With unemployment below 5%, the stock market near record highs, inflation contained, and the possibility of pro-business policy changes, what could go wrong in the U.S. economy? Realistically, quite a few things. Besides the more obvious issues of war with North Korea, tensions with Russia, terrorist attacks from ISIS, the ongoing probe of President Trump and the potential that Trump may not be successful with his agenda for economic growth, there are other less reported on issues in the background.
Investment as a percentage of GDP appears to be hitting a plateau approximately 11% below pre-crisis levels. One of the primary arguments in favor of continued economic growth (and therefore stock market growth) has been the optimism of business owners. The question we have to ask is, “If business optimism were truly as robust as surveys indicate, why are investment levels stubbornly low?”
Further, productivity levels seem to be struggling to pass 1%. Historically, productivity levels have been an important input with respect to wage growth. There has been a lot of discussion over when we will see the more meaningful increase in wages that many predicted would follow the drop in unemployment. In past cycles, we would have already begun to see stronger wage growth than is now present. Perhaps the less than desirable productivity levels are indicating we will not see the wage growth so many anticipate will come.
Looking deeper into the details, we observed a drop in U.S. manufacturing, durable goods, non-durable goods and transportation equipment. The ratio of U.S. wholesale inventories to sales is also weakening. Construction spending has been on a stable decline over the last year. Additionally, there has been a slowdown in automobile sales. We also recently saw a drop in consumer confidence and U.S. retail sales. These data points are supported by the fact that we are witnessing both a drop in U.S. personal spending and personal income. In addition to these data points, we have seen the 3-month moving average of U.S. consumer credit slow (meaning people in the U.S. are less inclined to want to access credit), and perhaps signaling consumer confidence is beginning to wane.
When we couple these facts with equity markets being on the high side of fair value (and over-valued according to some metrics), we believe a thoughtful approach to where investors should accept risk is in order. Further, we are witnessing a fall in correlations among equities, indicating a more active approach to stock selection may be expected to outperform passive or index investing. In April, CNBC reported that 52% of stock-based mutual fund managers were beating their benchmarks. We believe the trend of active management beating their benchmarks will increase over the coming year.
In choosing where to allocate risk, we believe it’s important to first understand how most equities are valued. One of the most common valuation methods is known as a Discounted Cash Flow Model (DCF). The basic idea of a DCF model is that a stock is worth the present value of its future cash flows. Without going into too much more detail, these models can be complex. The process of forecasting future cash flows of high growth companies that operate in new areas of the economy is very sensitive to the assumptions used in the model. For example, when computers were in their infancy, it was very difficult to project when growth would level off in that industry and when competition from new entrants to the industry would compress profit margins. In late 1999 and 2000, analysts began to observe a slowdown in the growth of tech companies; growth in the industry began to level off before most expected. Upon observing the slowdown, the prevailing DCF models were re-evaluated, and it was then determined tech stocks were incredibly over-valued, causing the massive selloff in tech stocks that we now call the bursting of the tech bubble.
Fortunately, not all stocks are as difficult to value as high growth new industry stocks. More established companies in more established areas of the economy have already passed through the high growth phase and the leveling off that follow it. These companies tend to produce more consistent and predictable growth patterns with more predictable and consistent profit margins. We can think of a company like Johnson and Johnson. Many of their products have been with us for decades, and while new entrants in any market can always present themselves, it’s less common in well-established niches of the economy. To show an example of the difference in outcomes during the tech crash, Intel (a high growth company in a developing niche of the economy) dropped in value 60.1% from January 1, 2000 to March 31, 2003. During the same time period, Johnson and Johnson gained 29.8% in value. Analysts did not have to completely refresh their assumptions on Johnson and Johnson during the tech bubble like they did with Intel. We see the same evidence in broad terms through comparing the Nasdaq with the Russell 1000 Value Index. The Nasdaq 100 (primarily newer, high growth companies) lost 72.4% of its value between January 1, 2000 and March 31, 2003) while the Russell 1000 Value (primarily older, more well established, lower growth companies) only lost 17.9% of its value.
Knowing what you own and how its market price is determined can go a long way in helping investors avoid getting blind-sided by something like the tech bubble. Our process focuses on the valuation of what we own with a deep understanding of the variables being used to derive a stock’s price in a DCF model. As in past cycles, growth will slow, models will be readjusted, and the price of over-valued stocks will fall. Because it is difficult to identify when the music will stop until it does, we believe the best course of action is to avoid following the herd and to choose sound investments with more predictable valuations. We actively monitor your investments to ensure we understand what is driving their price.
