Dorato News, January 2018

A Quarterly Newsletter for the Clients of Dorato Capital Management, LLC.

Portfolio Issues


After we’ve just had a year where stock market returns surpassed most estimates, it’s worthwhile to remember why we have markets. Markets exist to set prices for things, from stocks to apples. Markets aren’t perfect, but they’re the best we have. Kind of like democracy. In the approximate words of Winston Churchill, democracy is the worst form of government, except for everything else that has been tried from time to time.

Some people don’t like the prices that markets produce, so they try price controls, or they try nationalization of assets. These invariably fail.

So the best thing to do is let markets set the price. This does not mean the price is always perfect. The old joke about a free-market economist is that he won’t pick up a $10 bill lying in the street because in theory it shouldn’t be there. The rest of us, who think markets have imperfections, will gladly pick up that $10 bill.

I give you this brief justification for markets because even though I think markets are mostly efficient, there are times where they overshoot or undershoot, when the $10 bill is not where it should be. I think this is one of those times. Specifically, it’s one of those times when the market is overshooting.

My advice is that you not consider all the wealth you can amass if the market surges higher, but rather consider whether you can stomach a 20% or 30% drop in the price of stocks, which might last a year or two; or whether you can handle several years of below average returns. If you can, fine. If not, it might be time to think again.

January 2018 Cartoon
"I don't have the slightest idea about your future, but can I tell you my prediction for the stock market?"

Market View


What to Expect

If you had predicted the US stock market would rise 20% in 2017, you would have been tossed into the trash bin, along with other far-fetched forecasters. And rightly so, in my opinion. Both stock and bond markets were expensive at the start of the year, and the economy plodded along at a 2% clip. The Price to Earnings ratio on US stocks was about 20, versus a long-term average of 15 or 16. And 10-year US Treasuries paid an interest rate of 2.5%, fine if you expect inflation to remain low for a decade, but not so fine if inflation picks up.

Yet here we are, 20% higher. Earnings have grown faster than expected, in the 8-10% range; and the economy has picked up a little steam, growing now at about 3%. And Congress has just passed a large corporate tax reduction. Ultimately, the stock market is tethered to earnings, and all those factors improved current earnings or the prospect for future earnings. So the stock rally has some justification.

The US bond market is up about 3% for the year, based on the aggregate US bond index. The 10-year US Treasury rate is still about 2.5%. The 3% return for 2017 is a little below the long-term average return for the bond index, but not dramatically so.

2017 stock and bond returns are a salutary reminder as to why it’s a good idea to stick to your long-term asset allocation. If you had gone to cash at the beginning of the year, fearful of a stock or bond market crash, you would have missed out on one of the better years of US stock market returns, double the long term average. If you stuck to your allocations, you did very well. And even if you held a little more cash than normal, you might have trailed the market returns a bit, but you would have captured most of them.

So what should you expect for 2018? Perhaps it won’t surprise you that I think you should not expect another 20% year. Returns are likely to be much more modest than that. And we are likely to see more volatility. Here are my reasons:

The US stock market is still expensive. In fact, it’s a little more expensive, because prices have increased faster than earnings. The Price to Earnings ratio for the market is now closer to 21, based on Value Line’s earnings measures.

We are in one of the longest economic expansions in US history. For how much longer can that continue? At some point expansions end and we have a recession, and stock prices invariably suffer during recessions.

The Federal Reserve is steadily ratcheting up interest rates, and it is starting to wind down its bond holdings. Both of these should serve to tighten monetary conditions and raise the risk of a recession or at least slower growth.

Junk bonds yield only a few percentage points more interest than investment-grade bonds. This is just one sign among others, such as the craziness around Bitcoin, that investors have forgotten what losing money feels like.

Predicting the coming year’s return in stock and bond markets can seem a bit like a parlor game, with limited consequences for being right or wrong. Most forecasters will extrapolate from the prior year, or hover close to long-term averages. Some will predict major reversals, in order to make a name for themselves if they’re right. But most of that isn’t particularly helpful for long-term wealth management. You can be a little more cautious when others are getting greedy, and a little more aggressive when others are selling indiscriminately, but otherwise it’s best to stick to your long-term plan.

Sources: Economist, Financial Times, Wall Street Journal, Value Line, Vanguard