October 30, 2017

Stocks closed higher on the heels of better than expected earnings from Amazon, Alphabet#, Microsoft# and Intel#, four leading tech names. Those earnings, and the ensuing surge in their stock prices sparked a huge rotation of equity money out of groups that are experiencing economic pressure and into the tech sector. As bull markets age, breadth often narrows. Money does exactly as it did on Friday, flowing from the have-nots to the haves. While there are individual exceptions, the haves today are dominated by tech names like the four mentioned above. Technology isn’t the only area of strength; financials, homebuilders and rails, just to name some other areas, are also doing well. As for the have-nots, retail would certainly be near the top of the list. Lately, with rising prices, oil seems to be escaping the cellar. However, drug companies, exposed to greater competition, are starting to lag noticeably after doing well through much of 2017.

Chasing momentum has its plusses and minuses. On the plus side, using the theory that a body in motion tends to stay in motion, in a bull market, following the leaders until they begin to lose their momentum can pay off handsomely, particularly when momentum stays on your side for an extended time. Looking back to the late 1990s, when the Internet bubble was growing, tech stocks were major outperformers for five years. However, momentum can change suddenly. If you choose to ride the momentum train, you have to know to get off. We all think we can jump off the train before it falls over the cliff but that rarely happens. More often than not, one overstays his or her welcome and gives back all the gains and then some. So how can one participate without ignoring the risks of an economic collapse? Again, it comes down to discipline. First, you can’t put all your eggs in one basket. Technology roughly represents a quarter of the market. Maybe, if you want to be aggressive, you can have as much as a third of your portfolio in tech, but that is about the prudent limit for true investors. Second, one always needs to pay attention to valuation. When the bubble bursts, stocks of companies whose value was built entirely on promise and hope will collapse, often losing 80%+ of their value. Furthermore, as Warren Buffett often opines, you can’t usually tell who is swimming naked until the tide goes out. In bull markets, hope mixes with reality. In bear markets, hope is replaced with skepticism. The impact on valuation can be dramatic. Third, one has to understand that bull markets are born out of despair working their way through skepticism and, ultimately, to euphoria. One hallmark of this bull market has been the persistence of skepticism, partly related to the memories of the Great Recession and partly to the unusually volatile political landscape of today. Perhaps the most common question I am asked today is “How can the market go up given the state of affairs in Washington?” That skepticism to date has kept euphoria at bay. But days like last Friday are destined to inspire other tech giants still in private hands to come public.

So far, the high profile tech companies that have come public haven’t had very strong receptions. Snap, Twitter and Blue Apron are three examples. Historically, meaning before the Great Recession, companies would come public much earlier in their life cycles. If they proved to be successful, public shareholders were able to participate in that success. But for a lot of reasons, many of them regulatory related, early and mid-stage companies are not coming public. That is not to say, however, that they can’t achieve spectacular growth in value as private companies. They can, especially when each funding round occurs at higher and higher prices. What has happened, as so much hedge fund and even mutual fund money has chased these “unicorns” is that price got ahead of value. In a few high profile cases, the companies themselves imploded and valuations dropped in spectacular fashion. Uber, the taxi and ride sharing alternative, reached a valuation of $80 billion despite legal and managerial problems and the fact that it has never made a dime and bleeds cash continuously. Just to put $80 billion into perspective, that is about a third more than FedEx# is valued at today. Thus, while this market may yet see the telltale IPO boom that happens at the end of almost all great bull markets, I wouldn’t be surprised if we never get there this time around.

Of course, markets are not just built on hype and hope. Their foundation is always value, i.e. earnings, interest rates and dividends. So far, this earnings season has been reasonably solid, lead by double digit earnings gains in the tech sector. This will be a busy week both for earnings and economic data. It will be the last big week for earnings, but there are still some important reports to come including Apple# and Facebook#. Later this week, we will get a first look at October economic data culminating in the employment report on Friday. October data will still be colored by the three major hurricanes. There will still be some after effects of the storms which, by now, may actually include some added economic activity related to recovery efforts. In particular, there should be a big jump in employment reported on Friday. Friday’s numbers should be combined and averaged with September’s weak report to get a more accurate reading on the current state of the economy.

Also this week, there is a two-day FOMC meeting. There is little chance of a change in interest rates. Before the meeting takes place, it is likely that President Trump will announce his nomination to succeed Janet Yellen as the Chair of the Federal Reserve. While Ms. Yellen could be reappointed, that appears unlikely. Speculation centers on Jerome Powell, a current Federal Reserve Board member who is philosophically close to Ms. Yellen, and John Taylor, a Stanford professor, who believes rate setting should be a formula-based process. Under his “Taylor Rule,” short term rates today should be close to double where they are now. To date, President Trump’s history has been to pivot away from anything and anybody related to former President Obama. But, at the same time, he understands and favors a low interest rate environment. That would seem to have him leaning toward Mr. Powell. We will probably know by mid-week before the President leaves on a planned trip to Asia. To Wall Street, who is selected as the next Chair will be more important than anything coming out of the FOMC meeting this week.

This week will also be the big reveal of the House Ways and Means Committee’s tax reform proposal. It is likely to be very pro growth with apparent benefits to all, including lower rates, higher standard deduction, a low repatriation tax on cash held overseas, and elimination of the alternative minimum tax. It will also reduce or eliminate some deductions. Republicans, businessmen and investors will love it. Those losing deductions and Democrats who want most or even all of the tax cuts to go to the middle class will scream bloody murder. For many years, Congress has caved in to all the screaming and yelling. There is no reason to believe this time will be different. The odds something gets done by next spring are reasonably good, but the odds that comprehensive tax reform that resembles anything the House puts forth this week gets done are pretty low.

Today, Ivanka Trump is 36. Henry Winkler is 72. Long live the Fonz.

James M. Meyer, CFA 610-260-2220

Additional information is available upon request.
# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

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