The Dow Jones Industrial Average set a new record high yesterday breaking the old record set in late January. The S&P 500 also topped its previous new high set in late August. The gains were led by financials now that 10-year Treasury yields are back over 3%.
The melt-up in stock prices follows persistently good economic data. This week highlights were a jump in August housing starts and a strong economic report from the Philadelphia Federal Reserve. While higher rates have the ability to stop advancing equity prices in their tracks, the rate of change has been slow enough that the thrust from higher earnings more than compensates. While investors have been focused on tariffs for many months, one needs to put them in perspective. 10% tariffs on $200 billion of Chinese goods may sound like a huge number but the math says it is $20 billion just 0.1% of a $20 trillion economy. Of course, the math doesn’t include China’s retaliation nor does it account for future escalations which are quite possible, some might say probable. But no matter how you frame it, the damage from a tariff fight spread over the course of a year shouldn’t exceed one percentage point of GDP. In other words, it isn’t trivial but it isn’t overly threatening either. Furthermore, as we have seen with prospective auto tariffs against Europe, not all threats become reality.
In the ideal, Washington can come to some trade agreements with Canada, Mexico and Europe between now and the end of the year and then get all our major trading partners to focus on China’s misuse of intellectual property. Regardless of the ultimate outcome, however, China is going to close the technological gap between itself, the U.S. and the rest of the world over the next 5 years given that such a goal is the cornerstone of its economic five-year plan. In technology, patent protected intellectual property is of somewhat limited value anyway because today’s technology becomes obsolete very quickly in a rapidly changing world. For several decades, China has grown as a low-cost contract manufacturer. Over recent years, as its labor costs have risen faster than some of its Asian neighbors, it has lost part of that advantage. In addition, rapid increases in the use of automation have lowered labor costs regardless of rates. China, going forward, wants to follow models used by Japan and Korea, moving up the quality chain eventually become best of breed in everything from semiconductors to medicine. Almost by definition, if it ascends to a leadership position, it will not have to steal lesser technology from others.
We have seen these threats play out in the past. In the 1980s the fear was that Japan would soon dominate technology worldwide. But a steep recession and a collapsing stock market in Japan caused its largest companies to retreat. Today, it is still a world power but hardly a world leader as it was three decades ago in television and semiconductors. But the U.S., overall is still number one.
Perhaps, however, that position is at risk if we don’t focus more assets on training and education especially in science, math and engineering. We have never seen a competitive threat as large as China and it will take changes in national policy to remain number one. Protectionism and tariffs can set up short term barriers but nothing will be knowledge and innovation. China does not yet have the venture capital/private equity infrastructure nor the freedoms of 2
governance that capitalism offers. Thus, even if China is successful, however one defines that, in five years, the U.S. will still be the dominant economy. But longer term, leadership won’t be guaranteed if we don’t improve education and training.
The threat of China isn’t going to change our growth prospects overnight. Right now, the benefits of tax cuts and strong confidence at both the consumer and corporate levels are keeping momentum high and that is what is driving stock prices. Third quarter earnings, to begin in a few weeks, will provide an exclamation point to that statement.
Another factor helping stock prices is the law of supply and demand. Companies have been heavy buyers of their own stock and surging cash flows have accelerated acquisition activity. While the Wilshire 5000 index still exists as the broadest market index, it no longer has 5000 constituents as there are no longer 5000 public companies. At the moment the number is 3,486 and it continues to decline. In part, the number of public companies is declining because of mergers, bankruptcies and companies going private. But another factor is the decline in the number of initial public offerings. While many successful private companies suggest they remain private because they have long term visions and don’t want to worry about quarterly earnings, that probably is more of a pat excuse than an expression of reality. Public or private, valuations rise and fall with success or failure. The real villain for the reduction of IPOs is the high costs and risks associated with going public. Regulations that govern the cost of going public have been increasing steadily since the end of the dot.com bubble.
Full and fair disclosure is important. So is avoiding fraud. But the government agencies that oversee the process of going public can’t eliminate risks via a prospectus with 50 pages of risks that could include everything for increased competition and product obsolescence to the possibilities of terrorism and bad weather. About 90% of the risks are so blatantly obvious that a third-grader can figure them out. Investing in young companies is inherently risky. It also can be extremely rewarding. Today, you have to be an accredited investor to buy private companies and, for all practical purposes, you have to be an accredited investor to get your hands on stock of promising new offerings. In a world where the rich get richer and the less advantaged march in step, the government should rethink how small companies can gain easier access to capital. Moreover, while the best companies will always have access to capital, those a bit below the top or in geographies far away from Silicon Valley, are stifled. One advantage American companies have always had was access to cheap capital. The House has passed legislation to make it easier for some non-accredited investors to have access to the private equity market but it would be really great if companies could raise $250-500 million once again in the public markets. Deregulation has been one of the positive hallmarks of the Trump administration. It is time that gets extended to capital raising.
Today, Faith Hill is 51. Bill Murray is 68. Stephen King turns 71.
James M. Meyer, CFA 610-260-2220
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