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  • James Tharin, CFA

Investment Playbook - October 2019


The first sentence of our 2019 Mid-Year Outlook read “Congratulations, you just made it through another bear market! We think the cyclical bear is heading back to his cave and that the secular bull will soon resume its charge.” With the benefit of hindsight, our call appears to have been early and in this business early and wrong can be used interchangeably. It’s okay to be wrong but its not okay to stay wrong. Failure to change one’s outlook as the facts change is usually hazardous to one’s wealth. Therefore, our current market outlook is that the U.S. stock market is still in a cyclical bear market but we are cautiously optimistic that the worst of it is behind us. In order to confirm that the next leg higher has started, we need to see the primary market averages hit and hold on to new highs. We have not wavered in our belief that the longer term stock market is in a secular bull that has lots of life left in it.

Emerald Asset Management Secular Bull Market Chart

Bull markets are usually born into times of despair (2009) and die into times of euphoria (2000). Think about the mood of the investing public in the late 1990’s compared to early 2009. The bearish arguments that I hear from the talking heads on CNBC are usually predicated on the idea that stocks are overvalued (i.e. investors are overly euphoric). But I don’t think that most people are overly euphoric about stocks right now. The articles I’m reading right now are focusing on impeachment, trade worries, concerns about the repo market, Iran and so on. In order to bolster the overvaluation argument there are lots of data points and metrics to which one can point. The problem is that most of those metrics (like trailing PE ratios) don’t consider interest rates and inflation. When interest rates are lower then valuations should be higher, all else being equal. Our favorite valuation measure, the Equity Risk Premium (ERP) does use interest rates and inflation in its calculation. The chart below shows that at the peak of the last cyclical bull market, the ERP stood at about 4.75% and it has now risen to 6.46%. Keep in mind that a higher ERP reading indicates a lower valuation. Said differently, stocks are about 36% cheaper today than in January of 2018.

Emerald Asset Management Equity Risk Premium

Does this mean that stocks have to go up? Absolutely not. Our point is that long term investors need to act in concert with the long term trend. We don’t think stock market valuations are at levels typically seen when secular bear markets start. The set up for the start of a 2000 to 2011 type bear market is usually nosebleed stock valuations accompanied by a catalyst that most of the general investing public doesn’t see or chooses to ignore. We think that once some of the political and geopolitical headlines fade into the history books stocks will reassert themselves as the dominant asset class. So while it’s always difficult to do, our advice is to remain patient - and collect those dividends. The bull will continue his run when he’s ready.

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