Seeing Markets Through Rose-Colored Glasses

by: Eric Parnell, CFA

It's over! How could I have seen it coming? We were so in love!

A bear market in stocks! How could I have seen it coming? Everything was soooo awesome!

Avoid wearing rose-colored glasses when viewing the U.S. stock market this summer.

This article is the first in the Market Sounds Of Summer series on Seeking Alpha.

“Des nuits d’amour à plus en finir
Un grand bonheur qui prend sa place
Les ennuis, les chagrins, s’effacent
Heureux, heureux à mourir”

- La Vie En Rose, Edith Piaf, 1945

Love is an intoxicating thing. So is investing. But love can blind us to the reality unfolding around us. And when it comes to love and/or investing, it is often the things that we cannot see or do not take the time to truly understand that can ultimately lead to our undoing.

It is amazing how great conditions are for the U.S. stock market today. Economic growth is accelerating at a time when corporate earnings growth is increasing by a double-digit rate. At the same time, U.S. Treasury yields remain stubbornly low as inflationary pressures are rising but remain firmly under control. This is providing the U.S. Federal Reserve ample flexibility to continue on their tightening cycle at a measured pace that is supportive of continued growth. Markets are covered in pink, and wow everything looks so darn awesome! What could possibly go wrong?

Beware of the sure thing. I always take pause when I hear how unabashedly awesome things are at any given point in time. And such was the narrative coming into 2018. Not only was the U.S. economy supposedly set to roar thanks to the tax cuts that had just been delivered by Congress, but the news was flooded with the narrative of globally synchronized growth. Throw in a chicken in every pot and a car in every garage and the sky was the limit for U.S. stocks in 2018. Apparently, if I was holding cash at the end of January, I was “going to feel pretty stupid.” Got it.

But things are still awesome today! Sure, we’ve had a tough start to the year, but stocks have got to consolidate their gains sometime, right? The U.S. economy is still strong, profits are booming, inflationary pressures remain in check, and the Fed has got it all under control. What about the recent jitters about trade wars and global markets?

Been there, done that so many times over the past decade and yet here we are at new all-time highs. This stuff is nothing more than crisis talk for the bears to keep their tired ‘sky is falling narrative’ going. And when are we going to finally accept that these permabears are nothing more than wrong, wrong, wrong! Stay bullish and keep climbing the wall of worry to new all-time highs.

I do think new highs are in store. While the S&P 500 Index continues to languish below its peak from late January, I am strongly of the belief that we will see fresh new all-time highs on the benchmark index before it’s all said and done. These new highs may come as soon as the summer in July. Despite the accumulating risks, the positives cited by the bulls is enough and the positive momentum behind stocks still sufficient to propel stocks to at least one more run to new highs before it’s all said and done. The fact that the Nasdaq and the U.S. small caps as measured by the Russell 2000 are already there suggest that the S&P 500 Index will eventually join at some point along the way.

It’s what comes after the new highs that matters. If our collective investment time horizon was the next few months, all of this would be fabulous. But it’s not. Risks are accumulating. And it is imperative that we keep our rose-colored glasses tucked away as we proceed through the sunny summer months of investment markets.

This is not the first time that “everything is awesome.”

"This is far and away the strongest global economy I've seen in my business lifetime"

- Hank Paulson, Former Goldman Sachs CEO and US Treasury Secretary, July 2007, The Greatest Economic Boom Ever, Fortune, July 12, 2007

I guess when it’s the strongest ever, there was only one way to go in the two years that followed. That, of course was straight down at an accelerating rate.

But as long as you're long technology, you're bulletproof against the risks accumulating for the global economy and its markets, right? Growth at any price has been awesome, why possibly wouldn’t it continue?

"Rising rates won't hurt the new techies, but they might impact the 'old economy'" - Nasdaq Sets Record Again, CNN Money, March 10, 2000

Oh yeah. That’s right. Technology stocks are cyclical at the end of the day, and this time is NOT different. Beware the siren call that everything is awesome.

But what about the booming economy? I’m with Billy Ockham (I'm guessing his friends called him Billy back in the day) who had this all figured out eight centuries ago. This time is not different, and it’s best to keep things simple. With this in mind, what exactly is reassuring about this unemployment rate chart?

The unemployment rate has been as low as it is today only one other time in the last half century. This was back in April 2000. And every time it has been this low or lower, it has been followed soon after by a recession. And recessions bring stock bear markets. Not awesome.

Also, beware the millions of workers returning to the labor force theme. That’s about as reliable as the cash on the sidelines idea. It’s not.

And if the economy was really that good and the attractive jobs so abundant, where are the workers demanding hefty pay raises from their employers? Nowhere to be found.

But what about disruptive technology? Doesn’t this help explain why wage pressures remain in check. If so, why does productivity remain so anemic? Are the new machines slacking on the job? Or is something else actually going on?

But what about rising inflationary pressures? About that. Exactly where are these inflationary pressures anyway? The current inflation rate is still below where it was two years ago in 2016. Oh yeah, that’s right, higher inflation is coming in “the second half of the year.” I’ll pencil that in so that when we get into late 2018, I can erase it and put down “early next year” instead.

But the growth story has to play out over time? OK. But if that’s the case, why then are investors, whatever their carbon or silicon makeup may be, willing to get paid increasingly less to lock up their money for an additional 28 years with the U.S. government. Don’t they have anything better to do with their money in today’s booming economy with no end in sight?

But corporate profits are booming? Sure they are according to the “adjusted” net income numbers that S&P 500 Index companies are reporting to their shareholders. But why then is the number that they are reporting on their corporate tax returns to the IRS look anything but booming? Hmmm.

And why when S&P 500 Index profit margins are soaring to record highs are corporate profit “margins” relative to gross domestic product stuck in chronic decline dating back to 2014 on a NIPA reporting basis?

And if the economy is so good and corporations are doing so awesome, why are pre-tax profits lingering at their lowest levels in two years and holding largely unchanged for seven years and counting at a time when after-tax profits are starting to perk up?

Maybe the underlying reality of corporate profits once the rose-colored lenses provided by the recent tax cuts are removed help explain why stocks have not responded as enthusiastically as we might expect to the “surge” in corporate earnings in 2018, because there may not be a whole lot of substance to it at the end of the day.


“Endless nights of love
Bring great happiness
The pain and bothers fade away
Happy, so happy I could die”

- La Vie En Rose (English translation), Edith Piaf, 1945

Happy, so happy. Let’s remove the rose-colored glasses and call this stock market for what it is today. Stocks rose virtually non-stop for the last nine years despite the pain and bother of otherwise sluggish economic and market fundamentals thanks to the endless love of global central bankers that brought great happiness in the form of zero interest rates and $15 trillion in monetary stimulus that leaked and leveraged its way throughout the worldwide financial system. The tripling and octupling of stock prices are joyous indeed, as long as they last.

So happy I could die. Now markets are so very happy, and many investors are now convinced after so many years that this love of higher stock prices is actually real and sustainable. But as we continue to travel through the summer of 2018, the stimulus is starting to come off at an accelerating rate. To this point, for the first time since the calming of the financial crisis, the balance sheets of the U.S. Federal Reserve, the European Central Bank, the Bank of Japan, and the People’s Bank of China all individually contracted in their most recent month of reporting.

This may very well be the start of a trend that may either play out over the next several years or stop more abruptly because global capital markets including U.S. stocks start to riot. International investors have already had their rose-colored glasses of synchronized global growth snatched by the reality of a world without monetary stimulus – it is amazing the illusions that central bank liquidity can create, and investors fall for it every single time – and U.S. investors may be next.

Love is an intoxicating thing. So is investing. But love can blind us to the reality unfolding around us. And when it comes to love and/or investing, it is often the things that we cannot see or do not take the time to truly understand that can ultimately lead to our undoing. Be prepared as we travel through the summer for events to unfold that may be entirely unexpected and potentially negative. And know that they are taking place because in reality, things are not nearly as good as they may seem or you may be hearing from the financial media today.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I am/we are long TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long selected individual stocks as part of a broad asset allocation strategy.