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Yellen nails it.

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The Days Ahead: Japan GDP and U.S. Factory Orders

Most of the week was waiting on the tax changes. The Fed Beige Book, which summarizes all the regions, was a sort of steady as you go report. Inflation expectations remain low. Some employment pressures but wage growth was flat and where there was some, employers tended to use bonuses or non-wage compensation (think benefits), which don't show up in the wage calculations. New house sales jumped, mostly because of new inventory in the Northeast. They're about 8% of all new houses compared to the south of 56%, so not a big move at the national level.

On Friday, the market tried to make sense of the Flynn news. I tend to think markets are not good at politics. They have a tough time trying to understand the financial implications of a cabinet change, investigation, a guilty plea or just daily dysfunctionality. Even the normally sedate German market faded 3% on stalled coalition discussions, most of which depend on a minor revision to health care providers (see, we’re not the only ones). In the U.S., the 10-Year Treasury had an unusual bout of volatility. For the last month, it has traded between 2.30% to 2.38%, which is a price change of less than 12c on a $100 bond. On Friday, it looked like this:

…which is about 10 times the price move. Has anything changed? Not really, but it shows i) Treasuries are a very good risk-off trade ii) uncertainty comes and goes iii) one of our favorites, “Prices change more than facts, don't confuse the two”. We'd say this is a time when the facts have not changed much.


1. Another record:

Stocks briefly hit another all-time high with only a minor correction on Friday. The Dow hit another thousand mark, at 24,000 on Thursday. It last did this in October. But as we've mentioned before, it's a lousy index and only takes a 4% move to break through another thousand handle.

One interesting point was that among the top performing stocks last week were Macy’s, L Brands, Kroger and Newell Brands. Sound familiar? Three are retailers. L Brands does the Brendel and Bath & Body Works among others and Newell does Rubbermaid, Sharpies and Mr. Coffee. And they're down around 40% each so far this year but up 10% to 15% last week.

We don't think they suddenly became better businesses in a week. It’s far more likely that these are classic “pain trade” when investors have to reverse their view. In these cases, it was likely short covering as volumes leapt four times (h/t Cameron Crise).


2. Thank you and good bye:

Well not quite yet but Janet Yellen gave her valedictory talk to Congress. She highlighted debt (high and about to get higher), productivity and inequality as things to worry about. She’s right on all three and the tax reform won't change any of those. The drop in the corporate tax rate is meant to make U.S. companies more competitive, increase wages, jobs and capex. It won't do any of those. And if anyone knows any CEO who said, “You know, I would be so ready to give employees a wage increase if it weren’t for those darned corporate taxes”, let me know.

As we've mentioned before, the S&P 500 companies pay an effective tax rate of 21%. For tech companies it's 10% and they pay around 17% of the S&P 500’s tax bill but make 21% of its EBITDA. No wonder they corrected last week.

janet yellen.jpg

Anyway, thank you Chair Yellen. Mr. Powell, you have big shoes to fill.


3. It's that time of year again:

When strategists put out their next year forecasts. Although, rather like Holiday decorations, it seems to come earlier every year. We'll write ours up in a couple of weeks but here's some history.

Blog 3 12-1-17 S&P 500 Price Index Annual Returns 1929 to present_SP50-USA.jpg

This shows the S&P 500 return every year since 1929. If you want your forecast to be broadly right, then pick the long-term average of 7.6% and you’ll be correct more than not. But that average includes the down years. There were 27 down years, or 30% of the time, and the average down year was 14%. The average up year was 17.6% putting the 2017 number, at 18.2%, bang in line.

It’s asking a lot for another 18% year in 2018 but with fundamentals, U.S. and global growth and still easy monetary policy, we’d forecast another up year.


Bottom Line:
We've had a great run on equities for all the right reasons. We're willing to stay with it but expect some strange trading patterns over the next few days. Year-end profit taking and positioning may take center stage.

 

Please check out our 118 Years of the Dow chart  

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Other:

Hummingbirds in super slo-mo

No one seems to like the CFPB

 

--Christian Thwaites, Brouwer & Janachowski, LLC


Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

House vs Senate Tax Codes

The Senate version, passed on Friday, needs to be reconciled with the House version.Here are the main differences. Neither changes our investment view for now. More to come. 

House_vs_Senate_Tax_Code_-_The_Big_Picture.jpg

See also here: Ritholz 

 

Please check out our 118 Years of the Dow chart  
Subscribe here for our investment updates
 
 
--Christian Thwaites, Brouwer & Janachowski, LLC
 
Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.
All charts from Factset unless otherwise noted. 
 
 

Stocks and patience

The Days Ahead: Big data day on Tuesday for U.S. and Japan

Slower holiday week. The Fed minutes reported that PCE increases are just round the corner at the same time as saying that there was very little loan demand and that inflation would stay less than 2% (I know they contradict themselves but contain multitudes). They’ll go for a rate increase in December but bond yields barely moved at the long end. It wasn't news. Stocks hit an all-time high but it’s not all clear sailing. The newly split Hewlett Packard businesses (HPE and HPQ) reported disappointing results.  Stall on the tax front. We reminded ourselves that the Reagan tax overhaul took from December 1985 to October 1986 to pass and that was revenue neutral. The House and Senate sit for only 12 more days in 2017.


1. Is the market overvalued?
There’s no one metric that gives an answer. One can use P/Es, a time tested measure, that tells one we’re in the top end of the range. Or we can use an earnings yield, the reciprocal of the P/E, and compare that to earnings and the 10-Year Treasury. That puts us at 5.6% for the earnings yield, at 3.5% for a real earnings yield and 3.2% for the earnings yield less the 10-Year Treasury. By those measures, we’re at the expensive end of the long-term average but still way cheaper than in 1999. Other measures like ROE (at the high end), net margins (strong), P/Es (slightly expensive), yield (cheap), dividend growth (strong) and earnings growth (solid), tell the same story. Somewhat expensive but not disconcerting.

There are a couple of other ways to look at it too. Here’s one:

It shows hours worked to buy the S&P 500. Right now, it’s around 132 hours with a ten year moving average of 88. This may say the market is expensive. Or it may say that average hourly earnings have failed to keep up with the quoted part of the economy. We'd lean to the latter.

Or we can look at this:

This is the S&P 500 market cap at around $24 trillion compared to the U.S. economy at $19.5 trillion. This one comes out regularly but our reaction has always been “eh?”. GDP is total U.S. production but the S&P 500 is only 500 companies (and not the 500 largest at that) and includes 30% of sales outside the U.S. These (mostly) won't get picked up by the Export/Import line of national accounting. It’s also comparing an asset value to an income value.

Anyway, the ratio is at a cyclical but not record high.

And that’s pretty much where we end up. U.S. stocks have done well. They're supported by valuations but overseas markets look cheaper and with more upside opportunity in the next 12 months.


2. Hedonic Adjustments.
We show this chart monthly because core CPI is critical for the economy, Fed policy and investment strategy. All investments should preserve purchasing power, otherwise just keep it in the bank. That's why deflation is so pernicious to an economy. No investment makes sense. If prices fall, cash, or negative yielding bonds, are a rational investment as they buy more tomorrow than today. There are other horrendous issues with deflation (banks stop lending, mortgages become unmanageable, economic activity seizes) that scares us silly when it happens (luckily not that often).

So, look at the bottom of the chart:

The price of wireless services and TVs has plummeted for years but here's the thing: I’ll bet your Verizon bill is as big as it ever was. You just have a better plan.

This is when hedonic adjustments come into play. It’s the BLS adjusting the price of a service for its changing quality. So if the price of a computer was $1,000 10 years ago and is $1,000 today, you're clearly buying a better product but for the same dollar amount. Instead of showing 0% inflation, the BLS will try to adjust for that clearer screen, faster CPU and that Lightening, Thunderbolt thingy that made your USB obsolete. Here are some other examples:

  • Your rent is $2,000 a month. The landlord refurbishes it. Your rent is $2,050 a month
  • Your health care is $500 a month. The deductibles are increased. Your healthcare is till $500 a month
  • You pay $200 for cable. Comcast improves the download speed. Your cable bill goes up $20.
  • The cheap cell phone you bought 10 years ago cost $200. It died. The cheapest one today is $300 although it’s loaded with features.

In every case, the BLS says prices have fallen.  But the effect on your wallet is very far from zero.  Now there’s no big conspiracy here… although the government saves or pays $8bn more in indexed Social Security payments for every 1% move in the CPI.

So what? For investors we need to a) stay well ahead of inflation and b) understand what our clients’ inflation basket looks like. Because while the headline number is benign, individual experience may be very different.


3. Tobacco.
We posted a note that got some attention.  It showed that shareholders in Altria made considerably more money than Apple shareholders since the day Apple went public in December 1980. Yes, Apple was dead money for 15 years when Steve was away. But our point is that steady earnings, dividend yields and predictability can be very good investments. Here’s a similar chart showing the world’s four big tobacco stocks against the S&P 500. It’s a startling outperformance.

Blog 4 11-22-17 tobacco by year.jpg

Now, we’re no fans of the product and cannot defend the harm cigarettes do. But as investments, we can't ignore them.


Bottom Line: Europe should come back after the German coalition issues.  

 

Please check out our 118 Years of the Dow chart  

Subscribe here for our investment updates

 

Other:

DOJ comes back to life with AT&T merger with Time

Some food sports

Your Uber account probably got hacked.

 

--Christian Thwaites, Brouwer & Janachowski, LLC


Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 

Nice end to earnings season

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The Days Ahead: Slow week. ECB minutes.

Some good earnings last week and not just from the tech, search, disrupt stocks. First out was Wal-Mart (WMT), which beat on sales and earnings. We view that as very important because i) it's the tenth largest company in the S&P 500 and fifth in the Dow Jones ii) it has the largest sales of any company in the U.S. at $485bn or 2.5% of GDP and more than twice as big as Apple, the next biggest by sales and iii) it employs 2.3m people or more than the next eight largest companies. The stock is up 37% this year.

Then Home Depot (HD), which is up 25% this year and raised sales by 6% excluding the one-off gains from the hurricanes. HD is a classic housing play but also a good indicator of confidence around large ticket items. It’s also very well managed. It’s up 780% since the recession.

On the other side, GE became the latest victim of “conglomeratism.” The recent CEO had to clean up an almighty mess of financial services. The new one has to work on the differing subsidiaries and get back to core businesses, which could be healthcare, aviation, transportation or energy. He’s cut the dividend. GE’s market cap peaked at $580bn in 2000 when it was on a P/E of 41. Today the price is down 70% (down 40% this year) and it has slipped from first in the S&P 500 to 33rd.


1. How’s Japan going?
Fine. It just completed seven quarters of growth for the first time in 30 years. This is not quite a vindication of the “Three Arrows” approach of newly re-elected Shinzo Abe, which is some heavy QE, promoting inflation and domestic reform, but exports performed well. We're looking for increasing household expenditure and for the 3% wage growth, both of which are heavily promoted by the government.

It’s a slow road. Meanwhile Japanese stocks have risen 17% for the large caps and 28% for small caps, which translate into 21% and 34% for a U.S. investor. The market is now at a 26 year high and has been the best performing developed market since 2013. We continue to like the market, not least because of this:

Earnings are growing and stocks trade at a 20% discount to the U.S. market (see the middle chart). The broad themes are i) domestic demand ii) easy monetary policy iii) profit growth and iv) foreign demand. We're not usually fans of the “weight of money” argument, which states investors are standing in the wings ready to buy. But in Japan’s case, foreign investors have underweighted Japan’s 25% share of the EAFE index for years. Two of the largest active international funds, for example, hold 10% and 14% in Japan. Eventually that gap will close.


2. Update on the yield curve.
We talked about flattening last week. We mentioned that an inverted yield curve is bad news and has been since around the early 1980s.

The arrows mark the time when the 2-year Treasury yielded more than the 10-Year Treasury. They seem to appear some six months before a recession. But we’d make a couple of points. One, the spread can get very close to zero and not mean anything more than the economy is doing well and inflation is low. Second, the full inversion happens when short-term rates increase as the economy speeds up but long-term rates think that a recession and easing are just around the corner. Third, short-term rates are policy driven. Long-term rates are market driven and right now, there is a lot of demand for long-term bonds.

We had good news last week about the growth of the economy and inflation. Industrial production was up 2.5%, with mining up 6%, and core inflation was up 1.8%, which is well down on what it was a few months ago. The low inflation puzzle is ongoing from Chair Yellen’s speech a few years ago and some regional governors (here’s our own John Williams at the San Francisco Fed) arguing for raising the target to 3% from 2%. Count me as favoring that because the Fed can't seem to forecast inflation to save its life and without some inflation, we’re not going to see meaningful real or nominal wage growth.

Anyway, for now we have low inflation, growth and strong earnings. Which is good enough.


Bottom Line:
We're at about the end of earnings season. Earnings and revenues are up 6%. Next week will be quiet and there is not much on the calendar. We're keeping an eye on Europe given its recent weakness around Brexit (again). Oil is on the move but we think it’s a geo-political short squeeze. Energy stocks haven’t moved.

 

Please check out our 118 Years of the Dow chart  

Subscribe here for our investment updates

 

Other:

We did a podcast on the tax plans.

Activism on under performing children

Facebook’s last true believer  

How to read a book

Equities will “perform poorly”, says Fed in 2011

 

--Christian Thwaites, Brouwer & Janachowski, LLC


Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Why we’re not fans of Floating Rate Note funds.

Floating Rate Notes are back in the news. Here's our take. 

1.     What are they? Floating Rate Note (FRN) funds come out to play whenever there’s a whiff of interest rate hikes in the air. They are bonds that reset their coupon as rates move. So, if the initial coupon is 4%, they may move to 5% if rates rise or 3% if rates fall. The price of the FRN (or floaters) will, therefore, be less volatile than a normal bond because the reset reflects current conditions. Nice. The price should stay around par value. What could possibly go wrong?

2.     Who issues them? Typically governments, financial companies and industrial companies. For governments, it's  a cheaper way to borrow for short periods and for financials, the liability of the coupon payment (i.e. it goes up and down) is very similar to the income of their assets (i.e. bank deposits). That’s not always the case for a manufacturing company.

 3.     How often do rates reset? First, understand that the reset period and the coupon period are independent. Coupon payments may be quarterly, semi-annual or annual. Reset periods are mostly quarterly but can be daily or annually and pretty much everything in between.

4.     What determines the reset? For U.S. Treasury FRNs it's relatively easy. The rate calculates as a spread from recent T-Bill rate auctions. Recent spreads have been in the range of 4bps to 7bps. As of writing a U.S. FRN maturing in October 2018 yields around 1.36% and a three-month T-Bill yields 1.25%.

For corporate bonds it’s more complicated and many FRNs are tied to a LIBOR (London Interbank Offered Rate and see below) spread and is often called “the index.”

5.     What are some examples of FRN? Let’s look at three examples. Some are quite straightforward. So first up, the Goldman Sachs FRN November 2018, which is a large component of the Bloomberg Barclays FRN  <5 Years Index. It has a BBB rating and pays a coupon of three months LIBOR plus 1.1% and has a yield to maturity of 2.19%. It’s a senior note and non-callable. For the last twelve months, the price has been between $100 and $101.

6.     Got it! And another? But to provide investors with a higher yield, things become more complicated. So for number two, let’s look at a major FRN fund’s largest holding, which is First Data Corporate New Dollar Term Loan, 3.00%, 7/08/22. There are several things to note here:

  • It's  a term loan, which means it’s a loan originated by a bank and then sold to investors.
  • It's  not tied to LIBOR but to ABR (Alternative Base Rate), which is a mix of LIBOR, Fed Funds and the prime inter-bank rate.
  • It’s not rated. This doesn't mean it's a bad credit just that given the amount of the loan, at $725m, a credit rating was probably too expensive. 
  • It comes with covenants, which lower the payment to investors if the company’s EBITDA falls below a certain ratio.
  • It's thinly traded and is a Level 3 asset. This means there is no observable price (like a trade) so values can only be calculated using estimates or risk-adjusted value ranges

7.     Are there mortgage or asset backed FRNs? Indeed there are, which brings us to our third example. One high quality FRN fund that holds Federal Home Loan Mortgage Corporate FRN of 25 Feb 2046 looks like this:

  • It’s backed by individual Adjustable Rate Mortgages or ARMs and by FNMA
  • It has a floor rate of 0% and is based off LIBOR 1-month. They can change the index any time
  • It's  subject to the normal pre-payment risk and the experience of the underlying mortgages.

8.     LIBOR is going away, so what happens to FRNs? The end is coming for LIBOR after banks manipulated the rate. It used to be that banks would report the demand for inter-bank funds, in any currency, take a daily average and publish the LIBOR rate. But with LIBOR going away in 2021, it looks like each country will take its own approach. Meanwhile, there is confusion all round. In the U.S., the Fed thinks there is no trading in about half of the standard LIBOR notes. This is why funds have to use Level 3 pricing. The Fed has yet to come up with a solution.

Bondholders could be at risk because if there is no LIBOR rate, issuers will use a “fall back rate” which will be the last, and increasingly stale, LIBOR rate. So if rates increase, investors could be left with low paying bonds and prices will adjust down.

9.     What has been the experience of FRN funds? Funds holding high quality rated floaters pay a little more than money market funds and should have a stable NAV. The trouble begins when funds chase yield and buy lower quality assets. Here’s a chart:

FRNs_BFRIX-USA.jpg

One of the promoted benefits of FRNs is low correlation to other fixed income assets and low volatility of principal. As you can see in 2008, rates fell and the recession began to bite. The problem with the FRNs was that credit fears took over, default fear rose and the price of the two FRN funds shown fell some 20%.

The next problem was in early 2016 when rates began to rise but the FRNs rate reset was slow to follow. So fund investors were left holding a lower rate bond at a time when rates were increasing. This time the price decrease was around 5% to 10% depending on the fund. Meanwhile benchmark long bond (the blue line) increased in price.

10.     And performance? Here’s a quick recap through November 16th 2017:

frns table.jpg

So what can we conclude?

  • FRNs should have a stable price but many don't especially if the credit cycle is deteriorating or rates are rising fast
  • Stretching for yield often means credit quality declines.
  • Many of the securities are illiquid or use Level 3 pricing.
  • The higher the quality of the FRN fund, the more it's  likely to concentrate on financial stocks. The Bloomberg Barclays FRN  <5 Year index has 65% invested in financials.
  • FRN funds seem not to have performed better than high quality bond funds in both rising and declining rate environments despite taking i) more concentration and ii) credit risk and iii) less interest rate risk.

Give us a call if you’d like more information.

Other information:

Fannie Mae on floaters

Quick definitions

How it's taught at business school

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Take me to Attorney Briefs

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Take me to Attorney Briefs

 

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted. 

"Equities to Perform Poorly" says Fed

Actually, they said it back in 2011. Here it is. Since then, the S&P 500 has risen 130% in price terms and by 162% with dividends. Here it is:

S&P Total Return since 2011_SP50-USA.jpg

It’s not that we’re making fun of the Fed. We would never do that. But it shows that making stock market predictions can trip up even the sharpest and most objective minds.

The Fed made the reasonable argument that stock markets returns were driven by multiple expansion (basically more expensive) and that was driven by demography (a larger population buying stocks).

This is true but stocks are driven by many variables including the price of risk-free assets, earnings, demand, dividends, valuations, cash flow and about another 100 we could think of and more beyond that.

Right now, we think stocks are somewhat expensive but well supported by earnings and the synchronized growth in the U.S. and overseas. It’s enough to keep us confident.

Subscribe here for our investment updates

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Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted. 

Tech Top Tools

Listen to our latest Market Chat Podcast episode


The Days Ahead:
Retail sales and NFIB. Surely small business will show better confidence?

More tech earnings but not the good kind. Snap, Priceline and Expedia all took big hits of 15% to 20%. Oil rallied but not energy stocks. The tax cut story lost momentum. Broadcom launched a bid for Qualcomm. They’re both $100bn companies so we’re talking some major M&A activity.

The tax discussions took a new turn. We're loath to comment on tax proposals. The proposed changes will look nothing like the end result and there’s no mileage in trying to trade the outcome. The original one-page tax manifesto back in April probably represented the optimistic high point. Now, even the corporate tax rate cut, which was the cornerstone of the entire proposal, looks like it's being delayed. Does it matter?

Yes to market sentiment. But not really to the economy. The blue bars are the corporate taxes paid. They stalled out more than a decade ago. The green line shows the amount paid as a percent of GDP. It’s a small and declining number. There is nothing to suggest that lower corporate taxes will lead to i) higher capex ii) investment iii) growth or iv) wage increases. Nothing. It is probably good for shareholders but the wealth effect of the stock market growth is dubious at best and charlatanism at worst. The sort of thing you’d draw on the back of a napkin and call it policy. 


1. Flattening.
When the yield curve starts to look flat and long-term rates do not look substantially different from short-term rates. Last time they flattened 10 years ago, the then Fed Chair said "The evidence [of a flat curve] very clearly indicates that its efficacy as a forecasting tool has diminished very dramatically because of economic events.” Er, no. Six months later the economy slipped badly and dropped like a stone a year or so later.

So what do we have now? Well the spread between the 10-Year Treasury and the 2-Year Treasury is at a decade low.

Blog 2 11-9-17 10s2s Second 10 yrs_TRYUS10Y-FDS.jpg

What does it mean? Well, we’re in the camp that bond markets are better predictors of trouble than stock markets. Because i) they’re more liquid ii) they’re traded off-market so prices and sizes don't have to be disclosed iii) they represent more types of investors than stocks (e.g. Central Banks, corporate treasurers, collateral posts, repos) and iv) have fewer variables to work with (you don't really care about Apple’s iPhone sales if you hold the bond…you care about the ability to repay).

So, if you have a flat curve, it means that investors don't believe the economy is going to grow at a fast enough to require a rate increase. We would agree that QE and Central Bank buying may have distorted the signal. But there is nothing the Fed is doing with its balance sheet assets that we don't already know.

This flattening trade also means corporate credit spreads are at 12-year lows as investors hunt for anything to create income. And it means that the bond market remains skeptical about tax changes.


2. Whaaat? Top of the market stuff, surely?
When it comes in acronyms, it’s time to get the red flags out. A few years ago, it was BRICs (Brazil, Russia, India and China), which were the dominant Emerging Markets countries set to take over the world. The idea was backed by growth, large populations and a Goldman Sachs marketing campaign. The timing was awful. The ETF launched at the time unperformed the S&P 500 by 73% in the next 10 years and is still 27% below its offering price. Further back, there were a bunch of companies called, well, BUNCH or Burroughs, Univac, NCR, Control Data and Honeywell. They were the tech dream team of their day. And yes, all gone except Honeywell, which massively underperformed the S&P 500 for 20 years.

Now we have the NYSE FANG where you can trade 10 underlying stocks on the futures market. It’s actually more than the Facebook, Amazon, Netflix and Google original line up. It has the Chinese equivalents (Alibaba etc) and some others like Tesla thrown in for good measure. So tech all day every day, with leverage. And this in on top of the FANG ETF launched in July, which is up about 12%. Anyway, FANG Is catchy and so breaks one of our core rules about ETFs: if they have a cute name, just, you know, check it.

Here is how the FANGs have done:

blog 3 11-9-17 fangs.jpg

So, from top to bottom, the six names have outperformed the S&P 500 by 48% in the last three years during which time you doubled your money. They're about 35% more expensive than the market and yield less than half the market average of 2.0%. They have delivered on growth with earnings up around 14% a year compared to the S&P 500 of 9.6%.

They're about 14% of the S&P 500 market cap, 5% of sales, 10% of the earnings and 2% of employees. Observant readers will have noticed three versions of FANGs: the original four, the NYSE of 10 and ours, which is the one currently in wide use, of six stocks. And that too is a problem. The NYSE reserves the right to change the components of the futures any time they want. So, you don't always get what you bought.

We're not about to call the top of the FANG market but we’d share that:

1.     Cute names don't work

2.     If something looks like it’s forever, it isn’t

3.     We've never seen an investment fad work

4.     Companies that look unassailable aren't and…

5.     Beware CEOs with overzealous PR departments.


Bottom Line:
Stocks had little news to trade on. We'd like to see a consolidation period in this post-earnings pre-Congress period. Of course, it never happens that calmly. And we’re keeping a close eye on those very tight credit spreads.

 

Please check out our 118 Years of the Dow chart  

Subscribe here for our investment updates

 

Other:

Being a bond manager in 1311 was tough

How the Russian ads looked on Facebook

Mongoose on golf course

  

--Christian Thwaites, Brouwer & Janachowski, LLC


Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 

Tax Cuts and Home Ownership

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The Days Ahead:
Winding down the earnings season. Consumer credit.

One of the busiest weeks of the year: Mueller indictments, Fed meeting, new Fed chair, tax proposals, rate hike by Bank of England (BOE), tech earnings and payrolls. But markets barely reacted with stocks remaining high (up 16% YTD) and Treasuries rallied. Bonds had priced in a concern that John Taylor, who tilts hawkish on monetary policy, would get the nod for the chair. So, when Jerome Powell was announced, bond yields fell to 2.32%. Long-term bonds are up 7.23% this year, which in a year of Fed tightening points to a disconnect between policy intentions and market expectations. Even U.K. stocks rose after the BOE raised rates for the first time since September 2007.

The U.S. market is almost entirely driven by earnings. We haven’t seen the stock market multiple higher in over a year. In other words, this is a market going up because of earnings, cash and dividends. It’s no more expensive. Here's what it looks like:

The bottom right hand shows sales of the S&P 500 increasing by around 5% and earnings by 7%. We haven’t seen two successive quarters of earnings growth since 2014 and that’s all down to the rebound in energy. They may not be the best loved of stocks but they're still 6% of the stock market and 7% of sales and their earnings growth is up 135% over the year.


1. Tax Cuts:
The House proposals came through:

  • Repatriated tax (discussed in blogs): 12% vs 35%
  • Corp tax: 35% to 25% 
  • 3 tax brackets: 12%, 25% and 35%
  • State and Local Tax deduction eliminated
  • Property tax deduction capped at $10,000
  • Mortgage interest relief capped at a $500,000 house value
  • Standard deduction doubled
  • Alternative min tax scrapped
  • No change on 401(k) deductions
  • Estate tax threshold doubled and then phased out
  • Tax on university endowments at 1.4% if assets >$100,000 per student.

We won't spend a lot of time on analyzing these because we’re a long way from a final bill. We would note that the corporation tax cut seems to be very much in the air and we’d be surprised if some final version did not survive the process. Interestingly the NFIB, who lean right and to lower taxes, will not support the bill because the vast majority of U.S. businesses do not incorporate. They're pass-through businesses where profits are passed untaxed to owners which are then taxed as income. So, they get no benefit. The plan may also hit multi-national companies with a tax on overseas earnings and transactions, even if neither are repatriated.

The corporate tax and the administration has become like a dog with a bone. The 35% rate sounds high, but companies pay around 20%. It’s also 2.4% of GDP, down from 3% two years ago, and 3.5% 10 years ago. So if legislators expect a big boom in capex, wages or employment from lowering taxes, experience suggests they are sadly mistaken.

Anyway, stay tuned and expect lobbyists to release the hounds.


2. Jobs:
Only one more jobs report before the December meeting of the Fed. There’s little in it to change their minds.

The headline number is a big bounce from the storm-driven September number. But the average of the two months is still way below prior months. The bottom line shows the earnings growth slowing to 2.4% and some earnings fell in nominal terms.

We know the NFP report is the biggest single trading report of the month. We also know it’s wildly unreliable, subject to revisions and with all sorts of caveats as to what day of the month the survey falls. It was not a strong report but is unlikely to derail the Fed.


3. Home Ownership:
We have a slightly different view on interest rates from the accepted wisdom. For most of the post-recession period, commentators either thought rates would bounce quickly as demand came back or were freaked out by QE and thought hyperinflation was around the corner. Even the Fed has consistently over estimated long-term Treasury rates.

But a careful look at bonds suggested that rates are far more likely to stay low for longer. Why? In no particular order 1) more boomers de-risking portfolios and investing in debt instruments 2) unfunded pensions that need to asset match long-term liabilities 3) international capital account surpluses that recycle into U.S. dollars 4) very low inflation and 5) a shortage of high quality assets (there are only two AAA rated companies in the U.S.)

But one area that recently caught our eye was the survey from Freddie Mac on housing affordability and ownership. Here’s the chart:

The dark blue line third from the bottom is all home ownership at 63%, a 30 year low. But what we’re seeing is that for many renting is a permanent strategic choice. For those aged 35-44, ownership plunged from 69% to 58% and for those starting out on their careers (the bottom line), from 43% to 34%. The strategic choices include affordability, student debt, slow household formation and the whole urban lifestyle. Depressingly, in western states, only 25% of renters think they are “very likely” to become homeowners, compared to 40% just a few years ago. There’s nothing in the tax proposals to reverse any of these trends.

How does this affect rates? Well, if the younger cohorts aren't buying and the older group are looking to downsize by renting, then the supply of houses will increase and demand for mortgages decline. So, score one more for a low rate environment.

h/t David Ader at Informa.


Bottom Line:
Stocks are hovering around all-time highs and bonds still expect no change in long-term rates. As we’ve noted before, it's an earnings driven market right now and companies are turning in good numbers.

 

Please check out our 118 Years of the Dow chart  

Subscribe here for our investment updates

 

Other:

Beer and taxes (no we don't understand it either)

Facebook says fact checking is expensive

History of Fed appointments by Tweet storm

  

--Christian Thwaites, Brouwer & Janachowski, LLC


Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted

Over in Japan

The Days Ahead:
Still on the Fed chair. And jobs numbers.

Another Thursday column so if we miss something on Friday, be sure to check back. It was a big week for earnings and we saw strong reports from Caterpillar, always a bellwether industrial play on global growth, 3M and then on Thursday after-hours, the tech giants Google, Amazon and Twitter. Full disclosure, I own Google (or Alphabet as I will one day end up calling it) and so do most of the funds we use. It’s been a good earnings season so far with no major setbacks. We even saw some big M&A talk with CVS ($75bn) apparently making a bid for Aetna ($60bn). A few years ago, that sort of merger would have headed straight to the DOJ but these days anti-competitive horizontal integration gets a pass. 

Elsewhere, the background was on tax reform where the main story is about corporate tax rates and the deducibility of interest payments. But highly leveraged companies did not have a bad week so the market may not think it probable. For us, the most important political decision is the next Fed chair. Here’s a decent summary. It seems as if Yellen and probably Cohn are out. We believe the best choice would be Powell with Taylor as the Vice-Chair. The name you don’t want to see is this guy, who would be a disaster.


1. Can we afford a tax cut?
We’ll leave aside the issue of a) whether we need one b) that there is zero evidence that tax cuts increase growth (granted they tend to mix up where that growth comes from but that’s about it) c) that they decrease tax revenues d) increase deficits and e) have little effect on capital expenditures (if you can expense capex at 100%, your tax rate makes no difference, which this guy seems not to understand). Oh, and increase inequality.

No, this is a simple, can we afford it? And the answer is, yes.

The blue columns are interest payments per quarter paid by the U.S. Treasury. The overlaid line shows interest payments as a percent of GDP and the lower black line, the rate on the 10-Year Treasury. We're interested in the overlaid line. It’s hovering around levels not seen since the early 1970s.

We could easily double that number which would be a function of a) higher rates b) more Treasury issuance or c) a combination of both. Would the market accept more Treasury bonds? We think so. It’s all down to the demographics of savings, the scarcity of quality assets and the real rate of return. So, we think any sharp upturn in bond yields, specifically anything above 3%, is years away.


2. How are things in Japan?
In another surge of populism, an unexpected election outcome…nah. This is Japan. They just reelected Prime Minister Shinzo Abe for the fourth time and his Liberal Democrats, who have been in power for all but four of the last 63 years. So, yes, things are going pretty well in Japan. We’ve discussed the “Three Arrows” economic program before, which is a combination of monetary and fiscal stimulus and “structural” reform. The first has been impressive, a high-powered QE which includes stocks and targeting, with considerable success, and a 0% 10-Year Government Bond yield. The second spotty. The last glacial. But the market was fine about the result and the Japanese market pushed to a 21-year high.

Japan has been a curious place to invest in for three decades. It’s had zero bound rate policies, a strong currency, shrinking population, low growth, and massive government debt but at the same time decent GDP per employed person growth and almost zero unemployment. There is a good explanation of it all here.

So, given all that, it’s no surprise that Japanese stocks, despite being the world's third largest market, have traded at a discount for years. But things are changing slowly and we pick this chart for an update:

Historically, and I mean 30 years ago, company management worked for customers, society, employees and their creditors. Shareholder came a distant last. But now we’re seeing record profit margins at just under 8% as the market (the blue line) climbed even higher after the election. Those numbers are still below U.S. company margins of around 9%. The bottom chart is the payout ratio (dividends as percent of earnings) at 30%. Again, the U.S. stands at around 40%. So, there is clearly room to increase dividends and profitability.

We’re not about to dive into Japanese stocks. We started to increase our weighting earlier in the year and have been fine with results so far. Nothing happens quickly in Japan. And we’ve already seen an 18% return in 2017. But we’re patient.


3. Oh darling it’s a flat world:
One very interesting feature of the bond market is the flattening of the yield curve. This is what it looks like:

The bottom green line at the left is the yield curve a year ago. One-year rates were around 0.5% and 30 year bonds at 2.9%. The top blue ine is the yield curve today, showing one-year rates at around 1.5% and 30-year bonds pretty much unchanged at 2.9%. Hence the curve has “flattened” or simply less steep.

Why and what does it mean? The Fed controls short-term rates so the increase in the policy rate feeds right through to short rates. But market demand drives long-term rates and they’ve stayed down. We think it reflects the market’s reluctance to believe a growth story and that debt, low inflation, productivity and investors’ general aversion to risk. It’s also, of course, the flipside of this being the “most unloved equity bull market.”


Bottom Line:
The Dow hit another record with some good earnings from industrials. Earnings drive the market right now and companies are turning in good numbers.

Please check out our 118 Years of the Dow chart  

Subscribe here for our investment updates

All the things you can't do with your Tesla 3 (like sell it)

 

Other:

Why banks like share repurchases

How to lose your job over a haircut.

Red panda

  

--Christian Thwaites, Brouwer & Janachowski, LLC


Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Cybersecurity 2: Checklist and Tips

Cybercrime and fraud are serious threats and constant vigilance is key.  While Brouwer & Janachowski plays an important role in helping protect your assets, you can also take action to protect yourself and help secure your information.  The checklist below summarizes common cyberfraud tactics, along with tips and best practices to stay cybersafe.  Many suggestions may be things you are doing now, while others may be new.  We also cover actions to take if you suspect that your personal information has been compromised. If you have questions, we’re here to help.  Cyber criminals exploit our increasing reliance on technology.  Methods used to compromise a victim’s identity or login credentials–such as malware, phishing, and social engineering–are increasingly sophisticated and difficult to spot.  A fraudster’s goal is to obtain information to access to your account and assets or sell your information for this purpose. Fortunately, criminals often take the path of least resistance. Following best practices and applying caution when sharing information or executing transactions makes a big difference.

How we can work together to protect your information and assets

Safe practices for communicating with our firm

  • Keep us informed regarding changes to your personal information.
  • Expect us to call you to confirm email requests to move money, trade, or change account information.


What you can do

☐ Be aware of suspicious phone calls, emails and texts asking you to send money or disclose personal information (such as login credentials).  If a service rep calls you, hang up and call back using a known phone number.

☐ The Internal Revenue Service (IRS) doesn’t call, text or email seeking payment of back taxes, fines or penalties—any such communication is fraudulent and should be reported to appropriate authorities.

☐ Never share sensitive information or conduct business via email, as accounts are often compromised.

☐ Beware of phishing and malicious links. Urgent-sounding, legitimate-looking emails are intended to tempt
you to accidentally disclose personal information or install malware.

☐ Financial institutions such as banks or brokerages won’t email you asking for your login credentials—user id’s and passwords—any emails asking for this information should be ignored and deleted.

☐ Don’t open links or attachments from unknown sources. Enter the web address in your browser.

☐ Check your email and account statements regularly for suspicious activity.

☐ Never enter confidential information in public areas.  Assume someone is always watching.
 

Exercise caution when moving money

☐ Money movements are prime opportunities for fraudsters, particularly if you’re conducting a real estate transaction and wiring money to escrow accounts at title companies or elsewhere for down payments or payment of fees.

☐ Review and verbally confirm all disbursement request details thoroughly before providing your approval, especially when sending funds to another country. Never trust wire instructions received via email.
 

Adhere to strong password principles

☐ Don’t use personal information as part of your login ID or password and don’t share login credentials

☐ Create a unique, complex password for each website.  Change it every six months.  Consider using a password manager to simplify this process.

Maintain updated technology

☐ Keep your web browser, operating system, antivirus, and anti-spyware updated, and activate the firewall.

☐ Do not use free/found USB devices. They may be infected with malware.

☐ Check security settings on your applications and web browser. Make sure they’re strong.

☐ Turn off Bluetooth when it’s not needed.

☐ Dispose of old hardware safely by performing a factory reset or removing and destroying all storage data devices.
 

Use caution on websites and social media

☐ Avoid websites that you don’t know (e.g., advertised on pop-up ads and banners)—fraudsters infect them with viruses.

☐ Log out completely to terminate access when exiting all websites.

☐ Don’t use public computers or free Wi-Fi. Use a personal Wi-Fi hotspot or a Virtual Private Network (VPN).

☐ Hover over questionable links to reveal the URL before clicking. Secure websites start with “https,” not “http.”

☐ Be cautious when accepting “friend” requests on social media, liking posts, or following links.

☐ Limit sharing information on social media sites. Assume fraudsters can see everything, even if you have safeguards.

☐ Password protect any attachments you fill out containing medical information, financial information, etc., and send by email.

☐ Consider what you’re disclosing before sharing or posting your résumé.

What to do if you suspect a breach

☐ Advise our office if you suspect your email account has been taken over so we can be alert for any bogus emails that appear to be from your account.  Call our office so we can collaborate with you on other steps to take.

☐ Request our “How to Respond to a Data Breach” flyer for more information.
 

Learn more

Visit these sites for more information and best practices:

  • StaySafeOnline.org: Review the STOP. THINK. CONNECT™ cybersecurity educational campaign.
     
  • OnGuardOnline.gov: Focused on online security for kids, it includes a blog on current cyber trends.
     
  • FDIC Consumer Assistance & Information, https://www.fdic.gov/consumers/assistance/index.html
     
  • FBI Scams and Safety provides additional tips, https://www.fbi.gov/scams-and-safety.

Uppers and Downers

Listen to our weekly Market Chat podcast:


The Days Ahead: Powell for Fed? And Spain.

We've been waiting for a correction for a while and the opening on Thursday gave us a, wait for it, a 0.7% fall. We don't really like to show day charts because a short time frame has a heck of a lot more noise than signal, but here it is:

What caused the drop? Well, take your pick. There was a weak overnight in Hong Kong, the head of China’s central bank warned of a Minsky Moment when asset prices freeze and Apple reputedly cut suppliers orders, which would hit companies like Samsung, Taiwan Semiconductor and SK Hynix. But no. As a rookie analyst some, cough, 36 years ago, I would ask senior Portfolio Managers about every move in the market. Some theories sounded grand but meant nothing: stops, trading limits, consolidation, rebalancing. One guy hit it though: “Son, there are more sellers than buyers. Now leave me alone.”

And, that was probably what happened on Thursday. As the chart shows, the market swiftly recovered for similar opaque reasons. We know volatility has been exceptionally low for a while. And many people would like a correction because, you know, it was expensive six months ago, and since then it’s risen another 11% and human nature being what it is, can't bear to move in now. But volatility is low for a reason:

  1. Central bank policy is clear, communicated and confirmed on a regular basis. We pretty much know what they’re going to do because they keep telling us.
     
  2. Growth is running around 2% and a little over in Q3. There’s no obvious upside or downside surprise to the story.
     
  3. Sure, there’s uncertainty on the political side but tax/no tax, healthcare/no healthcare outcomes are not that big a deal in the short run. The market also seems to know how to parse between outrageous but not financially meaningful statements.
     
  4. All the above may change but seem good reasons why markets are not easily phased.

1. Global Growth:
We have three strong tailwinds right now. Global growth, broad U.S. growth and a lower but not weak dollar. This is the first time we've had all three since the recession. We had China coming out of 2008 very quickly, with a massive credit infusion, but Europe had two start/stop phases, then the commodity and energy sectors fell out of bed and Emerging Markets followed. There always seemed to be one laggard. Not so today and here’s one quick chart:

It shows the spread between U.S. 10-Year Treasuries and their German equivalent (Bunds). When this is wide, we can infer that if U.S. yields are high and Bunds low (e.g. 2015), then the U.S. is growing more than Germany, which is a good enough proxy for Europe and indeed overseas given its export sector. So the world is out of balance. When the spread is narrow or declining (e.g. 2001, 2007 and all the grayed out boxes), growth is more synchronized and it’s good for equities. We're in just that phase now.


2. It was 30 years ago today:
Yes, that was the 1987 crash. When the Dow dropped 508 points from 2,600. You can read about it here, which is from practitioners, not commentators, and here, which looks at the overlaps between now and then. I wish I had a great war story about staring at screens, paralysis, fear, and making or losing the firm’s annual profit in a day. I don't. I was in a classroom that day. But the school had the wisdom to bring out a professor who had worked on Wall Street in 1929. This was 1987 and had all happened 58 years before...so like listening today to someone who remembers the launch of Kind of Blue or the Mini.

His take was “Ha, 30% correction, that's nothing. Try 1929 when we watched the stock market capitalization fall from $89bn to $15bn in three years.” Which reminds us of this. He was right. A slow grinding bear market with a collapse in jobs, asset prices and trade barely registers against the quick down and recovery of stocks in 1987.

And here's the chart showing the S&P 500 30 years ago with today’s market superimposed.

I would not read too much into that. Superimposed charts are easy to do but always insightful.

What was 1987 all about? A combination of a steep market upturn, some bad news out of Germany, a weak bond market. But the big culprit was an investment strategy called Portfolio Insurance, which sold futures as long positions increased. The trouble was, markets were quickly overwhelmed and the selling momentum accelerated. In the days of person-to-person trading, no one wanted the other side of the trade. Answer, mark prices down.

The good news to come out of it was that Fed, with a newly installed Alan Greenspan, quickly dropped the Fed Funds rate from 7.7% to 6% and the 10-Year Treasury followed, falling from 10.2% to 8.7%. The Brady Commission was set up to investigate and reported in 60 days (pause for effect), recommending things we now take for granted like circuit breakers, supervision across markets (the NYSE and Futures regulators didn't talk back then) and better clearing systems.

Could it happen again? Well probably not in the same way. A one-day 30% correction would never get that far. And better information and price discovery would prevent the “get me out at any price” mentality. Also, see the highlighted section, real interest rates were high and Fed policy was extremely tight back then, unlike today.

Anyway, we still like the dividend, quality parts of the market and international and Emerging Markets, which are still quite a bit cheaper than the U.S. despite the run up.


Bottom Line:
The Dow hit the 23,000 mark but it only takes a 4% move to hit another round number these days. As we've explained, it’s a meaningless index and did well only because one its fourth and seventh largest companies rose 5% and 9%. Earnings will continue to define stocks in coming weeks and so far have kept with expectations.

 

Please check out our 118 Years of the Dow chart  

Subscribe here for our investment updates

 

Other:

Income equality worse in U.S. than all OECD

Betting it all on Bitcoin

Apple cuts production

  

--Christian Thwaites, Brouwer & Janachowski, LLC


Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Railroads and Points

Listen to our Market Chat Podcast


The Days Ahead:
Earnings and China and Germany updates

Sometimes market and economic data looks like this:

Painting 1 detail.jpg

 

Not really a pattern or system but a lot of noise. So, you have to wait, stand back and see what the big picture is, which in this case is this (the above is the black rectangle) and of course, well known to Ferris Bueller fans.

Painting 2 full size.jpg

 

In the last week we had some very odd payroll numbers, the first job losses since October 2010, an uptick in consumer confidence, some weak retail sales and FOMC minutes that revealed a very lively debate about whether inflation is dead, mostly dead or just sleeping. The CPI numbers on Friday came in at 1.7% which is well below what it was when the Fed started tightening in 2015 and 2016 when they were on hold. We know there’s a lot of hurricane noise in the data right now but recent trends don't seem that much different from trends before they hit.

Our view is that inflation will stay stuck at less than 2%, simply because wage pressure seems low and likely to remain so. The 10-Year Treasury market seems to think so as yields fell 10bps in the week. Meanwhile stocks pushed on ahead based on some early but strong earnings reports, the prospect of tax cuts and ongoing good economic reports out of Europe. Elsewhere:


1. People are talking about tax cuts:
More than that, it’s been the major driver of stocks for the last few weeks and one reason why small companies, with an average tax bill of 28%, have ripped ahead of large cap, with an average tax rate of 19%. A cut in corporate tax falls immediately to the bottom line, so there’s no waiting around for the benefits. Of course, we're short on details and whether the House version, which reduces tax revenues by $2.4 trillion over the next 10 years, will square with the Senate version, which limits deficit increases to $1.5 trillion, will square with the White House version, which cuts taxes by $1 trillion… remains to be seen. We'll hold off on opining but there is little doubt that changes are coming.

One item that seems certain to change is the treatment of overseas cash holdings. S&P 500 companies hold around $1.8 trillion in cash, or 8% of market cap and 27% of equity. Tech firms dominate, holding 40% of all cash, which makes sense for businesses that have very low needs for working capital or physical assets. We looked at seven of the biggest firms with high (over 20%) overseas cash as a percent of market cap. Here’s the chart:

We know there are many other factors at play here but the immediate benefit of a tax cut for companies repatriating cash should cause shareholders to bid these stocks up. Which they did for a while. The top line sloping up shows they outperformed the S&P 500 by around 12% for most of the year. But this changed in September and they began to underperform. Why?

Well one reason is that the market had already discounted the likelihood of a tax cut. But we think it’s also because that with stocks expensive (and they're in the 95th percentile of valuations like Price to Earnings Growth, EV/Sales, Forward PE etc), management won't only use the proceeds for share buybacks. That leaves special dividends, M&A, capex investment or just keep it for dry powder.

We'd prefer investment for organic growth. At least that would indicate confidence in future demand. But either way, we’re not convinced the tax cuts on repatriation will make a big difference to market returns despite the press attention and the market seems to have drawn the same conclusion.


2. Investing with Uncle Warren:
We're fans of Berkshire Hathaway (BRK) and, full disclosure, I own it. This is not the place for an exhaustive recount of the wonders of Warren Buffet. There are plenty of books about him here, by him and of course, the annual reports are always worth a read. We were surprised to hear that JP Morgan just initiated coverage on Berkshire, which seems odd for one of the largest sell-side firms to start looking at the country’s sixth largest company by value and second largest by sales. Anyway, here's how we think of BRK:

  1. It’s four businesses i) insurance (personal and corporate) ii) rail iii) manufacturing and iv) utilities. Those account for 84% of sales. There’s other stuff like real estate, candy, furniture, Duracell, a motorcycle apparel company and a mobile home builder. Fine businesses but the big four drive the stock.
     
  2. It has a fortress balance sheet, with $86bn of cash. Most of the big four fund their operations internally or with debt not guaranteed by BRK.
     
  3. The well-known investment portfolio is around 30% of the company’s value or $137bn. To us, they're a sort of gimee. If they do well, they throw off more equity value and cash and if they fall, say 30%, in a stock market crash, they only reduce book value by 9%.
     
  4. There’s a sort of floor on the price at 1.2x book value, which would be around 20% below what it sells at today. Buffet goes into some detail about what this means but to us it just means he’s not going to stand by and let the company become a value trap.
     
  5. Finally, BRK uses an “intrinsic” value method, which to us, is the cash that can be taken out of the business for their remaining life and the value of the businesses over recorded book value. Sometimes, this is just the difference between a goodwill write-down and market value but in some cases it’s the value of the business after accounting for big but initial underwriting losses on its insurance businesses.

Basically, GAAP and Statutory accounting must expense the pure loss of an insurance contract and so ignores the deferred benefit of the float. So say, BRK writes an insurance contract for $10bn. They receive $10bn in premiums but must recognize that eventually they will pay $16bn in claims. So that’s a loss on the income statement in year one. But the claims come in over many years so BRK gets the famous “float” or investment returns from excess cash. This is way above the claims cost (e.g. $10bn at 5% for 25 years returns $34bn) and eventually flows back through the income statement and to shareholders.

Anyway, it’s all part of conservative financial management.

Finally, the ROE number looks pretty meager, right? I mean 8%. That's the bottom third of S&P 500 companies. But that incudes the $137 bn equity portfolio, which has a zero return on an ROE basis because it's just stock holdings. Exclude that and the number is more like 12%, which is pretty good for a financial and manufacturing company. And look at the two smaller charts. The growth in book value and earnings  (the green lines in the second and third chart) is poised to grow by around 10% for the next two years, mainly because rail, insurance and businesses like Precision Castparts are rebounding.

JP Morgan figure the book value of BRK is at least around $210 in 2018 (price today is $187) at a 2% growth and up to $266 at 4% growth. We'd look at it more simply. It’s a collection of superb businesses that operate independently and probably worth a lot more if they were ever sold. At this time of highly appreciated stocks, that’s somewhat comforting.


3. Spain:
We're not big experts on Catalan independence but given the Scottish referendum and the history of separatist moves in Spain, it seemed bound to happen. The Spanish constitution allows for some pretty drastic intervention if the region tries to break away. For now, tensions have lowered and we saw spreads on Spanish bonds lower this week. This does not change our view on European stocks, which we increased some six months ago, but is a reminder that political risk can come from very unlikely sources.


Bottom Line:
Stocks are at or near all-time highs and the S&P 500 continues to trade at around 17.5x earnings. Expensive but not at nose bleed level by any means. It’s an earnings week with inevitable Washington stop/go progress on taxes.  

 

Please check out our 118 Years of the Dow chart  

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Other:

We need to talk about Kevin Marsh

Tax cuts not good for rich…no scratch that

Google to buy Apple

 

--Christian Thwaites, Brouwer & Janachowski, LLC


Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

How to Create an Investment Program for Retirement

Whether you have had an investment portfolio for years or are just starting out, this podcast episode is guaranteed to give you clarity on the best strategies for creating a strong investing program for retirement. A few topics covered in this discussion are:

  • How to automate savings and investments
  • 3 areas of risk
  • Importance of compounding


Is my Fed hawkish?


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The Days Ahead: Consumer confidence for September

Stocks reached an all time high this week. It’s been pretty much a straight line all year. The biggest correction was less than 2% in August. We've not had a correction of more than 10% in over five years. That's not great but all market cycles are different and any “exuberance” is taking place away from public markets...in our view it's in the VC, privates and Bitcoin…see below. The narrative was the Fed, renewed healthcare legislation and some stocks hit for missing earnings. We’ll discount the latter because it’s unusual for companies to report an end-August Q3 number.


1. The Fed, no change though you lie under:
The Fed held rates but left open the possibility of a December increase. The full release is here. They don't feel the hurricanes will leave much impact on the economy, which sounds right. Rebuilding and new auto purchases are likely to be balanced by wage loss, some price increases and supply disruption. They announced the start of the balance sheet “normalization” which means smaller but we’re not sure how much smaller. The way they'll do it was announced back in June but is basically:

i) Treasuries: stop reinvesting maturities at a rate of $6bn a month up to a cap of $30bn in 12 months

ii) Mortgages: stop reinvesting maturities at a rate of $4bn a month up to a cap of $20bn in 12 months

Given they hold $2.4 trillion of Treasuries and $1.8 trillion of mortgages, this could take a while. But we think it’s absolutely the right approach and the market regards it as a “nothing to see” event. The 10-Year Treasury rose from its 2017 low of two weeks ago to 2.25%, which was where it was in August. 

Here’s the Fed projections at the time they started the rate hikes in December 2015 and now. Back then, they expected rates to be 3.5% going into 2018. Now it's 2.1%. We realize estimating inflation and growth has become trickier lately. Productivity growth has stumbled and the core PCE inflation seems to have a series of one-offs depressing it but it has only broken the 2% target in 16 of the last 120 months and 13 of those were prior to 2009. 

The Fed’s inflation debate is around two camps.

One, those who believe there are temporary forces at work and that inflation will stabilize at around 2%. The Cleveland Fed Governor even said that it’s going to be 2% because that’s been the most accurate forecast for the last 30 years, which to us smacks of some very lazy thinking.

Two, that post-crisis trend inflation has fallen permanently and deflation is a constant threat. Governor Lael Brainard takes the lead on this view.

We'd side with the latter because wages (here, Europe and Japan) have absolutely failed to move and without wage inflation, there is slime chance of broad inflation. Also, we’re always paranoid about deflation, which tends to kill an economy dead in its tracks.

It could be taken that the Fed is overtly predicting more volatility to come with rates increasing 200bps in two years. But back in 2015 it was 275bps and it just didn't happen. You’ll read plenty of forecasts about increasing volatility (if you're a hedge fund or running a bank FICC desk, you dream nightly of higher volatility) but we believe it will be slow, gradual and ultimately all a bit disappointing on the rate front.


2. Bitcoin everywhere:
We don't pretend to be experts on Bitcoin but we think we know a thing or two about bubbles. There’s lots of information on it. Some of the better sites we've seen are with the BIS here,  here and here.  Here’s an interactive map showing the number of active nodes (nodes are people running Bitcoin software and actively trading) exploding and here’s some instructions on how to trade it you're in North Korea or New York. Apparently, the computing power needed to run Bitcoin takes up 90% of your computer’s processing power so you may want to get a burner phone if you want to explore (definitely not investment advice).

We lived through 1987, the Asian Crisis, the tech crash and of course 2008 so looked back to the Nasdaq boom in the late 1990s and overlaid it with the price of Bitcoin today. We know Bitcoin is just one of the group of crypto-currencies, but we’ll use Bitcoin for now. But anyway, guess what? They match.

So, if you’d bought Bitcoin two years ago, you’d have made 20 times your money and three times since May. At its heart, Bitcoin is a ledger system allowing transactions across multiple users. Its benefits include encryption, anonymity, fixed unit amounts and peer-to-peer management. Which suits well if you want to transact stuff anonymously and cheaply or you believe that having a fixed supply of a currency prevents devaluation (which is why gold bugs like it).

But…but, it's still a bit all wild west out there and we’re seeing multiple copycats and free riders. Here’s one for dentists using Bitcoin called, wait for it, Dentacoin, which, I don’t know, sounds like a solution in search of a problem. Anyway, we put together a mini checklist of what our concerns are here. But if you get approached with a deal that has a spanking new team with a lot of dodgy Phds, a spiffy big font website, a whitepaper attached, security system that you can't quite understand (what is “offline multisig wallet”??) and pitched by a B-list celeb (not this one, he’s A-list), just, you know, don't. The SEC says it best here.


3. How’s International doing?
Depends where you're sitting. If you're in the U.S., then very nicely, thank you. We looked at the returns of the S&P 500, Japanese and Eurozone markets for a U.S. investor and a local investor. Here’s the chart:

The top three lines are for the U.S. investor, with Europe up 20% and the U.S. and Japan tied at around 12%. But for European investors stocks are up around 6% and for their S&P 500 investment, it's negative.

Most of the story this year has been the decline in the dollar, down some 11% this year. Some stock markets are highly dependent on the exchange rate. A strong Yen has not typically done well for Japanese stocks and vice versa. With some markets, a strong currency has just done just fine for stocks. The Aussie dollar strengthened in 2001 and again in 2009 and stocks were up 143% and 46% (ignoring the 2008 crash). It has to do with exporting of U.S. dollar priced commodities and importing secondary goods (we’re over simplifying, we know).

In the U.S., it's a bit of a mix because a weaker dollar flatters many S&P 500 companies that collectively derive 37% of their sales from overseas. For some companies like PM, WLTW, and AVGO it’s well over 90% and they're on a tear this year. It’s one reason why we're quite optimistic about the upcoming earnings season, which we don't think has adequately compensated for the 12% depreciation against the Euro the last three months.


Bottom Line: Stocks remain within a whisper of their all time high. Rates have taken the Fed in their stride and essentially round tripped from the early September low. Watch for politics because if there’s a deal on healthcare, tax reform may come soon after.

Please check out our 118 Years of the Dow chart  

Subscribe here for our investment updates
 

Other:

Google and Amazon new age fascists” says Peter Thiel

Corgis coming down stairs

Vermont’s Montpelier just got free jerseys from Montpellier

 

--Christian Thwaites, Brouwer & Janachowski, LLC

(Note I own PM personally)


 

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Bitcoin Bubble

Bitcoin Bubble

The Bitcoin bubble is well and truly underway. It reminds us of the Nasdaq in the late 1990s so we overlaid the tech stocks then with Bitcoin now. Is Bitcoin a bubble? Well, you may want to check here. We think it is.

1. Are cypto-currencies easy to understand?

2. Is the lack of regulation a concern? 

3. What recourse do you have if they're sold fraudulently? 

4. Bitcoins will put banks out of business. 

5. The high level of ICOs (Initial Currency Offerings) is not a problem. 

6. Do Bitcoins have an intrinsic value? 

7. Is the market in Bitcoins driven by FOMO (Fear of Missing Out) or is there a fundamental economic reality behind them?

8. Do your neighbors talk about Bitcoin? 

 

nasdaq bitcoin_COMP-USA.jpg

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Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted. 

Back to '99


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The Days Ahead: Fed meeting and presser.

Slower retail sales, slow growth in job openings and better claims. Something for the bulls and bears. Oh, and Apple announced new stuff which left the stock price unchanged. Nestle bought Blue Bottle coffee, a local company for us. The price values the company at $700m against a total of only $115m in raised capital over five years. Google, Jared Leto and Bono were all investors. It’s a sign that big companies are desperate for new and innovative ideas and will get growth where they can find it. Full disclosure, I own NSRGY. But back to work.


1. Well that took long enough.

We passed a rather dismal milestone last week. The Census Bureau announced that median household income returned to the same level it was in 1999. That's right. It took 17 years to make it back to where we were. Here's the chart:

Median household income is $59,039 and up from $58,665 in 1999, a laughable compound growth rate of 0.03%. That's the median so it would have been pulled up a bit by inequality at the top end. The 95th percentile out earned the median by 3.8x against 2.7x 50 years ago. Other fun facts show that male head of households earned 40% more than female head of households. And the poverty rate fell to 12.7% or 41m Americans.

What the household income doesn't tell us is how the earners got there. So, yes, $59,000 is a new high but did it take more earners working longer hours to get there? Our guess is yes, given the green line of real hourly earnings growth has pretty much stalled out for the last 10 years. And, while we’re at it, if prices go down 5% and your earnings stay the same, the above Census Bureau methodology, says “Congratulations, your real income just rose 5%.” It did. But did it? We talked about this a few weeks ago here. And while, we’re still at it, they don't adjust for size of household. Same income with three people at home isn’t the same as with four. Now, we admit, that cuts both ways and our guess is that the average household size has dropped.

Why are we going on about this? Because consumers are stretched and real incomes are barely moving, despite known labor shortages. It's tough to see the economy moving to a 3% growth rate with household income at these levels. It’s just possible that a tax cut may help but as most of the talk is about corporate, not personal tax rates, it seems unlikely.


2. Low inflation again.

The CPI came out and, while up on the monthly rate, is still only 1.9%, and for the core (so less energy and food) up 1.7%. So, no worries there. Here’s the chart:

Gasoline costs skyrocketed, up 10%. That was mostly due to Havey but as you can see, it’s a wildly volatile price point, which is why the Fed ignores it for monetary policy. Still, it’s 7% of the CPI weighting so people will feel it. Housing costs (OER) were also up 3.3% and they're the biggest slice of the CPI by far at 24%.

Finally, wireless costs fell by 13% YOY mainly because of Verizon’s unlimited plan. This brings us into the world of “hedonic adjustments.” Here’s the full explanation but we don't think the BLS goes far enough. So, which of these is a price increase?

1. Your wireless bill is $75 a month. You get 1GB of data. It goes to $100.
2. Your wireless bill is $75 a month. You get unlimited data. It goes to $100.

Your pocket says both but the BLS says only the first because you get so much more quality in the second. They'll go further and say it’s a price decrease, which is exactly what’s going on in that lower graph. But for us, the fact that households end up paying more for a basic good means they have less for other things. And if the adjustment is plain wrong, then inflation is over or understated. There are plenty of conspiracy theories that inflation is deliberately understated and here's one of the calmer ones.

We won't go that far except to say that inflation is on a low and steady path. We don't expect big increases and the Fed may stay its hand even beyond December if we continue to see inflation below 1.5%.


3. Cash Overflow.

An interesting article came up with Microsoft last week. Microsoft has a balance sheet of $240bn of which $133bn is in U.S. Treasuries. Some of that is non-repatriated earnings that build-up because bringing them back to the U.S. triggers a tax liability. But man, that’s a lot and makes them a bigger Treasury holder than all but 12 countries. Apple, Cisco and Google (all right, Alphabet) have another $280bn.

We looked at the market numbers and here they are:

That's the market cap of the S&P 500, around $23 trillion, and the cash percent. It climbed rapidly after the crash and seems to have plateaued at 8% of market cap. It’s around 25% of the S&P 500 equity (the bit that's left over in the balance sheet once all liabilities are paid).

So what? Well i) if the corporation tax cuts comes, that potentially frees a lot of money for shareholders or capex ii) it’s some buffer against a downturn or rising rates (although about 10 tech companies account for 25% of the cash) and iii) it provides a lot of support for Treasuries.


Bottom Line:

We expect stocks to stay well bid… again. Talk of tax cuts help and the dollar will help earnings. The Fed will probably sound dovish which will keep Treasuries in their 2.15% to 2.25% very tight range.

 

Please check out our 118 Years of the Dow chart  

Subscribe here for our investment updates

 

Other:

Tech lobbying (they're good)

Day in the life of a backpack corgi

Electric vehicles “unaffordable and unachievable

 

--Christian Thwaites, Brouwer & Janachowski, LLC

(again, I hold NSRGY)


Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 

Quick Read: Claims and Hurricanes

Expect jobless claims to jump a lot in coming weeks.

That blip on the right is only one week of Harvey. Katrina pushed up claims by 100,000 back in 2005 and Houston and Florida have twenty times the population of New Orleans. 

Claimsbasic storms_SP50-USA.jpg

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Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.