Commentary: March 1, 2017

A collection of today’s economic, market, political, geo-political, and human-interest news, thoughts, and analysis.

 In This Month’s edition:

  • Milestones, P/E Ratios, and Starting Points
  • Never Let a Good Crisis Go to Waste
  • A Nation Divided
  • Democracy, Capitalism, and Morality

Milestones, P/E Ratios, and Starting Points

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WSJ 3/1/2017: “The point gains in the Dow match the epic 1999 stock rally for the fastest-ever thousand-point milestone, and set a new standard for the fastest-ever 2,000-point milestone.”

There is little reason to bet on this market collapsing in the face of probable public policy tailwinds and continued economic growth even if below historic averages. In fact, recent data points are showing signs of real momentum in the domestic economy. The Trump rally is in clear control. Consumer spending and factory production are on the rise. Inflation is making a little noise, and the Fed is hinting at another interest rate hike sooner than later. Both suggest pricing power and job creation to follow.

Nonetheless, economic growth is only estimated to remain at an uninspiring 2% per year. Britain is leaving the EU, we have a protectionist president, and the front runner in the coming French election wants out of the EU. Somehow, with all this uncertainty, investors have found the world safe pushing the DOW through 21,000.

Neither economic or market fundamentals can explain this euphoria. These milestones tell us little about the past or the future. They are notches on a belt that by themselves offer nothing about the how or the why we got there or about the risks and expectations we face ahead.

Actually, purists find it very hard to be excited about each subsequent milestone. There is a solid argument that trying to compare today’s DOW to the DOWs of the past is a fool’s errand. There are many flaws in the index which should be considered. The impact of the index being price-weighted results in a potential bias that may distort the goal of using the index as a broader measure of the total market. For example, moves in Goldman Sachs have an eight-time greater impact on the average than do changes in General Electric’s price.

Survivorship bias introduces the ‘comparing apples and oranges’ metaphor. Gluskin Sheff’s David Rosenberg found that had the same blue chip stocks making up the index in April 2004 defined the DJIA today, the index would only be at 12,885 or 35% lower than the 20,000 milestone. If you went back further than 2004, some of the companies making up the 30 stock index are gone creating even a greater risk of comparison distortion.

The makeup of the DOW Jones Industrial Average isn’t so industrial anymore. In 1999, the DOW had 2% of its weighting in technology stocks. Today it’s about 25% according to Rosenberg. While this certainly makes the index a more appropriate surrogate for today’s market, it assures that comparing it to past index levels is a useless exercise. However, it is still a valid index when applied to current conditions.

Stocks are trading at 21 times trailing 12 month earnings versus 15 times when the index broke 15,000 in 2013. U.S. expansion is 7 years old and while risks to the economy no longer point down, expansion is getting long in the tooth. Recessions normally start when unemployment is around or below 5%. Corporate profit growth is relatively slow, yet the Fed is likely to raise interest rates more quickly. Inflation is rising but remains low by historical standards. This financial squeeze could may find us in recession within the next 18 months. If that is the case, the DOW may find itself revisiting 20,000 from above and below for quite a few years. History suggests the same.

The current state of economics suggests that profits for the next 10 years are going to be tougher to come by than the last 10 years. The DOW hit 10,000 during the irrational exuberance glory days of 1999. It then took almost 17 years for the DOW to double again which underscores how this newest century has offered less than optimal economic growth and prosperity so far.

Let’s look at some historical doublings and how long they took to accomplish. Note, in almost every case, the first time a milestone was achieved was not the last time we saw that number again:

  • 100 to 200: 22 years
  • 250 to 500: 28 years
  • 500 to 1,000: 16 years
  • 1,000 to 2,000: 14 years
  • 5,000 to 10,000: 4 years (Irrational exuberance)
  • 7,500 to 15,000:             16 years
  • 10,000 to 20,000:             17 years
  • 15,000 to 30,000:             ???
  • 20,000 to 40,000             ???

If you are in a position to invest capital you won’t need for 10 – 15 years and you can guarantee that you will have the emotional fortitude to stay the course no matter what path the markets take, then a reasonable bet would be to invest in the DOW or S&P 500 today. You can make a legitimate case that history will repeat in some form or fashion over the next 15 years or so. Unfortunately, most people are not in that position.

Using 15 years as a doubling goal, would see DOW 30,000 in 2028 and 40,000 in 2032. With history as our guide, these milestones will almost certainly happen. Only the actual time frame and from what levels they will be achieved remain a mystery.

These milestones almost all have one thing in common. They are achieved following the market making a significant run to the upside…often very quickly. However, the compounded annual growth rates when measured peak to peak in these milestone doubling efforts are typically well below the historic market averages reinforcing the concept of ‘your starting point matters.’

Our starting point today finds us at the precipice of a very significant milestone. What type of average annual growth rate can we expect for the next doubling from current levels? Using 1999’s DOW 10,000 as an example, the DOW grew at an average growth rate of 5.9% over the subsequent 17 years on its way to 20,000…assuming you stuck around for the recovery. Far too many didn’t. If your starting point was 2002 or 2009, you experienced an average annual growth rate of 11% or 21% respectively. WOW! Imagine where would you be today if you had the patience and ability to not take the two huge rides down that occurred in between?

Are you itching to get into the markets at these levels or do you have the patience to wait until the probabilities of success from your starting point works far more to your advantage? Are you willing to take the next ride down? You probably don’t need to, but if you do, will you be able to stay the course and benefit from the subsequent recovery? History suggests that most investors won’t.

During the course of the next doubling, intelligent arguments can be introduced that suggest we have not seen 7,500 for the last time. While this outcome is quite remote, the possibility still exists. An even more plausible case can be made that we may not have permanently left 10,000 in the rearview mirror. 15,000 is only a hiccup away. In addition, you have to take into consideration the complexity and interconnectivity of today’s global economies and markets as they contend with unheard of levels of debt and geopolitical uncertainties.

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Again, your starting point matters in this game of odds. The odds of success are far different today than they were in 2009. With today as your starting point, are the odds of an orderly ascent to the next milestone more like 2007 or more closely aligned with 2009? If you picked 2007, you may stand a better chance of making better investment decisions from here, possibly miss a future correction, and achieve the kind of returns earned following a correction.

Crestmont Research has done extensive work using Price/Earnings ratios to help define ideal starting points. As they point out, market valuation (P/E) increased further in 2016 to levels that have been historically unsustainable regardless of whether or not the markets find themselves in a secular (long term) bull or secular (long term) bear market.

An elevated P/E has generally indicated that returns over the next 5-10 years will be demonstrably below average. Years with excess returns (2016 and 2017 YTD) merely pull forward future returns and increase the magnitude of subsequent corrections. You know, “the higher they rise, the harder they fall.”

The first 4-5 years of the current bull market displayed the characteristics of a typical cyclical (short term) bull within a secular (long term) bear market; it was a recovery from the trough. During this period, the P/E for the S&P 500 index increased significantly as expected in a low inflationary environment. But in the past few years, P/E has moved beyond rational valuation levels reflecting a stock market that is significantly overvalued.

Stock market volatility declined in the second half of the year which signals good market conditions. The current period of below average and declining volatility tells us we remain in a good market for now, but this is not necessarily a predictor of good markets in the future.

Current conditions are consistent with our being inside a secular (long term) bear market, but the current cyclical (short term) bull may continue for now even though it has been unusually long having run for more than 7 years. The secular bear arguably began in 2000. As I have previously shared, typical secular bear markets average 17 years in length and experience three major corrections. The current secular bear is 17 years old, and we have had two historic corrections. Is the third one on the horizon?

When P/E starts at higher levels, subsequent returns are generally lower going forward. Even generational returns (20+) years seem defined by P/E starting points. When P/E is relatively high or above average, as it is currently, investors’ returns over the subsequent 20 years are below average or negative.

In the years ahead, the markets will soar, they will plummet, and they will trade sideways. No matter your starting point or the eventual outcome, investors today are armed with sophisticated strategies that place the odds of success far more on their side. Most, unfortunately, do not avail themselves of these strategies where downside capture can be mitigated or defined and upside capture realizes a reasonable fair share of the ups.

These alternative strategies offer the ability to achieve the same long term averages of the stay the course, rollercoaster crowd, but because of reduced volatility, you end up with many more dollars in your investment accounts. These strategies replace traditional equity and fixed income asset classes where most of the relative and directional influence dictated by the traditional markets is removed.

In summary, don’t get caught up in the euphoria of milestones. Pay close attention to market valuations and your starting points. Investment starting points are just like that old saying, “today is the first day of the rest of your life.” Each new day defines a new starting point which should define your investment strategy. Find strategies that truly mitigate or even eliminate downside risks when valuations are high, and be prepared to dial up your risk following a correction. Studies have shown that you only need about a third of the upside to beat the market if you don’t participate in the downside. Easy to say, tough to accomplish, but it can be done.

Never Let a Good Crisis Go to Waste

Since our founding, American citizens have generally been skeptical of an overbearing government with too much power over the people. In this nation, the government exists to serve the people…not the reverse.

The concept of limited government was exactly what our founders had in mind when authoring our Constitution. The Federalist Papers was a collection of 85 articles and essays written by Alexander Hamilton, James Madison, and John Jay explaining and promoting the ratification of the United States Constitution. One of the primary concepts articulated was the principle of Federalism. Federalism, in this context, limits the federal government to doing only what the individual states cannot or are not able to do for themselves including conducting and waging war, managing the massive interstate highway system, maintaining the military, managing a common currency, and controlling the immigration process.

Too often we have seen states either abdicate their sovereign rights or sit idle as the federal government coops them. Unfortunately, this takeover is very often done through the courts where activist judges bend or rewrite the intention of the constitution. Simply stated, the U.S. Constitution was framed in such a way that the federal government has no business doing what the states can do for themselves.

The natural course of government creep, especially at the federal level, will always be tough to corral and control. The economic burdens introduced by continually expanding federal bureaucracies is suffocating and eventually unsustainable. Government bloat is an albatross around the neck of free market expansion that has always been the most powerful tool against poverty, unemployment, and inequality.

History demonstrates that most Americans favor the slashing of spending and the size of government. However, our elected leaders within the framework of a representative republic will always be biased towards believing they know what is best for the average citizen. While this this may be exactly what we elect them to do, when you add the natural tendency for these leaders to continually attempt to amass power and wealth, they find it hard to resist the temptations to work in their best interests first under the guise of working for the citizenry.

Government creep occasionally mushrooms into huge power grabs following periods of war and extreme economic disruptions. Americans ordinarily would have never stood for the massive governmental expansions that occurred during the Great Depression. How is it that once the problem has been resolved, we never go back to where we were prior to the disruption.

Were it not for 9/11, the Homeland Security Department would probably not exist. While still necessary, will it be wound down once the threat is diminished? The 2008-2009 financial crisis opened the door for massive regulatory controls and expanded government bureaucracies under Obama. Today, we are experiencing how tough it is to unwind federal controls that rose out of a disaster even after stability is again achieved.

The takeover of 15% – 20% of the U.S. economy by our government (ACA) was accomplished on the back of false promises, inflated needs, and the creation of a crisis that was manageable following a far less costly path with far less governmental control or involvement. While there is much good in ACA that should be preserved, we are witnessing how government will fight any effort to change or improve a failing enterprise. The tendency is to layer new laws and regulations over old creating an impossible bureaucracy to comply with that inhibits growth and progress.

Winston Churchill originally offered the phrase, “Never let a good crisis go to waste.” Former Obama advisor and current Mayor of Chicago Rahm Emanuel expanded on the thought, “You never let a serious crisis go to waste. And what I mean by that it’s an opportunity to do things you think you could not do before.” This is exactly what government will do when given the opportunity. It will use any type of crisis, disruption, or unusual occurrence to increase its control over the people. Eventually the people have to take back control and place the politicians in their place. That may well be the metamorphosis we see happening today.

On their own, most government agencies are wasteful and inefficient economic black holes whose mere existence was born out of a real or made up crisis. Most would never be missed if they went away and the federal powers they assumed were given back to the states and local communities where decisions and budgeting authority would be much closer to the recipients of the service. At the federal level, a one size fits all bureaucratic rats nest of rules, regulations, and wasteful spending strangles economic growth, creative ingenuity, and the entrepreneurial spirit that made this country the great nation it still is today…for now.

For years we have heard fiscal conservatives advocate for the elimination of the Department of Education, the Department of Energy, and other bloated and worthless agencies that continue to expand government overreach and create massive regulatory burdens that have the power of law but were never introduced through the legislative process. At this level, unelected government bureaucrats make laws that bind us at all too many levels.

I for one would embrace an effort to scrap many of these departments and agencies and benefit from the massive savings and the repatriation of the responsibilities for these initiatives to the local level. If it happens, we will have to endure the false hysteria from those opposed to the unwinding of an invasive government even after the benefits and efficiencies are realized. Only in politics do results not matter.

 A Nation Divided

In my lifetime, I cannot remember a period when our nation has been as divided as it is today. The late 1960s and early 1970s certainly rival today’s emotional disconnect, however fifty years ago we were in the middle of a major post war cultural shift book marked by the burgeoning civil rights crusade and a vibrant anti-war movement.

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The societal split today can only be defined by politicized emotional immaturity where we have allowed our political leaders to drive wedges between all segments of society. Wars defending the very freedoms we enjoy today have been replaced with culture wars that pit the very citizenry, who fought side-by-side in two world wars, against each other because the leaders we elect to unify us instead work to divide us.

We are taught to demonize success, blame others for the problems we face, depend on government to determine our outcome, and view the world through the eyes of a victim as opposed to through the windows of opportunity that are available to everyone in a free society…maybe not logistically equally yet, but we are getting there. There is no switch to throw that gets us there immediately. We have made tremendous progress, and the pace will increase if we work together and not divided.

For purposes of perspective, let’s look at some of the major transitionary stages our young nation has gone through since its founding. We didn’t always go through the process well and the growing pains left scars no one is proud of, but somehow we staggered our way through an evolutionary maze that created the freest and most successful society ever witnessed in the history of human kind.

  • 300 years ago, people from varied backgrounds and nationalities came together to begin to lay the foundation of individual freedoms never before seen, eventually fought a war for liberty, and built a governmental framework that gave power to the people with ingenious checks and balances that survives to modern day.
  • The Civil War was a pivotal time as a divided nation went to war where clashing cultures stood in the way of evolving freedoms. Slavery lay as the root of the societal split as good eventually defeated evil, as it always does, setting the stage for an explosion of growth rising out of the ugly ashes.
  • Our growing free nation expanded as the world took notice and the territories to the west began to be settled as progress continued on its inevitable march forward. Cultures again clashed like tectonic plates leaving warring American Indian nations in disarray as progress overwhelmed in a way that was not always pretty. The lawless west eventually became civilized as it embraced the young nation of laws to the east and joined the expansion of freedom.
  • Our nation was born at the beginning of the Industrial Revolution and her internal growth correlated with the pace of industrial expansion leading us into a new 20th Evil had to again be defeated as this expansion led us into two world wars. The unique character chiseled into the framework of this great nation eventually led us to become the defender of the free world and take the seat as the greatest nation in the history of the world. Between the two wars to end all wars we suffered through a crippling economic period born out of a rapidly expanding private sector capitalized by an emerging Wall Street and an expanding banking industry taking advantage of the principles of a free market, capitalistic society. While this was a good thing as a whole, the Great Depression was a costly growing pain where many suffered. Rising out of despair, this partnership eventually resulted in an exploding middle class like never before seen. Unfortunately, this catastrophic economic period was arguably worsened by the beginning of intrusive governmental re-engineering process that resulted in aggravating unintended consequences that are even worse today.
  • Finding a voice in the industrial, economic and educational expansion occurring in the postwar era, America began to further expand freedoms and opportunities in areas that had lagged over the previous 100 years. The most significant and long overdue revolution at the time was the Civil Rights movement. Again cultures collided in a way that is a constant byproduct of progress. Tremendous advancement has been achieved with much yet to be accomplished. However, much of this progress has been masked by the introduction of the politically inspired culture wars of present time.
  • This is where we find ourselves today. Younger generations are ushering in cultural changes that older generations are slow and often loath to embrace. Government continues its unquenchable thirst for money and power. So much of the cultural splits that separate us today are invented, created, or inflamed by political rhetoric and the false creation of victimization and a culture war that pits the various segments of society against each other instead of building on the strengths of a unified partnership. Instead of working together, our society is defined by a war on gender differences or identities. Instead of finding ways for businesses to succeed, we demonize success and create a war between the rich and the poor in a way to suggest that people are poor because others are rich. Progressive thought believes that we are a racist nation instead of a country that has done more for minorities than any other through time. There is still much that needs to be accomplished and it will happen as progress continues to advance. It won’t be a perfect path. It’s the toxic environment where power is achieved by falsely dividing constituencies that truly holds back this advancement.

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Imagine if the energies expelled in the attempt to divide us were released in an effort to focus us all on what I believe are in reality common goals. As a fiscal conservative, I thought I would do a self-assessment of where I stood on issues of the day. In examining how I lead my life, I have come to believe that I have much more in common with the average person than not. I took inventory of my belief systems and found them to be such that most people would find difficulty in taking issue with any of them on their merits. Thus, for purposes of this self-indulgent exercise, I am proclaiming myself the norm. You are free to disagree.

So here are my belief systems. I believe…

  • …in hard work coupled with personal responsibility and accountability where success is earned and not ordained.
  • …in the U.S. Constitution and the rule of law.
  • …in a free market, capitalistic society which, while imperfect, offers the greatest opportunities for individuals from all backgrounds to achieve success and happiness.
  • …in a safety net for those who truly need help, but not one that becomes a way of life for the able bodied.
  • …in racial, gender, and lifestyle rights and equality.
  • …in the freedom of, not the freedom from, religion as well as the intended separation of church and state.
  • …in a small and limited federal government whose primary focus is keeping us safe, creating and enforcing laws for the social good, protecting individual rights as well as the sovereign rights of the states, protecting interstate commerce and the highway systems, protecting those not able to fend for themselves, managing a common currency, managing foreign policy, and maintaining a world class military.
  • …in limited tax and regulatory interference.
  • …in fiscal responsibility and prudence where individuals and governments live within their means.
  • …that freedom must be aggressively defended against evil.
  • …in a nation that opens its arms to other freedom loving individuals from other parts of the world who wish to come here, embrace our way of life, assimilate, and become productive citizens instead of demanding that we change to embrace their ways or their becoming a burden on an already overwhelmed social welfare and educational system.
  • …in an educational system that truly educates and not processes. A system that is focused more on delivering core foundational instruction in the areas of math, science, language arts, history, economics, civics, and physical education and less on social engineering and the indoctrination flavors of the day. A system that demands excellence from its teachers and administrators where critical thinking and debate are encouraged, embraced, and rewarded. A system that prepares our youth to compete in the competitive world of today and not one that shelters them from the real world to come and leaving them with a feeling of expectancy and entitlement.

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Democracy, Capitalism and Morality

The above WSJ headline recognized the works of lifelong Democrat and well known philosopher, journalist, novelist, and diplomat Michael Novak who recently passed away at the age of 83. The Journal republished a Novak article that originally appeared on December 27, 1994. I was struck by his thinking about the relationship between capitalism and democracy and wanted to share.

On capitalism and democracy, he posits that one cannot exist without the other. He invoked Churchill who said, “It has been said that democracy is the worst form of government except all the others that have been tried.” Novak believed the same is true about capitalism. He wrote, “…in combination, democracy, capitalism, and pluralism (diversity of views) are more protective of the rights, opportunities, and conscious of ordinary citizens than any known alternative.” He went on, “…better than socialism, capitalism makes it possible for the vast majority of the poor to break out of the prison of poverty; to find opportunity; to discover full scope for their own personal economic initiative; and rise into the middle class and higher.”

Novak stipulates six critical components required to allow the marriage of democracy and capitalism work together towards an efficient end:

  1. The rule of law.
  2. Limited government.
  3. Protection of the rights of individuals and minorities.
  4. Human morality.
  5. A representative structure offering a voice to all economic constituencies.
  6. Free and fair elections along with peaceful succession of leadership.

Reread those six points and ask yourself how they compare to our nation today. In my humble opinion, it would seem that we would be found lacking in a number of areas.

He believed that democracy will be embraced so long it brings with it the opportunity for solid economic progress for individuals and their families. This makes capitalism the indispensable partner for democracy. “Capitalism delivers the goods that democracy holds out as one of its promises.”

The following passage really hit home given the state of our nation today.

“Another service provided by capitalism to democracy is less well understood. The founders of the U.S. understood it very clearly, however, as one can see by a careful study of Federalist No. 10 and No. 53. Benjamin Franklin in London and Thomas Jefferson in Paris searched libraries to find out why previous republics had failed. Envy, it turns out, is the most destructive social passion—more so than hatred, which is at least visible and universally recognized as evil. Envy seldom operates under its own name; it chooses a lovelier name to hide behind, and it works like a deadly invisible gas. In previous republics, it has set class against class, sections of cities against other sections, leading family against leading family. For this reason, the early Americans stood against division (“divided we fall”) and sought ways to neutralize envy.”

This speaks directly to the cultural, economic, and social wars that divide this great nation today.

The founders shied away from clerics, aristocrats, or military as the new nation’s foundation. Instead, they turned to a humble structure linking a society through commerce. Novak expanded…

“They chose commerce for two reasons. First, when all the people in the republic, especially the able-bodied poor, see that their material conditions are actually improving from year to year, they are led to compare where they are today with where they would like to be tomorrow. They stop comparing themselves with their neighbors, because their personal goals are not the same as those of their neighbors. They seek their own goals, at their own pace, to their own satisfaction.

 Indeed, in America, as de Tocqueville and others noted, there was a remarkable freedom from envy. On the whole, people rejoiced in the success of others, as signs of the coming prosperity of their village, city, and nation. Democracy depends on a growing economy for its upward tide—for social mobility, opportunity, and the pursuit of personal accomplishment.”

Maybe we need to revisit this whole envy thing. Our founding fathers would be very disappointed at how today’s politicians abuse the concept in their quest for power and control.

Novak concluded by addressing another great threat to free republics which the Framers understood as the “tyranny of the majority.” The constructs of separated powers, federalism, and the varied interests introduced by commerce and industry defeat the risks coming from the majority laying waste to minority interests.

Novak was a great thinker. He will be missed.

Random Thoughts

 I had to chuckle at the recent use of the song You Can’t Always Get What You Want by the Rolling Stones at some of Trump’s speaking events. The lyrics may prove to be very prophetic:

                 You can’t always get what you want

                 But if you try sometimes well you might find

                 You get what you need.

Media coverage so far during Trump’s presidency has been 88% negative. The silence by the media on issues or news that would otherwise be supportive or positive for Trump has been deafening. Some may deny that there is media bias or that mainstream media is agenda driven, but evidence suggests otherwise.

Still ticking. The Chicago Half Century Club took several teams in different age groups to compete in January’s USASA’s Florida Classic. My team competed in the over 60 age division this year. We advanced out of group play, but lost in the semi-finals. Great fun…tough competition…awesome teammates. Our team consisted of many former college and national team players representing 10 different nationalities.

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Critic’s Corner

Go see the movie Lion. Over 80,000 children go missing each year in India. This movie is based on a true story about one five year-old destined to become a statistic until life took an unlikely path. The movie gets a bit long in the middle, but the beginning and end are worth your price of admission. Take a Kleenex.

Have a great month.



Bruce Anderson

Managing Partner

South Georgia Capital, LLC

2135 City Gate Lane, Suite 460, Naperville, IL 60563


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