Client Note April 2021

May 10, 2021

The close of April brings us 1/3 of the way through 2021.  After a very rapid start in January and subsequent pullback, April was a strong month across all asset classes.  For the month, the S&P500 gained 5.8%, gold gained 3.8%, corporate bonds gained 1% and long-term Treasuries gained 2.4%. Stocks in Asia have weakened while European shares have been catching up to the US.  Portfolios gained in April and the average Moderate portfolio is up 6% year to date.

We are still in a “value over growth” market, where traditional industries like materials, industrials, financials, utilities are outpacing the growth areas like technology and biotech.  We had been in a market were large-cap growth” (aka technology, aka FAANG) and small-cap stocks had been dominating, but since mid-February markets have been driven by dividend paying stocks and other cyclical areas.  This will likely continue until evidence that we are not going to grow as rapidly as investors currently believe.   Friday’s massive miss in unemployment (1million new jobs expected; 266,000 actual) may be the first data point that could show a much more moderate pace of growth going forward.

The still high expectations of rapid growth see inflation data as evidence that the economy is about to run red-hot.   If we read below the headlines, we can see that commodity prices like lumber are being driven by more than US housing demand.  A years-ago beetle infestation in Canada has limited US lumber imports; sawmill shutdowns due to Covid, AND housing have been sources of supply disruption.  The combination has pushed prices to extreme levels.  China is the world’s largest consumer of raw materials.  China’s early control of Covid-19 and truly massive stimulus spending (approximately 10% of GDP in 2020) has underpinned demand for such commodities and agricultural products.    This makes much more sense than inflation driven by US aspirations to get back to pre-Covid levels, which saw sub-2% growth for several years.  In addition, supply chain disruption due to a varied array of local shutdown conditions across the US has made year over year comparisons and identifying specific bottlenecks a challenge.   Currently, China’s credit impulse is on the wane, while US stimulus takes the reins in 2021.  US stimulus usually takes longer to impact the economy, however.  In the longer run, the US needs to maintain our reserve currency status—by creating enough US dollars for the rest of the world to use—but that is a topic for another day.

I expect forward-looking estimates of growth in the US to decline to more normal levels and at the same time, interest rates and inflation expectations to decline moderately.  Interest rates have been sideways now for almost 10 weeks. I will be looking for further confirmation of this in economic data into the end of the quarter.

 

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.

Client Note March 2021

April 13, 2021

The first quarter was marked by two distinct phases. The first phase was a continuation of markets climb from the late October early November lows which peaked in mid-February. The second phase was characterized by a distinct outperformance in value or cyclical areas of the market. This is the third instance in the past 16 months where we have seen value outperform growth.  Generally, this does not persist for more than a month or two.

The S&P 500 gained 5.5% during the first quarter while the aggregate bond index fell 3.7%.  Oil gained 26%, aiding the energy sector’s gains of 31% and gold fell by 10%    Corporate bond prices fell by 5.4%. Junk bond prices were unchanged.  This is a slightly odd relationship, but indicative of ‘risk-on’ alongside a rise in interest rates.   The gain in the general stock market and decline in bonds (and gold) left most balanced and multi-asset portfolios flat or in the low single digits.  With energy up, bonds and gold down, and seemingly only the largest companies are carrying the general stock indices higher.

Most recently, gold appears to have formed a “double bottom” in late March and has made slight gains. Stocks continue to grind up, but with the largest names leading.  This contrasts with the period from April 2020 to February where micro- and small-cap stocks dramatically outperformed large stocks.  If we do not see a re-rotation into smaller stocks and those outside the major indices may be the prelude to a larger market pause in the coming months.

Bonds too may have realized a bottom in mid-March as prices have been net sideways.  A bit more improvement in prices (rates lower) should begin a nice rally, giving a reprieve to the general investor who have gained in stock prices, but lost some on bonds, especially for the more conservative.

How could or would interest rates actually decline?  Again, we see in the media how ‘everyone’ knows rates are going higher and inflation is at the door due to either ‘cash on the sidelines’ (doesn’t exist), or bank savings, or ‘pent up demand’.  Once ‘everyone’ knows something its more likely the near-term trend is over or soon will be.  We may already see this in gold and bonds, as interest in these areas is low, while SPACSs and cryptocurrency are all the rage currently.

Inflation concerns are due to the recent and quick rise in rates that have its roots in price increases due to supply-chain problems and the Asian/China resurgence and stimulus.  Supply chains issues will be resolved on their own in short order.  High prices attract businesses to produce more/fix problems which lead to lower prices, the essence of a free market.   Very recent news tells us that China’s credit impulse/stimulus has begun to wane.  The past 10 years we have seen two previous large credit cycles in China.  China is a massive buyer of raw materials and we have seen prices in commodities rise the past year driven by easy money from China.  There is about a 3–6-month lag time until we see the impact of a change   in China’s rate of credit creation.   Given that this China credit data is already 4 months old should mean, as recent price action alludes, a decline in interest rates and commodity prices and thusly, inflation expectations.

While stocks look to have another 5-7% upside momentum, the asset classes that have faired worse recently should see gains alongside stocks.  As mentioned in the past Notes, its post July 4 that concerns me the most when we may see a flattening of economic growth and decline in expectations of rapid growth which can weigh on risk assets.

The reason I am concerned about the second half of the year comes from a few places.  Valuations are exceptionally high right now.  Many metrics are above 1999 levels.  This is commonly discounted due to the low interest rates.  If we are elevated over 1999 levels, how much more elevated should we accept? Another element to today’s market is the ever-present Fed liquidity.  Yes, the Fed could continue as long as there is dollar-denominated debt to liquify.   And finally, there is the current expectations that we are entering a new era of high growth.   Its this last item that is most sensitive to changes in short term economic and Covid data.

The high growth thesis stems from stimulus in the pipeline and the observations that inflation is occurring.   Stimulus, or government infrastructure spending will take years to filter through the economy.  Inflation as measured by the CPI varies greatly, while the PCE is smoother (and what the Fed watches).  One can clearly see the past overshoots of the CPI vs. the PCE, and PCE is trending down.  Once supply chain issues are resolved/lessened and Chinas credit impulse fade, its likely CPI will catch down to PCE.

If inflation expectations come down, while job growth and spending data come in cool, beginning in the next few months, we could see forward expectations and valuations come down, pulling ‘risk assets’ with it.  Add in any kind of Covid 4th wave or failure at herd immunity via vaccinations, we could see the most powerful driver of asset prices, optimism, take a hit; and along with it create a more volatile period for stocks.

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.

Client Note July 2020

After a brief pause in June, financial markets continued their climb, trying to get to even on the year.  Of the major indexes, only the tech-heavy NASDAQ has managed to make new all-time highs.  The discrepancy across indexes is significant.

Off its all-time high             year to date price return

The Dow:                              -10% (Feb 2020)                                  -7%

S&P 500                                 -4% (Feb 2020)                                 +1%

Russell 2000 (small cap)    -12%   (Jan 2020)                               -10%

NASDAQ                                  -3% (July 2020)                                 +20%

EAFE (Eur/Afr/Far East)      -15%  (Jan 2018)                                 -8%

 

Inside the NASDAQ, the top “6” holdings are Apple, Microsoft, Amazon, Facebook, Alphabet A shares and Alphabet B shares.  These 5 stocks make up 44% of the index.  What this means is that only a handful of stocks, in one sector, are keeping the overall indexes up.  One can say, “so goes tech, so goes the markets”.    US mega cap growth/tech has been the only game in town.   More recently tech has weakened against the rest of the market.   If tech loses it dominance without another sector or two to take the reins, equity markets will have a bumpy second half 2020.

Portfolios I manage continue to do very well.  Gold is in the news a lot recently.  Over the past 15 months, gold has dramatically outperformed equity markets, and climbed 65% since November 2018.  The last 15% of that has come in the past two weeks.  Trimming and taking profits is on the schedule for August.   The individual stocks I choose from time to time have become a mixed bag.  IRBT and APRN recently reported significant upside earnings surprises, only to be sold off hard.  I am seeing this in several areasIts feeling like a ‘sell the news’ kind of market.  After a 50% climb since the March lows, its not inconceivable that stocks will take a breather.  Perhaps even give back some as we adapt to living with Covid19.     Clients can probably observe the steps I have taken to reduce exposure and take some profits, so that if/when we get a correction, it should not be too painful.

July 30, 2020 has the potential to be a historic day.   GDP for the second quarter 2020, covering March 30 through June 30 will be released.  Current estimates are to see a contraction in US GDP of -30%.  This would be the worst quarter since Dec 1946 and sets up the worst year since then as well.  While this is widely known to people who follow it, I am sure it will be a shock to some, and widely covered in the financial press.   In addition, all the tech stocks mentioned above will report earnings.  They will all be very profitable, but if this is indeed a ‘sell the news’ market, beware.  Microsoft already reported on July 22, beating estimates, and was sold off by 6%, recovering only a part of that decline this past week.

The economy is not coming back as fast as hoped and is already showing signs of levelling off.  Roughly 10% of our economy has disappeared (hospitality/tourism).   As long as the Fed promises, and CONTINUES to inflate the monetary base, financial markets can remain elevated However, if a small correction gets out of hand, the Fed has little influence in the very short term—and not much new to offer.  .  The real economy however will not come back without greater spending from consumers and businesses—either through earned wages, or stimulus, or loans/credit.

 

Adam Waszkowski, CFA

Client Note May 2020

June 1, 2020

Like April, equity markets started the month of May off slowly, but over the past 10 days, the S&P500 has gained roughly 4.5% on the month putting it at -5.7% year to date.    International equity indices gained a bit more for the month but continue to lag the U.S. by a wide margin.     Bonds were generally flat, with junk bonds moving up alongside stocks, while a small move up in interest rates pushed the long bond (TLT) down slightly on the month.   Gold moved up almost 3% on the month, after being up almost 4% mid-month.  And our individual stocks continue to do well, enabling our average moderate portfolio to add just over 3.5% for May and for year to date returns approaching 4%.

Looking ahead, it appears investors are pricing the market in expectation of a solid second half recovery and near full economic recovery into 2021.  While investors have bid up prices in anticipation, there is a loooong way to go to recover from the sinkhole we are in.   Current earnings estimates for second quarter are expected to drop 35%, reflecting a full year estimate of around $100/share of the SP500. If that occurs and the expected earnings bounce in Q3 and Q4, we have a forward Price to Earnings ratio of 30x, which is extremely expensive.  We will see earnings in mid-July; first read on GDP at the end of July; and all the while we will see employment numbers each week.   On going jobless claims have now exceeded 20 million, reflecting an unemployment rate a bit under 15%.   Economic data will remain dire.  The hope is that employment and spending figures rebound rapidly in the coming weeks. 

As mentioned last month, the expectations and sentiment that direct short term prices are well ahead of actual improvements in employment or spending (declining).  We have made significant progress in flattening the curve with the virus.  We have seen stock prices climb dramatically alongside the hope of a rapid economic recovery. However, we are seeing an even more stretched disparity between current prices and reality on the ground.  This does keep markets at risk of wide price vacillations.

Attaining and holding 3000 on the SP500 does allow for further upside in the markets and while I rotate out of individual stocks that have lost their ‘mojo’ (or take profits), there is another handful I am tracking and may show up in portfolios in the coming days.  In my April Observations and Outlook, with tongue firmly in cheek, I outlined a path for stocks to 4000 if the Fed continues to add liquidity/monetize debt. Since that writing, the Fed has covered a quarter of that quantity.  The rise in the Fed balance sheet has paralleled a rise in equity prices. The Fed continues to plan for and express willingness to continue its balance sheet expansion in pursuit of its stated mandates: full employment and stable prices.

Prices across virtually all asset classes remain constructive considering Fed actions and optimism towards renewed economic vigor.  State re-openings have occurred, and the expectations are for rapid improvement in employment and spending.  There is a nascent uptick in the outperformance of equal-weighted and value indexes versus the general market.  This market characteristic often shows up at the beginning of economic expansions and longer bull markets.  June’s economic data and market price action should give us a great deal of insight into the remainder of the year.

Adam Waszkowski, CFA

Client Note April 2020

Equity markets moved up strongly in April.  The S&P500 moved up 12%, and currently off 3% from the April 29th intraday high.  Gold jumped early in the month, then flat for a gain of 7% in April.  Long treasury bonds moved up in price by 1% but have been on the wane since April 21st.   Most asset classes have been rangebound (+/-3%) since early to mid-April, reflecting a decrease in market momentum.  The average moderate portfolio gained approximately 9% vs the SP500 gains of 12% in April.  Year to date, through April 30, SP500 is off 9.9% while most portfolios are very close to 0% year to date. 

Economic data continues to come in at extremely negative levels.  Auto sales fell by 45% April 2020 vs April 2019.  China, in February saw a 90% drop.  Current market sentiment is bearish and consumer confidence declined from 101 in February to 71 in April.  This is similar to the decline from February 2007 to June 2008 (the month Fannie and Freddie’s first attempted bailout, after losing 50% of their value that month), which saw a decline of 35%.  This could be another reflection on how this recession is being ‘front-loaded’.   We have seen already how GDP and employment has fallen as much as the entire 2008 Great Financial Crisis, but now expect robust rebound by year end.

In light of all this, equity markets have remained buoyant, after the March decline.  This may further indicate the front-loaded- ‘ness’ of this economic period.  And at the root of it all is the expectation that the economy will rebound strongly in the second half and especially in the 4th quarter of 2020.  While GDP estimates for Q2, which will come out at the end of July, range from -10% to -30% (annualized basis), some estimates for Q4 are as high as +20%.    I believe that we are again priced for perfection.  The past few years saw valuations (price to earnings, price to sales, etc.) elevated with expectations of an acceleration in earnings and wages to justify the then-current prices.  Today a significant economic rebound is priced into the market.   If the economy in late May and June isn’t picking up quickly enough it could put pressure on equity prices.  It depends on re-opening the economy and that depends on subduing the pandemic.

We have seen momentum decline recently and thus increases the potential for volatility in equity markets.  If the S&P500 cannot breakout above 3000 in the near term, we’re likely to remain rangebound vacillating +/- 6%.  Bonds and gold are at a point where they are testing support and have the potential to move several percent as well.  If we are to remain rangebound, my preference would be to reduce risk until there is more confidence in further upside.

On a side note, I have significantly reduced the amount of cable and national news I watch on TV.  It’s the same sad and fearful story we’ve heard the past 6 weeks.  I have noticed I feel better doing this.  A client went back north recently and was surprised/disheartened at the difference in the local news in Naples vs the local news in the tri-state area.  Avoiding the bad news TV and enjoying the good news of spending time with family/projects/hobbies/exercise can be an important factor in getting through this time and being ready to embrace the other side of this crisis.

Stay safe and thank you,

Adam Waszkowski, CFA

March Client Note

The collapse in prices is the fastest decline of 20%, off the market highs, ever.   Looking into the immediate future, the economic/unemployment/earnings data will be horrible.  GDP for Q1 will come in at -15%, Q2 may see -20%.  These should be expected given we’ve shut 1/3 of the economy down.  In a ‘normal’ recession, this data accumulates over several weeks and months, not all at once.  Most of the bad data were going to see is going to be front-loaded, and we will see this throughout April and into May.   Over the same 8 weeks, sentiment will change much more rapidly as the light at the end of the tunnel becomes more/less apparent.   Prices of financial assets will react even more quickly.  Those 3 elements (econ data, sentiment, market prices)  work together but at different paces, and appear to contradict at times (like the day the Fed announced all the backstop measures, markets fell—not because stimulus is bad but probably due to the increasing alarm over the virus).

As of March 31st, the SP500 is down 20%; the Dow is off 23%; US small cap stocks -31%; Nasdaq -14%; eurozone stocks -25%; long treasury bond (TLT) +21% and gold +4%.    The average moderate portfolio is down about 9% year to date.

During the quarter, we hedged the equity side of portfolios during the early decline (not changing actual positioning, just owning the hedge then removing it).   The idea is always to buy low/sell high and removing the hedge was akin to buying/gaining exposure at lower prices.   Long treasury bonds have done very well, and we have sold some into strength, locking in some gains.  Technology has been one of the stronger areas and have increased this area substantially.    In addition, we’ve added equity exposure via SP500 etf, IVV, at the 2550 SP500 level.  I plan to add more, once the pullback eases and prices are constructive again.

As it stands now, most portfolios have increased equities compared to the beginning of the quarter, with less exposure to bonds.  Gold still has some potential, but as I’ve mentioned before gains will be more gradual and believe $1700+ is attainable.  The near-term market movements will likely be tied to the general expectations of when the US can get back to work.   The past couple of days’ weakness, I believe, is tied to the extension from April 12 to April 30 of guidelines established to slow the spread of covid19.

My expectations (given the truly massive and quick stimulus) are that we are now in the pullback from the initial bounce in stock prices.  I believe it is likely to see another leg up over the next couple of weeks.   Staying over 2400 on the SP500 is very important.  The combination of several trillion dollars of stimulus, both fiscal and monetary, combined with the concept that the covid19 crisis will end, does set the stage for possibly, a very substantial rally in stocks in the coming months.  Very generally, if there is now (or soon will be) $2-5 trillion (new money) in the financial system and we get back 90% of GDP that has been lost,  prices could go much higher even if fundamentals don’t recover–that’s post-2009 in a nutshell.   Before that we need to turn the corner on the virus.

The past couple months has been a lesson in which is more difficult:  to sell high or buy low?   Buying high and selling low are easy choices.   “Everyone” is doing it and it feels better to be a part of the crowd, ‘getting a piece of the action’ when in bull market; and conversely ‘stopping the pain’ in a bear market.   Believe me, it is much more difficult to lean into the market in early stages than to jump on the bandwagon once most of a move has already occurred.   This is weighed against market outlook and risk tolerance.       The other lesson is basic financial planning:  do you have 2-6 months of living expenses on hand in case of financial disruption?  And is your at-risk money truly a multi-year holding period.    It’s no fun to be forced to sell into a weak market to raise cash for living expenses.

Adam Waszkowski, CFA

Winter Solstice

They say its always darkest before the dawn, which seems appropriate as we meet the Winter Solstice today, at the lows of 2018.

There is a lot of commentary out there right now about hos investors are ‘worried’ about certain things like Brexit, slowing economies in China and Europe and if that slowing will seep into the U.S.  All these areas of concern have been with us for most of the year.  I have pointed out the Chinese credit impulse (slowing) more than a few times.  Housing and auto sales have been slowing for months.  The only difference is now there is a market decline and all these issues are being discussed.   If the market had not been declining these issues would still be with us, only accompanied by the tag line: “Investors shrug at concerns in Europe”.

In past posts I have described the coming year over year comparisons, 2018 v 2019, regarding earnings and GDP growth.  Every time I have mentioned that 2019 will look much worse than the stellar numbers put up in 2018, thanks largely in part to the one time cut in taxes.   That gave markets a boost and it was hoped that business investment, and wages would go up as a result.  Well it’s the end of 2018 and were still waiting.

The Federal Reserve gave a modest tip of the hat towards global economic concerns by reducing its estimate of rate increases in 2019 from 3 to 2.   There were even rumors that the Fed would skip raising its rate on December 19th and guide to 0 rate increases in 2019.   The Fed NEVER overtly bows to market or political pressures outside of an official recession or panic.   The Fed is in the process (as usual) of raising rates into the beginning of a recession.   Besides the yield curve, there are several other indicators that make recession in 2019 likely.  These indicators have been leaning this way for several months, and finally have tipped far enough that the markets are now concerned and discounting this likelihood.

As this is likely the beginning of a bear market (average -33% post WW2 era), we should expect large rapid moves, both down AND up in the markets.  During the bull market, a 2-4% pullback was common and quickly bought.  Today we see 2-4% intraday moves that continue to fall to hold support.  I expect several more percentage points south before a significant rally in stocks in the first few months of the year.   This will be an opportune time to reassess one’s risk tolerance and goals over the next 1-3 years, as well as make sure that one’s portfolio is properly diversified across asset classes. When stocks go down there are often other asset classes that are performing better, the core idea behind diversification.

It Doesnt Take a Weatherman….

Volatility Continues

2018 is sizing up to be a very volatile year.  Including today, there have been 11 2% down days this year.  There were 0 in 2017, 0 in 2006, and 11 in 2007.

The major indices are currently holding their lows from late October and Thanksgiving week, approximately 2625 on the SP500.  The interim highs were just over 2800, a 6% swing.

The big question of the quarter is if the highs or lows will break first.  Volume today is extremely heavy, so if the markets can close in the top half of todays range, that should bode well for the next few days.

Looking at the big picture, the 200- and 100- day moving averages are flat, the 50 day is sloping downward.  We see the longer term trend is flat while the short term trend is down.  The 50 day and 200 day are at the same level and the 100 day is near 2815.   The averages are clustered together near current prices while the markets intraday are given to large swings in both directions.

Concurrent news topics are the recent good news item of a 90- day trade war truce, and the bad news topics are the problems with Brexit, and the arrest of the vice-chairperson of Huawei, China’s largest cell phone maker.  She is a Party member, daughter of the founder who is also a Party member and has close ties to China’s military.  Maybe not the best person to arrest if one is trying to negotiate a Trade Truce.

My forecast from late 2017 was for large swings in market prices and we have certainly seen this play out.  When compared to past market tops, 2001 and 2007, one can plainly see plus and minus 10% moves as the market tops out then finally breaks down.  Its my opinion that a bear market has likely started, and we have a few opportunities to sell at “high” prices, and get positioned for 2019.

Fundamentally while employment and earnings are good, these are backwards looking indicators.  These are the results of a good economy, not indicators it will persist.  Housing and autos are slowing; defensive stocks are outperforming growth stocks, and forecasts for 2019 earnings range from 0% to 8%, a far cry from 2018’s +20% earnings growth rate.

So, what to do?  Is it more difficult to ‘sell high’ or ‘buy low’?   One is fraught with fears of missing out, the other fears of further declines.   Selling into market strength and perceived ‘resolutions’ to our economic headwinds might be the best bet.  Especially considering the chart below, where in 2019 the global Central Banks will be withdrawing liquidity until further notice, while the Fed insists on raising rates further.

cb balance sheets QT

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

Observations and Outlook April 2018

First quarter of 2018 turned out much differently than investors had been expecting at the turn of the New Year.  In January’s note, there were many sentiment indicators that had eclipsed their all-time highs. The highest percentage of investors expecting higher prices in twelve months was recorded.  Equity markets peaked on January 26 and fell 12%, followed by a large bounce into mid-March then subsequent decline that left us at quarter end about 4% above intraday lows from February.  We may be seeing the first stages of the end of the 9-year-old bull market.  Looking back at 2007 and 2000, the topping process can be choppy with market gyrations of +/-10%.   This is a complete 180 degree turn from the past two years where volatility was non-existent and equity markets went the longest period ever without a 5% decline.  Expect continued choppiness as the impact of Tax Reform filters through the economy and if corporations can continue the blistering pace of earnings growth going forward.  At the same time for mostly the same reasons, interest rates are likely to be range-bound.  Very recently the price of oil climbed on a news release that the Saudis would like to see $80/bbl oil.  Rising oil prices would be akin to a tax on consumers and hamper US growth.

Sentiment as seen by the AAII % bullish rolling 8-week average has declined from its euphoric high at 49% in January, down to 33%.  At the bottom of the last correction in early 2016 this average was 23%.  The current correction may be over and a lot of selling pressure has been exhausted there is room to the downside still. A reading in the mid 20% has been a good area to mark a low in the markets.  Sentiment is often a lagging indicator.  Investors are most enthusiastic after large price gains.  The opposite is true too in that sentiment numbers go low after a price decline.   It can be helpful to take a contrarian view as sentiment measures move to extremes.

aaii rolling bulls 4 2018

Blame for the downturn in January was due to a slightly hotter than expected print of Average Hourly Earnings (AHE), and the resulting concern over how quickly the Fed will raise interest rates.  The rapid change in AHE has not followed through into February and March, yet stocks remain well off their highs.  Analysts have been looking for wage pressures due to very low unemployment numbers for a long time.  The lack of wage growth is likely to the re-entrance of discouraged workers back into the labor force.  As a discouraged worker, who ‘hasn’t looked for work in the past month’, they are removed from the workforce.  When the number of unemployed decreases (the numerator) along with the total workforce (the denominator), the unemployment percentage rate goes down.  A low unemployment rate at the same time there is little wage pressure is due to the workforce participation rate being very low.  Focusing on the total number of people employed, which is still growing on a year over year basis, may give us a better read on employment situation without looking at the unemployment rate.  Any impact from Tax Reform should show up in an acceleration of year over year Total Employees growth.

total employed 4 2018

A more telling chart, and perhaps the real reason behind President Trump’s fiscal stimulus is the following chart. Using the same raw data that created the above chart, the chart below tracks the monthly, year over year percentage change in total nonfarm employees in the United States.  There are no seasonal adjustments etc.  While we are growing, the rate of increase in the total number of people working, is slowing.

% change in total employed 4 2018

Forward guidance from companies will be critical.  Expectations are still quite high regarding full year earnings and end of year price target for the S&P500, currently about 3000, 15% higher than todays price level.  During the first quarter, when earnings from Q4 2017 were reported, companies beating earnings estimates were rewarded only slightly, while companies missing earnings had their stock prices pushed down.  It seems there is still a ‘priced to perfection’ hurdle that companies must overcome.

 

The largest macroeconomic driver for the remainder of the year is the now global shift from QE (quantitative easing) to QT (quantitative tightening).   This global liquidity spigot the Central Banks have been running on full blast for the past 9 years has begun to end.  The US Federal Reserve stopped buying bonds (adding dollars to markets) and began raising rates.  These are tightening liquidity.  While in 2017 the European and Japanese central banks more than made up for the Federal Reserves actions, both have been broadcasting plans to temper their liquidity injections.  China is tightening as now in preparation for increased stimulus to coincide with the Communist Party’s 100th anniversary in power in 2021.

Over the past 9 years global liquidity additions has been the key driver to global asset prices.  As these additions slow and become subtractions, one must assume it will impact financial markets.  Most importantly global US Dollar-liquidity is the most important as the Dollar is the global reserve currency.  Recently the LIBOR-OIS has been in the news, having risen dramatically over the past few months.  This index is a rate that compares the overnight cost of interbank dollar borrowing in the US vs Europe.  The cost to borrow US Dollars in Europe has gone up dramatically.  A low cost would reflect ample Dollars for those who need them, a higher cost reflects a shortage of dollar-liquidity.  The TED Spread compares the interest rate on 90-day treasury bills and the 90-day LIBOR rate.  The TED spread is 90-day rates and the LIBOR OIS is overnight rates, and they follow each other closely.    The crux of it that they both measure the availability of funds in the money markets.  If these rates go up, it is seen as a decrease in available funds.

ted spread and us dollar 4 2018

The chart above tracks the TED spread and the US dollar.  The relationship is loose but fits well over multiple quarters.  If this relationship is correct, the US dollar should dramatically increase in value in the coming months.  An increase in the US Dollar will push the prices of non-US assets lower, make dollar denominated debt widely used in emerging markets more difficult to pay back and have further repercussions in debt markets.  A weak US Dollar is the underpin of global asset prices, and a stronger dollar, along with Quantitative tightening will be a strong headwind to asset prices in the second half of 2018.  If earnings can continue to growth strongly and more workers can be added at a strong pace, both leading to more credit growth, this headwind may be able to be offset.

In addition to international money market rates, the slowing velocity of money has been a constant impediment to economic growth.  Or, rather, the low velocity of money is indicative of an economy that continues to languish despite massive amounts of new money put into the system.  If the pace of money flowing through the economy slows, GDP can be increased by putting more money into the system.  More money moving slowly can be like a small amount of money moving quickly.   If money is removed from the system via tightening measure from central banks, and we do not see an increase in the velocity of money, GDP will decline.  The slowing of VoM has been a problem since 2000 and is likely directly related to ‘why’ the Fed keeps rates extremely low for very long periods of time.  Of course, if VoM were to return to 1960’s levels, interest rates would be substantially higher, causing a re-pricing of all assets—which is a topic for another day.

fredgraph

Adam Waszkowski, CFA

awaszkowski@namcoa.com    239.410.6555

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