Oct 2018 Market Update

Just wanted to drop off this note that I just wrote quickly to give you a general update on the market.
 
Since the beginning of this month we’ve had a pullback in many asset classes. From stocks, to bonds and even real estate holdings as prices are down from their peak levels. Basically a reversion to the mean prices.   Bond prices given their inverse relationship with interests rates are down because interest rates have been moving up.  
 
The reason why rates are going up has to do with several factors from the Federal Reserve raising short term rates for the banks to borrow money from the Fed and from each other on their overnight lendings.   Which has also led to upward pressure on rates in longer term maturities. 
 
Another factor that is probably causing interest rates to move up, specifically in the U.S. treasury market is because there has been a reduction in number of foreign government buyers.  Given the trade tensions especially between U.S. and China, foreign buyers like the Chinese although may not resort to outright selling their treasury holdings, but they can substantially reduce buying new issues of bonds.  This lack of having new marginal buyers can push bond prices lower and thus the rates higher.  
 
As far as the stock market goes there are several questions that in the short term (1-2 years) are casting a cloud over the market.
 
The first one is that are the effects of 2017 tax cuts on the economy but more specifically on stock prices coming near the end or there is still room to push prices higher?  My thinking is that we are nearing the end.  Actual number that is available shows that in first quarter alone, multinational companies brought home about $300 billion of the $1 trillion held abroad and as expected a good chunk of that repatriated money went to buying back the shares of their companies.  Worth noting not much of it went toward capital expenditures.  The reason why I think we are nearing the end is based on assuming they probably repatriated and bought back shares at roughly the same rate since Q1 this would suggest that there isn’t much left to buy back stocks. 
 
The other question is whether the current Chinese tariff policy is just another bluff / grandstanding by the U.S. administration; just like what happened with pre NAFTA 2.0 negotiation, or is it a prelude to a long-term trade policy shift toward China?  To really make a good guess on this, one has to know which one of the key people inside the administration is really running the show on this matter.  

One can make a case that in order for U.S. to force China to cave in to U.S. demands they have to project that they are willing to make these tariffs permanent at all cost to U.S. economy, but they don’t really want to impose a tariff which is a tax on U.S. consumers just after they worked to have a tax cut.  However, given the past views of anti-China advisors to Donald Trump like Peter Navarro there is also a chance that if the congress continues to relinquish their power to the White House on trade matters then this is not just a bluff rather than a long-term policy.  
 
If it is a long-term policy then all the sales and earnings models that have been created for multinational companies that use China for their supply chain operation or do business there has to change. And in the long run the effect of those changes will not be limited to only multinational companies as those costs and shock will regurgitates in the overall economy.   
 
Finally are the earnings “growth rate” for S&P 500 companies at or near their peak levels?  S&P 500 earnings are expected to grow at a rate of 26% year over year from 2017 to 2018. They are expected to grow by another 12% for 2019.  However, if the sugar high from the tax cuts and the trade policy with China is permanent then yes given all the upward pressure coming in wage costs, borrowing cost, fuel cost, material cost basically higher inflation in 2019 we are more than likely at or very near peak earning growth levels.  
 
As you have noticed one of the underlying factors behind what is happening in the markets and economy is dependent on politics.  One of the main reasons why this pullback is getting attention not just from the usual chorus of financial media but also from the White House is because of its effects on mid-term elections.  
Usually a sitting U.S. president doesn’t opine or make too many comments about the stock markets or the Federal Reserve policies but they are forced to do so now all to justify the pullback because this administration has been using the performance of stock markets as their north star to gauge and judge their economic performance.  
 
That said if in the mid-term elections the democrats are able to gain control of the House then more than likely this administrations’ hands will be tied on pushing through their remaining agendas such as making the 2017 personal tax cuts permanent. 
 
So, what does this mean for investors.  If you don’t need your money (all or most of it) in the next 3-5 years or more and you do like buying things that are on sale then these pullbacks should be viewed as opportunities to realign your asset allocation into a basket of diversified asset classes that are trading at attractive valuation, that meets your risk tolerance and have the best chance in helping you reach your long-term financial goals.  
 
More importantly it is important to understand the long term expected returns for different asset classes.  Based on various capital market assumptions put together by various financial institutions U.S. stocks should give somewhere about 5% to 6% in the next several years, while U.S. bonds should provide about 3%-4% return.  
 
Of course, most people or advisors won’t put all investable assets in just U.S. stocks. If we assume a 70/30 diversified where 70% is invested in stocks and the remaining portion in bonds then a balanced diversified portfolio should have about a 5.5% average annual return.  
 
Now this 5.5% is an ‘average’ expected return.  For example, in the first year the portfolio can go up by 10%, and the following year it can go down by -4% and the average for those two years will be 5.6%.   I am mentioning this to make sure you have a realistic return expectation on your investments in financial assets.  These expected returns will give you a better idea on assessing your risk tolerance and more importantly evaluate to see if that your current investments growing at these expected returns will not help you in reaching your financial goals then whether you want to add more funds, take more risk or change your goals.  


The views expressed in this blog reflect those of Grayeli Investment Management as of the date of the write up. Any views are subject to change at any time based on market or other conditions, and Grayeli Investment Management disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.

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