What is Pat’s commentary for the week of February 22, 2017

Dear Inner Circle Member,

Here’s the text of the most-recent letter I sent to our Portfolio Management clients in late January:

“In 2017, déjà vu could turn out to be the investor tool of the year.

History always tries to repeat itself, but never quite succeeds—especially in the stock market. That’s why investment success comes more easily if you develop a balanced, healthy sense of déjà vu.

In other words, when the investment scene gives you a feeling that you’ve seen it all before, you should try to figure out what it is about the current situation that makes it seem familiar. It may be a trivial similarity. Or, it may be that history is indeed trying to repeat itself.

Of course, things won’t work out exactly the way they did before. But examining the earlier outcome can help you narrow down and prepare for what’s likely to happen next.

That’s what market indicators aim to do. However, most market indicators look at a narrow range of factors, and try to come up with an all-or-none answer. If you want to profit from a balanced, healthy sense of déjà vu, you’ll look for analogous situations, rather than instant replays.

The best example I can think of is one I’ve seen three times over the course of my investment career. It occurs when the two factors below come together in what you might call a “double-barrelled buying opportunity”:

  1. Investors generally are fearful and have low expectations for market performance; and
  2. There’s a lot of hidden value in the stock market—that is to say, value that is not yet evident in the economic or business statistics.

These two factors both improve your chances of making money in the stock market, but they do it in two different ways.

When investors are fearful and have low expectations, stock prices tend to be on the low side. They can rise by merely getting back up to average. Hidden value also works in your favour. Hidden value should eventually start to generate profits, spurring a rise in stock prices.

Each of these two factors improves the odds that prices will go up after you buy. Notice, though, that I’m talking about a “buying opportunity”, not a guaranteed profit. Keep in mind as well that the combination may need time to pay off.

The unexpected post-war boom set the pattern

The classic example of a “double-barrelled buying opportunity” came after World War II. When the war ended in 1945, many advisors and investors were glum. They expected that when the troops came home and military production shrank to peacetime levels, joblessness would soar. Many thought the U.S. and the rest of the world would sink back into another 1930s-style depression.

Businesses saw things differently. They recognized the public’s vast pent-up desire for consumer goods. People were eager for the things they wanted but couldn’t have in the 1930s Depression and the war. Returning soldiers were eager for jobs that would let them get on with their lives. Companies were eager to hire so they could step up production of civilian goods. All this led to unexpectedly fast economic growth, starting in the late 1940s.

Full employment and soaring stock markets followed. While the boom was going on, however, you’d often hear that stock prices had gone up too high, and were headed for a crash. These doubts were common in 1964, when I was in high school and got my first investing-related job, as a part-time assistant to a financial writer.

The postwar boom and market rise lasted into the early 1970s, far longer than most people expected. By then, oddly enough, the doubts were mostly forgotten. In fact, many observers expected a whole new post-war boom after the U.S. pulled out of the Vietnam War in August, 1973. (They made the mistake of zeroing in on the end of the war, rather than looking at the overall situation.)

Instead, the market went into its worse plunge since the Depression.

The stock market recovered from that plunge, but stayed below its 1960s highs for another decade. Prices rose and fell, but stayed within a broad range. In fact, it’s fair to say that the stock market stagnated between the end of the 1960s and the early part of the 1980s.

This lack of progress led many investors to worry that the next big stock-market move would be downward. Meanwhile, business and financial journalists remained heavily downbeat. In December 1979 Business Week ran its infamous “Death of Equities” cover story; it predicted economic and stock-market ruin due to inflation. Economies in the third world and parts of the industrialized world seemed on the verge of collapse, if only due to rising oil prices. The Soviets had invaded Afghanistan; interest rates, inflation and gold were soaring.

However, corporate profits kept piling up in company accounts. In addition, the value of real estate and other assets kept rising, thanks to inflation. As the 1970s progressed, in the midst of this negative investor outlook, stocks built up a great deal of hidden value.

The opportunity of a generation

As time passed, I felt more and more nostalgic for the easy stock market gains of the postwar boom. I also felt those good times were sure to return one day. In my view, the market had built up a lot of hidden value in its decade-long run of bad performance. Investor sentiment was so depressed that it could hardly get worse. President Reagan had a new approach that just might work. It looked to me as if a re-run of the post-war boom was possible.

By this time, I was writer/editor of a weekly investor newsletter, The Investment Reporter. At the start of the 1980s, the publisher came in my office one day and asked if I had any ideas for an advertising theme that would sum up the investment prospects of the new decade.

I said, “How about ‘The opportunity of a generation’?” I told him about my low-investor- expectations/high-hidden-value idea, and how it fit the times we were living in. So we went with “The opportunity of a generation” in our advertising.

We were a little early—the market only hit its ultimate bottom in August, 1982. But after that, for the rest of the decade, stock prices went up further and faster and longer than most people expected.

A decade later, it happened again

In the early 1990s, I was still writer/editor of The Investment Reporter. It had grown a great deal in the previous decade, thanks to our “Opportunity of a generation” advertising theme. I had begun writing a front-page column for Investor’s Digest of Canada. I remarked in October 1991, in one of my first Investor’s Digest columns, that I was the most bullish person I knew. All the investors and investment professionals I spoke to were down-in-the-mouth about something: soaring interest rates, high unemployment, bank failures, the possibility of a coming MidEast War, etc.

A few weeks later, a major Canadian book publisher called to ask if I wanted to write a book about investing.

We met in her office a few days later. She wanted a book about investor concerns such as soaring interest rates, high unemployment, bank failures, the possibility of a coming MidEast War, etc. The title she had in mind was “Wrestling the Bear.”

I told her I was the wrong person to talk to. She needed to get in touch with somebody who had a negative point of view, such as Robert Prechter, say, or Howard Ruff, or Joe Granville, or any of a half-dozen prominent perma-bears from those days. 

She asked how I could be optimistic in light of the investor concerns she mentioned. I told her that current stock prices already reflected these concerns. Everybody knew about them, so they took them into account when deciding how much to pay for stocks.

She asked what would make stocks break out of the sideways trend and go up?

I told her I expected a post-Cold War boom. It could rival the 1980s boom, if not the post-World War II boom. My guess was that the new boom would begin soon and last throughout the 1990s, and possibly beyond.

After all, we had the two key elements for a surprise market boom: a downbeat investor outlook, plus hidden or disregarded assets. In particular, I was able to point to these three “economic energizers”:

  1. The move toward economic and political liberalization that swept around the world after the 1990 collapse of the Soviet Union;
  2. The maturing of the baby boomers, who entered their peak earning, saving and investing years in the 1990s;
  3. The productivity explosion that grew out of advances in computer and communications technology.

After some discussion, we settled on “Riding the Bull: How You Can Profit in the 1990s Stock Market Boom” as the title for the book.

Riding the Bull came out in 1993, as the 1990s boom was getting started. Around that time, I decided I wanted to offer portfolio management services to investors who chose not to do-it-yourself, while continuing to publish investor newsletters. My employers did not share that vision. So I left The Investment Reporter In 1995, and launched my own company, The Successful Investor Inc.

Like the postwar boom and the surprise boom of the 1980s, the surprise boom of the 1990s lasted longer and took stock prices higher than most people expected. For the third time, the two-part formula led to a record-breaking market boom.

I stayed optimistic, with varying levels of enthusiasm

For a variety of reasons, I’ve been optimistic on the stock market outlook for most of the time since I launched my own first newsletter, The Successful Investor, in 1995. My level of optimism has of course waxed and waned. My favourite recommendations have varied with my view on risk in the market. I’ve always kept my eyes open for a new instance of the two-part formula that could give rise to another low-risk opportunity to “ride the bull”. Seems to me that a new one came along with the surprise result of the 2016 U.S. presidential election.

Mind you, I was optimistic about the stock market prior to the November 8, 2016 U.S. Presidential election. Like most people, I assumed that Hillary Clinton would win. I took her at her word that she would “build on the Obama legacy.” I took this to mean that she’d keep raising taxes and adding to regulation of the economy and business. I blame these uncertainty-provoking policies for the weak economic growth of the Obama years.

(Just to refresh your memory, tax increases raise business costs, so they hold back new business investment. That’s especially so for start-ups, which are often short on capital and unsure about their business plans. That’s bad news for job growth, since start-ups and small businesses tend to produce a majority of new jobs.

New business regulation also holds back new business investment, especially for start-ups. New regulations increase the complexity of starting or running a business. They raise legal and lobbying costs. Along with complexity, new regulations introduce an extra element of uncertainty. There are just too many regulations for any company (or, for that matter, the government) to keep track of. That’s why multi-billion and even trillion-dollar companies spend vast sums trying to comply with regulations, yet still run into regulatory snarls that can bring multi-billion-dollar penalties.)

Of course, the U.S. stock market went up throughout the Obama years. The Canadian market also went up, but with more volatility. We stayed optimistic or bullish about the stock market throughout Obama’s time in power, mainly due to the extraordinary low interest rates of those years.

The U.S. Federal Reserve and other central banks around the world worked together to push rates down, as an economic stimulant. This has side effects. Stocks and bonds always compete against each other for investors. Low interest rates make bonds less attractive than stocks. During the Obama years, stocks were the obvious choice for value-oriented and income-seeking investors. So the stock market went up.

Under a President Hillary Clinton, I expected interest rates to stay low, due to continued central-bank activity aimed at holding rates down. Mind you, I didn’t expect rates to fall much lower. (After all, how much lower can they go when some bonds pay “negative interest”—at maturity, buyers get back less than they paid!) This meant that stocks would continue to offer investors a better deal than bonds.

I expected the economy to keep on growing, though at a sluggish pace. That would spur continued gains in corporate earnings and dividends. This too would enhance the appeal of stocks over bonds. This, in my view, meant stocks would continue to gain. So I still saw reason to be optimistic about the stock market under Clinton, but little reason for any enthusiasm. (I also felt the U.S. was in the grip of some highly negative long-term political and economic trends, as I explained in previous 2016 client letters.)

Trump’s surprise victory and your investments

Trump’s victory, coming as it does with Republican majorities in both houses of Congress, means he can peel back the Obama-era obstacles to growth. Many of them went into effect in the last few years by Presidential edict, after the Democrats lost control of Congress. Many are too new to have had much direct impact on the economy, but they still had a depressing effect on business expansion plans. That’s why the Trump election victory sparked the recent rise in the stock market. This suggests that some investors agree with me. But even the optimists under-estimate the gains that lie ahead, in my opinion.

I see something of an analogy between the backlog of business and consumer demand that built up during the Depression and World War II, and the situation today.

Since 2009, the U.S. economy mostly grew at 2% annually or less, compared to the yearly growth of 4% or more that is common in the recovery from a recession. That means lots of consumer purchases and business projects got shelved. Over the next year or two, if the Trump administration merely eliminates Obama-era growth impediments, this demand backlog could fuel a business boom.

For example, the 2015 U.S. census showed that almost 40% of young adults (aged 18 to 34) were living with their parents, siblings or other relatives. That’s the highest rate since 40.9% of 1940, 75 years ago, one year after the Great Depression officially ended. From 1980 through the mid-2000s, this rate hovered between 31% and 33%. The average age of marriage and having children has also moved way up. All this reflects the fact that more young adults are working part-time, and/or at low-wage jobs.

If Trump’s tax and regulatory reforms make it easier for young adults to find well-paid, full-time jobs with a future, all three of these rates could rise back up to historical averages and beyond.

My view is that if you disregard politics and simply focus on Economics 101, the 2016 Presidential election created an overnight treasure trove of hidden value in the U.S. economy. Like any store of hidden value, it may need time—months or years—to have an effect on the stock market. Or, the effect on the stock market may have already started. It may have a long way to go.

This, though, is only one half of the ”double-barrelled buying opportunity”.

Anti-Trump fear and hatred creates low expectations

Trump’s surprise election victory set off the climate of fear and hatred that makes up the second part of the “double-barreled buying opportunity.” 

The two major U.S. political parties used to have a lot more in common than they do today. In the 20th century, 3rd party Presidential candidates ran on the idea that, “There’s not a dime’s worth of difference between them”, and dismissed the two major-party candidates as “Tweedledee and Tweedledum” (two foolish characters in 19th century English folktales who look and act the same). In the past decade, however, the two parties have clearly diverged. There’s much more than a dime’s worth of difference between Donald Trump and Hillary Clinton.

Soon after he entered the race, Trump’s aggressive style of campaigning made him one of the most reviled major-party Presidential candidates in U.S. history, judging by published comments by rival and opposing politicians (some from his own party), not to mention journalists and celebrities. The Democrats quickly decided they could win the election by simply referring to and exaggerating the differences. When Trump won, they felt cheated and outraged.

Since then, Trump opponents have scoured every news item that comes along, in hopes of finding anything they can (pardon the obvious pun) “trump up” into a grave threat to the country or the world.

Trump wants to re-negotiate trade deals? He’s risking a trade war and 1930s-style depression!

He accepted a congratulatory call from the President of Taiwan? Risking war with China!

Russian hackers had more success with cyberattacks on Democratic than Republican computers? Russia rigged the election!

Trump’s choice for Secretary of State was chairman and CEO of Exxon, a company that works with the Russian oil industry? Putin controls the White House!

He’s against illegal immigration? He’ll destroy Hollywood by deporting all our fine foreign-born actors!

You can find a lot of reasons to criticize Trump’s demeanor, compared to today’s theatrically rehearsed and scripted opponents. Since he lacks polish, he may feel he has to talk and tweet with crude gusto, just to get the public’s attention, even if it makes some people cringe. When I disregard the packaging and strip the content down to its essence, however, I rarely find anything related to the stock market that I disagree with. You have to focus on the essence of the news if you want to make any sense of the stock market.

Most investment professionals and economists are aware of the potential I’m talking about, but few are willing to bet their jobs on it. They realize Trump may fail. That explains the uniformity of opinion among Wall Street forecasters. They are uniformly optimistic, but only mildly so. Stock strategists are looking for an average gain of 4% for the year. That’s their lowest target since 2003. But it’s just high enough that nobody can mistake it for a “sell” signal.

The average forecast for U.S. Gross National Product is growth of 2.4% for 2017 and 2.5% for 2018. That’s a modest gain, little better than growth in the Obama years. 

When you see a high degree of conformity among forecasters, it often turns out that they are all wrong—either too high or too low. However, the year has just begun and Trump has not yet officially taken office.

Forecasters traditionally start the year with high forecasts, then tone the numbers down as problems attract media attention. The reverse may happen this year. When the public gets bored with reading about potential problems that never materialize, the media may switch to initial signs of success.

As you know, I generally avoid price targets in my work. But I do think now is a particularly good year to stay fully invested, to the full extent compatible with your finances, goals and temperament.”



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