Keep INVESTING Simple and Safe (KISS)
****Investment Philosophy, Strategy and various Valuation Methods****
The same forces that bring risk into investing in the stock market also make possible the large gains many investors enjoy. It’s true that the fluctuations in the market make for losses as well as gains but if you have a proven strategy and stick with it over the long term you will be a winner!****Warren Buffett: Rule No. 1 - Never lose money. Rule No. 2 - Never forget Rule No. 1.
A year ago, in the wake of President Trump’s tax cut, euphoric investors pushed the Dow Jones industrial average past 25,000, a record. The Dow had just gained 25 percent in 2017, and the Nasdaq had leapt 28 percent. Volatility was so low that there wasn’t a single day in 2017 when the S&P 500 fluctuated more than 2 percent.
Not everyone was celebrating.
“If there are any certainties, one will be that this party will eventually come to an end,” James Stack, president of InvesTech Research, told me a year ago. “And when it ends, it will end badly, and with high volatility.”
Mr. Stack turned out to be right. He lowered his recommended asset allocation for United States stocks from 82 percent last January to 72 percent in September, when stocks hit new all-time highs. He urged investors to raise cash in October, and at the end of November he recommended an even more defensive posture — including putting money in a fund whose value would rise when stock prices dropped. That brought his recommended net exposure to stocks to just 55 percent, the lowest since the depths of the last bear market in early 2009.
Stocks plunged in December, posting their worst monthly loss since the financial crisis and the worst December since 1931 and the Great Depression.
Yet most economic indicators are benign. Unemployment is an exceptionally low 3.7 percent. Wages are rising. Inflation remains below the Federal Reserve’s 2 percent target. The Fed raised rates a quarter point in December, citing “a very healthy economy.”
Given Mr. Stack’s track record last year, I reached out to him this week for his current views. Even though valuations have come down and macroeconomic indicators “have remained remarkably strong,” he said, he’s still defensive and hasn’t changed his bearish allocation. He believes that the worst isn’t over and that the Dow and S&P 500 will soon be down 20 percent from their peaks, retreating into a bear market. (The Nasdaq Composite and the Wilshire 2000 index of small-cap stocks are already there.)
“A lesson from history is that the market leads the economy by a lot longer than investors realize,” Mr. Stack said. If the economy is headed toward recession, as the latest stock market declines suggest it may be, “we won’t see the first economic warning signs until the first three to five months” of 2019. Among the leading indicators he’s watching for signs of weakness are consumer confidence, housing starts and unemployment claims.
On Thursday, the Institute for Supply Management manufacturing index, a leading indicator of industrial activity, fell sharply. That suggests that “serious cracks” are starting to appear in the economy, Mr. Stack said.
Mr. Stack is right that bear markets typically precede recessions by many months: CNBCcalculated in 2016 that bear markets since World War II had begun on average about eight months before a recession. That means that if a bear market did begin after major indexes peaked last fall, a recession might not start until June or even later. Even then, recessions are often over before economic data confirms their existence.
That’s when bear markets are, in fact, followed by recessions, which often isn’t the case. As the economist Paul Samuelson famously said, “The stock market has forecast nine of the last five recessions.”
Since World War II, there have been 13 bear markets. They were followed within a year by a recession just seven times. As a predictor of recessions with just 54 percent accuracy, bear markets are little better than flipping a coin.
Indeed, Mr. Stack’s data show that two down years in a row are quite rare: There have been only four instances since 1928, suggesting that stocks may well be in positive territory by the end of 2019, even if a bear market does materialize in the meantime.
Which is one reason the Wharton economist Jeremy Siegel told me that he’s bullish on the stock market this year. He predicts it could rise between 5 percent and 15 percent, even if there is an economic slowdown.
Stocks are much cheaper now than they were before the December sell-off. The ratio between stock prices and projected earnings for companies in the S&P 500 is about 17, down from over 19 a year ago and the lowest in the past five years.
[Stocks rose Friday after the release of a strong December jobs report and comments by the chairman of the Federal Reserve that the central bank would be flexible on raising interest rates this year.]
Mr. Stack, however, argued that in the event of an economic downturn — or even a significant slowdown — “those projected earnings will go out the window.”
“I would not call today’s market undervalued,” he added.
Mr. Siegel bases his forecast of a market rally on the belief that the Fed will stop raising short-term interest rates. “I think the Fed got the message from the markets that it should not have hiked in December,” he said.
Mr. Stack, too, said he was surprised the Fed raised rates in December. “I think the Fed will stand down and put future rate increases on hold,” he said, “which could stabilize the market, at least for the time being.”
But Mr. Stack’s technical indicators are still pointing toward a bear market. He’s also worried about the shaky housing market, with price drops and slowing sales showing up in major cities.
“We’re not trying to time the market, but we’re very comfortable with our defensive allocation,” he said. Although he predicted higher volatility a year ago, he was nonetheless surprised by the extremes reached in December, without even “a single hard warning sign of recession on the horizon.”
“Can you imagine,” he asked, “how volatile it will be when we do have those warnings?”