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Q4 2017 Commentary - The Annual Ritual of Predicting the Future

| January 18, 2018
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“Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.” - Lao Tzu

As we enter the new year, many newspapers, magazines and financial news programs are sharing their financial market forecasts for 2018. Never mind that most of these predictions will be wrong, as was the case last year when the consensus expected the U.S. dollar to strengthen and interest rates to rise. The dollar actually fell and longer-term rates didn’t budge. This annual ritual of attempting to predict the future can be fun, but it can also be harmful to your financial health if taken literally. But that doesn’t necessarily mean we can’t know anything.

One of my favorite investment books of all time is The Most Important Thing Illuminated by Howard Marks. In one chapter of the book, Mr. Marks explores the notion of dealing with an uncertain future and how cycles might be a useful tool. 

In the world of investing, nothing is as dependable as cycles. We cannot know how far a trend will go, when it will turn, what will make it turn or how far things will then go in the opposite direction. But I’m confident that every trend will stop sooner or later. If we can’t know in advance how and when the turns will occur, how can we cope? On this I am dogmatic: We may never know where we are going, but we better have a good idea where we are. That is, even if we can’t predict the timing and extent of cyclical fluctuations, it’s essential that we strive to ascertain where we stand in cyclical terms and act accordingly. The essential ingredient here is inference. Everyone sees what happens each day, as reported in the media. But how many people make an effort to understand what those everyday events say about the psyches of market participants, the investment climate, and thus what we should do in response? Simply put, we must strive to understand the implications of what’s going on around us. When others are recklessly confident and buying aggressively, we should be cautious; when others are frightened into inaction or panic selling, we should become aggressive. So look around, and ask yourself: Are investors optimistic or pessimistic? Are securities offerings and fund openings being treated as opportunities to get rich or possible pitfalls? Has the credit cycle rendered capital readily available or impossible to obtain? Are price earnings ratios high or low in the context of history, and are yield spreads tight or generous? All of these things are important, and yet none of them entails forecasting. We can make excellent investment decisions on the basis of present observations, with no need to make guesses about the future.”

Using the list outlined above, we observe that the answer to most of these questions is a resounding yes. Investors are growing increasingly optimistic stocks will continue to rise. In fact, the following recent headlines reflect this very sentiment:

 “As Stocks Reach New Highs, Investors Abandon Hedges” – Wall Street Journal

“The Stock Market Never Goes Down Anymore” - Bloomberg

In addition, credit is readily available, price earnings ratios are high by historical standards, and yield spreads are very tight. All indications that we are well along in this current cycle. Which then begs the question, is the bull market in stocks nearing its end? To address this, I will turn to a recent note written by investment legend Jeremy Grantham of GMO. Mr. Grantham’s latest missive is entitled “Bracing Yourself for a Possible Near-Term Melt-Up” in which he shares his personal view on how this bull market is likely to end.

I find myself in an interesting position for an investor from the value school. I recognize on one hand that this is one of the highest-priced markets in U.S. history. On the other hand, as a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market. The data on the high price of the market is clean and factual. We can be as certain as we ever get in stock market analysis that the current price is exceptionally high. The classic examples of bubbles are not JUST characterized by higher-than-average prices. Prices alone seems to me now to be by no means a sufficient sign of an impending bubble break. Among other factors, indicators of extremes of euphoria seem much more important than price. Recently an academic paper titled “Bubbles for Fama” concluded that in the U.S. and almost all global markets, the strongest indicator, stronger than pure pricing or value, was indeed price acceleration.”

The following is a condensed summary of Mr. Grantham’s guesses about the path of U.S. stocks from here.

  1. A melt-up or end-phase of a bubble within the next 6 months to 2 years is likely, i.e., over 50%, with a price rise to around 3,400 to 3,700 on the S&P 500.
  2. If there is a melt-up, then the odds of a subsequent bubble break or melt-down are very, very high, i.e., over 90%.
  3. If there is a market decline following a melt-up, it is likely to be a decline of some 50%.

In summary, Mr. Grantham believes stocks are already overvalued but he is not yet observing the signs that the cycle is nearing its end and expects stocks to rise over the next 6-24 months that may take the market substantially higher before a significant decline ensues.

Strategy

Given that we believe the U.S. equity markets are not cheap and that we are likely in the back third of this bull market, what is an investor to do? Stick with your fundamental investment discipline and don’t get carried away with the crowd. For PYA Waltman this means the following.

  1. We should spend our time finding value among the knowable: industries, companies, and securities rather than base our decisions on what we expect from the less-knowable macro world of economies and broad market performance.
  2. Given that we don’t know what the future holds, we have to focus on value by having a strongly held, analytically derived opinion of it and buying for less when opportunities to do so present themselves.
  3. We must practice defensive investing, since many outcomes are likely to go against us. It’s more important to survive negative outcomes than it is to maximize returns under favorable ones.
  4. To improve our chances of success, we emphasize acting contrary to the herd when it’s at extremes, being aggressive when the market is low and cautious when it’s high.

As always, we appreciate the trust you place in us and remain committed to helping you achieve your financial goals.

Financial Planning Focus

Check out Melissa's blog post covering Key Takeaways from the New Tax Rules

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