Mid-year Market Review
Since the presidential election, the stock market has marched forward on the prospects of faster economic growth, regulatory reform and tax cuts. So far, we have gotten none of these. The economy continues to grow at about 2%, there has been no significant regulatory reform and tax cuts are a hope on the distant horizon. We have no idea if or when any of these things will emerge, but investors are acting as if not only are they a done deal, but that the outcomes were exceptional.
Unbridled optimism is a foolish way to manage money. We are aware of no president who came to office and successfully implemented all of their campaign promises. Yet somehow, investors thought this time would be different. The reality is whatever policies get passed will be a tough slog, and we won’t know their true impact for years down the road.
Combine the enthusiasm investors had for swift pro-business policy changes from Washington with the continued easy money, low-interest rate environment, and we are facing a situation where all publicly-traded asset classes are expensive on a historical basis. How expensive? Roughly 30% above their historical averages.
High valuations are a reality that all investors need to acknowledge, and there are basically two courses you can choose. The first is to ignore the valuation issues and assume market valuations will be permanently higher. The second is to confront the valuations, and invest in businesses you think are more reasonably valued.
We have chosen the latter approach for two reasons. First, the great weight of financial history indicates that valuations generally do not stay at elevated levels forever. And second, we are concerned with both protecting your money and growing it. Currently, the U.S. stock market is in its second longest bull market expansion in history. The only one longer ended in 1999, with a significant market decline. While we cannot know how this bull cycle will end, the longer it goes and the more speculative it becomes, the higher the risks are of a significant correction.
In our view, the most practical way to address the question of high valuations is to continue to focus on cash flow from businesses in the form of dividends. The dividend payments are what we call a “real” return. You received the cash. That’s a lot different than a price return, where the price increases, but you haven’t recognized any cash yet. Unless you sell it, the gain is pending.
As an investor, we want both types of returns: real income returns and then sustainable pricing gains. The key to having sustainable pricing returns is to raise the odds that the pricing returns are anchored in business fundamentals. Otherwise, the pricing returns are more likely to be fleeting.
Dividends and their growth play an important role in this valuation process. As a company produces more cash for its shareholders, the value of the business should rise over time. This is a time-tested relationship in finance, and the more pricing gains deviate from income production, the more speculative the pricing gains become. This is what’s happening today in the U.S. and global stock markets. Prices are going up, but economic fundamentals like earnings and dividends basically haven’t moved much in almost three years. S&P 500