Bad news can be like waves sweeping in and breaking along a sandy shore. The quiet rumble as the watery walls form, break, and lap upon the shingle fades from our conscious awareness until the surge from a sudden harmonic convergence leaves us scrambling for higher ground. It feels like one of those moments right now, with the ebb and flow of daily crises seeming to have surged past some invisible threshold that leaves us feeling off balance and scrambling for a firm place to stand. Our sense of well-being is undermined daily by headlines that tell us of strife between Ukraine and Russia, of the Islamic State, sweeping pandemic-like through the heart of the Middle East, sending hundreds of thousands fleeing their homes. And to this human scourge is added the risk of real pandemic as the Ebola virus leaps from country-to-country in our jet-connected world. All of which can leave us susceptible to heightened pessimism about the world economy and the financial markets and wondering what we should do to protect ourselves.
Unfortunately, we’re all evolved to notice the worst and the news media is only feeding us what we naturally seek as it offers up a steady stream of dark omens. The good news is that the underlying nature of reality, its deep structure if you will, is geared toward growth and progress, if we’re open to seeing it. Toward that end, we thought we’d take a few minutes to unpack the news of the day and place it within a wider and, ultimately, more optimistic frame.
The Good, the Bad, and the Ugly
We’ve already touched upon some of the things that are truly ugly in the world at the moment and will only say that we trust that our political and other public institutions will ultimately be up to the task of curbing them. While we can always wish for better foresight and faster responses when crises arise, our leaders and public institutions, whether fast or slow, do generally find their way to effective action once properly focused.
As for what’s “bad” in the world, we’ll note recent economic and financial trends that have been filling the headlines. First, is the International Monetary Fund’s (IMF) warning that global growth is slowing, especially in Europe and Japan, where, except for the lone bright spot of the United Kingdom, economic growth this year and next is projected to barely attain one percent. And with inflation in Europe projected at only one-half percent, the fear of deflation has also returned (source: IMF). Beyond this we’re being told that market valuations in the U.S. have reached dangerous levels, with one increasingly popular measure of market valuation, Shiller’s CAPE, having attained a multiple of 25 compared to a long-run average of 16. Such observations seem particularly pointed in light of recent market turmoil (the Dow is down by more than 300 points as we write this) with the Standard & Poor’s 500 stock index as of Monday suffering a three-day decline that we’re told was the worst since 2011. So how are we to interpret the seemingly shaky state of the world?
At moments like this, I’m reminded of a scene from Apollo 13, the great Ron Howard film from 1995. During the “Houston we have a problem” scene, when the astronauts and engineers on the ground are reporting one failing system after another in quick succession, flight controller Gene Krantz stops everyone and says, “let’s look at this from the standpoint of status . . .what have we got on the spacecraft that’s good?” And so, like Gene Krantz, let’s ask ourselves, what have we got that’s good?
To begin with, we have resurgent growth in the U.S. economy. After declining in the first quarter, our Gross Domestic Product (GDP) came roaring back in the second, advancing at a 4.6% annualized rate. All of this in an environment of continuing low inflation with the latest 12 month rise in the CPI barely reaching 2%. And the long run prospects for the U.S. economy look even better when you consider the technology-driven advances in the energy sector that have resulted in the U.S. overtaking Russia and Saudi Arabia to become the world’s largest oil and natural gas producer. Not only does this development bode well for domestic energy prices and our balance of trade, it has also begun to spark a shift toward “on shoring” energy intensive manufacturing plants.
As for the situation in Europe, worries about economic growth and sustainability in the Eurozone have been an ongoing and favorite theme for the worrying class. We experienced a sense of deja vu when we recalled our words from two years ago (TheLiveBigWay Digest – it’s like deja vu all over again), “the Eurozone is back in the news today as economic and political events have given rise to fresh doubts that European policy-makers will get their financial house in order.” A quick check of our international fund holdings, however, shows that they’ve risen 30% from that worrisome time until now, perhaps validating the old Wall Street saw that “the market climbs a wall of worry.” Another way of looking at the situation outside the U.S. is to note that financial markets are sporting much lower valuations than here, leaving much more upside, especially if (when) economic growth picks up again.
And speaking of market valuations, we must turn back to the U.S. stock market, which has been the target of a growing number of dark prognostications of late. Many of these come from “market technicians” and the less said about this voodoo art the better. Let’s just say that charts tell you little or nothing about what’s really going on in the economy and the underlying economy is what matters (see Live Big Digest – Aftershocks edition for the dog and dog walker analogy of the relationship between the markets and the economy). But what about market valuation measures like “Shiller’s CAPE” (Cyclically-Adjusted Price-to-Earnings), a smoothed measure of the Price-to-Earnings Ratio that is currently at 25 versus a long-run average of 16. To begin with, that long-run average is calculated using data from 1871 to the present and one must ask how relevant the state of the economy in those far distant times can be to conditions today. If we instead calculate the CAPE from 1980, we find that the average is above 21. Jason Zweig, writing in the Wall Street Journal, relates his recent conversation with Professor Shiller, noting that “Today’s level, Prof. Shiller argues, isn’t extreme enough to justify a strong conclusion.” Indeed, we’ve seen examples of this before. We recall the year 1995, when the S&P 500 soared 37.5% and many declared that the party was over. Although no one was particularly paying attention to the CAPE back then, it hit 25 at the end of that year, the same level as today. What followed were four more years of high returns (22.96%, 33.36%, 28.58%, and 21.04%) before the dot-com bubble burst in 2000 and the S&P 500 saw three years of declines. However, it’s worth noting that one would have been vastly worse off moving to the sidelines after the gains of 1995. Even though you would have missed the three down years of 2000 to 2002, staying invested for the full eight years would have given you a 119% gain versus only 37% had you chosen to time the market.
And when this past Monday marked a three day decline in the S&P 500 that was touted as the worst three day loss since 2011, we thought we’d better look that one up. What we found is that the market has risen by more than 60% since those fateful three days in November of 2011. Clearly, that was not a sell signal then and we don’t think it marks one now.
It’s Better to be Resilient than Nimble
Cyclical downturns in the economy and the markets are an inevitable feature of our landscape. We do not believe it is possible to foresee trouble in a way that would support anything like market timing. Rather, we believe it is better to have a system for assembling and managing an “all weather” portfolio that can withstand the shocks and surprises both large and small that roll through our world, while at the same time harnessing the natural propensity of the U.S. and world economy to adapt and grow. For more on this, consider two of our prior offerings:
Or, if you’d just like to distract yourself from the headlines with something fun and uplifting, please consider these wonderful videos.