The Charles River from the Boston bank. (Creative Commons, Jeff Turner)

How wise is it to be invested in today’s stock market?

Investment Commentary by Robert Zevin of Zevin Asset Management in Boston.

Many peo­ple, includ­ing a num­ber of our clients, have been con­cerned in recent weeks that the long stock mar­ket rise since 2009 has finally reached unsus­tain­able heights that will soon lead to a crash. Our first pri­or­ity has always been to avoid or min­i­mize losses in bad mar­kets. Finan­cial mar­kets are always more or less unpre­dictable and sub­ject to sud­den declines. How­ever, we believe the like­li­hood and poten­tial mag­ni­tude of such set­backs can be esti­mated with some degree of accu­racy before they hap­pen. Use of such esti­mates is an impor­tant part of our invest­ment process. At the moment, we esti­mate that the prob­a­bil­ity of a major stock mar­ket set­back is low for the next 12 months or longer, and that prop­erly diver­si­fied port­fo­lios may reduce to a greater extent than usual the net dam­age from most of the poten­tial declines.

As long-​term investors, we are focused on pro­tect­ing against mar­ket losses that are large and long-​lasting, rather than trad­ing in and out of stocks around small and brief fluc­tu­a­tions. Bear mar­kets rep­re­sent exactly the type of major invest­ment pot­holes we aim to avoid. A bear mar­ket is defined as a decline in value of more than 20 per­cent. After bear mar­kets occur it usu­ally takes at least a year, some­times many years, before the pre­vi­ous peak price level is regained. The most fre­quent cause of bear mar­kets is an eco­nomic reces­sion or depres­sion. In fact, every reces­sion or depres­sion through­out the his­tory of cap­i­tal­ism has been accom­pa­nied by a bear mar­ket. Other bear mar­kets have occurred because of extreme over­val­u­a­tion or a finan­cial cri­sis in which peo­ple and busi­nesses are scram­bling to sell assets in order to pay their debt oblig­a­tions. These two causes are closely related since most peri­ods of irra­tionally high prices, or stock mar­ket “bub­bles,” are fueled with increased debt used to buy stocks and other assets that con­tribute to the bub­ble. In fact, all three causes are related and inter-​related. The increased debt that leads to finan­cial crises is also typ­i­cally a dri­ver of the eco­nomic expan­sion that pre­cedes a reces­sion or depres­sion. And declines in the stock mar­ket can them­selves be not only the signs but also the causes of recessions.

The Good News

With this in mind, here is our assess­ment of poten­tial causes of a bear mar­ket in the near future. Although the cur­rent eco­nomic recov­ery is old by his­tor­i­cal stan­dards it has also been weak and slow com­pared to ear­lier recov­er­ies. The weak­ness has extended to both real eco­nomic growth and price infla­tion. We con­tinue to believe, as we have for some time, that the U.S. (along with many other coun­tries) is in the midst of a pro­longed period of slow growth and low infla­tion. It seems para­dox­i­cal at first glance, but weak expan­sions typ­i­cally last longer than strong ones. Reces­sions usu­ally start with the col­lapse of a mar­ket in which there has been rapidly expand­ing activity — internet infra­struc­ture invest­ing in 1998–2001 or home con­struc­tion and resales in 2006–2008. At the moment almost every cat­e­gory of invest­ment spend­ing is already quite weak, so there is not much fur­ther for them to fall. New home con­struc­tion has been very strong but is cur­rently stalled for lack of resources, includ­ing land to build on. How­ever, it is now too small a por­tion of the Amer­i­can econ­omy to cause a reces­sion if it col­lapses. The same is true of the decline that has been under­way for some time in U.S. auto sales although not in the rest of the world.

Mean­while, the global econ­omy is expe­ri­enc­ing an unusual coin­ci­dence of expand­ing economies in almost every coun­try. This means that each coun­try is able to grow faster and is less likely to expe­ri­ence a reces­sion. Thus, for both global and domes­tic rea­sons even a mild reces­sion in the U.S. is highly unlikely for the next year or more. There­fore, the recession/​depression cause of a bear mar­ket can pretty much be ruled out for at least the next year.

What about a finan­cial cri­sis? The enor­mous level of debt in the finan­cial sec­tor of the Amer­i­can econ­omy has been cut in half since 2007. Mort­gage debt has also been dra­mat­i­cally reduced. Inter­est rates remain extremely low. Infla­tion is also low, sug­gest­ing that inter­est rates will not rise steeply in the next few years. One major excep­tion to this benign out­look is that stu­dent loans are approach­ing the one tril­lion dol­lar level while default rates con­tinue to increase. Like many of the finan­cial debts that con­tributed to the finan­cial cri­sis of 2008–9, these government-​guaranteed pri­vate loans are often scams cre­ated by the gov­ern­ment to ben­e­fit banks and other pri­vate lenders at the expense of lower-​income stu­dents seek­ing their way to higher incomes. The inevitable high rate of defaults on these loans has been harm­ful to banks and oth­ers, but banks also are now sig­nif­i­cantly less lever­aged and bet­ter cap­i­tal­ized than they were at the end of 2007. In sum, cor­po­rate Amer­ica has accu­mu­lated enor­mous amounts of new cash since the 2008 finan­cial cri­sis, and house­holds have about 20 per­cent less debt and more assets rel­a­tive to income than they had at the end of 2007, mak­ing a new finan­cial cri­sis very unlikely at this time.

A Ques­tion of Value

Even with­out a reces­sion, aren’t stocks still just too expen­sive? Of course this is pos­si­ble and by some well-​established mea­sures even prob­a­ble. U.S. stock mar­ket aggre­gate prices are at his­tor­i­cally high mul­ti­ples of earn­ings and trade at a high level rel­a­tive to the replace­ment cost for all cor­po­rate assets. In fact the lev­els are as high as or higher than the start­ing point for vir­tu­ally all the bear mar­kets of the past.

But there is a catch. The aver­age ratio of price to earn­ings (P/​E ratio) appears to have been increas­ing for a very long time, although fluc­tu­at­ing wildly along the way. This could reflect the grow­ing por­tion of national prod­uct for which pub­licly traded com­pa­nies are respon­si­ble or grow­ing monop­oly power and polit­i­cal influ­ence. A sec­ond catch is that we are now in a period of slow growth, low infla­tion, and low inter­est rates. If a 10-​year U.S. gov­ern­ment bond pro­vides a guar­an­teed return of about two per­cent today, com­pared to an aver­age of around five per­cent for the lat­ter half of the twen­ti­eth cen­tury, then pric­ing stocks to pro­vide a sim­i­lar three per­cent excess return above bonds would imply earn­ing eight per­cent on your stock invest­ments in the past and five per­cent today. In the long run, the earn­ings of your stock in a com­pany are indeed what you earn (or should earn, absent cor­po­rate skull­dug­gery). When earn­ings are eight per­cent of the price of a stock, the mul­ti­ple of price to earn­ings is 12.5, which is below the long-​term aver­age. When earn­ings are five per­cent of the price, the mul­ti­ple of price to earn­ings is 20, close to the present situation.

Catch num­ber three: the mod­ern cor­po­ra­tion has become increas­ingly asset-​light. Some com­pa­nies own lit­tle besides patents, trade­marks, office fur­ni­ture, and desk­tops con­nected to the cloud. Any nec­es­sary man­u­fac­tur­ing, trans­port­ing, ware­hous­ing, and sell­ing is sub­con­tracted to oth­ers. The value of such com­pa­nies often will be enor­mously larger than the replace­ment cost of its assets, while the sub­con­tract­ing com­pa­nies may often be over­seas or not owned by pub­lic share­hold­ers. Gen­er­ally, brand names and monop­oly power are not included in most com­pa­nies account­ing of their assets. Since both monop­oly power and asset-​light busi­ness mod­els have grown over time, it makes sense that the ratio of stock mar­ket value to mea­sured assets should also increase. Indeed, the one time this mea­sure peaked higher than today’s level was the top of the dot-​com bub­ble, which in ret­ro­spect may not have been as irra­tionally exu­ber­ant as many of us thought at the time.

But What About Trump?

So far Pres­i­dent Trump has mostly suc­ceeded in alien­at­ing the rest of the world and much of Amer­ica with bombs, mis­siles, and words. The courts and many Repub­li­cans in Con­gress have dead­locked almost all of Trump’s agenda, to an even greater extent than they did Obama’s. Fail­ure to raise the debt ceil­ing or pass a bud­get might go fur­ther and cause more dis­tress than sim­i­lar fail­ures have in the past, but those ear­lier expe­ri­ences sug­gest that they will not cause cat­a­strophic or irrepara­ble harm to the Amer­i­can or global economies, nor to stock markets.

If the pres­i­dent were able to imple­ment any of his pro­posed poli­cies, the eco­nomic dam­age would likely be focused in only a few places. Cut­ting off immi­gra­tion or imports would hurt the U.S. econ­omy more than any­where else, with impor­tant neg­a­tive effects out­side the U.S. lim­ited to a hand­ful of coun­tries like Mex­ico, Guatemala, and the Philip­pines. Imple­men­ta­tion of var­i­ous other threats would typ­i­cally also do most of their dam­age in spe­cific regions or to spe­cific indus­tries. One plau­si­ble inter­pre­ta­tion of the recent turnover in the White House staff is that cor­po­rate Amer­ica has regained some of its cus­tom­ary influ­ence over the U.S. gov­ern­ment. As much as many of us might con­sider this trad­ing one bad thing for another, it will surely not be viewed that way by the stock market.

In this envi­ron­ment, and remem­ber­ing that coun­tries all over the world are expe­ri­enc­ing healthy recov­er­ies, inter­na­tional diver­si­fi­ca­tion of invest­ments is a more effec­tive pro­tec­tion against risk of loss than is nor­mally the case, as some regions and types of economies are likely to con­tinue doing quite well even if oth­ers suf­fer. In addi­tion, the for­eign recov­er­ies are mostly younger than the recov­ery here, with more room for profit recov­ery and stock mar­ket appre­ci­a­tion. We con­tinue to favor invest­ments in Europe, Japan, and Emerg­ing Mar­kets, as well as in e-​commerce. At the same time, we think that more tra­di­tional cycli­cal stocks are likely to do well in the younger over­seas recov­er­ies. For­eign stocks are still less expen­sive than U.S. stocks despite the gains they have already made, but in Europe the strong appre­ci­a­tion of the euro adds an addi­tional obsta­cle to future prof­its for an Amer­i­can investor.

From cur­rent lev­els we expect quite mod­est returns from most of the world’s stock mar­kets over the next 12months, but still sat­is­fac­tory and bet­ter than bonds.

Robert Brooke Zevin has been a leader in socially respon­si­ble invest­ing since his pio­neer­ing work in SRI forty six years ago. He is cur­rently Chair­man of Zevin Asset Man­age­ment and has held var­i­ous senior posi­tions at the for­mer United States Trust Com­pany of Boston. In the 1960s Robert was also a pio­neer in the use of Mod­ern Port­fo­lio The­ory and com­puter tech­nol­ogy applied to invest­ment deci­sion making.

Diclosures

1. Reg­is­tra­tion with the SEC should not be con­strued as an endorse­ment of Adviser’s invest­ment skill or acu­men.
2. This com­mu­ni­ca­tion may include forward-​looking state­ments. All state­ments other than state­ments of his­tor­i­cal fact are forward-​looking state­ments (includ­ing words such as “believe,” “esti­mate,” “antic­i­pate,” “may,” “will,” “should,” and “expect”). Although we believe that the expec­ta­tions reflected in such forward-​looking state­ments are rea­son­able, we can give no assur­ance that such expec­ta­tions will prove to be cor­rect. Var­i­ous fac­tors could cause actual results or per­for­mance to dif­fer mate­ri­ally from those dis­cussed in such forward-​looking state­ments.
3. Past per­for­mance is not indica­tive of any spe­cific invest­ment or future results. Views regard­ing the econ­omy, secu­ri­ties mar­kets or other spe­cial­ized areas, like all pre­dic­tors of future events, can­not be guar­an­teed to be accu­rate and may result in eco­nomic loss to the investor.
4. Invest­ment strate­gies, philoso­phies and allo­ca­tion are sub­ject to change with­out prior notice.
5. Noth­ing in this com­mu­ni­ca­tion should be con­strued to imply that ser­vices com­pa­ra­ble to those offered by the Adviser can­not be found else­where. This com­mu­ni­ca­tion is intended to pro­vide gen­eral infor­ma­tion only and should not be con­strued as an offer of specif­i­cally tai­lored indi­vid­u­al­ized advice.
6. While the Adviser believes the out­side data sources cited to be cred­i­ble, it has not inde­pen­dently ver­i­fied the cor­rect­ness of any of their inputs or cal­cu­la­tions and, there­fore, does not war­ranty the accu­racy of any third party sources or information.