Navigating an Improbable Year and Preparing for More Surprises to Come

Don’t fall into the extrapolation trap that snares most investors. Too many investors extrapo- late the recent past into the indefinite future. They believe whatever has happened in the economy and markets recently will continue to happen. Behavioral finance economists and psychologists call this “recency” bias. (I know most dictionaries don’t accept “recency” as a word, but economists and psychologists do.) These investors com- pound the error by investing based on these forecasts.

A good example occurred in early 2016. After markets dropped in January and early February, investors concluded that inflation and interest rates would be low or just fall indefinitely. They loaded up on interest-rate sensitive investments such as long-term bonds and utility stocks. Profits on those investments soared as more investors were attracted by the momentum.

After a few months, it appeared to us that there wasn’t much of a margin of safety in the prevailing forecast. The risks of betting on further declines in inflation and interest rates were higher than the potential returns. Economic fundamentals also made higher inflation and interest rates more likely than they were earlier in the year. We sold bonds and utility stocks over the summer. Now, long-term bonds are down about 8% from their highs in July and utility stocks are down about 10%.

It is easy to find many other examples of investors falling prey to “recency” bias.

Many avoided emerging market assets after the bear market that began in 2011 only to see them recover in 2016. Of course, the technology stock bubble of the late 1990s perhaps is the classic example. But the same thing happens regularly on much smaller scales.

Investors need to follow the factors that matter to the markets and look for signs that recent trends will change instead of continue indefinitely.

The U.S. economy still is growing. The  reliable early recession warning signals haven’t given cause for concern. Real retail sales and unemployment have positive trends over recent months. It is not strong growth, but the economy is growing at about its maximum potential given the headwinds it faces. Manufacturing is pulling out of the doldrums that were caused the last few years by the combination of cratering commodity prices, a strong dollar and weak global growth. U.S. manufacturing soon should begin a modest bounce off of the bottom for this cycle. The services sector, which makes up the bulk of the economy, continues its strong leadership.

Job growth has been solid, and wage increases consistently are reaching the high points for this recovery.

Things are far from perfect,  but analysts who extrapolated a continuation of the trends that started the year missed the key moves of 2016.

Central banks in Europe and Japan continue their easy monetary policies. The Federal Reserve tightened its monetary policy in 2014 and plans to raise rates and tighten policy again soon. But the easier policies outside the United States are likely to more than offset any Fed tightening. Even so, the greatest risk to the economy remains the potential that the Fed tightens much more than the markets expect. I’m watching carefully for early warning signs of that.

The stock indexes and economy move together over the long term but not al- ways in the short term, and we’ve seen a divergence lately. Easy monetary policy propelled stock gains after 2009, causing stock prices to increase much faster than earnings, cash flow, dividends and economic growth. In fact, quarterly earnings growth has been weak for a while. I expect that to continue, because there are pressures that are likely to make record profit margins shrink. Wage and salaries are increasing at a higher rate, while productivity is declining. With an extremely low unemployment rate, those pressures on margins will continue.

Financial engineering has been a major source of earnings and stock gains the last few years, but that’s winding down. Fewer corporations are borrowing to buy back stock and pay dividends. There’s been a burst of merger activity the last couple of months as businesses rush to make deals before interest rates rise much more. That’s probably a deal-making peak.

Stock prices can’t continue to significantly outpace earnings, dividends, cash fl w and the economy forever. That’s why I’m cautious about U.S. stocks.

The best stock bargains and prospects remain outside of the United States.

Stock prices in Europe and most emerging markets lagged significantly behind

U.S. indexes the last few years. Earnings growth in those regions is likely to be better than in the United States going forward, and that should push stock prices higher. I remain optimistic about select companies in Europe and Japan and on companies in commodity-based economies.

China and economies reliant on China are a bigger risk. Though no longer making headlines as it did early in 2016, China still faces significant economic challenges.

Investors are right to be concerned about a number of long-term factors. But the things that matter to markets in the short- and intermediate-term favor our recommended investments and are likely to persist for a while.