Taking Precautions

Jonathan Clements

INVESTMENT contrarians are having a good year—but not a great one. In 2016, U.S. stocks outpaced foreign shares, smaller companies outperformed their bigger brethren and value stocks beat growth stocks. In 2017, all those roles have been reversed, with foreign shares, big-cap stocks and growth companies topping the performance charts.

For those of us who like to see the mighty fall and the downtrodden lifted up, this has been quite satisfying, except for one small issue: Even as the stock market’s leadership has changed, the market itself has continued to charge ahead. I try to avoid having any opinion about the market’s short-term direction. But after eight years of rising prices and given today’s lofty valuations, it wouldn’t be surprising to see share prices decline—and yet stocks keep barreling ahead.

Initially, I assumed the so-called Trump Bump reflected optimism that the U.S. corporate tax rate would be cut and that we would see massive infrastructure spending. Neither, however, appears close to becoming reality, but that hasn’t stopped share prices from climbing. Are stocks soaring simply because there’s an excess of capital sloshing around the global financial markets and no other asset class appears attractive?

It’s baffling—especially given all the reasons to worry. Back in March 2016, I wrote that investors faced four key questions: Is the economy slowing? Will profit margins shrink? Has capital spending been neglected? Are valuations permanently higher? All four questions are still relevant today.

The economy remains sluggish—and that isn’t good for corporate profits. After adjusting for inflation, the U.S. economy expanded 1.6% in 2016 and at a 1.2% annual rate in 2017’s first quarter. No doubt faster growth is possible, but we shouldn’t expect too much.

Why not? Historically, half of the economy’s roughly 3% average annual growth rate has come from increasing the number of workers and half from raising the productivity of all workers. But with the labor force growing at just 0.5% a year, rather than at its historical rate of 1.5%, we should probably expect 2% growth, not 3%.

Moreover, there are increasing concerns about the other component of economic growth: productivity. Increases in output per hour have averaged 0.5% a year over the past six years, versus an average 2.4% over the prior 20 years.

“Forget trying to guess the market’s short-term direction and instead focus on risk. Today, three risks loom especially large.”

Meanwhile, profit margins remain fat by historical standards. After-tax corporate profits currently stand at 9.1% of GDP, below 2012’s 10.8% peak but still well above the 50-year average of 6.5%. With unemployment at 4.3%, employers may need to increase wages to attract and retain workers, and that could put pressure on profit margins.

What about capital spending? Is it being neglected? This one is harder to assess. It seems companies are weighing two competing uses for their cash: They can invest in their business—or they can invest in their own stock.

Lately, the latter has been the clear priority. For more than a decade, companies have devoted huge sums to buying back their own shares. That suggests they see no reason to lavish their excess cash on capital spending, perhaps viewing it as unnecessary, given today’s lackluster economic growth and tepid consumer demand.

Finally, valuations grow ever richer. By almost any measure—dividend yields, price-earnings ratios, cyclically adjusted price-earnings ratios, Tobin’s Q—U.S. stocks appear expensive.

So where does that leave us? We have slow economic growth and hence slow growth in corporate profits. We have fat profit margins that could narrow. We have corporations that prefer to buy their own stock rather than invest in expanding their business. And we have valuations that look mighty rich.

This, of course, tells you absolutely nothing about the U.S. stock market’s short-term performance. I could have presented similar arguments last year and the year before that—and, indeed, did so.

What to do? Forget trying to guess the market’s short-term direction and instead focus on risk. Today, three risks loom especially large.

First, there’s the risk we could get a sharp market decline. If you have money you’ll need to spend within the next five years, it should be out of stocks and invested in nothing more adventurous than high-quality short-term bonds.

Second, there’s the risk that the market rally has left you with more of your portfolio in stocks than you intended. Consider rebalancing back to your target portfolio percentages.

Third, there’s the risk you’ll end up amassing less for retirement and other long-term goals than you had hoped, because stock returns over the next decade prove disappointing. Worried that rich valuations will mean low returns? As always, your best defense is a healthy savings rate.

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