Some Common Cents for October 20, 2017

October 20, 2017, by John Norris

One of my wife’s co-workers recently turned us onto a PBS Masterpiece series entitled ‘Poldark.’ As an aside, in case you didn’t already know, Masterpiece is a code word for: 1) originally produced by and aired on the BBC well before PBS got ahold of it, and; 2) a dramatic piece of historical fiction set in the United Kingdom at some point prior to, interestingly enough, television. ‘Poldark’ is no different.

Without going into exhaustive detail, the story, at least the first season, is set in Cornwall presumably during the 1780s and 1790s. The viewer knows this because the protagonist, Ross Poldark, has returned from fighting in the American Revolution, but the Napoleonic Wars have yet to begun. If they have, the news has not reached Cornwall.

While I like reading history, I would not have been able to tell you the first meaningful thing about this section of the world at this particularly point in time. To be sure, I could bluff it a bit with broad, generic ‘observations’ about what life was like in general, but the economy in Cornwall? Not a chance. You could have threatened me with any amount of physical violence, and I wouldn’t have been able to tell you that part of the UK was once reliant on tin and copper mining.

Now, had you threatened me with same said violence to name the antagonist in the story, I would have probably guessed it was the banker, if there was one. After all, it always seems to be the banker. ‘Poldark’ is no different.

Obviously, I helped start a bank, so perhaps I am a little biased or sensitive. However, I have always found it strange how many people think bankers are out to ruin people. To what end and for what purpose? In the series, it is quite obvious the writer did a lot of research on what life was like back in the day, and I mean a lot. But an understanding of how banks operate? Not so much.

You see, the villain, a certain George Warleggan, apparently likes to foreclose on things like mines, regardless of the borrowers’ ability to repay their debts. The modus operandi seems to be destroying the local business community and forcing people out of work. Why? Because in Cornwall during the 1780s, this type of behavior apparently made your rich. Years later, Mr. Potter was able to unleash this same genie in Bedford Falls. I suppose that is just what bankers do.

But let’s think about it. If the value of a business or piece of property were greater than the lien against it, why would any borrower default on their debt? They could simply sell the asset, pay the lender, and pocket the difference. So, you can reasonably intuit bankers would rather not take possession of their collateral.

After all, banks are in the business of making loans and not, as in the series, owning copper and tin mines. Indefinitely inventorying underperforming assets in the hope they will improve at some point in the future ties up precious capital…which most banks would rather lend out at a spread. As a senior banker once told me years ago: “banks love making real estate loans, but they don’t want to be in the real estate business.”

So, if ‘Poldark’ is truly indicative of the economy in Cornwall at this time in history, a banker could get rich by taking possession of their underwater collateral. Man, I wish I had lived back then. You know for what else I wish: a somewhat positive characterization of a banker in literature.

Okay….now that I have that off my chest. The bigger issue at hand is the continued strength of the stock market. While folks love the continued strong returns, a lot of them are beginning to wonder how much longer the good times can last.

Consider this email exchange I had this week from a client:

 

Dear John,

Without sounding like I’m trying to do your job, and sparing you my mental gymnastics, I’d like to get your take on the markets right now. Quite frankly, I’ve come to believe there will be a significant drop in the markets (significant) in the next 6-15 months, so much so that I’m not sure I’d rather be in cash before the end of the year and ride a known 2% return over 2018. 

For the record, I am not someone who believes in market timing. This strikes me as a bit different as I’m old enough to have been through a series of “crashes”.  I’ve no idea what traditional market metrics might indicate, but the emotions and the vernacular of the markets do look familiar.  This is especially true in real estate: construction costs are outpacing sustainable rents; landlords are assuming all the TI risk; brokers are pushing for Kong’s free rent periods; etc.  In my experience, the markets are not decoupled as much as we want to think, especially when a good bit of wealth is embedded in the stock market and the equity position of retirement plans.  It’s not like gold is a bargain either.

Long story short: I happened to anticipate correctly the 2008 market collapse (as I did the prior real estate “adjustment”).  Likely, that was blind luck.  With similar feelings today, I’m trying to decide if the feeling in my gut is experience / intuition or merely the bad dinner I had last night. 

Thoughts?

 

This is a very good question, to which I replied (with some editing after the fact):

 

Hey X:

I have been recently telling folks to expect a “red” year in the markets before the end of the decade. Technically, that takes us through 2020, and I think this is a decent bet. The only questions I have are: “what will finally precipitate it and what will the magnitude of the downturn be?”

While certain sectors and geographic regions of the US economy are relatively overheated, the entirety isn’t at this time. I perceive the biggest problem area could be multifamily housing, specifically so-called Grade A apartment buildings. This could end badly in some markets, but the overall contagion effect should not be anywhere close to what we experienced in 2008. The financial engineering to disintermediate risk isn’t as great in complexity, acceptance, and size as it was with the single family mortgage market leading up the Financial Crisis.

Basically, when push comes to shove, more than a fistful of community and smaller regional banks will have some balance sheet difficulty and the FDIC will arrange for healthier players to absorb them…with relatively little real impact to the overall financial system outside of investor psyche/confidence.

 

I believe the straw that breaks the camel’s back will emanate from Europe, specifically the European banks. IMHO, there is no way the whole negative interest rate environment will end well due to the relatively poor capitalization of the European banking system (in aggregate). As for timing, the tea leaves would suggest ‘we’ could possibly be discussing this by the end of next year…certainly no later than 2Q 2019 to some degree.

With that said, this next financial system hiccup should not have the same tentacles as the one in the US in 2008….our banking system is in much, much stronger shape than it was back in the day. Further, it is currently much stronger than Europe’s. I hate to say it, but not all of Dodd-Frank was all that bad.

As for magnitude, I think we are probably staring up to a -10% number in the S&P 500 for one of those calendar years coming up. We will have to see whether that amount is enough to: 1) attempt to time the market effectively, and; 2) realize a sizable capital gains tax bill for our taxable clients. After all, I would hate to permanently erase up to 28.8% of the unrealized gains in our clients’ portfolios in order to potentially avoid maybe a 10% correction which could happen at some point in the future.

As I type, that is a hard call for us to make. When the time comes, we will position our clients’ portfolios more defensively than they currently are.

I hope that makes, and I hope this email finds you both well.

John

 

Finally, let me leave you with what I submitted to the newspaper this week for publication at some point in the future. As a caveat, one of my co-workers told me: “John, it isn’t one of your better ones, but it is okay.”

 

Not surprisingly, I have had a lot of discussions about the stock market’s surprising strength this year. While we thought things would be pretty decent in 2017, our crystal ball didn’t suggest returns would be approaching 20% or more. Why would they? Everything seemed to be pointing at 7-9%, and that is what we told clients.

After all, stock returns ultimately come down to corporate profits and how much investors are willing to pay for them. As you might expect, there is generally a positive correlation between corporate profitability and economic growth. So, for all intents and purposes, if you think the economy is going to grow, the odds are corporate profits, and therefore stock prices, should be okay.

Of course, there is a little more to it than that. However, for cocktail party purposes, that is a decent enough summation to fake about 5 minutes of chit chat to keep from looking like a fool. If the conversation starts to get down in the weeds, say something along these lines:

“I don’t care what they say in the New York Times. I say running massive budget deficits in Washington without having any sort of fiscal policy, let alone a coherent one, is not what Keynes had in mind. Deficit spending to stimulate aggregate demand in a weak economy is one thing. Throwing money down the drain to no real purpose during an expansion in quite another. Now, please excuse me.”

Unless you have an actual economist in your group, this should be good enough to save a little face while making good your escape. Further, make every attempt to avoid the other members of that particular discussion group for the remainder of the evening. This last thing you really want to do is get into a discussion about academic economic thought at a social event. All the more so if this newspaper column is the only ammunition you have. It would be like bringing a joy buzzer to a gun fight.

Obviously, this is skirting the question from the first paragraph: why wouldn’t our crystal ball have predicted such a strong stock market in 2017? Well, there was nothing in the data to suggest a sudden surge of meaningful growth this late in the cycle, particularly with the Federal Reserve trying to suck cash out of the economy at a leisurely pace. To be sure, the prospects for meaningful tax and regulatory reform engendered some market optimism back in January. However, political promises and economic reality aren’t always the same thing.

To be sure, I am not complaining about this year’s market strength. After all, the path of least resistance was to either stay the course in the stock market or maybe even add a little bit to the equity allocations. What else should you have done with your money? Stick in a bank deposit earning next to nothing or some bond yielding less than the historical rate of inflation? Liquidate all your assets and put the cash in a coffee can because nothing makes sense?

I won’t say those thoughts haven’t crossed my mind and probably just about everyone else’s. However, when push comes to shove, the US economy looks like it should continue to grow at an acceptable pace absent some sort of outside shock to the system.

As long as that is the forecast, it is will be hard to keep folks out of the stock market for long.

 

I hope all have a safe and happy weekend.