The economy is roaring, the stock market is at record-highs, the unemployment rate is at a 50-year low, inflation is tame, we are drowning in monetary stimulus with a tax cut to boot, and borrowing costs are at historic lows. Everything is seemingly awesome! In fact, it can't get much better. Yet, the S&P 500 has been flat for the past 16 months.
There is simply no replacement for experience. I've learned this the hard way over the past 30 years. It has given me a much better perspective of the big picture over the long term, allowing me to see things today that I would have either ignored or not been able to appreciate, 10 or 20 years ago. Here are four concerns I have about the market and economy today that I don't think investors are appreciating.
I'm not talking about the price-to-earnings multiple on the S&P 500 when I raise this concern. I'm talking about the ridiculous valuations on IPOs, such as Lyft (LYFT), Pinterest (PINS), Beyond Meat (BYND), and many more companies that are trading at more than 10 times SALES! I spend my time looking to buy stocks that are trading closer to 10 times earnings, while these companies are priced at 10 times sales with no profits. That is insane.
I understand that these companies are growing sales rapidly, but I don't think investors realize how long it will take these companies to produce the profits necessary to validate the prices they are paying today. The last time I saw such absurd valuations, unbridled optimism, and lack of appreciation for risk was in 1999 during the technology bubble.
Public companies have collectively been horrible at timing the purchase of their own stock. They bought back more than $1 trillion worth of shares in 2018, and the first quarter pace of $270 billion has 2019 on track for another record year. Yet, this self-indulgence isn't necessarily a good thing, as the more money companies spend buying back their own shares, the closer we seem to be to the end of the economic and market cycle. This is a serious concern.
I see few investors concerned about the prospect of lower short-term interest rates. To the contrary, the stock market surged at the beginning of this year as investors cheered Chairman Powell's pivot from a hawkish to a more dovish monetary policy stance. I never understood why this pivot was a bullish event. Look what happened the last two times shortly after the Fed cut rates, following a protracted period of rate increases. The first such time preceded the technology bubble bursting in 2000, while the second preceded the Great Recession. Rate cuts following a rate hike cycle don't have a great track record, especially when they follow booming bull markets that leave stock valuations at historic highs.
If the Fed must lower short-term interest rates, it means that something is wrong. It is not a good sign, and it should call into question the optimistic economic outlook and the market valuations reflecting that outlook. It is difficult to determine what the Fed will do moving forward, but if it is a rate cut, it will be another serious concern in my mind.
Loan Loss Reserves
My concern with respect to loan-loss reserves should be self-explanatory in the chart below. The ratio of reserves to total bank credit at the 25 largest U.S. banks has fallen to just 0.7%. Evidently, banks don't see any credit risk at all. Look at the last two times when this ratio fell below 1%. Does this give you pause? Is it different this time?
If I were a bank CEO, I would be building up reserves as the economic expansion continued rather than reducing reserves. This is common sense, but not in the world of finance. Here, history not only rhymes but also repeats. The last time we saw such a low level was during 1999-2000 and 2006-2007, which also corresponded with peaks in the stock market. Additionally, the charge-off rate, or percentage of loans credit card companies consider uncollectible, rose to 3.82% in the first quarter of 2019, which is the highest level in seven years.
Ludicrous valuations for initial public offerings reminiscent of 1999, record levels of stock buybacks by corporations that are supporting the broad stock market indices, a rate-hike cycle that has come to a foreboding pause, and a loan-loss ratio that has fallen to levels only seen prior to the last two major market tops and economic downturns, everything is awesome, if you are looking in the rear-view mirror.
What Do You Do?
I have been below my targeted allocation for stocks since the beginning of this year, but I have been in that position for most of last year as well. What I have done anew this year is hedge the stock exposure I do have with bull-call spreads on inverse ETFs that track the major market indices. I have added to these insurance policies when increasing my gross stock exposure, so that my net exposure remains the same. I am still participating in the upside of a stock market that makes no sense to me, but I am now positioned to profit from another decline like the one we saw in the fourth quarter of last year. That will give me even more dry powder to capitalize on the next downturn.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security