account at Trend has been virtually 100% invested in stocks during this period. Ten years later the S&P 500 is at record highs. Your confidence in the world economic system not collapsing has been profitable.
We say all of that to remind you what a difference 10 years makes. Mark said it was the worst market he had ever seen (Mark started at Merrill Lynch in 1983). The bad news is we don’t think bear markets have been outlawed. We will enter another bear market at some point. We just don’t think we will see another “run on the bank” like 2008 for quite a while. Twenty percent declines in stocks can and will happen at any time. The bear market in 2008-09 hit the banking system. When the banking system gets hit, you are faced with the possibility of more than 50% declines in stocks. As we look at the banking system in the U.S today we think it looks very healthy. A healthy banking system keeps our fears low of repeating 2008.
We want to highlight a letter we wrote to our clients almost six years ago. Here it is if you would like to read it:
The interesting thing about that letter is we were sort of embarrassed to write it. We were predicting a big bull market in stocks. At that time, it wasn’t fashionable to say the stock market was going up. It was more fashionable to say the rally is over and we are going to experience another devastating bear market like 2008. At the time we wrote the letter the S&P 500 was at 1,425. Today it is around 2,900. Betting on all stocks going up made sense to us in 2012. Today it is a little less clear.
Let’s talk about one of our big predictions that has yet to happen. It may never happen. We think we are right on this one, even though our timing has not been great.
In March of 2016, we wrote that the U.S. dollar is going much lower, commodities are going much higher and emerging markets will benefit from this. Commodities have rallied about 10% since then but emerging market stocks and the dollar have been a mixed bag. Instead of declining as we predicted, the dollar is up 2% versus developed country currencies. Against emerging market currencies, the dollar is up 10%. Emerging market stocks have gone up but they have not done as well as American stocks. This has hurt our relative performance versus the S&P 500 the last two years.
We continue to believe that the dollar is at risk of a very large decline. There are two big factors that have held the dollar up that we didn’t see coming in 2016. One is the U.S. continuing to increase its production of oil. The other is the currency market’s reaction to this trade war.
We flat-out didn’t think oil production in the U.S. would make it to 10 million barrels a day. It is now 11 million barrels. The U.S. oil fracking industry is continuing to grow even though drilling for new wells is half of what it was at its peak. Something must give here, and we think it’s oil production declining. The increased oil production lessens our need to import oil, which is positive for the dollar. The U.S. is sending less money overseas for oil, which helps our currency. Should oil production roll over, that would help our prediction of a lower dollar and higher commodity prices.
The other factor in holding the dollar up is the Trump trade war. We have been predicting a trade war going back almost 7 years. It’s here now. There is an economic school of thought that in a trade war you buy the U.S. dollar as money comes from outside the country to build factories here. Those factories being built increase the demand for dollars. At best we think that’s a short-term phenomena. We aren’t big believers of this theory, but that theory has been winning versus our view. We think the more likely scenario is that our inflation in this country accelerates versus the rest of world causing our currency to decline. The currency markets hate inflation and I think ours will pick up versus everyone else’s. We are at full employment. We see wage growth accelerating above 3% in 2019. The Fed’s mandate is 2% inflation. When President Trump started this trade war he gave U.S. workers a better chance to increase their wages. We believe they will take advantage of it. When they do, we are concerned how the market will react to this.
We see the S&P 500 as being 15% to 20% over valued. We view commodities as being 50% undervalued. To invest in this view, we have placed around 20% to 25% of your account in stocks we think will benefit from commodities going up and the dollar going down. We have three stocks that we don’t plan to sell based on our inflation views, BGC Partners, CenturyLink and Berkshire Hathaway. There could be more but those are the three we want to mention now. For older accounts these three positions represent around 30% to 35% of your accounts value. For now, lets say that our three core holdings plus our commodity/dollar investments represent 55% of our average accounts assets. Of the 45% that is left over, around 10% of that is in cash. This leaves us with 35% of our portfolio that we think is at a greater risk of a market decline should our view of inflation occur. Should we decide to lighten up on stocks due to market concerns, this will be one area we look at. There has been only one time in the last 10 years when we raised cash due to market concerns, January of 2015. The cash level we raised back then was 20%. We reinvested that money back in the markets in August of 2015. We are not making a market call at this time, just alerting you to the possibility that we could do this in the future.
The average dividend yield of BGC Partners and CenturyLink is 8%. If we enter a bear market, those yields will help support the stocks. Berkshire Hathaway doesn’t pay a dividend, but it increased the price it’s willing to pay to buy back their stock this quarter. We view that as a form of a dividend and we think it would support the stock should times get tough. Berkshire Hathaway also has over a $100 billion in cash looking for a home. That always helps in bad markets.
The question we get asked the most often is “Describe THE MOST LIKELY bearish scenario that causes you to get worried.”. Fair enough, here it is. If this market plays out like the bull market’s of 1999 and 2007, commodities will have to go up enough to cause the Fed to tighten more than the economy can stand. The most likely culprit of higher inflation is the price of oil. Oil prices went from $11 a barrel in January of 1999 to $32 by March of 2000. That was the end of the dot-com bubble and the economy entered a recession. In January of 2006 oil was at $60. By January of 2008 oil was at $100 (on its way to $150). The economy entered a recession in 2008. We think some combination of Fed tightening and higher oil prices (or the CRB index) could cause problems for this market. The average consumer in the US has very little excess cash flow. When the price of oil goes up, so do your car mileage costs, heating costs, airplane tickets, UPS shipping costs etc. The rising costs of everyday food and energy will keep the average consumer from spending it somewhere else. Hence the recession happens.
If the key factor in the Fed’s decision to raise rates is rising inflation, then having money in inflation stocks should be the last area of the stock market to rally before this bull market is over. You can consider it a late economic cycle indicator. If the price of commodities never goes up, then theoretically the Fed could print all the money they want forever. In other words, the next 10 years would look a lot like the last 10 years. We view this as a low probability but it’s possible. Commodity stocks won’t be as good an investment as owning the general market would be in a low inflation world, but they will do OK. If inflation comes back, these stocks will do much better than the general market or cash.
If our scenario on inflation plays out like it did in 1999 and 2008, we would have the opportunity to raise cash by either selling the commodity plays if they go up a lot or selling the general market stocks if they didn’t. We will have to wait and see how this one plays out. No cycle ever repeats itself the exact same way on Wall Street, and we are sure this one wont either. Stay tuned.
If you have any questions on this feel free to give us a call (417-882-5746). Our holiday party is on December 20th this year. The time is 6-8 p.m. and it’s still at Highland Springs. We will send you an official invite in November.
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR