Give your Portfolio a Non-Correlated Gift this Year!

Adding a non-correlated investment theme to a portfolio may be the perfect holiday present this year to consider.

In addition, ESG type investments have become popular because investors want to know the property they own will have a positive impact on the local community and the broader environment. This allows real estate investments to align with what matters most to investors and their families.

One example, is what McLemore is doing in northern Georgia.  Adhering to a strong ESG program, McLemore and its management team strives to provide a profitable return by balancing the Company’s economic goals with good corporate citizenship:

  • Economic Development Incentives: The Company has worked with local and state officials to secure millions of financial incentives.
  • Employment: The Company is targeting over 1,000 new full-time employment opportunities within Walker County, Georgia.
  • Good Stewardship: The Company has remodeled and rebuilt an existing golf course, which now includes the “Best Finishing Hole in America since 2000” by Golf Digest magazine.
  • Visitors: The Company is attracting many more visitors into Walker County, Georgia, where they can enjoy existing parks and protected wilderness areas, including Cloudland Canyon State Park, the Crockford/Pigeon, Mountain Wilderness Area, and many others.
  • The Company is the owner and operator of the McLemore Community, which is an upscale residential golf community that is in the process of developing a Hilton Curio Collection hotel, resort and conference center as well as other amenities. The McLemore Community sits on approximately 825 acres of real property, is located on Lookout Mountain, Georgia and currently consists of the
    many planned components, click here to view the McLemore Executive Summary Overview Deck 10.28.20.

This blog post nor any links above are a solicitation of securities, that may only be performed by a private placement memorandum.  To view McLemore Due Diligence files, including their Private Placement Memorandum and learn more “How to Invest” type information, click here. This offering is for Accredited Investors only. 

The Positive Impact of ESG Investing

ESG type investments have become popular because investors want to know the property they own will have a positive impact on the local community and the broader environment. This allows real estate investments to align with what matters most to investors and their families.

One example, is what McLemore is doing in northern Georgia.  Adhering to a strong ESG program, McLemore and its management team strives to provide a profitable return by balancing the Company’s economic goals with good corporate citizenship:

  • Economic Development Incentives: The Company has worked with local and state officials to secure millions of financial incentives.
  • Employment: The Company is targeting over 1,000 new full-time employment opportunities within Walker County, Georgia.
  • Good Stewardship: The Company has remodeled and rebuilt an existing golf course, which now includes the “Best Finishing Hole in America since 2000” by Golf Digest magazine.
  • Visitors: The Company is attracting many more visitors into Walker County, Georgia, where they can enjoy existing parks and protected wilderness areas, including Cloudland Canyon State Park, the Crockford/Pigeon, Mountain Wilderness Area, and many others.
  • The Company is the owner and operator of the McLemore Community, which is an upscale residential golf community that is in the process of developing a Hilton Curio Collection hotel, resort and conference center as well as other amenities. The McLemore Community sits on approximately 825 acres of real property, is located on Lookout Mountain, Georgia and currently consists of the
    many planned components, click here to view the McLemore Executive Summary Overview Deck 10.28.20.

This blog post nor any links above are a solicitation of securities, that may only be performed by a private placement memorandum.  To view McLemore Due Diligence files, including their Private Placement Memorandum and learn more “How to Invest” type information, click here. This offering is for Accredited Investors only. 

Client Note September 2020

Client Note                                                                                                                                                      

October 8, 2020

September saw the S&P500 slip approximately 3.8%, ending a streak of 5 positive months in a row.  While equity markets and precious metals (oddly) are moving together, our cash and bond holdings kept average portfolio declines to approximately 1.5% on the month. Year to date through September 30, the S&P 500 is up 5.6%, while our average Moderate Portfolio is up almost 10% year to date.  The fact that financial markets are up this year, despite 2020 being on track for the worst GDP contraction since 1946, is remarkable.

Estimates for 2020 GDP growth will come in around -4%, while the 2007/2008 era saw only a 2.7% contraction.  But this time markets are faring far better.  The key difference between today and 2008 is the emergency actions of the Fed.  The Fed acted far faster and far more substantially than it did in 2008.  The labor market bottomed out in February 2010 with total losses of 8.8 million jobs.  Not until May 2014 did the US recover all the jobs lost.  Currently, we have recovered half of the 22 million jobs lost.  IF, the now-slowing recovery is similar to post 2008, it could be 5 years before all jobs are recovered.  Fortunately, the S&P500 mirrors the Fed’s balance sheet growth more than the economic data.   

History shows us that markets recover more quickly than jobs or the economy.  As such, it appears equity markets have priced in a full profit recovery in the coming year.   In 2008, corporate profits bottomed almost the same time markets did.   Profits and markets grew alongside each other for several years. This time, markets have already recovered and are waiting on profits to back fill the massive valuation gap that now exists.  Because of this mis-match in timing, we could see a few more bouts of 20% gains and declines, as data/news shows economic activity slowing or increasing; as governments decide to add fiscal support or skip it; and as hot spots of the Covid virus spike and recede over the next year or longer.

Some analysts see rising inflation and higher rates coming because of economic growth.  In order to create the ‘good’ inflation (demand-pull), consumers need to spend.  They spend wages, new credit (loans/credit cards) and transfer payments (social security/welfare/stimulus checks).  Banks’ lending standards are increasing; lending is decreasing.  Aggregate wages have declined each month since May. Finally, in August the Cares Act $600/week stimulus ran out while 10 million remain unemployed, keeping pressure on consumer spending.  The Chairman of the Federal Reserve has asked Congress for fiscal stimulus to lift the economy.  As it stands now, there is no real impetus for market rates to rise, and may bode well for bond prices, as rates stay low or perhaps decline again.

My outlook for markets and rates remains the same as during the Summer.  Rates remain low and there is a good likelihood of large swings in market prices.  That outlook will remain until either a large stimulus package with money going right to consumers or control of the spread of the virus occur, maybe both.  I am expecting a post-election rally that may start mid to late October, simply because regardless of the winner, markets like certainty.  Precious metals appear to have completed their correction and a nascent rally may have started.

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 June 2020

As we close June and the first half of 2020, financial markets continue their rebound from the first quarter’s corona-crash.  In very volatile markets there will be many “best/worst X since Y”.  The close at 3100 on the SP500 reflects the best quarter in the sp500 since 1987, with a gain of 19.9%.  After a 36% decline off the all-time high and subsequent 40% gain, puts the SP500 at -4% year to date and -9% below the all-time highs.  Our average moderate portfolio gained almost 15% for the quarter and is up 4% on the year.  While further upside is possible but in the short term, US equity markets are in a downtrend since June 23.  On a larger time, frame, we have downtrends since June 8 and off the highs on February 19thGetting over 3200 should open the door towards 3400+, but if we lose the 3000 level, my medium-term outlook will change.  Our individual stocks continue to do very well.

International equities continue to sorely lag US equities.  European shares gained 2.5% on the month, and currently sit at -14% year to date.  Japan gained 1% and China ebbed 1.6% on the month and both fall well short of the SP500 at -7% and -9%, respectively, year to date.  Emerging markets were the winner on the month at +6% but also have made far less progress recovering post-crash, coming in at     -11% year to date. We sold the last bits of emerging and international equities towards the end of the month.

In credit markets, treasuries have dominated over all other areas of the bond markets.  The long bond/20-yr treasury ebbed by 2.25% during the month, is flat for the quarter and up a massive 20% for 2020.  Even with equivalent maturities, treasuries are outpacing investment grade and junk bonds by 5% and 17%(!) respectively.  The investment grade corporate bond etf, LQD is up 5.1% ytd, while junk bond etf, JNK is -7.7% ytd.   This disparity is due to the rapid credit deterioration seen during this severe recession.  Given this, and spike in covid19 cases, its unlikely rates will rise appreciably in the near term.  Our long treasury position was reduced late March at slightly higher prices.

Economic data released in June continue to show improvement over the April/May shutdown (naturally).    The pace at which the economy would rebound after reopening is a hot topic.  We are seeing rapid improvement in some areas but the estimates versus data are showing extremely poor forecasting ability by economists in the short term.  I am watching year over year data to see how much rebound we are getting.  If July and August data show similar growth as May and June, we could see 90% of more of the economy back by Labor Day.  The trend of economic recovery is far more important than the level.  Ideally, we will trend higher and higher until full recovery.   At the end of July, we will get the first read on GDP for the second quarter.  The Atlanta Fed current estimate has risen to   -36%. 

Looking forward, the recent spike in virus cases has opened the door to the risk that the re-opening of the economy will be slowed, as we are more likely to see county or regional shutdowns.  Continued support from the Fed and continuation of stimulus programs are critical.  A bit higher in equities may provide some momentum to get to 3400 and Fed intervention can keep rates low.

Adam Waszkowski, CFA

Observations and Outlook April 2020

Current State of the Markets

After the most precipitous fall in market history and now a 50% bounce-back, investors are trying to figure which way the wind blows.   The NFIB (Natl Federation of Independent Businesses) estimates that half of all small businesses cannot survive the shutdown through June.  Small businesses make up half of all employment.   We are already seeing massively negative numbers in unemployment claims and PMI surveys.  This is expected given our current situation.   IF unemployment is going to 25%, has the market priced this in already, albeit briefly?  Will the several trillion dollars in stimulus and liquidity overpower economic gravity and keep asset prices elevated?  Valuations for stocks had been in the top 2% most expensive of all time, for a couple of years.  If prices stay or climb higher without commensurate wage/economic activity, valuations could surpass recent levels—inflation in assets, deflation in wages.  In the past, these two generally have not gone together, except in the post 2008 era.

In addition, past recessions have seen job losses increase over several periods.  This time, a lot of the economic impact is happening in a short period of time.  Much of the impact is being front-loaded AND is expected to be short-lived.  Estimates are that GDP has contracted as much as all the previous recession.  As we contract further, the risk that we have not done enough stimulus becomes greater, extending the timeframe for recovery which in turn will lower sentiment and expectations for asset prices.

Which is it? Bull or Bear Market?

The terms bull and bear have a long history, dating back to the 18th century during the South Seas Bubble.   Some attribute the attacking postures each animal takes, the bull goring and lifting upward; the bear, swiping its claws downward.  The definitions we use today though are very new, dating only to the 1970’s.  The arbitrary 20% measurement to label a market as a bull market or bear market can be misleading.   We say today that the recent fall was greater than 20%, thus a ‘bear’ market; and now we have seen prices rise more than 20% from the bottom, a ‘bull’ market.  Do these labels help us in determining whether to be invested in stock markets? Do these labels provide any clarity to the nature or outlook for the markets? No, on both questions.   For a far longer time the terms bearish and bullish have been used to describe the nature of the market.  Bear-ish and bull-ish can better describe the character of the market one is in.  A trend can be described with these terms, also the behavior can be better characterized with these terms.  In bearish markets, large daily movements can be seen in the context of a downtrend.  Bearish markets move fast.  Bullish markets are a slower daily grind in an uptrend with a rare day showing more than 1% or 2% move.   Its certainly a subjective interpretation, but the change from a bearish market to a bullish market, in addition to a visible trend change, should also see smaller intraday percentage moves.   While the daily trend has turned up, the daily percentage moves remain elevated.

A Visual of Fed Interventions

Recently, some famous names from the 2008 crash reflected on that period and concluded they should have acted faster and with larger amounts of stimulus.   The Fed certainly has taken that to heart this time around and indeed has acted with vigor.  The first chart below tracks the Fed’s actions overlaid with the S&P500.  Even after the bottom, the Fed continued with QE 1, 2, Operation Twist, and QE 3.

fed actions vs sp500 2008

All the Fed actions, in real time, did nothing to stem the decline in prices.  The S&P 500 Price to Earnings ratio in early 2009 exceeded 100 (trailing 12 months earnings).  In late 2008, we saw 50+, prior to banks recognition of their losses.  Here is another chart, with recent Fed actions overlaid against the S&P 500.

fed actions vs sp500 2020 resized

Looking at these, an honest question is whether the Fed has any influence over equity markets in the short term.

Covid-19 or Global Dollar Funding Issues?

Few remember way back in September 2019 when the US overnight interbank lending rate increased by a factor of 5, rising from the targeted 2.2% to almost 10% (annual rate, intraday) on September 16th.  This caused the Fed to intervene, putting $53billion into interbank lending on an overnight basis.  The overnight lending quickly morphed into multi-day and multi-week repurchases agreements totaling more than $300B in a few weeks.  Previously banks had been lending to each other, overnight, secured with collateral (red line).  The Fed went from no participation in the $1 trillion+ overnight market to more than $350 billion, and then moved from repurchase agreement to outright permanent purchases and began the massive balance sheet expansion we are seeing today.  The Fed balance sheet rose from $3.76T in mid-September 2019, to $4.3 by March 11, and now is $6.4 trillion. Another $1 trillion and the recent expansion will be larger than QE 1, 2 and 3 combined.

The red line secured overnight lending began spring 2018, right after the February 2018 market correction, AND foreign dollar-funding costs (TED spread- orange line) jumped to the highest level since 2009.  The volume of funding increased for several months until banks ran short on capital to use as security, as dictated by liquidity rules in the Volcker Rule.   While demand (red line) had been growing for liquid cash dollars, the amount of collateral used to secure this lending was not enough, and when demand outpaces supply, the price (overnight funding rate—green line) goes up.  But that price was too high, and the Fed intervened, and the total volume of dollar funding continued to increase (red and blue lines together) at an increasing rate.

repos global dollar

We can see how due to the demand for US dollars began to increase in early 2018 (orange line), funding for dollars increased to a point where major banks could not meet demand for dollar liquidity, and the Fed stepped in and took over funding.  There was balance in the supply and demand from November 2019 to the end of February 2020.  From February 26 to March 4, the TED spread (a measure of stress in markets) began to grow rapidly.  The economic contraction stemming from Covid-19 exacerbated the serious issue of dollar funding (less activity means less trade/less dollar flow).  Today the Fed is fighting the dollar crisis AND the loss of over $2trillion in US output/GDP.

Monetary Base and the case for S&P 500 to 4000

For most of the post WW2 era, the growth of the monetary base (all currency and bank reserves) tracked the growth in GDP.  Historically, growth in GDP lined up very well to growth in the S&P 500 over a full business cycle.  During the Great Financial Crisis (GFC) with hundreds of billions of mortgage loans going bad, there was a risk that if all the loans were marked to their true worth that the monetary base would contract, resulting in a deflationary debt spiral.  In our current system all money is created by new credit.  If too many loans go bad, the monetary base declines as money that was lent/created disappears as collateral prices decline, and loans are not paid back.

The solution was for the Fed, for the first time in its history to accept as collateral (and purchase outright) mortgage-backed securities.  As the Fed accepted these securities, it provided cash to banks. Without the burden of non- or poor- performing loan, banks were freed up to lend again.  As this new cash was put into the system it also flowed into risk assets like the stock market.

The chart below clearly shows the relationship between QE and the S&P 500.  New cash found its way into stocks and pushed prices up.  The period after QE3 and the brief ‘balance sheet normalization’ saw the most significant corrections post GFC.  A minor 15% correction after the base stopped expanding in early 2016 followed by a 19% decline late 2018 and now the 30% decline most recently.  Other banks, namely China did keep expanding their monetary base in late 2015 and into 2016.  Then as China’s credit impulse wore off and as mentioned earlier, demand for US dollars kept increasing while the Fed lowered supply, we had the late 2018 market sell off.  The Fed backed off its plan to raise interest rates and cut rates summer 2019.  These actions aided liquidity and stock moved up after both actions.

With each QE period we saw the monetary base and the S&P 500 market capitalization increase.

Change in S&P 500             Change Monetary Base

QE 1              +37%                   +33%                                                                                   QE 2              +12%                  +33%                                                                           QE3/Twist    +53%                  +52%                                                                               2019 Cuts    +34%                 -20%  needed rate cuts were due to MB decline  2020             -15%                       +43%

monetary base

Currently the Fed is trying to increase the monetary base to keep asset prices and liquidity up.  We do not know yet to what degree the current recession will lead to loan losses and other credit destruction.  In addition to loans going south there is the general decline in output as we are locked down.

Through April 8th, the Fed has increased the monetary base by $1.2T, or 35% over late 2019 levels.  $1.2T may be the approximate output lost during the lockdown.  The Fed has expanded its collateral and purchases from treasuries and mortgage backed securities to now include junk bonds, corporate bonds, and other collateralized loans.   Over the past week and going forward the Fed will likely continue to monetize these securities, further expanding the monetary base.  If we see another $2T to the monetary base (Fed balance sheet expansion) that would approximate a 100% change in the MB and potentially impact the S&P500 similarly, going from 2100 in late March to 4000 by end of the year.   In this scenario, one would have to accept a reality of 12% unemployment concurrent with S&P500 at 3500+, and a $2 trillion annual deficit.  The wealth disparity would be substantially more extreme than in recent past.

We are entering a period in US history like no other.  The reaction to the Covid19 virus has put the economy into a self-induced coma.   Current expectations are that monetary and fiscal stimulus will pave over/fill in lost income and liquidity setting the stage for a return to economic growth.  The problem with this thesis is that we do not know how long the shutdown will last and after many small businesses run out of cash and close, how many people will get hired back.   There is substantial risk of extremely poor economic data to persist for several months.   The knock-on effects of a prolonged shutdown are difficult to estimate.  The more unknowns, the longer the shutdown, the worse the global dollar shortage, the more extreme market movements we are likely to see.

 

Adam Waszkowski, CFA

 

 

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

Observations and Outlook October 2019

October 8, 2019

Perspective

 Over the past 3, 12 and 18 months there has been a wide dispersion in the returns of various asset classes.  US equites remain range-bound while ex-US, stocks continue to ebb.  Risk-off assets like bonds and gold have done very well over the past year, while stocks vacillate.  Interest rates continue to fall, and inflation expectations are subdued.  Earnings growth for the third quarter are expected to be negative year over year, and likely zero growth for full year 2019. US economic data continues to be weak while Eurozone and Asia may be entering a recession.  Below are the approximate returns over the 3-month, 12-month and 18-month time frames.

 

3 mos.            12 mos.                 18 mos.

S&P500                                          1.7%                 4.25%                      13.5%

Russell 2000 (US small cap)      -2.4%                  -8.9%                         .5%

Euro Stoxx 600                                .8%                    -.5%                      -2.4%

Emerging stocks                            -4.2%                  -2%                       -14%

Gold                                                    4%                 23.1%                     10.4%

Long-bond price (TLT)                 8.1%                 25.2%                     21.8%

Aggregate Bond Index                 2.3%                   7.5%                        9.6%

 

Economic data in the US continues to roll over.  The chart below shows the top three inputs into the LEI (Leading Economic Indicator) as published by the Conference Board.  Data continued to slow and is now in contraction in some areas like manufacturing.  Payroll growth has declined significantly during 2019.  These data points must reverse very soon otherwise we will undercut the 2015 slowdown and increase chances of a recession in the coming months.

econ rolling over 10 2019

 

We’ve been seeing risk-off assets outperform substantially in recent quarters under the pressure of slowing global economic data and lack of growth in earnings.   More recently there are been reports of large-scale rotation from growth stocks (like Consumer Discretionary sector; XLY) to more value-oriented stocks (like Consumer Staples; XLP).  Value has begun to outperform growth.   While not completely uncommon, it is uncommon to see this while Consumer Confidence is very high.  Recently I came across the chart below from Sentimenttrader.com which shows how rare this is.

discretionary vs stpales vs consumer confidence

Discretionary items are what people buy with ‘extra’ money, while Staples are what people need for everyday life.  Defensive areas usually outperform only when consumers and investors are less confidence about the future.  Only just after the market peak in 1969 (far left side) and the 2000 peak (center) confidence was high (survey results) while defensives were beginning to outperform cyclical stocks.  If this rotation continues it may portend tough times for the general stock market.

Why might consumers be confident while investors are buying more defensive stocks over more cyclical stocks is a difficult question.  Sentiment is often a lagging indicator.  People feel good and optimistic after good things happen.  The long string of employment growth and a long bull market has buoyed sentiment, perhaps so much that any contrary information is being discounted.  A poor job report or two may change this outlook.  But again, we are faced with an imminent need for very good economic data points to counteract current downtrends.

Credit Expansion (aka QE/liquidity/debt)

china credit impulse pmi

 

us pmi 10 2019

 

These two charts show how China’s credit impulse (QE/liquidity/Reserve Rate reductions etc.) have a lagged impact on US manufacturing.   Coming out of the 2009 recession, China had the spigot wide open and we can see US PMI hit a high mark in early 2011. The Impulse was removed during 2010 which resulted in a decline in US PMI.  The renewed impulses in mid-2012 and late 2015 helped create the rise in US PMI in 2013 and 2016.  There is about a 6-9 month lag between an expansion in credit and its impact on the real economy.

Today we are seeing the impact of a lack of significant credit expansion which should continue   Global economies appear to be completely reliant upon increasingly larger credit impulses to maintain growth.   China has eased during calendar year 2019, but not as much in the past.  Hopefully we will soon see better US PMI numbers to avoid outright recession in the very near term.

Update on the Yield Curve

fed funds vs 2 year inversion 10 2018

We’re not hearing much on the Yield Curve lately.  It remains inverted with the 10-year Treasury yield being lower than the 90-day T-bill rate.  The 90-day bill and Fed Funds rate (set by the Federal Reserve) follow each other hand in glove.  We can see market rates, the 10-year Treasury yield began to decline in earnest about a year ago.  We can also see how the 90-day rate moved lower prior to the Fed lowering rates.  It is clear that the Fed follows the market.

Current market expectations are that the Fed will lower its rate again in October by another 25 bps (.25%).  I have showed in previous writings how the last two recessions began (the official dating) as the yield curve regained normalcy with the 10-year yield rising above the 90-day/Fed Funds rate by .33%.

If the Fed Funds rate decreases by .25%, from 1.75% to 1.5%, and the 10-year yield remains constant at 1.56%, the yield curve will un-invert and become positive.  Further decreases will cause the spread to go above .33%.   In 2007 the Fed lowered its rate enough (following the 90-day T-Bill) to get below the 10-year yield, resteepening/normalizing the curve again.  This occurred August-October 2007, and the official dating (which was given to us November 28, 2008(!) that it started December 2007.   Waiting for economic data regarding a recession, before reallocating one’s investments will always result in very poor returns

 

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.

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

Was that the Top or the Bottom?

The Wall Street Journal had a very good article detailing one of the root causes of the February decline.  A classic ‘tail-wagging-the dog’ story about derivatives and how they can impact other markets that are seemingly unrelated.  While the outlook for global equities informs the level of the VIX, we have just seen an incident where forced trades of VIX futures impacted futures prices of equity markets.   Its as though the cost of insuring against market declines went up so much that it caused the event it was insuring against.

Even with that being known, the impact to market sentiment has been dramatic.  Most sentiment indices went from extremely optimistic to extreme fear in a matter of days.  This change in attitude by market participants may have a lasting impact.  A rapid decline like we saw in February will reduce optimism and confidence (which underpin a bull market rise), and increase fear and pessimism, which are the hallmarks of a bear market.   Short term indicators turned very negative and now are more neutral, but longer-term sentiment indicators will take a longer decline to move negative.

Often the end of a bull market is marked by a rise in volatility, with equity prices falling 5-10%, then climbing back up only to get knocked down again, until finally prices cease climbing back up.  This can take several weeks or months.  We can see this in the market tops in 2000 and 2007.  This may be occurring now.  Many of the market commentary I follows the approximate theme of ‘markets likely to test the 200-day moving average’.  This is the level the February decline found support.  This would be about 7% below current prices, and have the makings of a completed correction, finding support once and then retesting.

Since the market highs in late January the major stock indices fell 12%, then gained 6-10% depending on the index.  Since that bottom and top; markets moved down about 4.5%, then again up into yesterday (3/13/2018) gaining 4% to 7%.  Tech shares and small caps have outperformed large cap along the way, rising more, but falling the same during this series.   Recognizing the size of these moves and the time frame can help manage one’s risk and exposure without getting overly concerned with a 2-3% move in prices.  But if one is not aware of how the 3% moves are part of the larger moves, one might wait through a series of small declines and find themselves uncomfortable just as a decline is ending—contemplating selling at lower prices as opposed to looking to buy at lower prices.  Hedging is a process to dampen the markets impact on a portfolio in the short term while looking for larger longer-term trend turning points. The high in January and current decline and bounce are likely a turning point over the longer term and in the near term provide investors with parameters to determine if the bull trend is still intact.

Observations and Outlook April 2017

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

Trump Trade Withers

trump trade

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

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

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

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

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

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

Other Considerations

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

10yr tsy yld

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

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

central bank buying 4 2017

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

usd eur bund rate differentialSource: SocGen

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

In Summary

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

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

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

Adam Waszkowski, CFA

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