-Hitchhiker’s Guide to the Galaxy
Douglas Adams was a British television writer who somehow managed to write both for Monty Python’s Flying Circus and Doctor Who. He combined these two seemingly disparate genres (absurdist comedy and science fiction respectively) in his novel “The Hitchhiker’s Guide to the Galaxy” which came out in 1979. For a slightly introverted kid growing up in the late ‘70’s and early ‘80’s who became a big fan of both Monty Python and Doctor Who thanks to the local PBS channel and not having cable TV, I devoured that book and it’s sequels. The general concept was that the Hitchhiker’s Guide is a book within the book – a guidebook used by the protagonists of the novels to give them information about the planets and species they were encountering as they journey through the universe. The most important thing to remember when finding oneself in these unusual situations, other than always bringing a towel, is found right on the front cover of the Hitchhiker’s Guide “in large, friendly letters,” the words Don’t Panic. Arthur C. Clark once said this is the best advice that can be given to humanity – so Don’t Panic, let’s think instead.
Not much has really changed in the level of the stock market since my last newsletter. We had a wonderful 1,000 point drop in the Dow on December 24
– Merry Christmas – followed by the last few days of 2018 making up that drop plus a little more. Since it takes a few days between writing this newsletter and getting it compliance approved for sending I don’t even want to discuss what the market it doing so far in 2019 – given that the second business day of the year the markets fell almost 3% and the next day made up that whole decline it could be up or down hundreds if not thousands of points by the time you read this. Suffice it to say it’s still volatile, we know this, and right in the midst of this volatility is not the time to make significant portfolio changes. The underlying economy is still very good, and even if it’s slowing and we’re headed toward a recession at some point – based on the employment, payroll and GDP numbers from December all of which show continued growth – it is hard to see even with the most pessimistic view how that reverses itself before the end of 2019. We have seen a shift in the markets, where some of the high flyers that had gotten too pricey regardless of underlying economic numbers have come back to earth and as we’ve bounced off the lows some of the solid but less flashy parts of the economy are making up a bigger part of that bounce – this is a good sign. As I’ve mentioned before, most of the stock market was in a correction all of 2018 – it was only a handful of companies; Apple, Amazon, Microsoft, Netflix and a few others, that made the S&P 500 & Dow look like they were doing well. On top of that, if the Fed either doesn’t raise rates or only raises them twice in 2019, the bond side of your holdings which were likely flat or down fractionally in 2018 will finally have a chance to participate in your portfolios. Since rates have gone up, that side of your investments is paying a much higher interest rate than it was a year ago, and without the downward pressure on prices it’s likely we’ll see a 4% or so return on that side of your portfolio. Likewise the international assets, that really got killed the first half of 2018 (Europe had its corrections before the U.S.) seem poised for some upside returns once Brexit is figured out. At the very least, the downside returns that were caused by the dollar jumping up in value compared to the Euro, Yen and other major currencies should at least stabilize if not slightly reverse itself.
The short-term (measured in weeks and months) doesn’t really worry me all that much. This recent correction has been right in line with historic norms and if the economic numbers for employment and wages translate into profits for companies in general (certain companies like Apple that are being hit more significantly by the Tariffs notwithstanding) then we could see some stock prices that look downright cheap when earnings start to be reported next week. Over the medium term we still have to deal with the Fed and Tariffs – you can go back to the December newsletter where I discuss those things - but also a few issues related to those two main ones that I didn’t touch on. For one, the Federal Reserve is not just slowly raising interest rates; they are also selling off the trillions of dollars of bonds that they purchased during the two Quantitative Easing (QE) cycles implemented in the wake of the financial crisis. The Fed really does create money out of thin air, so the purchasing of those bonds created new dollars that then went out into our economy – when those bonds are sold the fed will effectively be destroying money. Pulling money out of the economy should slow the economy down – which in a growing environment can be okay, that’s why the Fed waited until now to do it. But this has never actually been done before, it’s all theoretical. So while it seems like the economy is growing fast enough and the bond sales are being done slow enough that we’ll still have a positive GDP, we don’t really know. An economic writer I follow named John Mauldin likens it to the Fed running an experiment with two variables and no control. Rather than just raise rates and see what happens or just sell the bonds and see what happens they are doing both at the same time – so if the economic situation turns negative how are they going to know which action to stop, or which one caused the reversal? The very low interest rates of the last decade have also led to companies borrowing massive sums of money – not necessarily because they needed to – but it was so cheap they could borrow to buy back their own stock and since the dividends they were paying on that stock were higher than the interest they have to pay on the loans, they were creating profit margins. When those bonds mature if they want to rewrite them the rates will be much higher – probably too high for that math to work out anymore. So companies are going to have less profits one way or the other – either they’re going to pay higher interest rates or they’re going to have to issue new stock and pay back the loans, which dilutes the current stock prices. This won’t happen all at once, but it could put a cap on stock market growth, especially in the very stocks that have been the big “leaders” the last few years that were the most engaged in this financial engineering. Assuming a continued bounce back from that big fourth quarter sell-off, we will be in a position to make some portfolio changes for these more worrisome medium term issues. We’ll give our current clients more information as the first quarter rolls on.
Long-term I have some concerns that we certainly don’t have to address when it comes to financial markets (at least not now) but continue to pester me deep in the back of my brain. Basically there are three expenses, that pretty much everybody needs to pay (with some obvious exceptions) that are getting out of hand compared to inflation and wage increases. Something has to happen that will inevitably drastically change how things have traditionally been done. Those three expenses are Housing, College Tuition and Health Insurance. Let’s start with housing costs (all these income and housing statistics are from the Census Bureau.) In 1968 the median household income in the United States was $7,800 a year and the median home price was $26,500 – so a new home was about 3.5 times earnings. In 1988 the median household income had risen to $27,250 and the average home price also rose to $121,000, so about 4.4 times the earnings. Today the median household income is $61,400 and the median home price is $320,000, that’s 5.2 times earnings. The historically low rates of interest have allowed this growth in the price of homes to outstrip the growth in earnings – in fact on a monthly payment basis a mortgage today is probably a smaller percentage of the median income than it was thirty or maybe even fifty years ago – but with rising rates that is going to have to change. Of course real estate is local and various locations can buck trends one way or the other – but in general a lot of the run back up in real estate values after the 2007 -2008 crash has been fueled by low interest rates, those rates are still low even with a few more Fed hikes, but I’m not sure what has to happen to housing values if mortgage rates are in the 7’s and 8’s again – much less the double digits we all remember. Similarly the cost of tuition has gone up far beyond any reasonable levels of growth. Based on numbers from the College Board, in 1968 the average tuition, room and board at a private, four-year college was $2,900 - or about 35% of the median income. By 1988 that cost had risen to $11,600 which would have used up 45% of the median income and currently at an average of $48,500 (and most colleges I’m seeing are more like $60-70,000) the average cost of school is over 80% the median income. No wonder kids are leaving school with student loan debt payments that exceed their entry-level job salaries all by themselves. This can’t continue. I don’t know in what way it is solved; a move to more online learning, an incorporation of entry level employment and schooling at the same time that maybe stretches out for seven to ten years rather than the traditional four or five, maybe colleges that have been remodeling dorm rooms and bringing in gourmet chefs as they competed for that huge Millennial generation will have to strip things down for the more cost sensitive succeeding generation? I don’t know what will happen – but as Isaac Stern is famous for saying – if something can’t go on forever it won’t, and this can’t go on forever. Last we have health insurance. It’s hard to compare over time like tuition or housing prices because we’re really not talking about the same thing. Once the HMO system was set up in the ‘80’s everything changed so trying to match up the costs in 1968 with today is a fool’s errant. Plus, expense notwithstanding, you do actually get a lot more out of your health care than you did fifty years ago. Cancer treatments, hip replacements, arterial stents, cholesterol medications – there’s a lot of stuff that costs more money but is also keeping us alive so it’s not really apples to apples. However, in 1988 the average cost of health insurance for a family of four (based on information from the National Institutes for Health) was $1,650 - today that cost is $28,000! That’s an average annual increase of almost 10% - and that’s just the insurance cost. We all know our out of pocket costs have increased along with it – that average cost in 1988 came with a $250 deductible and a 20% co-pay up to $2,500. Today the deductible is at least $2,500 and the 20% co-pays can be tens of thousands of dollars more. If I had a serious medical condition I certainly wouldn’t want to be treated with 1988’s technology – but I don’t think I’m going to get 20 times better treatment today either. It’s impossible to do that median income comparison because most health care costs are paid through employers and a big part of the reason incomes haven’t gone up as much as in previous periods is because that raise you would have taken home in your paycheck is being used to pay this higher cost of medical coverage. But once again, this rate of increase cannot go on. In some manner the costs of health insurance need to not just be controlled or the rate of growth stopped – it has to be reversed where the rate of economic growth is actually faster than the rise in health care costs for a sustained period of time.
Since I’ve already quoted Douglas Adams, John Mauldin, Arthur C. Clark and Isaac Stern in this newsletter, I’ll sum up my thesis today by quoting another of my favorite authors; Gregg Easterbrook, who likes to say “Don’t panic, there will be plenty of time for that later.” While we don’t like to see the market go down, especially in a short period of time, this sell off really isn’t statistically significant. We all lived through 2008. Going through this after going through 2008 would be like a WWII vet dealing with a traffic accident – not fun but nothing they can’t handle. In the longer-term as you can see there are plenty of things to worry about and we will address those with our clients and make the rational changes that need to be made in a logical, methodical way. Panic never does anybody any good. Talk to you next month!