Written by David Young, President and Founder of Paragon Wealth Management

Last quarter was a continuation of what has gone on since last year’s election: The markets keep going up. Leadership changed and rotated to Small Caps taking the lead this quarter. Small Caps lagged in the first quarter (and again in August), but then took off in September to get back in line with the other averages.

The leading indexes change from quarter to quarter, rotating between the S&P 500, the NASDAQ, Emerging Markets, International Markets and Small Caps. But the bottom line is that the market trend is up.

Assuming your investment strategy is sound, this past quarter proves the “long term argument” of waiting patiently for your strategy to pay off. Our portfolios continue to provide good performance.

I am repeatedly asked, “How long can this market keep going up?” and “With all of the problems and concerns, why does the market keep going up?”

Regarding “how long,” no one knows for sure. We are currently breaking records for the period of time we have gone without a correction. Based on our models, the market is fully valued. We are to be cautious — but still stay invested.

History shows that markets can continue going up even when they are at full value. Last year, before the election, many pundits recommended jumping out of the market. Sadly, they are now significantly behind and are still waiting for their opportunity to get back into the market. Others got out during the 2008 Crash … and have still never gotten back in. The markets are seemingly biding their time and waiting for earnings to catch up with stock prices. Usually, you would have seen a sell-off by this stage in the cycle.

THREE PERCENT GROWTH 

To answer the question of why the market is going up, I’ve pulled some content from a recent article in the Wall Street Journal by Phil Gramm and Michael Solon. They were making an argument unrelated to the stock market, but I will use talking points from their article to explain the “why.”

Stock valuations are based on their underlying earning power. When companies are expected to make more money, their stock price goes up. Conversely, when companies are expected to make less money, their stock price goes down.

Complicating things, stock prices are not necessarily based on what is actually happening; they are based on investor expectations.

Looking at the big picture, GDP is a measure of the growth of the U.S. economy. In the postwar era, the U.S. averaged 3.4% annual growth from 1948 through 2008. We averaged 3% growth for half of the George W. Bush presidency (2003-06).

Only with 3% or higher growth does America experience measurable progress in poverty reduction, strong job creation and income growth.

Many talking heads argue that the days of 3% growth are gone and that America’s economy has lost its ability to grow at 3% above inflation.

From 2009-12, the Obama administration, the Congressional Budget Office and the Federal Reserve all thought they saw 3% growth just around the corner. If the possibility of 3% growth is gone forever, it hasn’t been gone very long.

America enjoyed 3% growth for so long it’s practically become our national birthright. Census data show that real economic growth averaged 3.7% from 1890-1948. British economist Angus Maddison estimates that the U.S. averaged 4.2% real growth from 1820-89. Based on all available data, America has enjoyed an average real growth rate of more than 3% since the founding of the nation, despite the Civil War, two world wars, the Great Depression and at least 32 recessions and financial panics. If 3% growth has slipped from our grasp, we certainly had it for a long time before we lost it.

During the Obama presidency, growth slipped to an unbelievable low of 1.47%. As a result, many Americans believe 3% growth is gone forever.

Phil Gramm argues that most of the growth constraints we face today are directly attributable to the Obama era policies. The Bureau of Labor Statistics reports that labor-productivity growth since 2010 has plummeted to less than one-quarter of the average for the previous 20, 30 or 40 years. Productivity fell during the current recovery, not during the recession. With high marginal tax rates, especially on investment income, new investment during the Obama era managed only to offset depreciation, so the value of the capital stock per worker, the engine of the American colossus, stopped expanding and contributed nothing to growth.

A tidal wave of new rules and regulations across health care, financial services, energy and manufacturing forced companies to spend billions on new capital and labor that served government and not consumers. Banks hired compliance officers rather than loan officers. Energy companies spent billions on environmental compliance costs, and none of it produced energy more cheaply or abundantly. Health-insurance premiums skyrocketed but with no additional benefit to the vast majority of covered workers.

In 2006, when the labor force participation rate was 66.2%, the BLS predicted that demographic changes would push it down to 65.5% by 2016. Under Mr. Obama’s policies, it actually fell further, to 62.8%, and the number of working-age Americans not in the labor market spiked to 55 million.

By waiving work requirements for welfare, lowering food-stamp eligibility requirements and easing standards for disability payments, Mr. Obama’s policies disincentivized work. Disability rolls have expanded 18.6% during the current recovery, compared with a 16% decline during the Reagan recovery.

If reversing the Obama era policies simply eliminated half the gap between the projected 1.8% growth rate and the average growth rates during the Reagan and Clinton recoveries, it would deliver 3% real growth generating nearly $3.5 trillion in new federal revenues over the next 10 years.

Since 1960, the American economy has experienced 30 years with growth of 3% or more. Seventy-nine percent of all jobs created since 1960 were created during those years. The poverty rate fell by 72% and real median household income rose by $20,519. In the 26 years when the economy had less than 3% growth, just 21% of all post-1960 jobs were created, the poverty rate rose by 37% and household income fell by $12,004. With 3% growth, the American dream is achievable and virtually anybody willing to work hard can live it.

BOTTOM LINE 

If you listen to the national narrative about how scary and awful things are, it makes no sense why the market continues to go up.

On the other hand, when you understand that as a result of our last election, most investors “expect” that there will be major tax, healthcare and regulatory reform that should take us back to the policies that brought us 3% growth, the upward market trend starts to make sense.

As always, let us know if you have questions or need anything from us.

Disclaimer: 1. Investment performance reflects time-weighted, size-weighted geometric composite returns of actual client accounts. 2. Investment returns are net of all management fees and transaction costs, and reflect the reinvestment of all dividends and distributions.  3. The S&P Index is a market-value weighted index comprised of 500 stocks selected for market size, liquidity, and industry group representation The Barclays Aggregate Bond Index is a benchmark index made up of the Barclays Government/Corporate Bond Index.  4. Benchmarks are used for comparative purposes only. The Paragon Top Flight Portfolio is not designed to track the S&P Index and will have results different from the benchmark. The Paragon Managed Income Portfolio is not designed to track the Barclays Bond Aggregate Index. 5. Past performance is no guarantee of future results. Investments in securities involve the risk of loss. Paragon Wealth Management is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from sources Paragon believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.