Staying Alert in This Transition Period

This is not the time to be complacent about the markets or our portfolios. There still are opportunities for safe, solid profits, but there also are potential problems ahead we need to keep on our radar screens.

The economy is humming along. It is growing a little above capacity and at a faster rate than during most of the recovery that began in 2009. Inflation is low but has increased, so we aren’t looking at near-term potential for deflation. Unemployment remains well below the historic average. Investment markets are doing well. Optimism and confidence are high among households and businesses.

Despite all the good news, I view this as a transition period that requires us to stay alert. We’re closer to the peak than to the valley. The Federal Reserve and other central banks are tightening monetary policy and other changes are afoot.

Since it began quantitative easing, the greatest risk to the economy has been that the Fed would raise rates too far, too fast. I don’t fear the Fed at this point. It isn’t tightening policy faster than the markets anticipate or faster than the economy can accommodate. But it and other central banks have made mistakes in the past, and we have to be aware of the potential for recurrence.

Also, there’s a shift in economic growth.

Housing and retail sales haven’t been as strong the last few months as they were over the last couple of years, but they still are contributing to growth. Recently, manufacturing and capital investments have improved, rebounding off the bottom of their long recession that was driven by the collapse in energy and commodity prices. Also, exports are increasing thanks to stronger growth overseas.

Growth in the United States and internationally appears to be sustainable. It was triggered by the extended quantitative easing of global central banks but now appears likely to continue without as much artificial support.

The key indicators of developing recessions aren’t revealing any signs of trouble. The indicators I follow include real retail sales growth, industrial production growth and employment growth. Industrial production has been the weakest lately, but all three early-warning indicators are positive.

Inflation has been rising over the last year or so and recently reached the Fed’s 2% target by most inflation measures. But I don’t expect inflation to rise enough in the near future to worry the Fed. A major part of the inflation increase was the rapid recovery in energy and commodity prices. That rally appears to have stalled. Also, the inflation calculation going forward will use the higher rates of the last year as the base instead of the near-zero rates that prevailed until recently.

Wages and salaries, however, are likely to keep a floor under inflation. Unemployment is near record lows, and most surveys indicate businesses expect to pay higher wages over the next year. While current levels of wage growth aren’t high by historic standards, they are higher than in the years that followed the financial crisis. Higher wages also could reduce profit margins.

Many investors continue to overlook the economic strength outside the United States. Coordinated actions by central banks over the last few years have led to coordinated economic growth.

As I’ve pointed out for a while, Europe and emerging markets are more attractive opportunities than the United States. Growth in Europe and the emerging markets resumed only recently, so they are starting from much lower levels than the United States. That gives their economies and corporate profits more room to rise.

We’ve seen that growth potential rewarded recently in the stock markets. But market prices and valuations don’t fully reflect the recovery that’s already occurred or the potential growth that is likely under current conditions.

To be sure, there are potential problems in Europe and the emerging economies that justify some caution. (Many emerging economies are tightly linked with Europe.) There’s a full election schedule in Europe. Recent results and polls are less worrisome to investors than a few months ago. But there still is a high level of uncertainty. Britain formally initiated its exit from the European Union, and that could have negative consequences for both the United Kingdom and Europe. Much of Europe still is at or near depression levels. The European Central Bank plans to reduce its stimulation late this year or early next year. That, of course, raises the risk it could tighten too far, too fast.

We continue to have a broader range of possible outcomes in the economy and markets than is usual. There are many risks from outside the markets that have to be monitored. These range from mistakes by policymakers to wars, with many potential risks between the two.

Also, we face asymmetric risks. The potential gains from most investments now are much less than the potential losses that would be incurred if things go wrong. There isn’t much of a margin of safety in many investments, and the potential payoff of being right often isn’t enough to justify the risks.

Those aren’t reasons to assume a worst-case scenario or keep your portfolio in cash. Following a few principles allows us to earn safe, solid profits in this environment and make changes if the environment changes. We look for investments with margins of safety. We follow the factors that matter to the markets over time, while ignoring the headlines and short-term market noise. We maintain diversification and balance and favor liquid investments. Following those principles will pay off in this and other market environments.