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 December 2020

January 12, 2021

2020, despite a massive pandemic and a severe global recession, central banks, with some fiscal assistance from governments, have managed to keep financial asset prices elevated.  Significant declines in revenues, profits and employment arguably the worst since the 1930’s alongside surging stock index price levels, have conspired to give us the most overvalued market since 1929 or 2000 (some argue “ever”).    How long can this endure?  Depends on when central banks begin to whisper about ‘normalization’.

For 2020, the SP500 gained 18.4%, the aggregate bond index gained 7.5%, and gold gained 26%.  European shares eked out a positive year while the Asian indexes fared very well.  My conservative portfolios gained mid to upper single digits while the average moderate portfolio gained a bit more than 13% on the year.   The pullback in Moderna and precious metals provided a weak end and lackluster start to the year.    The energy sector was the worst sector in the SP500, losing 28% and the tech sector fared the best gaining 48%.  Healthcare and energy are likely to be strong outperformers in 2021.  The addition of TSLA to the SP500 has increased the risk of market volatility. Past observances of new additions to the index show they generally perform worse than prior to their addition.  TSLAs outrageous market value (valued more than the 9 largest global auto makers combined; selling at 28x sales) and the 7th largest company in the index, put the index and any sector it is in at risk of increased volatility.

Gold and gold miners are at risk of starting another correction.  Recent lows at Thanksgiving are being approached.  The rally from late November to January 6 was the largest run up since gold’s consolidation began in August.  However, IF we can hold the longer-term uptrend, upside potential is significant.   Bonds too, are seeing prices under pressure as metals/lumber/agriculture/oil prices’ surge is generating calls of “Inflation!”.   It’s quite early to claim prices are going up due to renewed growth.

Asia came out of the COVID-19 lockdowns much quicker and effectively than western nations.  This re-opening (as a result of very stringent testing/tracing/ and effective lockdowns) allowed those economies to re-stock and re-open driving up demand and prices for raw commodities.   From 2015 to late 2017 base metal prices and oil were moving up quickly.  Cries of inflation were heard then as well.  Inflation never showed up (unless you count 2.1% as INFLATION).  This is due directly to US consumer spending growth, or lack thereof.

Aggregate consumer spending is significantly below trend.    Dig a little deeper and you can see many economic indicators picked up in 2015 through 2017, then rolled over during summer 2018, after the brief impact of tax reform (most of the benefits went to the top where additional money isn’t spent). Current total annual spending was $14.8trillion and growing at 4.2% for the past few years (income at almost the exact same rate).  MOST recently spending has declined the past few months while aggregate income also is declining.  Today we can see the next few months will likely show a spending gap of $1trillion.  A $1trillion gap is almost 7% of total spending and reflects the concurrent GDP output gap and an outright decline in GDP of around 4% year over year.  Looking ahead, the real problem may lie in the US inability to deal with the virus effectively.  Yesterday, an article stated that in Ohio, 50% of nursing home workers are refusing the vaccine.   Layer in low compliance with mask mandates (>70% compliance in order to be effective), and I truly wonder if an end to the virus is, in fact, in the offing.

As a consumer driven economy, the point is, while one can find prices of products higher (or packaging smaller at the same price), we spent a lot less in 2020 and will continue into 2021.  And unless personal spending increases, we should not see a difference in the economy or inflation going forward.  This may bode well for bonds.  TLT the 20-yr treasury bond elf, gained more than 15% in 2020, but has fallen a similar amount off its highs this summer.  Expectations for higher rates may have gotten ahead of itself and we could be near a low in prices.  Layer in the fact that bets against prices are near extremes may indicate the decline in bond prices is nearing an end.

In addition, or perhaps running parallel to the decline in spending is the truly massive amount of people on unemployment insurance.  In 2006, Continuing Claims for unemployment insurance hit a low of 2.35 million.  This began to increase in early 2007 and hit a high of 6.62million in June 2009, after the Great Financial Crisis. By June 2010, this fell to below 4.5million, and continued to decline into October 2018 to 1.65million. Claims remained flat until February 2020.  May 9, 2020 claims hit 24.91million.  And over the past 8 months has receded to only 5.1million.  It was only in November that our current Continuing Claims for Unemployment Insurance fell below the GFR Peak in 2010.  The number and duration of unemployment today has not been seen in the post WWII era.  Fortunately, today, we have unemployment insurance and a Federal Reserve acting to support financial markets (almost perpetually since 2009).

We should not expect any kind of normalization in the economy or improving numbers at least until employment, and thusly spending, improve rapidly.  This is completely dependent upon containing the spread of covid-19.

Due to the length and depth of the declines in spending and employment, the longer-term collateral damage will not be seen until things begin to normalize. Once all the rent and loan deferments, PPP loans, random stimulus checks, and enhanced unemployment benefits disappear we will be able to see the extent of the long -term damage.   Ironically, that knowledge will come at the same time we declare victory over this virus-recession and may be concurrent with a market decline.

In the meantime, let us hope the Fed does not mention ANYthing about tapering the current $120billion per month they are pumping into the financial markets, hoping that the Wealth Effect is more than theory.  So, while prices continue to climb, we will participate and listen intently for any signs the Fed is “confident” enough to reduce the variety of market interventions currently underway.

 

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 November 2020

December 2, 2020

The headlines are touting how November was the best month in 30 years.  It was a very strong month that also had the benefit of October closing at its low on October 30th.  The September and October lows are the bottom of the sideways range we have seen since early August.  The post-election rally has broken out above that range and we are likely to see higher highs in the near term.  I do not expect to see more than a 5% decline in the coming weeksThe SP500 gained 11% on the month, bringing it up to 12.1% year to date. The first four days of the month saw the SP500 gain 7.4% and since then has been a slow grind up. Woe unto those who were out of the markets for whatever reason in early November.

While the S&P 500 gained 11% in November, our average moderate portfolio gained 7% on the month.  Bonds (TLT) gained slightly, and gold went from 1880/oz. to 1780/oz, a decline of 5.6%.  Gold has given up 15% from its all-time high in early August through November’s close. If one looks very closely at GLD’s price movement, there are two approximately equal declines of 11% since August.  This may indicate the end of the decline.  Gold has gained more than 3.5% the past 2 days. Over 1850 should be the all-clear.  The only changes I have made in the precious metals area is to have sold gold miners in August and then buying that portion back recently. Gold has dramatically outperformed stocks over the past 2 years through August, but stocks have been catching up during gold’s respite. I remain bullish on gold and stocks.   Bonds and interest rates continue to vacillate, with prices continuing to ebb as expectations of economic growth assume a higher demand for and ability to obtain new credit.

Over the past few months, the number of individual stock holdings has waned as markets have fluctuated.   Expect to see several names added soon with our usual starting allocation.  One name that we have held for several months finally came to life in November as its vaccine was approved.  I plan to continue to hold MRNA and look to reduce it gradually into higher prices.  Its weight in portfolios has grown so much that its weight amongst other holdings is too high, which could lead to too much portfolio volatility.

On the sector level, energy has come up strongly, outpacing all other sectors the past month.  This may seem counter intuitive, given that there is a Democrat coming into the White House.  The energy sector was so undervalued/oversold/hated that it has no where to go but up.  Since the recent low October 28th, the sector had climbed some 45%(!!) through November 24th.   More recently it gave up almost 30% of the initial climb.  Ideally, another 10% decline would make for a great long-term entry.  Energy has been exceptionally strong the past month and is still substantially below where it was early this year.

Overall, we are on track for a very solid year and I am optimistic going into first quarter of 2021.  Sentiment has been and likely will remain the primary driver of asset prices near term.  Fundamentals have a long way to catch up and traditional metrics remain at ‘all time most expensive’ range.  While sentiment can carry prices further, we really need to see earnings catch up substantially in Q1 and Q2 to avoid any large “air pockets” for prices.   Sometimes prices climb much faster during the anticipation of good things (back to normal life for example) and then progress slows.  The grind in prices since the first week of November might be an indicator of such.

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 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

The Yield Curve Un-Inverting Is Not Your Friend

I have talked about this phenomenon before and must do it again today.  All over the news recently is how the previously inverted yield curve is now no longer inverted.

Yield curve inversion is when short term Federal Funds Rate, set by the Federal Reserve, has a higher yield than longer term rates.   The most common curve-inversion metric is the Fed Funds rate versus the 10-year Treasury bond.  One can also make comparisons between the 30yr, 10yr, 5yr, 2yr and 1yr Treasury yields.  Inversion is regarded as an indicator of a higher risk of recession in the near future.

The chart below shows, in blue, the spread between the US 10 year Treasury yield and the Fed Funds Rate.  The orange is the Fed Funds rate, set by the Federal Reserve.  Red is the 10-year Treasury.

We can see without a doubt that the past 3 recessions (grey bars) were preceded by a decline in the 10-year yield to BELOW the Fed Funds Rate.  Longer term bonds carry higher rates of interest primarily due to inflation expectations.  The natural state is to have the longest-term bonds pay more than shorter term bonds.

When the 10-year is below the Fed Funds rate, the curve is said to be inverted, as its expected longer-term rates are normally higher than short term rates (the Fed Funds rate is an overnight rate).  The curve un-inverts when the 10-year yield goes back above the Fed Funds rate.

The financial media have spilled a lot of digital ink on this topic.  When it first inverted, reports were based on a recession indicator.  Now that it has normalized slightly, I’m seeing reports that the recession risk has passed.

The chart below clearly indicates that the past 3 recessions began as the curve un-inverted. Recessions are the grey vertical bars.

resteepening 11 2019

The process the last 3 times this has occurred was that; 1) market-driven yield on the 10-year bond went down, generally due to deteriorating economic conditions. 2) the 10-year gets below the Fed Funds rate (blue line under the 0% level), inversion. 3) The Fed begins to lower rates to stimulate the economy. It continues to lower rates basically until the recession is over (orange line).  4) The 10-year Treasury bond yield remains flat or vacillates some as the Fed lowers its Fed Funds rate below the Fed Funds rate, un-inverting.

The problem lays in that the Fed is doing the ‘un-inverting’, not market forces.  Had the Fed left rates alone at 2.5% and the 10-year market-driven rate had gone up (due to increasing economic activity)—THAT would be healthy and a good sign for earnings and the economy. 

It is important to remember that stock prices and the economy are only loosely tied together in the short term, stock prices can rise and remain elevated in the early stages of a recession.  Also, it is possible that the curve inversion is falsely predicting a recession, however this indicator has a very high success rate.

Adam Waszkowski, CFA

Client Note August 28 2019

August has been a volatile month.  Since August 2, the SP500 has seen 5 moves of 3-4% in both directions for a net, -3%, through today.

Gold, gold miners and long treasuries (TLT) continue to do well putting portfolios into the green for August.  For August, gold +9%; miners +15%, TLT +11%.  Prior to this almost 12 month run in these areas, it was commonly known that ‘gold is languishing”; and “rates will go up”.  Now, its “gold hits 5-year highs”, and “rates seen to continue to fall”.  Often by the time the media reports it widely, the trend is nearing completion.

As we approach Labor Day and the seasonally worst time of the year (Sept/Oct) I am watching for the SP500 to at least stay over 2850, and if we can get over 2940 it opens the door to climb further-but until then markets are under pressure.   Small cap, international stocks are still well below their highs.

Recently it appears the when the US Dollar weakens, US stocks fall while ex-US are more stable.   If the Fed continues to acknowledge further Fed funds rate cuts are likely, this can weigh on the Dollar—unless Europe et al jump ahead and push rates lower via more bond purchases.   So, we may see relative outperformance from ex-US stocks.

Of the individual names purchased recently, one has bee sold out.  IPHI was falling as the sector and general market was climbing, falling below a recent low in July.  The loss was less than 5%.  Cannabis remains under pressure.  Curaleaf reported 200%+ gain in year over year revenue and today saw a drop of 9% at the open, followed by a 23% climb!  This may mark a turn for the sector, but a reversal of these gains will see us abandon this sector in the near term.

The yield curve inversion has been big news.  The 10-yr treasury yield crossed below the 2-yr yield on 8/13 and again on 8/27.  While many other curve inversions have been occurring, this pair, coinciding with a 700 point down day on the Dow has gotten much attention.  The past 3 recessions have occurred as this curve normalizes, that is un-inverts and re-steepens.  I first pointed this out in my quarterly Observation piece January 2019.

 

Adam Waszkowski, CFA

Yield Curve Inverts (again, and continuing)

Yesterday, and this morning, the yield on the 30-yr Treasury bond made its all-time historic lows.  This is extraordinary, especially given the vast amount of stimulus and low unemployment rate.

However, the news on the teevee seems to be harping on the Yield Curve Inversion regarding the 10-yr and 2-yr treasury rates.   This is old news.   Yield curve inversions have been everywhere over the past several months, yet barely a mention from the mainstream financial press.  What I was expecting when I turned CNBC on late in the day was the never-before-seen rate on the 30-yr going below the Fed Funds effective rate.   Additionally, the classic ‘inverted yield curve’ is when the 10yr treasury rate goes below the Fed Funds rate (which tracks closely to the 90-day t-bll), which almost occurred January 2019 and again in March.   This inversion first took place May 23rd well into the stock market swoon that began on May 1.

Below is a chart of the Fed Funds rate, 2-,5-,7-, 10-, and 30-yr rates.  In a normal environment the curve steepens from low short-term rates to higher long-term rates.  Inflation expectations and time value of money are what drives this structure.  So, when we see longer term rates move below shorter-term rates it is at a minimum, unusual.  Analysts generally agree that when this normal structure changes, that changes in the economy and markets are afoot.

Yield Curve Inverts - Rates below Fed Funds

As you can see, yields have been falling since late summer 2018.  This coincides with many data points (durable goods, autos, housing starts, etc.) that peaked and began to move down, indicating slower growth (still growing but slower and slower).   It was the last rate hike (light blue line) where the structure began to invert, and March 2019 when rates began to invert strongly.   There was very little reporting about the 2-/5-/7-yr rates going below the Fed rate.   The reason behind the lack of attention is that the stock market was doing well.   If stocks are up, any negative news is spun as “investors brush off X”.   Ignoring information that doesn’t agree with what we see or would like to see is a form of confirmation bias.

In 2007 Bernanke raised rates right through the 10-yr yield to slow down the real estate bubble.  Powell has raised rates and ended QE, making effective rise in the Fed rate much higher and faster than past, going against other central banks, leading to a very strong dollar.   Powell’s statement in July and fair economic data today, make a rate cut in September unlikely, despite market rates screaming to lower.

As I have mentioned before in my Observations, while there will be a recession again in the US, when it occurs is difficult to predict.  The last 3 recession were immediately preceded by a re-steepening of the yield curve.  Stay tuned!

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.

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

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

“Good” Inflation: Rising rates and falling stocks

Over the past week, the Dow fell by 4%, more than halving its ytd gains through Friday 1/19 (all time high).   Bonds continued the decline started in mid-December, bringing losses during the current ‘bond rout’ to -5.7% year to date.  That is a one week decline in the Dow of 4% and a four-week decline in long-bond prices of 5.7%.  Balanced investors have seen stocks gain and bonds lose, putting most investors (moderately conservative to moderately aggressive) at a mild gain or loss so far this year.  Generally, diversification across asset classes reduces volatility when bonds go up, stocks generally are weaker and vice versa.    When the classes move together differentiation across risk profiles diminishes.  Stocks remain in a strong uptrend and given the substantial gains over the past few months, equity centric investors should be able to take this in stride (or they shouldn’t be equity-centric) as 4% is a small blip in a strong multi-quarter uptrend awash in investor optimism, all-time low cash levels, all-time high exposure to stocks and financial assets and expectations of higher wages, earnings and GDP growth.   In this light, a rebound, or ‘buy the dip’ would not be surprising.  The new feature though is that volatility has returned.

The ‘bond rout spilling into equities’ explaination has to do with relative attractiveness.  If rates keep rising, bond prices are hurt, while becoming more attractive (due to higher yields) to equity investors, putting pressure on equity prices.  At some point, earning safe interest attracts enough investors from stocks to weaken stock prices.  The S&P 500 dividend yield is now 1.8%, similar to what can be found offered on 18 month CD.

Rate have climbed due to rising inflation expectations.  Inflation is expected to, finally, exceed the 2% goal set by the Federal Reserve ‘in the coming months’.  Current thinking is that a tight labor market is pushing AHE (average hourly earnings, +2.9% Jan ’18 vs Jan ’17), combined with more take home pay (via tax reform), will result in more spending from consumers and investment from business.  This will take time but markets have already priced it all in.  Just like the stock market has priced in exceptional earnings growth to match its exceptional valuations.  The chart below shows us that we’ve been in a tightening labor market for years without being able to hold above 2.0% inflation but briefly.

infl vs unemplmnt

Given the new feedback loop between stocks and bonds, perhaps we shouldn’t be so excited about inflation, even if its ‘good’.  On the bright side, the past few years has seen 3.25% as a top in 30yr bond yields and perhaps a decline in rates near term may help both bond holders and stock investors alike.