How I see the economic news shaping the stock markets over the next twelve months generally doesn’t change between Thanksgiving and the start of the New Year. So most years my “look forward” post has pretty much written itself in my head by mid-December and I just need to get around to putting it on paper.
This year is different. This year I wanted to wait to see what happened in the aftermath of the Inauguration. To be sure, a week and a half isn’t nearly long enough to figure out how things are likely to sort themselves out and what direction we are really headed on some pretty consequential issues, but I can’t very well wait until June to put out my New Year’s forecast.
As I sit down to write my forecast, I’m reminded of a quote from Warren Buffett: “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” I always hesitate to stray from the numbers, and having this quote in the back of my mind makes me even more leery about discussing the unknowns instead of just pointing at historical data the way I usually do. But this year I think the unknowns are going to cause more volatility than normal, and in some cases even be significant enough to overcome the numbers.
The stock market (and our Thrift Savings Plan) is usually moved by earnings, economic data and monetary policy. In the first year of the Trump administration, I suspect that short term moves are going to be driven by political events to a degree which we haven’t seen in my investing career. That is going to cause a lot of anxiety for people who breathlessly follow every move of the market.
The good news is that no matter what happens on TV (or Twitter), stock prices are still going to come down to earnings over the long term. But a lot can happen between now and the long term. I generally believe that politicians get much too much credit and often too much blame for the economy’s performance, but there certainly are some political decisions which could change the trajectory of earnings and the long term direction of the stock market.
If We Were Only Talking About the Economy
The stock market goes up two years out of three. Pull out the years when the US is in recession and it gets even better than that. All indications are that the US will avoid recession in 2017.
I believe the overall stock market will in all likelihood end the year higher than where it started. From a price to earnings ratio perspective, right now the stock market doesn’t have a lot of room to grow (meaning the market’s current P/E is well above average), so don’t think the market is likely to grow double figures again this year as it did last year. A significant corporate tax cut (to effective rates, not just to listed rates) and a deal to repatriate overseas profits could add a point or two to returns if implemented. If I was guessing (and it really is a guess), I tend to think we will see mid-to-high single digit returns.
But even if I have guessed exactly right and we wind up with a 7.5% or 8.5% gain at the end of December, it isn’t going to be a gentle curve from where we are now until then. In 85% of the years since World War II in which the stock market has been up for the entire year, the stock market was down year-to-date at some point during that year. That’s 85% of the up years (and 100% of the down years for those of you who haven’t had your caffeine yet), so there are really good odds that we will lose all the gains we have had since January 1 and then some.
And in 75% of those up years, that dip below break-even came during the first quarter. We are a month into the first quarter, up 2.6% year-to-date, valuations are high, sentiment is starting to waver – I’d say there is an excellent chance we will see a 5% to 10% correction at some point in the next two months.
So why aren’t I hiding out in the G Fund and waiting until that dip to move back to the C Fund? Because there is also a pretty good chance that we will see the market go up 10% in the next two months before it has a 5% correction. And there is absolutely no way of knowing which scenario will play out.
As at the beginning of every year, I will confidently predict we will see four or five 5% corrections, and probably a 10% correction at some point (because that happens pretty much every year). With history as a guide, I am convinced the timing of those corrections isn’t predictable, and that the market will recover and move higher in each case within a matter of weeks.
Risks to the TSP Stock Funds in 2017
The first week and a half of the Trump presidency coupled with a GOP Congress no longer checked by the veto generated a lot of headlines. I don’t think that is likely to slow down anytime soon. So far we have mainly seen domestic issues in the foreground, but China, Russia, North Korea, other adversaries and even our allies are going to test the new administration. I suspect that both sides will miscalculate in some instances, causing uncertainty in the stock market. And everyone knows how much the stock market hates uncertainty.
So which of the headlines is it safe to shrug and ignore, and which could cause real damage to the economy? It is hard to even guess at all the possible issues which are going to cause jitters, but as in most years I think my only option will be to ignore and ride out most of the volatility we see. It is important to remember that the economy and stock market are both very resilient. The market will jump around a great deal, but typically recovers from “disasters” fairly quickly.
There is a lot of talk about trade wars in the news these days. There has been a lot of posturing so far, but even if most of the threats play out as badly as possible (significant tit-for-tat with Mexico, withdrawal from NAFTA, etc.), those aren’t by themselves going to cause the recovery to fail. The trade war which could push the global economy into recession would be between the US and China.
China is in a fragile position with its massive debt bubble. A significant economic conflict with the US could well cause a financial crisis in China and start a chain reaction which would pull down markets all over the world. The US would do better than most in that scenario (we export relatively little to China compared to Europe, for example), but a major Chinese correction would certainly be reflected by a double digit pull-back in US markets.
The other thing we are seeing in the news every day are protests. I don’t think that it going to let up anytime soon. But I also don’t think that is likely to impact economic growth. At the height of the protests agains the Vietnam War in 1967 and 1968, we saw 23.8% and 10.81% returns. Charts of negative investor sentiment match up nicely with unpopular administrations, but investor sentiment is actually a contrarian predictor of market performance – the more negative investor sentiment is, the better markets typically do.
Political news can certainly cause volatility, but it is generally short lived and I’m not sure I can find an example of lasting damage to the economy in the last 100 years. Scandals, indictments and resignations are usually good for a few days downturn at most. Even impeachments aren’t necessarily a big deal – the market was in considerable turmoil as Bill Clinton’s Monica Lewinsky scandal unfolded, but that was largely due to the Russian debt default – markets actually gained 9% during the impeachment hearings themselves. And as huge an event as Watergate was, the bear market of 1973 and 1974 was probably much more a result of inflation taking off (4% to 12% in the space of a year) and the Arab oil embargo which started in 1973.
Saturday marches and airport sit-ins aren’t going to break the economy, but widespread, sustained middle-class civil disorder would certainly stifle earnings and cause massive uncertainty on Wall Street. Anything is possible, but that scenario is so unlikely in my opinion that it isn’t something I would factor in while making investing decisions at this stage.
So what else are people worrying about when it comes to investing right now? Not to be glib about absolutely horrific events which devastate lives, but a widely publicized terror attack usually causes only a one or two day blip in the market, and a war of our choosing is usually a net positive for the stock market (it turns out government spending is good for the economy after all).
So which TSP fund?
Typically at this stage in the business cycle, large cap stocks (the TSP C Fund) will outperform small and medium cap stocks (the TSP S Fund). And for that reason, I usually wouldn’t consider moving any part of my allocation to the S Fund. So what factors might weigh into the decision to deviate from the business cycle strategy?
The main argument we have been hearing in the financial media is that if the GOP enacts significant corporate tax cuts, small and medium sized companies will disproportionately benefit. That is because they are actually paying something close to the listed tax rate, whereas the effective rate of the huge multinationals which make up the TSP C Fund is much lower because they have the opportunity to shelter many of their profits overseas.
Additional arguments are that (1) because these smaller companies do less business overseas, they will be impacted to a lesser degree by any trade wars which might break out, and (2) because their production and sales are already predominantely here in the US, any “buy American” rules in new government infrastructure and defense spending will push their earnings up more than large caps, which are producing their products overseas.
The argument against moving money into the TSP S Fund is that small cap stocks have had quite a run over the last year and are very richly valued (currently at 22x, which is way over their median P/E). That doesn’t mean they can’t go higher, but the Russell 2000 has only traded above 19x for a total of six months in the past 38 years. Read that last sentence again. That’s about 1.3% of the time.
Those harsh realities make it a fairly easy choice for me – I think the S Fund is just too rich right now and the possibility for earnings to grow significantly enough to bring that ratio back into line exists, but a lot of things would have to go right for that to happen. So I am keeping my TSP allocation at 100% C Fund. (The C Fund is also well above its historical average, mind you, but not to the degree the S Fund is.)
This is where those big disclaimers come in about how you should set your allocation based on your own circumstances, because they are almost certainly different than mine. I have several hundred thousand dollars in small cap ETFs in my other investment accounts. So I did well with those last year as small caps ran up, and I have that percentage of my overall investment portfolio in small caps if they continue to outperform. I don’t still own these small caps because I think they will outperform large caps – I don’t. I still own them because they are in regular (non-tax advantaged) accounts and if I sell them I am going to pay a lot of taxes on my profits. I would prefer to wait and see what my tax rates are going to look like under the new administration before I start writing checks to the US Treasury.
If I didn’t have fairly substantial small cap holdings outside the TSP, I would probably hedge a little bit and have some small allocation to the S Fund – 10% or 15% perhaps.
What about the TSP I Fund? No. Just no. For all the reasons I discussed in last September’s update.
Please don’t ever forget that these allocations are based on my circumstances and the strategy which I have chosen to employ. Your circumstances may be very different and my strategy may not work, so I encourage everyone to read widely and consider a range of different viewpoints before making investing decisions for themselves.
“Nobody knows anything…”
Over the holidays I was at a dinner party with a couple of venture capitalists and hedge fund types, which led to a fantastic conversation with some really clever people who have made a lot of money investing. We debated all the things I wrote about above – the politics, valuations, economic data, and allocations – but really couldn’t reach a consensus on anything. Is Tesla horribly overvalued, or will we look back and kick ourselves for not buying it at this level? Will all the Goldman Sachs alum in the new administration be able to keep the economy moving in the right direction? Even if Congress, the President and the Federal Reserve all do just the right things, could something else push us into a recession?
As we finished a bottle of wine and went quiet for a moment, one of them looked around at the rest of us and said, “Nobody knows anything about what’s going to happen this year.” And it’s true. All we can do is look at the history of stock market performance and extrapolate from that, but even then a year is too short to forecast with any sort of confidence. Over the long term (much longer than a year), the market is almost certainly going to go up. And there are some patterns in the past for which good arguments exist to suggest they may be repeated in the future. But don’t let anyone fool you into thinking they can do much better than that.
In my next post I will resume discussing the economic indicators which I think are important, and hopefully find some time to talk about how I see investing outside the TSP in the coming year.
In the meantime, if you find this website useful or interesting, you can help me out by linking to this site from your own webpage or blog; liking it on Facebook (updates will show up in your news feed if you do); sharing on Twitter and in other investing forums; or actively participating on our Message Board. Please do me the favor of sharing it with your friends and colleagues using the email and social sharing buttons below right now.
And if you are still looking for something to read, there’s always this gem which I post a link to at this time every year: Debunking the January Myth