Not a Matter of If but When…

I am talking about the next Bear Market. The stock market has been going up pretty much non-stop since March 2009 (see below). Stock market advances do not end just because of old age, but nothing grows to the sky and eventually we will get a recession and a market downturn after this impressive expansion.

The U.S. economy is in good shape today, growing 2% to 3% in real terms with moderate inflation and only slightly rising interest rates.  The recent tax loss changes will benefit both corporate profits and consumer spending. But a recession and a stock market correction will occur at some point.

How should you prepare?  First, if you have done your homework, meaning you have established a sensible asset allocation between things that are safe (bonds and cash) and things which will grow (stocks) then you really don’t have to do much. Just don’t let your emotions get the better of you.  Common stocks tend to go up 6 or 7 years out of every 10 and stock returns over long periods of time will equal the long term growth in corporate profits (4-6% today?) plus a dividend yield of 2%, or a total return of 6-8%. Keep this positive investment message clearly in mind especially when the ominous dark clouds start to appear. 

Second, review your spending and borrowing. Now is a good time to reduce your borrowings and prudently look at any spending that can be cut.  Don’t panic, just do some realistic planning and realize that finances get more difficult in tough economic times. 

And finally, avoid market timing at all costs.  The world is uncertain and the one thing we know is it is very difficult to predict the future.  You might be right to sell now and go to cash but you usually miss the subsequent low point when you need to get back in.  There are people out there who can successfully do market timing but there are many more who think they can, but who can’t. The stock market is very effective at getting investors to do exactly  the wrong thing at the wrong time. We buy at the top and sell at the bottom.  We should all learn better how to go sit quietly in our room. Best to establish an asset allocation that is just right for your needs and temperament and then….exercise extreme sloth. 

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Why China May Very Well Win a Trade War…

In a recent New York Times International piece (May 4, 2018) Thomas Friedman noted that America and China are coming at the current trade discussions from very different angles. The Trump Administration wants to draw the line now on trade before it is too late, before China gets too big. The Chinese believe they are already big and need to be treated as such. As one Chinese expert noted, “No one can contain China anymore.”

China has come a long way from the 1980s when it was simply the location of choice for cheap manufacturing. Under Xi Jinping’s vision of “Made in China 2025,” the country hopes to dominate 10 next-generation industries including robotics, self-driving cars, artificial intelligence, biotech and aerospace. America is scared and angry now. Part of the anger is justified. The Chinese have required foreign multinationals to share their best technology with local partners, who in turn often use this knowledge to set up competing operations. This is not right but it is the brutal fact of life of economic history. One hundred and fifty years ago we stole textile technology from Britain and took the center of the clothing industry from Manchester, England to Manchester, NH. Now it is our turn to feel the pain.

So why will China win a trade war? My father, Haldore Hanson wrote a book back in 1939 (Humane Endeavour, Farrar and Rinehart) recounting his 5 years as a newspaper reporter in China. In the last chapter he speculated that the Chinese would eventually win the war (which they did in 1949). Why? Because the Chinese have a peculiar indifference to time and an age-long patience. As one banker told him, “we must make enormous sacrifices for the next five years and perhaps ten. But I have complete faith that China will again be independent within twenty-five years.” Anglo Saxon impatience would not tolerate this but China is a country that bides her time.

Second, China has moved quickly to develop its own national champions, aided by the Government to keep foreign competitors out. Alibaba in online sales, JD.com in logistics, Tencent in social media, Huawei and Xiaomi in cellphones, the list goes on. An all-out trade war would just increase China’s urgency to produce national champions.

And finally, China’s ‘pragmatic authoritarianism’ can move much more quickly than our Democratic institution in countering the painful affects of a trade war.

The reality, however, is that China’s economic ascendency is not a slam dunk. They have many things to worry about. First is demographics. China is getting old fast. The one child policy has been very successful and with fewer young people, China’s employment pool is already shrinking. As the saying goes, China will get old before it gets rich.

A second concern is the income and opportunity gap in the country. Migrant labor has moved from the country to the city for better jobs. This group is now just about equal in number to the rising middle class. The migrants are discriminated against in education and health care and this group of younger workers may not be as docile as their parents.

And finally there is the whole issue of ‘pragmatic authoritarianism.’ Whenever China’s growth has lagged, the government has quickly initiated a stimulus program. This can’t go on forever. Debt is rising rapidly and there are only so many fast trains and subway lines the country can afford.

So it is a complicated world out there. President Trump needs to work hard to open China to American business but I would be careful of an all-out trade war. The Chinese have a lot of trump cards in their arsenal so to speak.

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What the S&P 500’s Composition Tells Us...

The S&P 500 is an index of 500 large U.S. stocks weighted by their market capitalization or market value. We know it today as one of the most important gauges of U.S. stock performance, covering a broad swath of 11 sectors. But when the index started in 1957 in its current form, its composition was vastly different. The original S&P 500 consisted of 425 industrials, 60 utilities, and 15 railroads.

The index always has reflected the state of the economy, and in 1957, the economy was built on industrials. It wasn’t until the mid-1970s that financials were introduced. By 1976, the index consisted of 400 industrials, 40 utilities, 40 financials and 20 transports, which included not just railroads, but also airline and freight companies. By 1988, the strict 400-40-40-20 format had to be abandoned because it became too difficult to find 400 industrial companies. 

Over time, sectors within the index have swelled and contracted as their prominence in the economy has waxed and waned. In the early 1970s after the oil embargo, energy stocks prevailed. In the late 1990s dot-com era, technology did. And in the mid-2000s in the run up to the Great Recession of 2008 – 09, it was financials.

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Today when we look at the S&P 500, there are a couple of things that stand out. First, technology dominates again, making up almost a quarter of the entire index. It’s not the same kind of tech dominance as we saw in the late 1990s with the ascendance of Cisco and Intel. Instead, it’s the dominance of consumer-facing tech companies like Apple, Facebook and Amazon (though Amazon actually is classified as a “consumer discretionary” company). That isn’t surprising given how we live. We swipe our credit cards at self-pay kiosks, buy much of our stuff with a click of a button, and use our smartphones to find highly rated restaurants and avoid traffic.

Second, it’s hard not to notice the famous FAAMA phenomenon – or the outsized effect of Facebook, Apple, Amazon, Microsoft, and Alphabet, the parent of Google. These super platforms make up a weighty 12% of the index, which means that to a great extent, as their fortunes go, so goes the index.

And third, it’s not just FAAMA that throws its weight around, but the biggest stocks overall. Mark Hulbert has called today’s environment a “winner-take-all” economy, where relatively few companies dominate. He’s cited a study by Kathleen Kahle and Rene Stulz showing that the percentage of total income earned by the largest 100 publicly traded companies has grown from 53% in 1975 to 84% in 2015. That is significant dominance. It also means that outside of the 100 largest companies, most companies are earning only relatively small amounts or actually losing money.

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One reason the big keep getting bigger is network effects. That is when the value of a company’s services for each user rises as more users join. For example, as more people buy Apple phones, more apps get developed. And as more people join Facebook, the platform becomes more valuable. Some have argued that these network effects are so powerful that some technology companies deserve permanently higher multiples -- but we’d be very cautious about that idea. High multiples can last a very long time, but few things in markets really are permanent.

Still, there are implications for investors stemming from these bigger, more powerful companies. Much already has been written about how hard it can be to perform relative to the index if you don’t own the big five FAAMA (or the “fearful five,” as they’ve sometimes been called). But the other thing is heightened volatility. A bad day for Facebook or Amazon really can become a bad day for everyone.  And if a giant should make a major misstep, a reversal of the network effect could be quite painful indeed.