The Independent Market Observer

Is This Normal?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Aug 11, 2017 3:42:54 PM

and tagged Commentary

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normalEvents of the past couple of days have me thinking about the entire concept of normal. “Normal,” by definition, means “usual, average, or typical.” It’s a good definition. But when you actually apply it to what we see around us, that definition makes you consider whether the current “normal” meets those conditions—and thus deserves the term.

Economic and investing world

Let’s look at some examples from the economic and investing world. Since 2012, employment growth has averaged around 200,000 per month (not exactly, but close). This has lasted long enough that investors now expect it and, in turn, react when the number comes in lower. In fact, looking at history, job growth of this magnitude is quite unusual. Even adjusting for population, the only time we have seen job growth like this was in the late 1990s and for a very brief period in the 2000s. This normal is in fact a boom; it just seems like normal since it has been going on for so long.

I could make the same point about stock valuation levels. Looking at forward earnings, the market is now about 20 percent more expensive than it was in 2007. Think about that. We know, in retrospect, that the market was very expensive and poised for a bear market in 2007. Today, however, we consider prices 20 percent higher than that to be normal. Why? Because it has been that way for some time.

On a slightly different note, President Trump has been taken to task for dealing with North Korea in a very different, non-normal way than that of his predecessors. I understand the risks and the reactions, I really do. But let’s keep in mind that the old normal approach led us to the situation we have today, where it is quite possible we will see a war. Arguably, the old normal didn’t work, and changing it up was worth a try.

This is not meant to be a political take but, rather, an illustration of a larger point. Specifically, presuming that whatever occurs is right guarantees that you will be vulnerable to unexpected change. What we need to do, as investors, is separate what we now see as normal from what really can be normal over the long term.

Looking at the stock market again, this calls a couple of things into question. The first is low interest rates, which are widely presumed to be the new normal. Maybe so, but how does that comport with keeping the old normal in economic—and, therefore, earnings—growth? Can we match the old normal and the new normal, or will something have to give? Profit margins and buybacks are another. Valuations are another.

If you think about it, every time we have had a significant change in the markets, it has been preceded by a redefinition of what normal means. In 1929, Irving Fisher famously predicted that stocks had reached “a permanently high plateau.” On the flip side, in 1979, Businessweek had a cover story on “The Death of Equities.” In the mid-2000s, houses had nowhere to go but up, and the list goes on.

The new normal

Right now, the major new normal I see is interest rates. Everyone believes they can’t go up. But what if they do? As the foundation of the entire financial asset pyramid, that would be an earthquake. Similarly, the old normal—since 1945—has been that no one would ever use nuclear weapons. That one may be being challenged as we speak.

As Mark Twain said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” Normal is full of things you know for sure. We need to prepare for when it turns out they just ain’t so.

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