Since last year’s presidential election, the stock market has been on an absolute tear. Most of the major U.S. stock averages are up roughly 17% since then. The biggest chunk of these gains came immediately after the election in November. However, just as the market never moves in a straight line, the various constituents of the overall stock market rarely move in tandem. During the big upswing in November, small and mid-cap stocks gained twice as much as their large-cap brethren.
This year has been a different story. The largest publicly traded companies have led the entire year. The disparity in returns this year between the large, mid and small segments of the market have been quite pronounced at times with large-caps out gaining mid-caps by two to one and small-caps by five to one. This out performance by the large caps has essentially made up for the fourth quarter of last year. All the three groups now have similar gains from November. This means that all the major indices now sit at all-time highs.
Interestingly, October marks the ten-year anniversary of the S&P 500’s record close just before the start of the financial crisis. It would take almost six years for the stock market to fully recover from the recession. With the market now reaching record levels so quickly, many wonder if these valuations are justified and if we’re in store for another big correction.
We’ve noted in the past that the U.S. stock market has experienced a fifty percent decline roughly every ten years since the 1960’s. The catalyst, speed and duration of these events has always been different but the frequency is surprisingly consistent. With that in mind, the anniversary of the last crash combined with the market highs can’t help but make one wonder if the next one is at hand. We think probably not – at least in the next couple of years. This belief is primarily based on the lackluster economic growth since the financial crisis and financial stimulus still being pumped into the global economy.
Our bigger concern is that many of the regulatory and tax reforms that the market has been banking on seem to be in doubt. That being said, market sentiment has been bolstered by many smaller rule changes enacted via executive orders but these are not the big post-election items business has been looking for. Tax reform is currently being worked on in Washington but progress is painfully slow. And based on recent legislative efforts, no one is convinced the two parties can come together and agree on anything. Should this become another failed effort, it’s unclear what the market’s reaction will be.
The backdrop to all of this are the major changes in monetary policy. During the financial crisis and for many years after, the Federal Reserve drastically reduce borrowing costs by cutting short-term rates and buying bonds in the open market. Those programs have now stopped and the Fed has finally begun the process, albeit very slowly, of allowing rates to find their fair market levels. There have been three rate increases in the past year and the first modest reduction in the Fed’s bond holdings.
Even though these policy changes are considered significant by historical standards, there seems to have been no impact on borrowing costs or bond prices. In fact, borrowing costs for companies are actually lower now than when the Fed started tightening. The reason for this is that other major economies, primarily the European Union and Japan, have instituted their own versions of Quantitative Easing and have yet to signal and end of their programs. This has led to a flood of money into our bond markets drawn to our relative higher rates.
These central bank programs are so massive in scale that the Fed seems to have lost full control over domestic interest rates. As we noted before, central banks now own roughly a third of all publicly traded global debt. Their influence over long-term rates and asset values cannot be over stated. The stocks and bonds have benefited from the low rates but their prices aren’t based on the economic realities. the catalyst for a significant correction will likely be when governments remove their support. At this rate, that may be years away.