Oberservations and Outlook July 2017

Selected Index Returns 2nd Quarter/ Year to Date
Dow Jones Industrials    3.95%/ 9.35%          S&P 500   3.09%/9.34%         MSCI Europe   7.37%/15.36%

Small Cap (Russell 2000)   2.46%/4.99%     Emerging Mkts  6.27%/18.43%     High Yld Bonds   1.37%/15.3%

US Aggregate Bond 1.45%/2.27%   US Treasury 20+Yr   4.18%/5.66%    DJ/UBS Commodity -3%/-5.26%

2017 and its second quarter continue to be kind to financial assets, with both stocks, bonds and gold all climbing year to date.    European and Emerging Market equities have been the strongest this year, rising smartly after falling by 10% during the second half of 2016.  Emerging Market equity funds are back to a price area that stretches back to 2009!

Bonds continue to vacillate in an upward trend since mid-December. The commodity index is down primarily due to oil, as agriculture and base metals are essentially flat on the year after a recent climb.

Correlations between stocks and bonds have increased recently, with equities being flat over the past 6 weeks as bond prices have declined over the last two weeks.   While this phenomenon is negative for investors, equities appear to remain well inside their uptrend while bonds (and gold) appear to be near medium-term support levels.  We may see both stocks, bonds, and gold again climb concurrently reflecting a continuation of the year to date behavior.

What has been driving stock prices?  Growing earnings, low interest rates, lack of inflation, and ‘moderate’ GDP growth are the most common reasons to explain how prices have gotten to these levels.  Earnings have been on the rise since the end of the ‘earnings recession’ that lasted from June 2014 through March 2016.   After a decline of some 14% we’re now growing again, even robustly, given the low base from the previous year.  Earnings are still one or two quarters away from hitting new all-time highs, yet the S&P500 is roughly 20% higher than in early 2015.  The chart below gives us a visual of what prices rising faster than earnings looks like. Anytime the ratio is moving up indicates prices climbing faster than earnings.

shiller cape 6 30 2017Source: www.multpl.com

By this metric (and there are many others) stocks are valued at a level only exceeded by the roaring ‘20s and the dot-com era.  Can earnings continue to grow to support valuations?  The continued lack of wage growth and continued generationally low labor participation rate are headwinds to growth in consumer spending.  Consumer credit growth has slowed dramatically over the past six months and without wage or credit growth it’s difficult to see how the consumer will spend more to support ‘moderate’ GDP growth.  Low interest rates, or the comparison of low rates to dividend and earnings yield have provided much support over the past several years to the reasoning behind bidding up stocks faster than their earnings growth.

Interest rates bottomed one year ago at 1.3% (10-year treasury) and then ran up to 2.6%, mid-range since 2010 and the upper range of rates since late 2013.  The jury is out still on whether this marks the end of the bond bull market that has lasted since 1981.  The problem is that if consumers and businesses must increase their interest expense, there is that much less left to expand their consumption and investment.   Low rates had been a key enabler of more borrowing, leading to more consumption, and higher profits.  Now, in some areas, analysts are saying that higher rates are ALSO good for stocks because it represents growth expectations.  Frankly we’ve been ‘expecting’ growth now for several years, and the only positive representation of growth (GDP) we have seen is due to a willful under-reporting of inflation.   Gains in expenses in housing, healthcare, and education have far outstripped the general inflation rate.  At the same time, official statisticians tell us our TVs, cell phones, and other tech devices are far cheaper, because we ‘get more’ for our money.  This is called hedonic adjustments.  Look this up and you will understand why one’s personal experience with the cost of living doesn’t mesh with the official inflation statistics.

It seems the main reasons we are given for buoyant stock prices appear tapped out or stretched.  The thing is, it’s been like this for a few years now.  So then, what really is driving prices?  Some of it has to do with FOMO, Fear Of Missing Out.  No one wants to get left behind as prices rise, even if said prices already appear expensive.   As fundamentals have deteriorated over the past few years what is causing or who could be that marginal buyer who always seems to have more money to put towards financial assets? Perhaps this chart has something to do with it.

Central-Bank-Balance-Sheets-Versus-MSCI-World-Index

As central banks have purchased outstanding bonds (and equities in the cases of Japan, Switzerland and Israel among others) the cash or liquidity provided has found its way back into the equity markets.  Additional effects have been to put a bid under bonds, increasing prices and lowering rates.  What many investors in the U.S. don’t realize is that the European and Japanese central banks continue to this day putting approximately $400 billion per month into the financial markets.  If this is the true reason behind stock and bond price levels today, any cessation, slowing or even anticipation of slowing will likely have negative effects on asset prices.  The chart below shows where the U.S. Fed ended its QE efforts while Japan and Europe picked up all the slack and then some.  The astute observer can see where the Fed tapered, while the ECB was not adding liquidity, from 2014 to 2015.  From mid-2014 to early 2016, the Vanguard FTSE Europe ETF dropped by 29%.

central bank buying 4 2017

Beyond central bank liquidity creation there is also the concept of growth in the private sector.  Here too we see that a phenomenal amount of debt must be created to sustain growth.   New debt creation in China dwarfs the rest of the world.  China has put up high growth numbers the past several years, more than 7% annually.

private sector debt creation qe

Going forward it will be crucial to watch for central banks’ behavior as to ending current ‘QE’ policies.  Japan is still committed to a 0% 10yr bond rate, yet the ECB has begun to state that its bond buying won’t last forever, and is likely to slow by mid-2018.  The U.S. Fed has indicated continued tightening via rate hikes (likely one more this year) and to begin to let ‘roll off’ maturing bonds.  The roll-off will take liquidity from the markets.  It will start small and gradually increase in 2019 and thereafter.  These cessation tactics are done under the current understanding that financial conditions are ‘easy’.  Put another way, the banks will start to slow new liquidity and then drain liquidity as long as financial conditions, which include stock market levels, don’t get to difficult.   What exactly is the Fed’s downside tolerance is unknown.  What is knowable, is that the decision-making process takes months to be put into effect and by that time, markets could move down and growth could halt.

Near Term vs Long Term

The concepts of credit creation and central bank balance sheets and their respective monetary policies are will have impacts on asset prices over the longer term.   Year over year earnings growth forecasts, specific companies’ ‘beats’ or ‘misses’ and monthly data on inflation, job growth, and wages all have short term impacts on the stock market.  Currently, earnings are expected to grow robustly, official inflation is subdued and official unemployment are all in the “very good” range.  Combine that with the Fear Of Missing Out concept and that should help keep the markets up and even higher for a while longer.  The problem is that simply because we want markets to move higher doesn’t mean they will.  At some point paying 30x earnings will seem too expensive and the markets will lose some marginal buyers and some will become sellers, for whatever reason.   Based on current valuation metrics and the business cycle, we know that equity returns over the next several years will be very low.  If rates go up, and/or credit (the ability to pay) worsens for individuals and businesses bond funds will likely suffer as well.  Over the long term, avoiding large losses or drawdowns, even while lagging the market on the upside, can have a dramatic positive impact over a full market cycle.

What Can Be Done

If one suspects returns will be lackluster, and prices volatile, should one endure it?  The solution is at once simple and difficult at the same time given our cultural of equity ownership and the media’s constant focus on one asset class: equities.

Diversifying amongst the other 6 asset classes is a start.  Most advice revolves around two classes, stocks and bonds.  If one truly wants to buy low and sell high, one must identify the other areas that are “low”, increase exposure there, and reduce exposure to “high” asset classes.  Not only does this smooth out volatility but can increase long term returns.   Given the outlook for more volatility in stock and bond prices; very low prices (historically and relative to other assets) in precious metals, agriculture and oil; there should be many opportunities to take advantage of short term swings to benefit and move some ‘eggs’ from the equity side into other, non- and lower-correlated asset classes that are currently much lower in price.

Easier said than done, yes.  This is exactly why investors should seek out Investment Advisors willing to do this difficult work and that have a strategy to deal with changing markets.  For more information on how I am doing this for my clients, please contact me.

Adam Waszkowski, CFA

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable, but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

Observations and Outlook April 2017

Equity prices peaked on March 1 and have been sideways to down since.  Interest rates (10-yr treasury) peaked on December 16 and were nearly matched on March 10, but since then have declined, going slightly below the range we have seen since November 22.  Gold bottomed in mid-December (along with bond prices), climbed to a high in late February and as of today, is pushing through that high mark.    On balance, risk assets have ebbed lower while bonds and gold have increased in price since the end of February.  Bond and gold prices have climbed back to their mid and early November (post-election) levels.  This price action speaks directly to the “Trump/Reflation Trade” we hear about in the news.

Trump Trade Withers

trump trade

Source: heisenbergreport.com
The “Trump Trade” is seen to manifest itself in a rising US Dollar (green), higher stock prices (purple) and higher interest rates (blue).  The Trade has gone nowhere since mid-December, and was decidedly weaker as ACA reform failed to pass in Congress

The past five months’ gains in the stock markets have been widely attributed to the policies the new administration hopes to implement.   At the same time, U.S. corporate earnings ended an Earnings Recession, that had pulled down earnings to 2012 levels.   In the fourth quarter of 2016 the earnings recession ended and had been forecast to do so since early in 2016.   Most of the gain in earnings was due to the base-effect seen in the energy sector.  Energy sector earnings plummeted in 2015 and provided a low bar for earnings to cease its ‘negative growth’.     The two concurrent topics that coincided with the latest rapid climb in stock prices were the cessation of declining earnings, and anticipated policy changes along with their presumed financial impacts.

For the remainder of the year, the focus will remain on these two areas:  earnings and implementation of Trump’s promised policy changes.  The repeal and replacement of the ACA (Obamacare) did not occur and its unknown when it may.  Recently this was seen as the gateway to then reforming the tax code followed by a fiscal spending plan focused around a decrease in social programs, a large increase in defense spending and a $1T to $2T ‘infrastructure’ plan.   With the defeat of the first attempt to repeal and replace ACA, the collective Trump Trade was dealt a blow and the remaining policies passage and implementation are less certain.

Tax policy and regulatory reform are next up and as the conversation around these begins, it’s likely that hope of tax law change will increase. The expectation that these changes will have a meaningful impact on earnings and disposable income will buoy stock prices in the short term.  Passage, implementation, and resulting impacts of policy changes are literally a multi-quarter process.  During that time, as I indicated in January, markets are likely to swing up and down several percentage points as hope of passage and fear of failure compete for investors’ attention.

The low bar for the energy sector remains low, and analysts’ expectations for earnings to grow remains intact, supported by the lower-than-usual reduction in earnings forecast.  Often a full year’s earnings forecast can drop by 1/4 through the course of the year, and when we see earnings estimates decline less rapidly the end of year reduction is often more like only a 1/8 reduction from beginning of year estimates to end of year final numbers.   Current 2017 earnings estimates are $119.80, which is about 5% lower than forecast a year ago and 1% lower than forecast at the end of 2016.   Continuing this pace of reduction, an estimate for 2017 earnings is $112.50.    IF that number is accurate it puts the forward Price to Earnings ratio at 20.9, which is higher than 90% of all other time periods since 1900.   Longer term forward returns from this level are often in the low single digits.

Over short periods of time (less than 3 years) investors often bid up prices well above longer term averages, which we have seen since 2014 and the start of the earnings recession.  Stock prices have risen far faster than earnings have over the past 4 years and its likely with growth resuming we could see even more extended valuations.

Other Considerations

The 30-year bond bull market is not dead.   Over the past few years, the idea that low interest rates were the ‘reason’ one should be accepting of high stock valuations (high p/e ratio, low earnings and dividend yields).  More recently we are hearing that increasing rates are also good for stock prices.   For rising rates and rising stock prices to occur together, there is a fine line to be tread.  Not too much inflation, not too much of an increase in rates while companies grow sales and earnings.   Essentially, we need the rate of change in the growth rate to be bigger than the change in interest rates.   Given the Atlanta Fed’s GDP Now Forecast shows only .6% rate of growth estimated for the first quarter.   This rate is lower than the past few quarters while the yield on the 10-yr Treasury has gone from 1.33% to 2.37%.    It’s more likely that along with stock prices, bond prices will vacillate within a range as policy expectations evolve and we await economic growth.

10yr tsy yld

Additionally, we have seen this, and higher increases in nominal rates without the bond bull dying out.  Some may say that as our national debt and aging demographics continue, our interest rate outlook may be similar to Japan’s experience over the past 20+ years.

While the US Fed has ended, its bond buying (“QE”) the eurozone and Japan continue to add liquidity by buying government and corporate debt of approximately $300 billion per quarter.

central bank buying 4 2017

This is referred to as “Policy Divergence”.  While the ECB and Japan ‘liquidate’ their bond markets, the US has ceased and expectations are that the Fed will tighten/raise rates while Japan holds their 10yr at 0%.  This expected interest rate differential leads to changes in exchange rates.  The changes we have seen since mid-2014 is a much stronger US dollar.   There is nothing on the horizon that indicates this Policy Divergence will end, which should indicate a continued strengthening of the US Dollar.

usd eur bund rate differentialSource: SocGen

This chart shows how the relationship between interest rates corresponds (currently very tightly) with the exchange rate, EUR/USD.  The future path of the US dollar will be determined by US economic and Federal Reserve policy vs.  ECB and eurozone policy and rate of growth.  Since the US has the early lead, ceasing QE and beginning to tighten, along with a new pro-growth President, it’s hard to see how the US Dollar will weaken without dramatic shifts in US and ECB policies.

In Summary

The outlook for stocks and bonds remains:  choppy with large swells.   Since November, markets have priced in passage of, and perfectly positive impacts from, Trumps tax and reform policies.   While at the same time, earnings have begun to grow anew, but are only at 2015 levels.   This combination has made today’s equity prices among the most expensive in history.   The Hope and Expectations born from Trump’s election are still with us, despite the recent healthcare setback.  As such, stock prices may very likely become even more stretched (higher) as debate regarding taxes begins and evolves into the summer months.

Bonds were sold off very dramatically post-election and will likely continue to gain in price as uninspiring economic data comes in while we continue in our multi-year vision of “growth in the second half of the year”.

While earnings may be increasing, the age-old question of how much are investors willing pay for $1 of earnings persists.   Their ‘willingness’ is often derived from feelings and expectations of the future.  If the future appears bright, prices can appreciate.  Sometimes this appreciation begets its own feelings and can lead to further appreciation without commensurate changes in earnings.  The risk there is that of an ‘air-pocket’ where future expectations are cut to match a duller present and prices move accordingly.

Adam Waszkowski, CFA

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable, but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

 

The Definition of “Long Term Investor”

What is the difference between long-term characteristics of the market, and owning the market for a long term and how can an investor benefit from knowing the difference.

The phrase “Long Term Investor” is used quite often, and there are many definitions.  The IRS defines a long-term investment as anything held more than 1 year.  Most people though would agree that long-term refers to a much longer time frame, usually at least 5 years.  However, when we read about equity market statistics, we are shown 30 and often 70 or even 100-year time spans.  I saw a recent article with a 500-year time span.  Given the average human life span, and that our peak earning and accumulation years are from our mid-40s to mid-60’s, most investors actually have about a 20-year time horizon of accumulation.

A “long term investor” isn’t one who buys and holds for a long span of time.  A long-term investor recognizes the long-term characteristics of equity (and other) markets.  For example, over the very long term (+20yrs), earnings per share follow GDP growth, the average 20yr annualized return is just over 7% (with dividends adding to this), and that over shorter periods of time, actual returns can vary greatly from the average.  The long-term investor also understands that the averages over the more volatile shorter periods of time are the pieces that create the 20-year average. One can see the volatility, or range of returns, over shorter periods below.

1-3-5-10-20-yr-avg-returns-schwab-ctr-for-financial-research      Source: http://www.investopedia.com/articles/stocks/08/passive-active-investing.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186

The periods when we most often hear the phrase “I’m a long-term investor” being used, unfortunately, are when stock markets have experienced a significant decline.  To assuage the pain of real or paper losses, investors will often claim this characterization, with the unspoken assumption that ‘it will come back’.  And it always has, if you waited long enough.   From Charles Schwab Inc., via Investopedia.com we can see that yes, over very long periods of time, 20 years in this case, the market always has a positive return.

The chart below shows us the extremes. The low seen in 1979 to 1982 at about a 3% 20-year annualized returns, and the late 1990’s, from 1998 to 2001 which saw 20 year annualized returns over 13%.  While still positive, it’s much more helpful for an investor to invest over the right period! But how can one tell when ‘the right period’ might be at hand? Or even better, when the ‘wrong time’ might, so one can avoid a period of poor returns.  While not widely disseminated, missing the bad times has a far more powerful impact than staying invested, per this study by Meb Faber of Cambria Investment Management https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1908469

avg-20-yr-returnsSource: https://www.quora.com/What-is-the-average-S-P-500-return-over-20-years

So, while it is clear that, ‘in the long run’, if you wait long enough you will have positive returns.  From the chart above we can see that there are periods when long term returns are well below and above the 7% average.   How can we avoid being drawn into the low return eras?   Another long-term characteristic of equity markets is that Price to Earnings (P/E) ratios expand and contract.  That is for $1 in earnings, sometimes people pay $25 in price (a 25 P/E ratio) and other times less than $10.

For those well versed in market history, we know that the exemplary 20 year annualized returns seen in the late 1990’s, saw their birth in the low Price to Earnings era of the early 1980’s.  There are many studies showing how long term returns are borne from low P/E multiples.   Given that currently we are only beginning to enter the 20-years-later period after the dot.com bubble, we only have the first 20-year cycle from 1995, which gave us 7.3% annualized price growth.  Given that the late 1990’s saw large price appreciation, this acts as a headwind to the 20yr annualized returns in the next few years.  The S&P 500 started 1997 at 766 and if we end at 2200 in 2016 that will give us only 5.4% 20yr returns.  The S&P500 started 1998 at 963, and to maintain the 5.4% 20yr returns, the S&P500 would need to end 2017 at 2765, a gain of more than 25%!    The propensity is for the 20 year annualized returns to continue the downward slope that began in 2002 and likely repeat the bottoms like 1980, 1949 and four other periods where long term (20yr+) returns were very low.  The chart below is from Barry Ritholtz.

rolling-20-yr-returns-ritholzSource: http://ritholtz.com/2011/12/dow-jones-industial-average/

The results since this chart was created in 2010 are indeed following the red dashed line down.  Knowing that the market in 2000 was amongst the most expensive ever (highest P/E ratio) it should be considered that the 20 years ending in 2020 may see results that are amongst the worst in the past 100 years.  To have 0% return from 2000 to 2020, the S&P 500 would only need to decline by 31%, about the average for a bear market.   To have 2.5% annualized return from January 2000 to January 2020, the S&P500 would end 2019 at 2335, a change of about 6%, or only 2% annually.    The moral of the story is outlook for equity returns over the next 2-3 years is low and likely volatile, not a good risk to return prospect.

What Should One Do?

While 20yr annualized returns are slow moving data points, it’s clear that the long-term average is in decline.  Paying a high price (high P/E multiple) leads to poor long term returns is a slow lesson investors simply don’t have the time to learn from experience, and that many Baby Boomers can ill afford to learn now.

Knowing, or rather, expecting returns from stocks to be low going forward will enable an investor to seek returns from other asset classes.   Few Investment Advisors currently work with models outside of the traditional stock/bond portfolio mix.   An Advisor who recognizes that there are indeed 7 asset classes with which to pursue returns has an advantage.  Being successful at putting that understanding to work, is, indeed, the work of portfolio management.

Investors who want to earn returns in the medium term should look to other asset classes for returns, ideally ones that meet the ‘low’ metric for their markets.   True diversification is the call today, not simply bonds and stocks, but also commodities like oil and agriculture, precious metals and even cash.

If you would like more information on my Volatility Based Dynamic Asset Allocation process that seeks positive gains regardless of how equity or bond markets perform, contact me via email at awaszkowski@namcoa.com.

Adam Waszkowski, CFA

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable, but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

 

 

Is Your Portfolio Ready to Rumble?

It is hard to believe that tomorrow night the United States will elect a new President, and I believe it worth discussing political risk.  Political risk is the chance a business or industry one is invested in will realize a boost or drag to do external governmental action. I also separate political risk from legislative risk. A pure political risk would be, for example, the nationalization of a mining operation. The management team running the mine may be completely on point but the stock goes to zero because the government claims it for itself. Legislative risk, which we see more often in the US, would be several states legalizing medical/recreational marijuana which may impact some drug manufacturers, and increase sales of pizza and Clear Eyes.

I will say, as a holder of a BA in Political Science, this is a difficult system to successfully game. Instead of trying to reconfigure a portfolio to take advantage of industries that may benefit from guessing the election outcome correctly, folks are typically far better off either sticking to the investment plan they had worked out with an Advisor, or speaking with the advisor to see if the portfolio has exposure to a universally hated industry.

The nice thing with American Legislative/Political risk is that change usually takes a while unlike other countries which may disappear a CEO or two overnight. To sum things up, unless you have an edge stick to your plan. We will be back to examining earnings and other things that make a difference soon. 95% of the noise one hears has nothing to do with one’s portfolio. And lastly, if this election has caused elevated stress and blood pressure, here’s some nice music and pictures of cute animals:

Disclosures

 

Cashing in on your Household Spending

Feeling a bit frustrated with your spending each month? Perhaps changing your mindset and approaching your house hold spending as an investment opportunity could be just the silver lining to cheer you up.

When was the last time you saw your cable provider lower their price instead of increasing it? Also, per the U.S. Department of Agriculture, over the last 10 year’s food cost has risen 30% for a family of four with children under 5 years of age. While the cost of living continues to increase each year so does the earnings and dividends of some of the companies which you buy your products and services from.

The NAMCO Monthly Needs Portfolio is designed to take advantage of this type spending. Of the 22 current stocks in the portfolio on average they have raised their dividend 7.07% in 2016. This is 5.57% higher than the inflation gauge of 1.5% (Consumer Price Index for All Urban Consumers 12 months Sept. 2015 to Sept. 2016). As of October 31st, 2016, the dividend yield for the portfolio is 0.51% above the same inflation index, and that is with 21.57% currently in cash.

So, as you know, even in good times or bad folks will eat, drink, drive, cut your lights on, take a bath, and carry your garbage out.

For more information and performance on this portfolio go to:

Walter M Hester Sr. Portfolio Manager

11/07/2016

Disclosures

Archived Portfolio Commentaries

Adam Waszkowski, CFA manages a series of balanced, risk-based portfolios.  Each portfolio is designed to offer investors returns based upon the investor’s tolerance for risk and volatility. Additionally, as market conditions change, the managers may increase or decrease exposure to asset classes in order to increase risk-adjusted returns.

Please contact Adam Waszkowski, CFA, awaszkowski@namcoa.com for permission as to redistribution of any of this report.