January 26, 2018

Stocks continued to move higher, but during earnings season, the gains are not across the board. Airlines, this week for instance, have taken a beating after United announced a significant anticipated increase in capacity. This remains an industry that vacillates between feast and famine. Small changes in capacity dramatically impact pricing and profits. Another industry that has been hit during earnings season has been the household products group that sell mundane items like toiletries and soap. Industry leader Procter & Gamble# precipitated a price war last year and the effects are rippling through the group. But almost everywhere else the news has been good and stocks continue to respond.

This week there is a major gathering of business and political leaders around the world in Davos, Switzerland. President Trump is addressing the conference this morning before the market opens. As we all are aware, Mr. Trump can be either confrontational or conciliatory at various times. This week, he seems to be wearing the conciliatory hat. He wants to tell world leaders that the United States wants to be everyone’s friend and work together. This is not the time or place to be isolationist or to talk tough on trade. But while his comments suggest a possible softening of positions (he even said TPP may not be dead), there has been no substantive change. He still wants a new or altered NAFTA agreement that will eliminate a $70 billion trade imbalance with Mexico, and he hasn’t changed his stance on the methodology of settling disputes. As for TPP, he said that if it is changed in ways that are more acceptable to him, he might reconsider. But let’s not misread this. Tomorrow, in a different place and forum, he might tweet a much harder line. It’s his way. By now we should all be pretty used to it.

One of the hot topics this week centered on Treasury Secretary Mnuchin’s remark that a weak dollar is good for trade. Factually, in the short term, he is correct. A weak dollar makes our exports less expensive and our imports more costly. Thus, we should sell more and buy less as the dollar falls. The media, however, then surmised that his statement of fact translated into a policy whereby the U.S. favored a weak dollar. Secretary Mnuchin never said that, and he spent several days trying to correct that media conclusion. President Trump got into the mix quickly and spoke in favor of a strong dollar.

At the core of President Trump’s economic philosophy of making America great again is the idea that if we are the best, whatever you take that to mean, companies around the world will be more attracted to doing business within the United States. That includes opening plants here and employing American workers. It also means that American companies will look more favorably toward manufacturing here rather than abroad. Money flows to strength. If a company builds a plant in the U.S. and the dollar subsequently falls 10%, then the value of the plant, expressed in the currency of a foreign company, would be 10% less. Likewise, the value of what is sold and the profits to be achieved would also be 10% less. While the dollar may help trade in the short run while the value of the currency is falling, and it might also help domestic company earnings translating overseas result into more dollars, if one’s goal is to attract business to this country, a strong dollar is the consistent goal, not a weak one.

That begs an obvious question. Why is the dollar weak? In particular, why is the dollar weak at a time when our interest rates are rising and are substantially higher than interest rates elsewhere in the developed world. There are several possible explanations. First, growth overseas appears to be at or slightly higher than the rate of growth in the U.S. Fourth quarter GDP this morning showed growth of 2.6%. While final sales growth was 3.2% (the difference relates to the change in trade deficit and inventory balances), China is growing at more than twice that rate and even Europe is growing faster. Second, inflation is beginning to rise. The chain weighted price index, perhaps the best measure of inflation, rose by 2.4% in the fourth quarter. While historically that isn’t a high number, it is higher than almost anywhere else in the developed world. Third, and maybe most important, the recently passed tax bill is likely to result in sharply higher deficits over the next two years at least. That will require more issuance of debt. Greater supply means lower prices and higher interest rates. Rapidly expanding deficits are not a sign of strength. Thus, interest rates are higher and the dollar is lower. While the dollar rallied a bit yesterday after Trump advocated for a strong currency, it is back down again this morning to lows we haven’t seen since the summer of 2015. Again, in the short run, that is a positive. Expect a pick-up in foreign tourists over the next year, for instance. But it won’t help to attract capital.

Another feature of a weak dollar, is the impact on commodity prices. By their nature commodities are global and most trade in dollar terms. A lower dollar generally means higher prices for goods from abroad. Everything from oil to imported steel will go up without any natural change in overall supply and demand. The U.S. accounts for about 25% of world GDP. We are the largest country in that regard. But we are still only a quarter of the world market. Thus, we don’t control commodity prices; world markets do.

An economy reaching its full potential, higher commodity prices and modest wage pressure as we approach full employment will undoubtedly get the Federal Reserve’s attention. Right now, markets are baking-in 3 Fed rate increases this year that would bring short term rates to 2%. That rate will likely be no greater than the rate of inflation, and therefore, not a rate that should stall the overall economy. But strong growth and slowly rising inflation are also likely to accelerate the end of quantitative easing in Europe and Japan. By the end of the year, most of the major central banks will no longer be net buyers of bonds. Rates, therefore, will normalize. So far this year the yield on 10-year Treasuries is up 20 basis points. If I assume each month were to see a 20-basis point rise, the rate by year end could be 4.5%. Of course, rates never rise or fall in a straight line, but you should be able to get my point. One of the things that can slow down the stock market would be a falling bond market.

In January, stocks have gone up as bond prices have fallen. That is not a trend that can go on forever. A favorite media question is “What rate of interest will cause the stock market to take notice?” It’s a dumb question. Markets can get out of balance with each other over the short term as emotions trump fact. Right now everyone is piling into stocks because that is the asset class working the best. But eventually stocks, bonds, currency, etc. will rebalance. It isn’t about what rate of interest will cause that to happen, it’s about when will the emotional buying slow down or stop.

Today, an incredible number of stocks are selling way above 50 or 200-day trendlines. That rarely happens without an ensuing correction. To me, that suggests a 5-15% correction is coming relatively soon. Before your panic and yell “Sell!” let me make a few clarifying comments. First, any such correction in a bull market will be quickly reversed. I sincerely doubt that you or I will be able to pick the exact top or the exact bottom that will be necessary to take advantage of the move. Second, if you have followed our repeated advice to stay close to your long term asset allocation, you have probably taken some money off the table already. Third, bull markets don’t end with all the economic indicators as strong as they are today. I am only talking about a mid-course correction, not the end of the bull market. Finally, markets make rolling tops and V-shaped bottoms. We will have at least one, and probably more than one, mid-course correction that will be completely reversed in days or weeks before the bull market ends. There is no reason to believe that the bull market only has weeks or months left. Quite the contrary. As long as economic growth continues and no economic or financial imbalances appear, we are in good shape. Right now we are in a sweet spot where growth is maximized, the dollar is unexpectedly weak, and interest rates are still low historically. At some point not far out, growth rates will moderate, the dollar will stabilize or begin to recover, and interest rates will move higher. At that point, markets may pause, but once again, pause doesn’t mean bear market. It means pause.

Against that backdrop, staying fully invested balanced to your asset allocation remains the proper course. But the rate of gains we have seen in recent weeks aren’t sustainable. Watch for a mid-course correction and don’t overreact when it happens.

Today, Ellen DeGeneres is 60. Wayne Gretzky turns 57.

James M. Meyer, CFA 610-260-2220

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