Observations and Outlook April 2017

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

Trump Trade Withers

trump trade

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

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

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

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

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

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

Other Considerations

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

10yr tsy yld

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

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

central bank buying 4 2017

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

usd eur bund rate differentialSource: SocGen

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

In Summary

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

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

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

Adam Waszkowski, CFA

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

 

Observations and Outlook January 2017

While 2016 ended on a positive note, market volatility has arrived.

 

Selected Index Returns 4th Quarter/ 2016

Dow Jones Industrials    8.6%/ 16.5%                                       S&P 500   3.8%/11.96%       MSCI Europe   -.4%/-.4%
Small Cap (Russell 2000)  8.83%/21.31%     Emerging Mkts  -4.2%/11.2%     High Yld Bonds   1.37%/15.3%
US Aggregate Bond -2.98%/2.65%   US Treasury 20+Yr   -12.16%/1.4%                        DJ/UBS Commodity 2.7%/11.8%

A brief perusal of the above numbers clearly shows 2016 was a “Risk-On” kind of year with small cap stocks and junk bonds putting up substantial returns.  The U.S. markets in general were the place to be outpacing emerging markets and European shares as well.  What isn’t quite as clear is the fact that investors who were geographically diversified and sought to own lower risk/higher quality bonds are feeling a strong dose of ‘return envy’.  An investor with a 50% S&P 500 and 50% Aggregate bond portfolio saw ‘only’ a 7.5% return for the year.  What is also not seen is that the ‘risk on’ investor spent the first half of 2016 with negative returns with the post-election period accounting for approximately 80% of the year’s total gains.  To summarize 2016 in one word: volatile.   While the volatility ended the year on the plus side, it should give investors a moment to reflect on what they are willing to endure to see outsized gains.

Forecast 2017: Large Swells and Wind Gusts to the North and South

Often after a rapid decline in stock prices, conditions become “oversold”.  In the near term, oversold conditions often lead to a bounce or snapback in prices.  The opposite is also seen when prices advance too far too fast.  The rapid rise in equity prices has put the market into an “overbought” condition and, given the rise in stock prices based on expectations of tax relief and government spending to boost the economy, hope once again springs forth that today’s extreme valuations will be justified with a rapid rise in corporate earnings in 2017.  In the meantime, prices have already risen and like bond prices in 2016 are likely to fluctuate greatly.

Actually, prices in both stocks and bonds have already begun to make large swings down and up.  The year ended up, so the tendency is to assume rapid ‘up’ moves are natural, and of course welcome.   Early 2016 bonds and gold did extremely well as stock prices fell.  The roles were reversed in the second half with bonds and gold declining through the second half, while stocks edged up and the lurched up in the last two months.  So, in fact, we have already begun a period of greater market volatility.   It’s likely to see prices swing between Hope and Anxiety as we await the actual changes and impacts of the change in monetary policy (tightening from the Fed) and fiscal policy (lower taxes, increased deficit spending).

What outside issues might impact global markets?

China Overnight Interbank Lending Rate Soars to 105%

Money markets are the source of short term funding for the financial system.  Recently the HIBOR, Hong Kong Interbank Overnight Rate, has soared to unprecedented levels, yet very little has been talked about in the US financial press. This is the rate to borrow yuan overnight, for banks in Hong Kong- known as the offshore yuan rate.   This was likely due to the PBOC intervening to make is cost prohibitive to short China’s currency.  In the U.S., though,  we seem to be preoccupied with the number 20,000 to observe severe stress in the world’s second largest economy.

Source: fxstreet.com

The last time an extreme liquidity crunch was seen was one year ago, and global equity markets became very ‘nervous’.   This also coincides with the annual reset of how much money China’s citizens can send out of the country.  The Chinese are allowed to take the equivalent of $50,000 per person per year out of the country. There has been a significant weakening of the Chinese yuan vs the US dollar in an attempt to keep the yuan’s strength versus other currencies low.  Foreign exchange takes some effort to get one’s head around, but in a world of paper money, it’s an important factor in trade, profits and interest rates.

China is at the same time trying to slowly deflate a massive real estate bubble, while not effecting other areas of the economy.  Leverage, aka credit, is fuel for higher prices in all assets like real estate and equities, as well as some areas of the bond market (borrow short term, buy long term bonds and earn ‘carry’ profits).   It is extremely difficult to remove leverage and not have prices decline, yet this is what China is trying to do, while also defending its currency.  China is using its massive reserves of Treasuries to manage its currency depreciation vs the US dollar, and going through it at a rapid rate.  IF the rate at which its spending its reserves continues, China, could see its reserves decline by 50% in as little as 2 years, which is very significant.

China being a closed, autocratic society means data can be obfuscated, changed, and outright fabricated with very little complaint.  As such China is a ripe source of potential Black Swans in 2017.  We are already seeing very strange, even for China, developments in its money markets.

The Big Picture

Here it is…….

Take a moment and understand what this chart says.

Given the level of household exposure to equities, or put another way, the percentage of stocks in portfolios, has had a very strong predictive value upon the next 10 years’ returns.  As household become more heavily weight towards equities, the lower the next 10 years returns from equities.  The dashed line ends in mid-2006 because there was return data for the following 10 years, through mid-2016.

Households’ exposure to equities was very low at the 2009 market lows (people tend to sell after prices go down unfortunately), and indicated a forward 10-year annualized return approaching 15%.  If the S&P 500 achieved this, it points to approximately 2800 by mid-2019, an increase of 23% from current levels over the next 2.5 years.  The gap between the dashed and blue lines shows this is not an exact science.

I apologize in advance for the math here.  23% over 2.5 years is about 8.6% annualized.  If the margin of error from our chart above gives us only 13% annualized from 2009, that points to about 2270, an increase of 0% over the next 2.5 years; and if our chart ends up at 11% 10yr annualized rate, we will be at 1987 in 2.5 years, a decline of almost 13%.

A range over the next 2.5 years of +23% or -13% is much lower than the return the market has given us over the past few years.   The past 2 years has seen the S&P 500 swing from 2130 to 1850 to 2280 currently, while corporate earnings have been declining and recently grew back to a level seen in early 2015.  While 2014 was a good year, the past two years have seen major price swings and rewarded investors with only 5.5% annually for the past two years.   It’s my opinion that this kind of earnings levelling off, slowing of annualized returns, compounded by very high current valuations are indicative of a late stage bull market.   Past Price to Earnings ratios (see my blog post Definition of Long Term Investor), and the chart above also point to reduced returns from equities in the next few years.

What Can Be Done

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

Diversifying amongst the other 6 asset classes is a start.  Most advice revolves around 2, stocks and bonds.  If one truly wants to buy low and sell high, one must identify the other areas that are “low”, increase exposure there, and reduce exposure to “high” asset classes.  Not only does this smooth out volatility but can increase long term returns.   Given the outlook for more volatility in stock and bond prices; very low prices (historically and relative to other assets) in precious metals, agriculture and oil; there should be many opportunities to take advantage of short term swings to benefit and move some ‘eggs’ from the equity side into other, non- and lower-correlated asset classes that are currently much lower in price.

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

Adam Waszkowski, CFA 

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.