Client Note December 2019

December was another strong month for US (+2.8%) and global equity markets (1.8%). Junk bonds gained 1.1% in price while treasury bonds were off, giving the Aggregate Bond Index a slight decline.   Federal Reserve intervention, beginning early September, as a result of the overnight inter-bank lending drying up, has totaled some $400billion.   The rate of additions to the Fed balance sheet, is faster than in QE 2 (Nov 2010-June 2011) which took 8 months to add a similar amount.  QE 3 was larger, adding $1.7 trillion, over 2 years.   Central bank liquidity is the primary driver of 4th quarter equity market gains.  Economic data and earnings growth remain slow and near zero.

Portfolios gained across the board in December averaging approximately 2%; owing largely to our individual stock holdings and exposure to gold and miners.  Bonds were muted and were a drag.  Bonds look best posed to gain in the near term. Gold can extend further, and stocks have hit a speed bump with the turmoil in Iraq/Iran and may be slightly choppy in the immediate term.

Gold and gold miners gained 3.6% and 8%, respectively, in December.  Both bottomed November 26th and earned most gains in the last week of December, prior to the assassination of the Iranian general.  International stock markets have outpaced US stock markets since 10/15 (as forecast in October’s Note).  Commodities, ex-US equities and gold have gained significantly since the US Dollar peaked October 1, and its most recent lower high, on 11/27.    The dollar has broken down and may find support another 1% lower, matching its level in late June, which would be 3% decline off its high on October 1.  A small change in the value and direction of the US $ can have large impacts on metals and other natural resources.

The decline in the US Dollar corresponds well to the Feds telegraphing its intentions to refrain from raising rates in 2020.  The dollar can fall/rise relative to other currencies for a variety of reasons.   The current decline is not getting much attention.  Most finance headlines are full of talk about “reflation”.  Given the SP500 is off its all time high by a mere .75%, its not a reference to stock prices.

Reflation, is the topic du jour.  This term refers to economic data.  Federal reserve interventions impact the markets first with a much longer lag to the general economy.  China’s recent modest liquidity injections are: 1) much smaller than in 2017 and 2014 and take about 6-9 months to impact the US/global economy. Positive economic data from central bank actions will take at least one quarter to begin to show up.  Easing amongst central banks is as significant today as during QE 2.  CBs have completely discarded the concept of ‘normalization’ over the next year.

The biggest risk I see in the immediate term is the start to earnings season.  Earnings estimates for the 4th quarter, as usual, have declined substantially over the past year.  IF stocks can ‘beat by a penny’ reduced earnings estimates, we should get through with only minor stock market fluctuations.  Conversely, if companies’ lower guidance and/or miss low estimates, we could see a more general ‘correction’.  Bonds appear to have completed a 4-month consolidation and any more gain will give it some momentum, while stocks consolidate 4th quarter gains.

Slow economic growth, questionable earnings growth and the ever present geo-political risk are risks to the stock market.  With bonds and gold looking up for a variety of reasons, diversifying across asset classes (into areas not correlated with the stock market) is always a prudent approach.

Adam Waszkowski, CFA

Market Volatility–October

I believe we’re seeing a large repricing of growth expectations. The one time tax reform boost will wear off into next year, and higher borrowing costs, fuel costs are reducing discretionary income. 

In addition there is a great deal of leverage in the markets which will exacerbate declines. 

Often, at the end of bull markets/beginning of bear markets we will see relatively large price movements, 6-12%, down and up. I believe this correction has a good chance of bottoming or at least slowing in the immediate term, and  it’s bounce back could be half the decline, maybe more, which will be several percentage points. 

 

Focusing on keeping portfolio declines to the single digits while raising cash to be able to redeploy later can aid longer term returns–one has to have cash in order to buy low!   There is a very large amount of ‘bond shorts’ in the market which could set up a large ‘short squeeze’. Bonds were positive today. This is reminiscent of other recent periods when many bond speculators saw bond prices move very rapidly against them (UP) as they rushed to cover their deteriorating short positions.

 

Inflation scare is not the culprit here as inflation rates are slowing in several areas.  Something recent is that with the Fed raising interest rates, the yield, on 1-year and longer bonds is greater than inflation,  a positive “real rate” which is new to this economic cycle and takes a lot away from the ‘bonds dont pay so buy stocks’ argument.  The Fed further reiterated that it currently plans to continue to raise rates through 2019–even though we have already raised rates MORE than in past rate-raising eras.  I will have a chart of this in my Observations and Outlook this weekend.

Please reach out to me with any comments or questions.

 

Adam Waszkowski, CFA

April Recap: Narrative Changes

Stocks rose a fraction of a percent, gold fell 1%, and the bond index fell 1% in April, continuing the very choppy sideways price movement we’ve experienced this year.   The month ended just below middle of the price range we’ve seen since the market top on January 26th.

Over the past few weeks, earnings have been spectacular, growing over 20% on an annual basis.  Unfortunately, stock prices have not reacted well to this great news.  Earnings season appears to have a ‘sell the news’ feel to it.  This could support the notion that stocks were priced to perfection going into reporting season.    The decline in prices and increase in earnings has reduced the market P/E (Price to Earnings) multiple, which could allow stocks to rise back to January levels.   Tax Reform has accounted for about 1/2 of the earnings growth.  There are two issues going forward.  One is that continuing

to grow at that pace will be difficult since we cannot cut taxes every year (and the tax changes to individuals are front loaded—the reductions we have seen will fade in the coming years). Secondly, earnings’ growth slowing, even from 20% to maybe 12%, can be seen as a negative: “slowing earnings growth”.   Surprising positive economic data because of tax reform needs to show up immediately, otherwise, the ‘hope’ baked into stock prices may be removed in the coming months.

Through the month of April, the narrative of ‘global synchronized growth’ has changed as European economic data has come in softer than expected and the US economy has pressed on.  So now we see the US as a main driver of global growth.  In the very short term, this narrative change has given the US Dollar a boost up.   Over the past few months, ‘dollar short’ and ‘rates higher’ have been very popular trades and have begun to unravel.   A stronger dollar will do harm to future US corporate earnings, make $-denominated emerging market debt more difficult to pay back, and serve as a headwind to ex-US assets (emerging, Asian and European stocks and bonds).  And slower growth will not support higher rates for longer term bonds.

The change in the growth narrative/data has been substantial enough for the Federal Reserve to remove from its FOMC Statement, “The economic outlook has strengthened in recent months.”   Often the Fed will change a word or two in certain sentences.  They could have change it from ‘strengthened’ to ‘remains strong’ or ‘continues to expand’.  Instead they dropped it altogether.   This is influencing perceptions of how many times more this year the Fed will raise short term rates.  In the WSJ today the front-page headline, “Fed is On Course for Rate Increases”.  Given the boldness of this headline, its odd to see in the article an inference that even if inflation was stronger, the Fed wont raise rates more than already indicated, which is twice more this year.  There is a dichotomy in the Fed’s statement: taking out the growth story but keeping to the idea that rising inflation is OK, or even good.  Last time I checked, slowing growth and rising interest rates weren’t a good combination: stagflation.   The Fed needs to review the difference between ‘cost-push’, and ‘demand-pull’ inflation.

AAII sentiment for the week ending May 2 came out this morning and Bullishness declined, and Bearishness increased.  This is as expected given that stocks were down over those survey days.  Bullishness isn’t quite as low as I’d like to see for a good bottom, but if stocks can undercut February’s lows, we should see Sentiment get negative enough to support a rally in stock prices going into the late Spring.

Adam Waszkowski, CFA

Observations and Outlook January 2018

Maybe.  It is a reflection of investor expectations though.  One can infer this by assuming investors own what they think will go up in price and therefore is investors are very long, then they expect prices to rise.  The American Association of Individual Investors (AAII) recorded the highest level of optimism in 7 years, since December 2010.  The historical average is 38.5%.   In an article from AAII, dated January 4, 2018 they review how markets performed after unusually high bullish and usually low bearish sentiment readings.

From AAII:    “There have only been 46 weeks with a similar or higher bullish sentiment reading recorded during the more than 30-year history of our survey. The S&P 500 index has a median six-month return of 0.5% following those previous readings, up slightly more times than it has been down.   Historically, the S&P 500 has realized below-average and below-median returns over the six- and 12-month periods following unusually high bullish sentiment readings and unusually low bearish sentiment readings. The magnitude of underperformance has been greater when optimism is unusually high than when pessimism has been unusually low.”

This does not necessarily mean that our current market will decline rapidly.  Actually, AAII finds that while returns are below-median, they are positive.  Positive as in ‘above zero’.   Sentiment drives markets and when sentiment gets too extreme, either in bullish for stocks or bearishness for bonds or any other financial asset, returns going forward are likely to disappoint.  If everyone has bought (or sold) who is left to drive prices up (or down)?   What we need to recognize is that investors become optimistic after  large advances in the stock market, and pessimistic after declines.  UM-Probability-of-Stock-Mkt-Rise-Oct-2017-1024x705_thumb1

Again, this chart above does not mean we are about to enter a bear market.  It only shows the markets progress at points of extreme optimism.  We can see in 2013 into 2015 rising expectations and a rising market as well as from 2003 to 2007.   Now that we can visualize the mood of the market, lets review some other metrics from 2017 and what is in store for 2018.

2017 was interesting in several areas.  It was the first time in history the S&P500 had a ‘perfect year’ where every month showed gains in stock prices.  We are also in record territory for the longest length of time without a 5% pullback, almost 2 years.   Historically, 5% drawdowns have occurred on average 3-4 times each year.  In addition to price records, there are several valuation metrics at or near all-time records.    The ‘Buffet Indicator’ (market capitalization to GDP) just hit 1.4, a level not seen since Q4 1999.  “Highest ever” records are exceeded well into mature bull markets, not the early stages.  Stock markets generally spend most of the time trying to recover to previous highs and far less of the time exceeding them.    Momentum and priced-to-perfection expectations regarding tax policy are driving investors to be all-in this market, as reflected by Investors Intelligence Advisors’ (IIA) and American Assoc. of Individual Investors (AAII) stock allocation and sentiment surveys each at 18 and 40-year extremes.  Combined with the Rydex Assets Bull/Bear Ratio, at its all-time extreme bullish reading, it’s difficult to argue who else there is to come into the market and buy at these levels.

However, bullish extremes and extreme valuations can persist.  Their current levels do likely indicate that we are well into a mature bull market.   The bull was mature in 1998 too and went on to get even more extreme.  This is the case many perma-bulls trot out, that since were not as extreme as 1999, there is plenty of room to run, and ‘dont worry’.

The US Dollar and Quantitative Tightening

The current ‘conundrum’ is why is the US dollar so weak?  We have a Fed that is raising interest rates growth likely to exceed 3% in the fourth quarter.  Usually a rising currency would accompany these conditions.    The dollar declined throughout 2017.  This was a tailwind for assets outside the U.S. whose value in dollar terms increases as the dollar declines vs foreign currencies.   If the dollar begins to move back up this will be a headwind for ex-US assets and for sales/profits to large companies in the S&P 500 who do almost half their business outside the U.S.

In addition, central banks have given notice that, while the Fed ended QE in late 2015, other central banks are beginning to end their programs with the European Central Bank reducing its bond purchases from 60 billion euros per month to the current 30 billion, and down to 0 in September 2018.   The Bank of Japan (and the Japanese Pension Fund) have declared they are reducing their purchase of stocks, bonds, and ETFs.  Only China hasn’t formally announced and end to market interventions.   Most pundits are pointing to the bond market as the area that will be most affected.  Possibly, but to claim that bonds will get hurt and stocks will be fine is ignoring how global equities have performed hand-in-glove with banks’ liquidity injections over the past 10 years.  Both stocks and bonds will likely be affected.

Yield Curve Inversion (or not)

I102YTYS_IEFFRND_I30YTR_chart

The chart above shows in red the persistent decline in 30-year treasury rates.  This week Bill Gross called the bottom (in rates, the top in prices).  This may be premature as one can see dips and climbs over the past few years, all of which have been accompanied by calls of the end of the 35 year bond bull market.

What is more interesting is that in the past 3 recessions, the yield curve as seen through the 10-2 Year Treasury Yield Spread declines, through the zero level (aka inversion, 10yr bonds paying less than 2 year notes) before a recession.   Our current level of .5% is not far from zero.   Most people are waiting to see it invert before saying a recession in on the way, often adding it will be a year beyond that point.    If one looks very closely at the chart we can see said spread actually increase after bottoming out, just prior to a recession starting (which wont be officially recognized until 6-8 months along).   While there are different factors influencing the 2yr and the 10yr rates, a spread widening might be a more important development than continued compression.

Finally, what does all this mean for an investor.   In short, we must all recognize that a 24 month span without a 5% decline is extremely unusual, as there are often 3-4 in a given year.   Also that when investors are most optimistic, returns often lag with the more extreme readings leading to more significant changes.  Mature bull markets eventually end and investors with a longer term horizon need to have a strategy not only for growing their investments, but also protecting the gains one already has.

We all know how to deal with a bull market, but few people have a strategy on how to deal with a bear market.

Adam Waszkowski, CFA

Vote at the Polls, Not with Your Investment Portfolio

As I was watching game 7 of the World Series the other night, I knew there could only be one winner of the game and the overall series, and I was OK with either team being crowned champion, as both the Cubs and the Indians were long overdue to lift the curse overhanging each team. I offer a hearty congratulation to the Cubs and their legions of dedicated fans.

Winning in baseball seems way more civilized than what we’ve seen in the Presidential race. We knew it would be ugly, but it’s worse than that and now both sides are pulling out scorched earth negative ads in the waning days of the election, Tuesday, November 8th.

A week or two ago, literally most pundits and voters alike were all concluding that Hillary Clinton was heading for not just an election win but a landslide victory. Now with polls basically a toss-up, uncertainty over the outcome is upsetting investors and they’re selling their investment funds.

One of the key reasons why angst is mounting is because investors believe that the combination of the continued investigation around Clinton’s emails and Trump’s potential unwillingness to concede could create a rather messy post-election situation. And, there’s no shortage of attention on what Trump or Clinton would do as President.

Living in California, I feel there are way more pressing matters – 17 state propositions and 24 propositions in San Francisco (collectively, nearly 550 pages of voter guides for me to peruse). Regardless of the Presidential race (let alone a few tight Senate races across the country), voters are ready to make some big changes locally and at the state level.

As for investors, uncertainty and nervousness is reaching a crescendo in the final pre-election days. Unfortunately, the election noise is blocking out some positives in the economy and corporate results.

3rd quarter earnings season is basically over, and it was a pretty good one. According to FactSet, 85% of the companies in the S&P 500 have reported earnings. The blended earnings growth rate for the S&P 500 is 2.7%. If that reported growth in earnings holds for the quarter, it will mark the first time the index has seen year-over-year growth in earnings since the 1st quarter of 2015, ending a 5 quarter negative trend.

Additionally, the latest batch of U.S. economic data doesn’t appear to foreshadow an imminent recession, which would typically lead to a bear market (20% correction) — consumer confidence (while shaken by political theatrics) has remained strong; housing looks good; the labor market is resilient; and wages are finally starting to rise (+2.8% year-over-year). Additionally, we’ve seen both revolving consumer credit and bank loans increase, indicating consumers are becoming more comfortable in taking on debt. None of this portends that anything bad, economically, looms on the horizon.

sp-tumbles-below-technical-levelHowever, given all of the anxiety around the upcoming election this Tuesday, investors’ fears have weighed on U.S. and global markets. U.S. stocks (as measured by the S&P 500) have fallen to their lowest levels since July, breaking below chart levels that have held for four months (as shown in the accompanying graphic). Concerns over Presidential and Congressional elections as well as an impending Federal Reserve rate hike in December have stoked investors’ desire to move to the sidelines and sit idly in cash.

Somewhat offsetting this negative trend was data on the labor market (out this past Friday morning, Nov. 4th) that showed solid progress at this stage of the business cycle. And stocks have dropped to a potentially oversold territory where the forward 12-month P/E ratio for the S&P 500 is 15.9 (based on the S&P 500’s closing price of 2,089 on Thursday, November 3rd, according to FactSet).

Uncertain times typically provoke investor concern and an urge to fiddle with portfolios and the 2016 Presidential election season seems to be heightening that trend. According to new research from BlackRock (one of the world’s largest asset managers and owner of iShares ETFs), in the run-up to the presidential election nearly 2/3 (63%) of Americans have made portfolio decisions in direct response to election uncertainty. Some of those decisions, however, might be ill-suited to long-term realities.

Research by BlackRock makes clear that many investors pondering the election’s potential impact could benefit, over the long term as well as now, from reviewing some portfolio essentials.

BlackRock recently surveyed more than 1,600 Americans, ages 25-74, on topics ranging from their financial future and investment concerns to portfolio changes, with special emphasis on the 2016 election. You can find the full extent of the survey here — BlackRock Investor Pulse Survey: Americans View Presidential Election As Pivotal For Investing, But Staying Focused On The Long-Term.

There’s no question that the election is much on the minds of American investors. About 1/3 feel it poses a threat to their financial future; 3/4 believe it will have a greater impact on their personal finances than the 2008 election (the last time there was no incumbent president running).

Furthermore in their study, nearly 6 in 10 also say the potential impact on their savings and investments will be an important factor in their vote. Many aren’t waiting until the election to see how that impact plays out. Among Americans saying they’ve already made an election-driven portfolio change, the most likely move has been classic risk off behavior: A net 12% of Americans said they’ve added to cash or savings accounts.

An appropriate cash allocation is part of many good investment strategies, but the fact remains that such positions earn investors very little to nothing in the current market environment. Compounding the potential problem is that, for many, cash allocations are already quite high — about 67% percent of personal portfolios overall. Even millennials, seemingly best positioned to shoulder long-term investment risk,  are over-allocated to low-yielding cash; it represents 69% of their portfolios (according to BlackRock).

For many Americans, then, an affinity for cash seems not only a short-term reaction to election uncertainty, but also a longer-term portfolio commitment, with potentially troublesome implications for achieving long-term goals of wealth accumulation.

While this Presidential race is having an outsized impact on investor behavior; historically, most people let their political fervor drive them to the polls but not out of the market.

If theirs is a positive spin on all of this, it’s that many Americans have bigger fish to fry. Again, according to the study, they have not lost focus on long-term issues that arguably have even greater impact on their finances — higher than the election on the list of perceived threats to their financial future are the high cost of living (52%), health-care costs (46%), Social Security changes (40%) and the state of the American economy (36%).

When it comes to politics, investors need to vote at the ballot box, not with their portfolios. Investors pulling out of the market in response to their fears of a Clinton or a Trump presidency isn’t a good idea, even though both candidates elicit intense reactions.

Our investments should be driven primarily by our own personal circumstances, not our political convictions. Short-term thinking rarely helps us meet our long-term financial goals.

Unfortunately, political campaigns engage our emotions. When it comes to investing, though, emotions aren’t usually very helpful. This extraordinary election gives us an extraordinary opportunity to keep calm and invest rationally.

With election day upon us, it remains an anxious time for investors. But that offers up an opportunity for advisors in providing guidance as the divisiveness we’ve witnessed won’t dissipate post-election. In fact, about ½ (52%) of all Americans—and 72% of advised Americans—say that market volatility this year has made them more interested in professional financial advice.