US Stocks Make Lonely Advance

After enduring a choppy start to 2018, US stocks rallied broadly in the third quarter with the Dow Jones Industrial index rising 9%. Every sector of the economy saw gains, with healthcare (+15%) and industrials (+10%) leading the way. Overseas markets were left behind as most major European and Asian indexes were flat. Japan proved the exception, but its 7% gain was partially offset by a 3% weakening of the yen to the dollar. The dollar also rallied against the Euro and most emerging market currencies, a trend that could undermine the President’s efforts to reduce the trade deficit. As we highlighted last quarter, rising trade and fiscal deficits pose a key risk to the medium-term outlook for the economy.

For now though, the US remains the world’s strongest economy. The private sector continues to add more jobs than there are people entering the workforce, a condition that has in the past given rise to inflation. This has persuaded the Fed to raise its key borrowing rate by ¼ point for the third time this year. Long-term rates have largely followed the Fed’s lead, with 10-year Treasury yields up ¾ points this year to more than 3%. Because bond prices fall when interest rates rise, returns on fixed income have largely been negative in 2018. Gold has also suffered from the rising rate environment, having lost 5% in the third quarter and more than 8% for the year.

The consensus outlook seems to be that fiscal stimulus and increasingly confident consumers will keep the US economy chugging along for another couple of years. Implicit in that view is that inflation will remain moderate enough that the Fed won’t feel the need to aggressively raise interest rates. This outlook also discounts the likelihood that a trade war with China (or even Europe) will meaningfully disrupt US industry.

The main problem with the consensus is that facts have a way of changing the outlook – quickly. Less than a year ago the consensus view was that European growth was recovering, the Chinese government had successfully slowed financial speculation, and that we were about to embark on a sustained period of synchronized global growth. As a result, every major stock market index returned more than 20% in 2017. It didn’t take much more than a couple of middling economic data points and the spectre of a trade war to upend that consensus and bring the global stock rally to a screeching halt.

We mention inflation and trade conflict as potential risks not because we consider either highly likely to upend the US economy in the near-term, but because we feel both are meaningful enough risks to factor into any assessment of whether stocks are attractively valued. In our opinion, the market is not properly considering these risks – at least when it comes to US stocks – which may be understandable: it has been more than 25 years since US inflation topped 3% and an entire generation of adults has no memory of anything resembling the kind of inflation that was the norm from the 1960s to 1980s. In addition, it has been more than 80 years since we last experienced a trade war and the economic convulsions that resulted when President Hoover greatly expanded trade protections and our trading partners retaliated, so relatively few living adults have any memory of that. Yet history suggests that the catalyst for the next major drop in stock prices may be something currently considered so improbable that it isn’t yet on most people’s minds as a risk.

Humans are inclined to believe that the recent past will repeat, a psychological phenomenon known as “recency bias,” so investors tend to pile into investments that have recently done well, such as US technology stocks. Most successful long-term investors, on the other hand, anticipate change and refuse to chase past performance. Instead, they implement strategies that work over the long-run, are aligned with their specific goals, and are durable enough to withstand reversals of fortune. Such investors also possess the temperament to stick to with their plans, even when the prevailing consensus suggests they are wrong. That’s a quality we all need now, when conditions are relatively benign, and especially in the future when they become less so.

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