2017 Q2 Legacy Group Commentary

Market Update – The Great Complacency

If no news is good news, then all I have is great news for you today. The first half of this year has seen stock markets across the globe make steady upward climbs.  The indexes in the chart below represent major markets across the world.  As you can see, almost all major markets are in positive territory for the first half of the year.

The markets seem as calm as Hindu cows.  These increases have, for the most part, come steadily without a lot of fanfare or turbulence.  Investors believe this calm will continue at least in the short term.  The VIX, represented in the lower-right chart, is an index developed and maintained by the Chicago Board Options Exchange (CBOE).  Commonly called the “fear gauge,” the VIX is the measurement of the expected volatility (how much the index will change in value) of the S&P 500 over the next 30 days.  As this chart illustrates, the VIX is at the lowest level on record since its development in 1994.  The S&P 500 is not alone in its low realized and expected volatility measures.  European and Asian markets are also at or near historical lows.    

In several markets around the globe, we would argue these market increases are warranted.  We have long held the opinion that Asian and European markets are under-valued, especially from a relative standpoint.  While the US market has continued to increase the last few years, these markets have stagnated until recently. Europe seems to be entering the stage in the economic cycle that the US began in 2009…slow yet steady growth.  Beyond foreign developed markets, emerging markets appear to have come out on the other side of another round of currency pressure in good health. This illustrates an economic resilience that hasn’t been there in the past. 

In contrast, the US economic expansion and bull stock market are getting a little long in the tooth.  The current economic expansion has lasted 96 months, the third longest expansion since 1854.  At almost 100 months long, the current US bull stock market is the second longest on record.  Neither of those facts spells near term doom, but there are other signs of frothy investment markets.  Just to cherry-pick a few:

Traditional valuation metrics are historically high – Total Market Cap to GDP ratio is around 120%, a number surpassed only at the height of the Internet Bubble in 1999/2000.  Shiller CAPE index has now surpassed the level it reached in 2007, just prior to the Great Recession.  In fact, there have been only two other times in history when it has been this high or higher – 1929 and 1999/2000.  When talking about stock markets, those are not good years to be associated with. 

Stock valuation metrics are being ignored – To site a specific stock overvaluation, during the last quarter Tesla, an electric car manufacturer, surpassed Ford in market value.  Tesla has a fraction of the revenue of Ford ($8 billion vs. $151 billion), a fraction of the assets ($22 billion vs $237 billion) and has never posted an annual profit.  This sounds familiar to the internet bubble, when everyone was banking on future revenue that was just supposed to come from somewhere. 

High Margin Debt Level – The New York Stock Exchange publishes monthly margin debt levels (borrowed money to buy stocks[i]).  It is currently the highest on record. When viewed as a relative measure to US Gross Domestic Product (GDP), it is at the same level as it was in 1999 and 2007. 

Low Institutional Investor Cash Holdings – Institutional investors are almost fully invested, with 2.25% of their account holdings in cash. This is the lowest level since 2008.[ii]

Argentina’s Bond Offering – To be fair, this is example isn’t from the US market, but it shows how desperate people are for higher yielding bonds. Just a few weeks ago, Argentina successfully issued $2.75 billion in US denominated bonds that mature in…wait for it….100 years!!!.  This bond issue was oversubscribed…there were 3x more buyers than there were bonds to sell.  This is Argentina, a country that has defaulted or rescheduled payments on external debts 5 times since 1950 (1951, 1956, 1982, 1989, 2001)[iii].  Their most recent external default holds the record for the largest sovereign external default at $95 billion and, for some reason, people think it’s a good idea to lend them money they don’t have to pay back for 100 years.  It befuddles me. 

These factors – steady increases in market value, low volatility, and a general disregard for risk and valuation – are indicative of a complacent market.  Complacency tends to create instability in furthering misallocations of capital. In other words, people feel safe so they ignore risk.  When you add to those factors a very long bull market by historical standards and investors who are fully invested and even leveraged (margin debt) then you have a scenario where things will likely change quickly when they change. 

The timing of the change is impossible to know. Equity markets could continue to go up.  The last time the Shiller CAPE ratio was this high, the market continued to go up for another 2 years.  Economic data continues to be generally positive and corporate earnings are still improving.  These factors could continue to support an overvalued market.  However, with the above risk factors we will maintain our conservative approach to US market exposure. 

Investment Theme – Water

For a midwestern boy, the concept of “water shortage” is completely foreign.  I grew up not far from the Missouri River.  Most of my Saturdays from the time I was 13 until I turned 20 were spent fishing on the large lakes of central Missouri – Truman, Stockton and Pomme de Terre.  As an adult, I’ve spent countless hours fly-fishing in streams.  One of these, Bennett Springs, has a daily flow of over 100,000,000 gallons that, as the name suggests, comes out of a hole in the ground. I’ve spent several weeks fishing in Canada, where you can’t seem to drive 3 minutes without passing a lake.  For the last few years, my family and I have vacationed several times at Lake Michigan.  In my world, water is everywhere and in abundance.

I – and all of you, except our west-of-the-Rockies clients – live in one of the richest water locations in the world.  The Mississippi River Valley stretches from the Appalachians to the Rocky Mountains.  Hundreds of rivers and streams contribute to the system as it meanders its way from as far north as Montana and Minnesota to the Gulf of Mexico. The Amazon and the Congo Rivers are the only river systems in the world with larger drainage basins.

Reality is much murkier in other places in the world, even some places in the US.  The graph to the right illustrates that much of the world is going to be under stress to provide enough water to support their populations[iv].  Global population growth over the last century has placed a lot of stress on water systems.  In most developed parts of the world, water infrastructure has been able to keep up with growth.  For example, during the 20th century, 45,000 dams were built around the world, which increased the world reservoir capacity by 4x, and aquifers were discovered and tapped to supply water to otherwise water poor regions[v].  But the efficiency of those measures is starting to hit their limit.  The number of dams that can be effectively put on a river is limited, and aquifers replenish at a very slow rate. 

In addition, current water infrastructure is aging and will need extensive replacement and repairs in the next 10 to 20 years.  The American Water Works Association (AWA) claims the US is hitting the “Replacement Era” of water systems.  The type of piping used in water infrastructure has changed over the last century, but oddly enough, newer pipes have less longevity than older ones.  In an almost perfect storm, 3 different types of piping will be hitting the end of their “life expectancy” within the next decade.  This same scenario is being played out in other areas across the globe.  For example, Mexico City loses 40% of the city’s potable water through leakage of old pipes every day[vi]

Developing economies face even greater challenges.  Having frantically thrown together water systems to meet the increased demand from industrialization and urbanization, many developing or recently developed countries are facing pollution problems.  It is estimated that half the surface water in China and India is contaminated to an unusable point.  In 2016 a report from the Chinese government, it was stated that 80% of underground well water was unfit for drinking or bathing[vii]

All of these varying issues will need to be solved, and solving them will cost money.  As global populations continue to increase, new systems and technologies will be required to meet demand.  Since water cannot be created, this will have to be done through increased efficiencies in use/reuse and delivery (desalinating ocean water is another potential). As to the aging infrastructure, the AWA estimates that the cost for replacing drinking water systems will be $13,500 per household (sorry…. your water bill is going up)[viii].  To stem the pollution of their waters, developing countries will need to increase regulations on industries on the water they release into the system, which will cost money to implement.

We like the investment opportunity this presents.  Besides oxygen, water is the most basic necessity in life.  People need access to it, and they want it to be clean.  Recent experiences in Flint, Michigan have demonstrated just how important it is to get right.  A lot of money is going to be spent on water over the next 10 to 20 years.  We currently have a small position committed to this area and will be likely be increasing it over the coming months. 

We will continue to look for opportunities to invest capital at an acceptable level of risk.


Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.


[i] Data can be viewed here: http://www.nyxdata.com/nysedata/asp/factbook/viewer_edition.asp?mode=tables&key=50&category=8

[ii] http://www.businessinsider.com/stock-traders-look-dangerously-overconfident-cash-holdings-2017-7

[iii] This Time is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart & Kenneth S. Rogoff

[iv] Chart from World Resource Institute http://www.wri.org/resources/charts-graphs/water-stress-country

[v] Water: The Epic Struggle for Wealth, Power, and Civilization by Stephen Solomon

[vi] ibid

[vii] https://www.nytimes.com/2016/04/12/world/asia/china-underground-water-pollution.html?mcubz=0

[viii] Water 4.0: The Past, Present & Future of the World’s Most Vital Resource by David Sedlock

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