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Record Highs. But elections coming

The Days Ahead: Fed meets and will raise rates.  

One-Minute Summary: Stocks reached another record high. We're now up 10.1% for the year and up 15% since the mini correction in February. Small caps have done even better at 16.1% and 19%.

We've seen stocks rotate. That's when stocks that were previously unloved come back in favor. We looked at sectors like Consumer Staples, one of the worst performing sectors, which was down 5% to the end of August but rallied 2.3% so far in September. Tech, the clear winner for most of this year, is down for September.

It’s happening at the stock level, of course. Exxon, the sixth largest company in the S&P 500, was down 4% from January to August. It’s up 6% so far in September. It’s the same story with companies like Caterpillar, Altria, Cigna and some major insurance companies. What this tells us is that prior favorites like Tech and Small Cap are taking a breather or open to profit-taking and lagging companies are having their day. It doesn't change our Small Cap outlook…Tech is different, it’s under some regulatory pressure and much more expensive. Small Caps have a relatively high exposure to REITs, Financials and Specialty Retail…all of which have come under recent, temporary pressure.

The dollar looks like it peaked a month ago. It was up 9% from February but has since weakened against some key currencies…down 4% against the Swiss Franc, 3.5% against the Euro, 2% against the Yen and 3% against sterling. Yes, the dollar has the rate advantage but exchange rates are also driven by confidence, diversification and capital flows. The U.S.’s twin deficits (current account and budget deficit) are heading the wrong way and eventually they’ll show up in the exchange rate.

We don’t think anyone’s winning the trade war. Despite the big numbers from the Administration, the tariffs amount at worst, to $60bn, which is less than 0.3% of U.S. GDP and a drop in the bucket compared to the $220bn of tax cuts coming into the U.S. economy. Because so much of the imports from China are intermediate goods (here’s the list, it’s 195 pages), the costs may show up in higher prices or squeezed margins some months from now. But it won't be big and it won't solve the broader “Made in China 2025” problems.

Also big news: the sector definitions for the S&P 500 will change on September 24. We’ll no longer have a tech sector at 28% of the index. Instead we’ll drop Telecom and have a new Communication Services group. It will bring in some companies which are now Consumer Discretionary, like Comcast and Netflix, and some which are now in Tech, like Google and Facebook and will be around 11% of the S&P 500. Expect some rebalancing trading on Monday.

 1.     “Tax Cuts will lead to pay increases”. Said some and indeed there was a 2.9% increase in hourly earnings (AHE) in the August payroll numbers. Hooray said some. Not so fast, said others.

There are a few ways to get a pay increase:

 1.     You're paid more

2.     You're paid the same but work less

But we’re not interested in nominal increases. We want to see increases in real purchasing power and wages, otherwise you're just pushing money around the economy, not really increasing broad wealth. And there are a few way you get a real pay increase:

3.     You're paid more than the increase in inflation

4.     You're paid the same but inflation falls

5.     You're paid the same but work less or get more benefits

It’s only #3 that matters and the results are mixed. The tax cut was meant to lead to higher investment, productivity and wages. It was one of those “it pays for itself” programs. As we pointed out at the time, that was a big ask because the tax cuts caused the deficit to increase by 1% of GDP immediately and by another 1% over 10 years.

We've seen companies increase share buy-backs. We've seen some increases in bonuses and time off. But wage increases have been very slow, even as the Fed frets about a sub 4% unemployment rate. Here’s the wage picture in one chart:

The blue bars are what’s reported in the payroll numbers with average hourly earnings up 2.9%. But if we deflate that by the CPI so get a picture of real purchasing power, we see a less impressive 0.23% (black line). And if we separate out the very large cohort of Non-Supervisory Employees from the All Employees category, we see the real hourly wage at $9.24, lower than a year ago.

Now, we bring this up again because of headlines like “U.S. wages grow at fastest pace in nine years” (Financial Times) and “Bumper Wage Growth”. Hey, we’d like nothing more. The U.S. consumer drives 70% of GDP, perhaps more than any other economy in the world. But it’s not showing up in things like retail sales or housing and it’s very likely personal consumption will grow a lot less than the 3.8% it showed in Q2.

2.     So, 3% on the 10-Year Treasury. Now what? Probably not much. There are some seasonal aspects to the Treasury market. They have to do with when new auctions come around, corporate cash needs, repatriation and even national holidays in China and Japan. This year, U.S. companies with pension deficits could deduct the cost of funding them using the old 2017 corporate tax rate up until September 15. That meant a CFO could save some 15% on buying Treasuries. We feel that kept the 10-Year Treasury under 3% for most of August. That buying has now stopped.

 We've discussed the inverted yield curve. After moving relentlessly from 60bps in January to a low of 19bps in late August, it has now reversed back up to 27bps. Here's the chart:

We're not sure if the move to inversion (i.e. the upper blue line falls to below zero) is a solid indicator of a recession. Sure, looking back over 30 years, there it is…the spread falls to below zero and a recession appears some 14 to 26 months later. So that’s three times in 30 years.

But here’s the thing: being early and right is the same as being wrong. There is no point heading to the long part of the curve in the expectation that all the price weakness will be at the short end.

 And as for coming out of equities, well, we’re not timers and markets can have strong and late rallies for quite some time. Here’s the curve shown in stark terms…compare the yellow line to the shape of the curve a month and year ago. It’s only the 2 to 10-Year Treasury spread which is flattening. We'd argue years of QE and low absolute and real rates mean that any inversion will have to look at 3-month bills and long-term bonds. And we’re not close there.

Meanwhile, here’s how we look at the Treasury market:

All we did here was look at several U.S. Treasury prices today and work out how much rates would have to rise in order to lose money on a Treasury trade over 2, 5, 10 and 30 years. The duration measures how much the price of the bond would fall if rates increase 1%.

The best risk/reward right now looks like the 2-Year Treasury (actually it’s about 19 months, maturing in April 2020). It yields 2.38% for a risk/reward of 0.56.

Another way to look at that is that rates would have to rise 1.7% immediately for that investment not to have a positive return. For a 30-Year Treasury, rates would only have to rise 0.16%. To be clear, we’re not ringing any alarm bells here. We're just taking advantage of the recent rise in yields, which makes a short-term Treasury investment look quite attractive and, for the first time in a while, a valid asset class.

3.     Any relief on Emerging Markets yet? Some. Performance in 2017, when Emerging Markets were up 45%, seems distant. So far in 2018, we’re down 8% but up 4% from the bottoms just two weeks ago. We've discussed before what’s happened (basically a dollar, interest rate and trade problem) but the question now, of course, is what next? Here are some quick thoughts.

  1. Buying into Emerging Markets is not an exchange rate or trade story. It’s about growth, demography and expanding economies.

  2. Turkey and Argentina are basket cases. They're not in the Emerging Markets asset class to any meaningful weight but their stories grab headlines. We don't believe the financial contagion story for a moment but agree there’s a sentiment problem.

  3. Drawdowns in Emerging Markets are common.

  4. 50% of global growth comes from Emerging Markets.

  5. The new NAFTA with Mexico is good for Mexico.

  6. The 22% annual increase in oil prices has hurt Emerging Markets but the supply issues (Iran and Venezuela) are no longer driving up prices.

  7. Seasonal patterns happen in Emerging Markets especially after a bumper year like 2017.

  8. China stocks had their best day in two years on Friday…these things move fast.

So while the short-term can stretch patience, the longer-term strategic case remains.

Bottom Line: Fed meeting. Much will depend on whether the Fed removes the “accommodative” wording. They’ll also review the long-term projections for the Fed Funds rate. It’s currently at 2.3% to 3.5%. If that heads up by 0.5% we may see some pressure on bonds.

 Please check out our 119 Years of the Dow chart  

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 Other:

Instagram can kill you

 --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.

 

Karl Hyde - 8 Ball 

While Away...

The Days Ahead: Trade and more trade. Unemployment numbers.  

One-Minute Summary: We're away but not absent. Off on a short recharge break. Back in two weeks.  While we’re gone, this is what we’ll be paying attention to:

1.     Trade Talks. China, Canada and Europe. We'd look for a de-escalation with China and some progress with the EU. There’s a sort of “good cop (Treasury), bad cop (Commerce)” play going on and Treasury is up first. We'd also look for Canada to be included in the “just don't call it NAFTA” discussions. There seems to be some urgency going into the midterms to get something done.

2.     Growth. We talked about some so-so housing numbers last week but Industrial Production keeps chugging along. The Q2 GDP revised numbers came out. They went up a bit from 4.1% to 4.2%. You can see from the graph what a rapid departure Q2 was from prior quarters (blue bars):

The big question is, how much is growth borrowed from the future? We'd say at least 0.5% but admit this is a very rough estimate and we’re not economists. Take a look at the second line. That’s GDI (Gross Domestic Income) and is an alternative way to measure GDP. They should be the same but there is a very big discrepancy right now. In the second quarter, investments in “Intellectual Property” were revised up by a whopping 2.8%. That’s basically software. But personal consumption and imports were revised down.

The theory behind the tax cut is that companies’ lower tax bills lead to increased profits, which mean more investment, which grow employment and wages. The first one is happening. Pre-tax corporate profits were up 7% YOY and post-tax up 17% (these are national numbers…. S&P 500 companies are way ahead). Investment growth slowed and the personal side is back to where it was a year ago.

So far the consensus is for another 3.5% GDP growth Q3 but the latest trade numbers were not great and are set to be a net drag in Q3.

3.     Employment and the Fed: First Friday in the month so jobs numbers next week. We would expect around 180,000 but given the margin of error on this number, +/- 40,000 would not make much difference to the market. Hourly earnings will also be mostly unchanged at 2.5% but down and close to zero in real terms. The Fed doesn't meet until September 26, at which time they’ll almost certainly raise the Fed Funds rate by 25bp to 2.25%.

Meanwhile, we’d expect 10-Year Treasuries to trade around 2.8% to 3.0%.

4.     Stock market breadth: We've seen some improvement in the advance/decline ratio. What we look for is wide participation in the market. A “bad” participation day would be if a few stocks are enough to push the index up but the majority of stocks fall. Recently it’s been about half the stocks up and half down on an upday, which is good.

5.     Emerging Markets. Markets bounced 4% this week, based on the Mexico trade deal and a weaker dollar. The big three influences are at work: trade, rates and the dollar. None of those will disappear overnight. But we’d look for some relief on the currency side. And on Emerging Markets….

6.     We had an interesting question come up in our Emerging Markets call-in (it’s here)

Is the term “Emerging" accurate? Or are the so-called "emerging markets" comparable to the time-honored description of Argentina, i.e., "has a great future and always will have?"

The Argentina reference comes from the fact that at the turn of the 20th century, Argentina was the world’s 10th largest economy. Now it's not even in the top 20.

We don't think the term “Emerging” is terribly helpful. It was 40 years ago but when you have the second largest economy (China) and South Korea or Taiwan all called “Emerging” there is a definitional problem. Just to confuse things further, Argentina is Emerging with some index providers and “Frontier” for others. Same goes for South Korea. Some say “Developed,” others “Emerging” and the differences are down to the Chaebols, not to South Korea’s heft in the world economy.

The “Emerging” definition these days is as much about governance as economic size. So countries with restrictions on foreign ownership, non-GAAP reporting standards, cross-holdings or voting shares are all in the Emerging bucket. When they start to address those they're promoted into Developed.

There are some real powerhouses in emerging markets: China, South Korea, Taiwan and India. They're 65% of the index. And even eastern European countries (12%) are pretty advanced these days.

We don't think there are many that are perennial hopefuls (i.e. probably not going to do much in coming years) and not one of those countries is more than 2% of the index. Here’s what it looks like:

So, yes, while “Emerging” has a nice ring to it, “Less developed” is probably more accurate. 

7.     And finally: In a month when we hit several all-time highs, we’d remind ourselves of the long term. Here’s the Dow Jones stock index back to 1900 (the S&P 500 is a better index but only goes back to the 1950s). Through some bad times, the market has powered ahead. On the 10th anniversary of the Lehman crash, it’s worth looking at how well the market has done over time.

As always, if something comes up please feel free to call Rita on 415 435 8330.

 Bottom Line: Stocks are trending up but with no big stories or conviction but on macro and political headlines.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

Five lessons from the ultimate innovators

 --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.

Summer Sun (Plein Soleil)

What's up with emerging markets

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Not the longest bull market

The Days Ahead: Second estimate of Q2 GDP and Personal Income.

One-Minute Summary: There are indications that markets are becoming inured to tweets. What would have shattered confidence a few years ago now passes for normal. The noise-to-signal ratio in investments is always high. What seems important at the time, probably doesn't count very much for long term investments. We look at the economic cycle, inflation, earnings and rates. Data on most of those fronts didn't change much.

Stocks had a good week, especially small caps. Emerging Markets were up 2.5% but the news from China (trade) and Turkey (currency) was unchanged. Put it down to summer volumes. The main story was the dollar, which weakened by 1.6%, its worst week since February.

1.     Is this the longest bull market ever? No, except when using a very arbitrary measure. So, last week the S&P 500 recorded a 410% gain from the March 2009 low, without a 20% drop. Cue, “longest bull market” headlines. But the definition of a bear market requires a 20% drop. A “correction” requires a 10% drop. Both definitions are nonsense. What about 19.5% or 9.9%? When you’re talking markets, it’s as much about sentiment as numbers.

 In the 1970s, stocks fell 53% over two years and took another five years to recover the losses. We would argue that was a more painful and meaningful bear market than the short-lived 30% bear market of 1987. The 1970s were a slow, grinding and persistent sell-off in the face of inflation, oil supply shocks, bank failures and property crashes. The 1987 sell-off was a by-product of an investment fad called portfolio insurance (as in, it claimed to but didn't).  

Similarly the 1990s bull market was a steady, all-round improvement in earnings, multiples and productivity. The current bull market from 2009 is a painful recovery from devastated financial markets. In the first, people made money. Market rose 405%. In the second, investors took nearly four years to make back their losses. Yes, stocks rose 316% from the bottom but investors made a less impressive 86% after getting back to break-even.

The previous “longest” bull market was from October 1990 to March 2000, when the market rose 405%. But that includes two 20% sell-offs that were relatively short. In our view, the real bull market was from summer of 1982 to March 2000, when the market rose 1,300%. We measure the current bull market from its 2000 peak, in which case returns are also around 86%. For a full 13 years, from 2000 to 2013, the market returned 0% excluding dividends. (We might add that an investor making consistent investments over that time would have experienced much better results given the many opportunities to buy low.)

The recent gains in the market mean that for 1, 3, 5 and 10-year rolling periods, we now have double-digit gains for all four of those reporting periods for the first time in 18 years. The 20-year number is less impressive.

So can the market keep going? Certainly. Price earnings ratios are quite high but have leveled off in recent months. Stocks are cheaper than they were in 2015. Dividend growth is strong. Earnings are up. The longest post-war bull markets were well over 18 years each. By those standards, the current one has some way to go.

2.     What’s the Fed up to? Not much. There were some fears that the President’s er…comments on the Fed chair may compromise its independence. We think that's highly unlikely. The Fed minutes were published last week and Chairman Powell delivered a speech at Jackson Hole. Our takeaways:

  • They see the problems in Emerging Markets but don't feel the need to act
  • They're thinking about moving policy from “accommodating” to “neutral”
  • Trade and fiscal policy may have downside risk
  • Inflation is not a problem
  • They have their eye on financial instability…to a degree much more than prior Feds

The bond market has barely reacted. The main concern is the yield curve:

That line at the top is rapidly pushing to zero, which means that two and 10-year rates pay the same. That’s usually good for medium and shorter bonds…the first for total return, the second for yield. And that's where we’re focusing our bond portfolio.

We don't think the inverted yield curve is quite the harbinger of recession that popular commenters believe. So, you won't see us reacting much if it does fall further.

3.     Are we looking at a housing bust again? No. Property and banks. That’s where we look for a systemic blow-up in the economy. It's mostly because unfettered credit extension reaches rapidly across and down the economy. There are credit problems today. Corporate and government borrowing are high and the latter is set to rise further. But they don't have quite the same reach as the first two.

So, we’re quite relieved to see some of the recent numbers on housing. The ones we watch are housing starts (down 12% from a few months ago), new home sales (down 5%), mortgage delinquencies (12-year low) and existing home sales (down 5%). Here’s the existing home sales chart:

Sales have stalled and we think it’s to do with the lower lone, which is the 30-Year mortgage rate. It’s 80bp higher than the beginning of the year and would increase a mortgage repayment by more than 10%...in a flat real wage environment, that's enough to push demand back. The new limits on tax deductibility haven’t helped either.

Anyway, it's also an illustration that monetary policy works with a lag. The Fed tightening this year may not show up for two to three quarters. Those housing numbers are the result of policy steps taken nine months ago.

4.     How bad are political crises for markets? We care about politics in our real life but markets are dispassionate. Let’s look at four examples:

  1. Nixon: from February 1974 to the resignation in August 1974, stocks fell 10%
  2. Clinton: from December 1998 to January 1999, stocks rose 6%
  3. Brandt: German Chancellor and spy ring in 1974, stocks fell 22%
  4. Chun Doo-hwan: drawn out saga of corruption in South Korea, stocks rose 25%

The trouble with any of these and more is that exogenous influences probably had a far greater effect on the markets. The purely political ones are very difficult to isolate. We think company profits, the Fed and trade will influence markets more than politics. For now, those are all on a steady path.

 Bottom Line: Stocks are trending up but with no big stories or conviction. We don't expect the political  noise to influence markets much.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

Five lessons from the ultimate innovators

 --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.

Karl Jenkins: The Armed Man

Whiff of Contagion

The Days Ahead: Jackson Hole Symposium, which is often a good source of Central Bank think. Very thin economic reports and corporate earnings season is all but done.

One-Minute Summary: Consumer confidence fell. That surprised some but we think it’s not tied to claims and employment, which are running well. But to wages. I know we bang on about this a lot and there are plenty of others following the same story. Here are the latest wage increases:

Wage increases are barely positive and we believe even those numbers are inflated by supervisory pay. In other words, non-supervisory employees are seeing negative growth in real wages. There are many more workers than bosses so we think the average number is misleading. And it’s been happening all year. There are plenty of plausible and conflicting reasons why this is happening but none are important to markets right here right now. We'll just leave it that consumer spending cannot sustain a 4% growth rate. Wages aren't strong enough.

Gold was down (it usually drops if the dollar strengthens). The S&P 500 finished mostly higher with defensive sectors (telecomm and staples) ahead. The 10-Year Treasury was up. Economic news was mixed. Slow housing starts. Strong retail sales. Productivity growth stayed around its recent, not-so-great trend. Tesla dropped and Elon Musk apologised.

1.     How’s Turkey doing? Not well. If you're an Emerging Market with an inflation and budget deficit problem, you're meant to:

  1. Increase your domestic interest rates…it helps to defend the currency
  2. Tighten fiscal and credit markets…anything, like raise the pension age, curb bank borrowing, but, you know, something
  3. Get some external funding, which usually means calling the IMF

It’s a pretty well-trodden road and see, passim, Argentina, Thailand, Mexico and even Turkey in 2002. What you're not meant to do is:

  1. Pick a fight with your allies
  2. Openly seek assistance from countries with sanctions against them
  3. Not increase bank rates and keep your son-in-law as head of Finance.

So Emerging Market bears continued to sell Turkish stocks, bonds and currency. The bonds alone widened out by 200bps in the last few weeks, which means they had a capital loss of around 22%. Here’s the chart:

One might reasonably ask why Turkey, with its 1% weighting in the Emerging Markets stock index brings everything else down? It’s mostly because of contagion fear.

First there are European banks with outstanding loans to Turkey. Those loans will be impaired. Banco Bilbao, in Spain, is down 13% in the last few weeks and down 25% over the year.

Second, investors start to look at countries that share the same problems as Turkey, and number one on that list is South Africa.

Third, there’s a problem with covariance in Emerging Markets. If a developed market runs into a recession, stocks fall and interest rates fall. So, there is some portfolio diversification benefit. But in Emerging Markets, currencies need protection so interest rates rise and stocks fall. There is no diversification benefit.

Emerging Markets are also caught up in the Sino-U.S. trade war. News of renewed trade talks later in August helped markets recover on Friday but China is still slowing…the trade talks may help but signs in the currency (it’s down) and commodities (way down) suggest the Asian correction isn't over. Again, we’re using protection for what might be a troubled few months.

2.     Fidelity launched a 0% ETF. Isn't that great? Perhaps. So, yes, Fidelity launched a zero cost ETF and even stuck “zero” in the name, so they would be taken seriously.  What could possibly go wrong? Well, not much, perhaps, but there are other things to think about when we get to near zero fees. For every $10,000 you have in the Fidelity account, you would pay $4 in a similar Vanguard fund and $3 in a Blackrock iShares fund. Fidelity is a fine company. But we’d also look at:

1.     Securities Lending: Many ETFs lend out their securities to custodian banks. We could not find how much of the securities lending proceeds Fidelity will credit to the fund and how much to the investment company. The split should be around 80/20. Our guess is that the investment company will take a larger share.

2.     Index: Fidelity came up with its own index to track the U.S. market. Again, nothing wrong with that but others like Blackrock, Schwab and Vanguard use external, independent indices. Which, we sort of prefer.

3.     Returns: not all indexes are created equal. We've written about the performance of the small cap S&P 600 (up 213% in 10 years) over the better-known Russell 2000 index (up 162%). While not quite as big a difference, here are the 10-year returns of five big, U.S. multi-cap stock funds and ETFs:

They’re all bunched together but squint at the end lines and the extra returns for a $100,000 portfolio over 10 years for an investment in the top and bottom funds turn out to be $17,530. The best fund was not the cheapest. Nor was the worst (we’re talking relative here) the most expensive. It all came down to which index the fund tracked. Some indexes are better than others.

So, pick your index, then the cost. Cheapest does not mean the best (h/t Dan Wiener).

 Bottom Line: Treasuries will remain bid, mainly because of the expensing of pension contributions we discussed last week. We'll be testing Emerging Markets contagion again.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

Pastafarianism is not a thing

--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.

Closing note: Aretha and Chains

Tesla, Turkey, Treasuries.

The Days Ahead: Earnings mostly over. Productivity report

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One-Minute Summary: Strong week for equities with not much to change the tone of good results, modest inflation and economic numbers and a truce of sorts on the trade side.

Tesla said, “enough of this reporting nonsense, we’ll go private”. Then thought about it. Then couldn’t decide. Normally, we’d ignore stocks like these but the company has a record short position and there’s a lot of money at stake proving or disproving the Tesla dream. We raise it because, well, it’s just not good when i) CEOs announce market sensitive news by Tweet ii) there are convertible and iii) regular bond holders to consider and iv) there’s a very convoluted process for buying out shareholders that may just leave them shareholders, if they want. It’s just, you know, not good governance. And they're not the only ones. Call us old fashioned. Here and here have the best take on it and the SEC is on the case.

Berkshire Hathaway (BRK.B) had a good week. It reports on a Saturday to keep the news cycle at bay. One big change was that unrealized gains on the stock portfolio now report through the Income Account. This is a weird rule. Berkshire holds $50bn of Apple stock, which is around 10% of Berkshire’s market capitalization. If Apple goes up, Berkshire now has to recognize that through the income statement. So, in Q1 investments showed a loss of $7.8bn and in Q2, a profit of $5.9bn. You get volatility in return for transparency, I suppose. Some might like that. The core operating business did well and that was mostly what drove the stock up 5% for the week.

The 10-Year Treasury auction went well. As we wrote last week, this was a record amount of $26bn and we were concerned dealers would have trouble placing it all. But no, it was well bid.  But it adds to our concern that the yield curve will invert. Meanwhile, the TIPS curve inverted last week for the first time in 10 years. We should note that the yield curve inversion is not a sure recession indicator (see here) but more of a concern that growth will slow. Which we already know from other data.

1.     Is inflation out of control? No. But you may think so from some Friday headlines. The headline inflation hit 2.9% and the core inflation hit 2.4%. Here’s the chart with the blue bars getting all the headlines.

We expected these numbers mainly because there was a big base effect from 2017.

First, remember the cell phone expenses? They were falling at an annual rate of 20% a year ago. Well those deals are over.

Second, gas prices were flat a year ago but are now up 25%.

And third, used car prices are running high, probably as a legacy from the hurricanes when people needed to replace lost vehicles quickly.

These account for around 12% of the CPI. Take them out and we’re left with an inflation rate of around 1.5%.

Treasuries rallied by about 1%, so markets do not think any of this will change Fed policy. We'd agree. Meanwhile, real hourly earnings didn't change and average hours worked dropped. So, the outlook for personal consumption (the bit that's 70% of GDP), which was half the headline GDP rate of 4% in Q2, looks not so hot.

2.     How’s Turkey doing? Not well. Without diving into the dodgy politics and economics of Turkey…oh all right, Erdogan’s son-in-law runs the Ministry of Finance (here but they took down his bio) and promises to do something about the financial mess.  But it all came to a head on Friday as the Turkish lira dived. Here it is:

It's not often you see a 25% fall in a week for a sort-of major currency. The problems are fairly commonplace:

  1. over leveraged banks with
  2. mismatched FX
  3. 10% inflation and
  4. high government debt.

These are not good headlines but Turkey’s role in the world and Emerging Markets is small. Its economy is around $850bn and its stock market, down 50% this year, is around 1% of the Emerging Markets index. But even at that level, investors tend to hit the sell button on whenever there is a story like this. It's not enough to change our long-term thinking but adds to our short-term caution.

3.     Stocks at record high. Time to sell?  No. The S&P 500 is slightly below its all time high from January 26, 2018. But the better index is the S&P 500 Total Return. This one takes the 2% dividends from the S&P 500 and reinvests every quarter.

 And wow, what a difference that makes.

 Here's the chart with the S&P 500 on the bottom line and the total return on the top. One hundred dollars invested in the S&P 500 in 1989 is worth $1,070 today. With dividends reinvested, it's $2,066.

The total return index has had four all-time highs this year. The regular S&P 500 only one. That’s pretty normal and the only reason it’s not more widely reported is because, well, it’s kind of boring. “Remember to reinvest those dividends” doesn’t quite have the ring of “Why stocks will crash next week.”

So, dividends matter.

 Bottom Line: Earnings drove stocks to an all-time high. There’s little corporate news in the calendar so expect macro/tweets/trade to drive returns short term. Treasuries to remain strong because companies can expense pension contributions at the old higher corporate tax rate for another month.

Please check out our 119 Years of the Dow chart  

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Other:

Best not to provoke bison

 --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.

Friday Music - Nils Lofgren

Apple adds a zero

The Days Ahead: Big 10-Year Treasury auction. Inflation numbers.

Listen to the Podcast: Apple Podcasts • Soundcloud • Google Play

One-Minute Summary: One of those weeks when you think lots of stuff happened, markets must be going bonkers. But stocks had a good week. Earnings continued to do well and of course, Apple, had a strong week. It’s now 4% of the S&P 500 and $1 trillion. It’s an even higher weighting in 8 out of 10 of the largest ETFs, ranging from 4% for an S&P 500 tracker and 15% in the Technology Sector fund (ticker XLK). Not to spoil the party, but we’d remind readers that Altria has been a much better stock since Apple’s IPO back in 1980. One hundred dollars invested in Apple back then is worth $55,000. For Altria it’s $88,000. The slow and steady increase in Altria along with dividends was a better investment than the long no-dividend policy of Apple and the 17 wilderness years. Still, great company and justifies much of the run-up in the S&P 500 in the last few weeks.

Trade was front and center again. The U.S. Trade Representative raised the stakes by increasing tariffs on $200bn of goods from 10% to 25% but not until September. The Chinese shot back announcing yet unspecified tariffs on $60bn of U.S. imports. The U.S. exports around $120bn of goods to China every year so, yes, the Chinese may be running out of retaliatory measures.

There’s a sort of trade truce with the EU right now so expect more on the China trade for a while. If markets seem numb to the trade issues it's because there’s still a big gap between what’s been threatened and what’s been implemented. However, the Yuan/$ rate is getting a lot of attention. The Yuan has weakened by 8% since April, negating much of the effects of higher tariffs. That's one reason why we’re a little cool on Emerging Markets right now and taking protection.

Elsewhere, the job numbers were lower than expected and average hourly earnings didn't move much. The numbers won't change the Fed’s mind on a September hike. The 10-Year Treasury broke through 3% for one day and settled back to 2.95%. If a 3.9% unemployment rate isn't enough to push yields higher, what is? We'd say earnings and wages (not increasing), a better trade deficit (no), more confidence from the Manufacturing and Non-Manufacturing sector (no), more aggressive talk from the Fed (not there either), or higher inflation (see next week but probably not).

1.     Should we care about the budget deficit? Yes, but not yet. One of the ironies of the last year is that the normally fiscally disciplined politicians signed on to a very big tax cut in the last stages of an economic cycle. The argument for such a move was that lower taxes would spur investments spending, growth, productivity, all sorts of good things and, of course, lead to higher tax revenue. So:

Step 1: Cut taxes

Step 2: Wait

Step 3: Higher growth and more tax revenue

Tax revenue is down $150bn in Q1. It will be more in Q2. Corporate tax receipts are down 48% and, as a percent of GDP, at a 70-year low. The OMB announced that the deficit in 2019 is now $1 trillion or around 5% of GDP.

We'll stay away from the soundness of such a policy and point to two things.

First, here’s a chart of the deficit and unemployment since 1948.

We've inverted the unemployment rate to show the relationship. As the economy enters a recession (the shaded bars), unemployment rises and deficit spending increases to make up the shortfall. There’s a drop off in tax receipts, of course, but the general approach is to smooth out demand when the economy most needs it. Once the recession eases, stimulus is removed and the deficit improves.

What's remarkable about the last year is that the two lines have gone in wildly different directions. This means that if there is a recession, there’s little scope to increase spending when it's most needed.

Second, there’s the increase in borrowing. The Treasury just announced funding needs for Q3 and Q4. It’s a very big number. In Q3 the Treasury expects to borrow a net new (i.e. after funding maturing debt) amount of $329 bn, up $56bn from April estimates. And in Q4 it expects to borrow $440bn. Again, net new. That compares to $72bn in Q2 and $192bn and $204bn in the same time last year.

The Treasury is doing all it can to help the process. They're introducing 2-month bills for the first time. They’ll come in November at a rate of $25bn for seven weeks. They increased the amount of 5-Year Treasuries by $1bn a month and the amount raised from bills (so less than 12-months) from 18% to 27% of the total. That should make it easier to absorb and keep longer-term rates from rising as fast.

What does it mean? One, we like the short end of the Treasury market. It’s a strong risk adjusted place to be in the yield curve. Two, we also like medium term (7-10 year) Treasuries as we think rates will peak some time in 2019 and not affect the middle of the yield curve.

2.     Why are asset managers not good investments? I mean, you know, they manage money for a living so you might say to yourself, “these guys know what they're doing, I’ll buy the stock and get a nice alpha-laden return on the S&P 500.” But no. The public fund companies have been pretty awful investments. Here’s a composite of some of the biggest (we left out Invesco and Blackrock but they are not the exception…we just ran out of names):

Over the last 10 years, an investment in some leading asset managers underperformed the S&P 500 by about 45%. It doesn't get better if we change the dates. Year to date, three, five and 15 years are no better. Are they just bad managers? Erm…no, but they're in a tough business. What has been investors’ gain in the form of low cost index funds has been asset managers’ loss. Many are caught between low cost providers, like Blackrock, State Street, American Funds and Vanguard and specialist hedge, private equity and venture funds. ETFs and low cost funds are now around 20% of all managed funds and take an even greater share of flows.

Many will adapt. Either by merging, shrinking or finding new areas of growth. But for now, it’s probably more disruption and declining margins.

 Bottom Line: Earnings are still doing well. The Yuan, trade and  macro numbers will drive sentiment. Meanwhile, stocks, as we’ve mentioned, stocks are trading on forward P/E of 16.6 cheaper than all of 2016 and 2017.

Please check out our 119 Years of the Dow chart  

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Other:

Charlotte takes on the world

 --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.

Friday Music: DIscover India

Summertime and Your Investments

This is a recording of our August 2018 conference call. If you want to join us live next time or get future updates about new episodes, subscribe to our email newsletter: bandjadvisors.com/subscribe

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Five tech hand

The Days Ahead: More corporate earnings, including Apple. Job numbers.

One-Minute Summary: Google and Amazon beat by a large amount and had small rallies. Netflix, Facebook and Twitter beat by small amounts and were hammered. There’s a lot of high expectations in the market. High, consistent growth is tough to find. Those companies that provide it are priced for perfection. But one miss and the leveraged and momentum buyers dump the stock. Volumes in the three that missed were 8 to 10 times higher than normal. We stand aside when that’s going on. It's not so much price discovery as sell first and ask questions later.

The S&P 500 didn't quite hit its all-time high of 2,872 but it probably would have if Facebook had behaved. It's 2% of the index. News on the trade front was better. The Trump/Junker deal was progress, even if some of the promises don't materialize. The ECB was optimistic on growth. European and Emerging Markets rallied. U.S. Treasuries were mostly unmoved, which is impressive given a big August refunding.

1.     Everything is awesome. In the most anticipated news of the season, Friday’s report on the Q2 GDP number was a barnstormer.  It came in at 4.1% more or less in line with consensus and pretty much as every economist on the street and the Atlanta Fed GDP Now guys predicted. Well done everyone.

So why are we skeptical? Well, first remember that GDP is skewed to the top 10%. They own/earn around 35% of GDP while the bottom 50% earn around 25% of GDP. Here are two scenarios which both produce GDP growth of 5%:

In Growth 1 everyone is happy. Everyone grew. Some more than others, yes, but all OK. In Growth 2 half the population saw negative growth, 40% none and 10% a nice jump. The outcome for total growth is the same in both: 5%. We think Growth 2 is far more like what is going on in the U.S. Which is why people look at the growth headlines and wonder where they missed out (h/t Equitable Growth via FTAlphaville).

Some of that is just the way economists calculate GDP. After all, in that world, the birth of a human detracts from GDP/PP and the birth of a calf increases it. We don't have a better way to measure growth. So, you know, good headlines and all but not a mic drop.

Moving on.

This is how GDP looked:

Good news

  • U.S. economy shot past $20 trillion. All the tariffs announced so far amount to less than 0.75% of the economy. At this rate, the U.S. economy would make that up in 10 weeks
  • Q1 revised up for Q1 and prior years
  • Exports were a big driver of growth. Have not been this big since 2016 and second biggest number in five years
  • Personal consumption (70% of the economy) was up 2.7% or 65% of the growth
  • PCE inflation (the one the Fed measures) was 1.9%
  • Nominal GDP grew 7.3%...good for equities

Not so great

  • Inventory buildup was negative. We see inventories very simply. If producers expect demand to be higher, they build up inventories. If they don't, they don't.
  • Some exports (the soybeans we’ve discussed) were brought forward to beat the July tariffs. 
  • Nominal GDP growth is way ahead of wage increases…consumption may not keep up
  • The 2017 tax bill front-end loaded spending and tax cuts.

The market had other things on its mind, like corporate earnings, trade stuff (stop me if you've heard this). Neither bonds nor equities moved much. It was all in the price. But, we’d still say it’s a good setup for the rest of 2018.

2.     One Fang just got smaller. The stock was down 20% in after hours trading on Wednesday and didn't recover much on opening. Why?

  • User growth was less than expected
  • Revenue growth revised down in 2H 2018
  • Expenses up
  • Missed (only slightly but there’s little margin for error with a stock like FB) advertising revenue target
  • Headcount up 47% YOY
  • Some negative comment about the EU privacy regs General Data Protection Regulation (GDPR…expect to hear more of this) where they lost 1m subscribers due to the new rules.

Quotes from the transcript (here) probably didn't help:

  • “…deceleration in ad revenue growth, kind of consistent with the trends we've seen” CFO
  • “…because the effective levels of monetization in Stories [videos and photos with a story; disappears in 24 hours] are lower.” CFO
  • “We're being very slow and deliberate with monetization [with Messenger]” COO
  • “But we won't know for a while if it's going to monetize at the same rate [when FB places Stories across Messenger, Facebook and Instagram]”. COO
  • “[Europe monthly average usage (MAU) was down] On Europe, yeah, we don't have any update on trends. We had indicated in the first quarter that we would expect to see a decline. We're not providing any guidance on MAU and DAU in Europe on this call.” CFO

Some of the +30% growth days must be numbered. This is a stock that's under regulatory scrutiny but, unlike Google, the facts and fines aren't known yet. There wasn't one reason for the miss…just lots of small ones such as privacy, currency, new ad formats etc. Since 2013, revenue and expenses have “beat” (i.e. been better than forecasts) by 5% to 7%. This time they missed by 1% and 2%. So, that's new for them.

But it’s a cash fortress. FB has a very strong balance sheet. More than $50bn in cash, which is half the balance sheet. Operating margins dipped but are at still at 44%. High ROE, EPS growth of 40% and large cash position, all shown here.

Bull case:  New products, management tends to guide low, mobile ad volume, ad pricing, not overly expensive

Bear case: Regulatory problems will grow, slower growth, expenses higher, opting out/privacy issues

Bigger picture: We’ve written about the FAANGs a fair amount in recent blogs. They’re big, profitable and growing. But there are high expectations around the stock and it sells at 75% more than the market and 85% more than Apple.

It’s one reason why we like small cap and the dividend Aristocrats. They lag when Big Tech is on a run but they're less likely to have a big sell off.

And if you own it: Many clients have low cost positions in FB, so selling is not an option. The stock is not going to crash. It’s a 20% correction so needs a 25% increase to break even. We'd certainly trim where possible if only for diversification reasons and we can help on that. Also, if you have tax gains elsewhere, or want to create a loss to offset some current income, we can help on that too. But otherwise it’s a HOLD.

Bottom Line: Earnings are matching the hype. They’re good and numbers for the back half of the year are being revised up. The market is on forward P/E of 16.5, cheaper than all of 2016 and 2017. But growth will slow.

Please check out our 119 Years of the Dow chart  

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Other:

Astronomy photographs of the year

 --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.

Friday Music: Valerie

Oh Mr Zuckerberg

You've probably seen the news at Facebook. The stock is down 20% in after hours trading (after hours volume is notoriously thin so we’ll see better indications tomorrow). Why?

  • User growth was less than expected
  • Revenue growth revised down in 2H 2018
  • Expenses up
  • Missed (only slightly but there’s little margin for error with a stock like FB) advertising revenue target
  • Headcount up 47% YOY

•  Some negative comment about the EU privacy regs General Data Protection Regulation (GDPR…expect to hear more of this) where they lost 1m subscribers due to the new rules.

•  Quotes from the transcript (here) that probably didn't help:

  “…deceleration in ad revenue growth, kind of consistent with the trends we've seen” CFO

  “…because the effective levels of monetization in Stories [videos and photos with a story; disappears in 24 hours] are lower.” CFO

  “We're being very slow and deliberate with monetization [with Messenger]” COO

  “But we won't know for a while if it's going to monetize at the same rate [when FB places stories across Messenger, Facebook and Instagram]”. COO

  “[Europe monthly average usage (MAU) was down] On Europe, yeah, we don't have any update on trends. We had indicated in the first quarter that we would expect to see a decline. We're not providing any guidance on MAU and DAU in Europe on this call.” CFO

Short term:

Some of the +30% growth days must be numbered. This is a stock that's under regulatory scrutiny but, unlike Google, the facts aren't known yet. There wasn't one reason for the miss…just lots of small ones such as privacy, currency, new ad formats etc. Since 2013, revenue and expenses have “beat” (i.e. been better than forecasts) by 5% to 7%. This time they missed by 1% and 2%. So, that's new for them.

Cash Fortress

FB has a very strong balance sheet. More than $50bn in cash which is half the balance sheet. Operating margins dipped but are at still at 44%.

Bull case:

  • new products
  • management tends to guide low
  • mobile ad volume
  • ad pricing
  • not overly expensive

Bear case:

  • regulatory problems will grow
  • slower growth
  • expenses higher
  • opting out/privacy issues

Bigger picture:

We’ve written about the FAANGs a fair amount in recent blogs. They’re big, profitable and growing. But there are high expectations around the stock and it sells at 75% more than the market and 85% more than Apple.

It’s one reason why we like small cap and the dividend Aristocrats. They lag when Big Tech is on a run but they're less likely to have a big sell off.

Action: Many clients have low cost positions in FB, so selling is not always an option. The stock is not going to crash. It’s a 20% correction so needs a 25% increase to break even. We'd certainly trim where possible if only for diversification reasons and we can help on that. Also, if you have tax gains elsewhere, or want to create a loss to offset some current income, we can help on that too. But otherwise it’s a HOLD.

If there’s more, we’ll include it in the blog. If you need more, please let us know.

Chart:

High ROE, EPS growth of 40% and large cash position

 --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.

 

Not happy about it but…

The Days Ahead: More corporate earnings. Initial estimate of Q2 GDP.

One-Minute Summary: There should have been plenty to upset markets this week. The President questioned the level of the dollar and Fed policy, trade tariffs rose again, the EU made a strong trade deal with Japan, housing starts were down, retail sales weak and one of the regional Fed surveys showed that companies are seeing higher prices which they do not expect to be able to pass on (which means a margin squeeze). The yield curve continued to flatten. Netflix had a bad quarter. Yet things kept moving along well enough. Why?

Let’s deal with the first one. The President can criticize the Fed for raising rates but we think Chairman Powell will disregard any and all such comments. He’s going nowhere and the Administration can do nothing about Fed policy. They're stuck with him.

On the others, the market is growing sanguine. The trade pressures are built into the market’s wall of worry for now. Sure, things could get worse but the underlying economy is moving slowly forward and, as we've said before, companies are reporting great earnings. Thank the tax cuts. The path of rate increases is steady and Chairman Powell reassured markets and politicians not to expect policy surprises.

We did see some increase in short-term rates with 3-month Treasury Bills trading above 2% for the first time since September 2009. This was expected. So far this year, the Treasury market has had to absorb $720bn of net new public debt. That’s what happens if you cut taxes in a late-cycle economy. In the same period last year it was -$74bn. Last week, there was $22bn of T-Bill (i.e. 3 month bills) net new issuance and there’s $130bn coming in the next two months. So why aren't rates higher? Because the economy is expected to slow, real wages are flat and because the Fed has clearly signaled where it expects equilibrium rates to settle: not much above where we are.

One item that got our attention was this:

This shows the yield on the S&P 500  (blue) inching below the rate now available on 3-month bills. That hasn’t happened for a decade. You would think equities should yield more. They're more risky. But dividends grow and bond yields do not and for much of the previous 50 years, from 1959 to 2009, equities consistently yielded more than bonds. Equity investors did a lot better, in real terms, than bond investors. It’s too early to say if this is a major signal but at its simplest, it shows that cash is now a viable asset.

1.     How’s Berkshire Hathaway doing? Quite well. Berkshire has never been a modish company. They only authorized share buybacks in 2011. Dividend? No. If investors want cash, they should sell the shares on the basis that dividends are i) taxed at higher rates than capital gains and ii) taxed twice, first by the corporation and again by the shareholder. They did pay a dividend once, in 1967, and Mr. Buffett said he must have been in the bathroom when it was authorized.

As for share buybacks, the Buffett philosophy was i) why would the company buy shares that are overvalued because it’s a waste of shareholder money and ii) even if they're undervalued, shareholders would be selling at a discount and why make shareholders mad at you by making them sell at a bad price? (This is horribly simplified and you can read his original thoughts here and here) So, you make money with Berkshire if the underlying investments and operating companies do well. And they've succeeded.

If only more companies followed those rules things would be simpler and executives would not waste shareholder money on over-priced buybacks.

But Berkshire also has a secret weapon. Its book value is one thing (the cost of assets less depreciation and liabilities) but its intrinsic value is much higher. It’s a subjective number but is basically the value of i) its stock portfolio ii) the cash generated by its operating companies and iii) the discounted cash flows of retained future earnings. The good thing about Berkshire is that for much of its life it has traded well above book value and well below intrinsic value.

It slipped to around 88% of book value (so a discount) in 2009 and in 2011 to 109%. Mr. Buffett then said, fine, we’ll make sure that doesn't happen again and in 2010, approved the buying back of shares if the stock traded at less that 110% of book value. He then bumped that to 120% in 2013. The black line in the middle chart above shows the threshold and you can see that the stock has consistently traded above 120%. Since 2011, the company has bought back less than $1.8bn in shares. Compared to its market cap of $490bn and the average buyback in the S&P 500 of 2% a year, that’s next to nothing. What Mr. Buffet was saying was he didn't need to use money buying back shares when he can earn a much higher return for shareholders. Shareholders were happy. The top chart shows Berkshire (blue bar) handily beating the S&P 500 (green) over most rolling 5 and 10-year periods.

Last week, the company announced it could repurchase shares at “any time”. That’s great news. The company has $100bn of cash so could use some to close any valuation gap. Berkshire is no high flyer. It’s a slow growing but predicable company with great franchises. It’s also “cheap” compared to the value of its business. We like it.

And if you're keeping score, you would have made more money in Berkshire than Apple since Apple went public. One -hundred dollars invested back in 1981 in Apple is worth $50,000 today. For Berkshire, it's  $61,700.

2.     Are those Fangs big? Well, yes, they are thank you for noticing. The story of the FAANGS dominance (so that’s Facebook, Apple, Amazon, Netflix and Google) has been around a while now. The race is on for the first company to break $1 trillion in market cap (which was actually done a few years ago by PetroChina back in 2007 but it fell 80%.)  While fun, the landmark is irrelevant.

 Performance of those six has been up between 25% and 90% in the last year. They're now giants and worth more than the bottom 300 companies of the S&P 500. They don't make nearly as much money. The sum of their earnings is around $184bn compared to $461bn for the bottom 300 (h/t John Authers via Michael Batnick).

Should we care? Well, they’re growing, of course, and are near monopolists in their respective businesses. They generate huge cash flows and are generally asset light. So that's all nice. But their dominance is high, they're expensive and the top 5 or 10 companies in the S&P 500 tend to change quite a bit over time. So, you know, probably won't stay that way. 

 Bottom Line: Stocks continue to move higher and become cheaper. It's all because earnings are coming through. Watch the dollar, if that begins to correct as the Administration wants, overseas markets will recover quickly.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

The last time a President pushed around a Fed Chair

--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.

Sophie Hunger

Stocks staying ahead despite trade

The Days Ahead: More corporate earnings. Industrial production.

One-Minute Summary: We’re in earnings season and it’s going to be a cracker. In most earnings seasons, companies “beat” expectations because that is how the game works. Analysts put out an estimate early in the season, the CEO (well actually normally the IR guy) sucks their teeth and says, “dunno about that…”, the analyst revises down (this can repeat a few times with knowing winks), and then the company comes in and beats. Everyone happy. That’s why 70% of companies beat every quarter. It’s not that CEOs are great or analysts incompetent. It's just how it’s played.

Anyway, if you're a CEO of an S&P 500, 400 or 600 company, you didn’t even have to show up in the first and second quarter and you would have a 10% to 15% gain in earnings just from the lower corporate taxes. But if you did show up and threw in some growth and buy-backs, then your earnings will be up 22% YOY this quarter.

So, we’re celebrating a great earnings season. But most of that was in the price of the S&P 500 seven months ago, which is why stocks haven’t moved much so far this year (although up 7% from the February mini-crash). Yes, small company stocks and growth had another good week.

There were good economic numbers as well. Job openings were strong, inflation moderate, producer inflation in control but the headlines were dominated by the latest round of tariffs, which now includes onions, buffalos and maleic acid (no idea, sorry) but not cell phones or computers. And of course NATO and BREXIT. Normally, when these stories dominate the fireworks are in FX markets and that was somewhat true last week. It seems as if markets are “What’d he jus’ say? He can't mean it. We hope he doesn't mean it. He doesn't mean it.” That cycle takes about two hours these days. Tailor made for neurotics.

Stocks were broadly higher here and in Europe but on summer trading, which always has a torpid feel. The 10-Year Treasury was flat but 30-Year Treasuries strong.

1.     The next recession. One of our favorite commentators over at Financial Intelligence asked this question recently.  One lore is that recessions do not die of old age; the Fed murders them.  Which is nonsense. Recessions are normally preceded by over leverage, inflation and crisis of confidence. The Fed is merely the instrument that starts the rate cycle.

 The Fed started hiking rates in 1972, 1976, 1986, 1993 and 2004, all without triggering a recession. And in some cases, as in 1973, 1984 and 1994 they started to lower rates some two years before a recession. And that points to another problem: insufficient data. Whenever you hear someone say “a recession always come when…” you can quietly muse that there have been eight recessions in the last 64 years (so 12% of the time) and 18 in the last 103 years. If a researcher from one of the hard sciences showed up with a theory based on 18 data points, you might politely sigh.

Anyway, here’s what we think might cause some problems:

  1. Politics and trade
  2. The fiscal stimulus from the 2017 tax changes running out sooner than expected
  3. High federal debt
  4. Corporate leverage

We don't really think the consumer is a problem this time round. Yes, things like student debt are off the charts and consumer and mortgage debt are at all-time highs in absolute terms. But so is GDP and we’re fine with personal debt growing in line with nominal income. Consumer and mortgage debt is now around 70% of GDP from a 2009 peak of over 90%. Also, we’ll stick to our belief that the forces causing the recession last time don't get to do it again. So, the consumer gets a pass this time round.

Corporate debt is a different story. Here it is:

This shows corporate bonds owed by non-financial companies (blue bars) doubling from 2008. But they've also increased cash so the net borrowing is around $4.5 trillion. That reached a record level of over 20% of GDP two years ago and has since plateaued (bottom graph).

We've excluded other corporate debt, like bank loans and payables. We'd add that not all these companies are financially stretched. Still, it’s a high number and at some point, rising rates, if only at the short end, are going to make life difficult for companies. That’s why we've been lightening up on corporate credit for the last few months.

2.     What's inflation up to? Not much. Last week’s report showed headline inflation at 2.8% and core (so knock out food and energy) at 2.2%. This is above the Fed’s goal but i) the Fed uses the broader PCE measure of inflation and that’s at 1.9% and ii) there are some important base effects going on, that we've written about. The main one is cell phone rates, which fell sharply last year when Verizon cut prices, and used cars, but both are pretty much done. The Fed’s, rather difficult, job is to differentiate between temporary and entrenched inflation.

The Atlanta Fed tries to do this with its Sticky and Flexible measures of inflation. Sticky prices are ones that don't change too much. The classic example is coin-operated laundries, which change their prices once every six years. The list also includes fees, rent and medical costs. Flexible prices are those that change a lot. So things like vegetables, gas and clothes change prices every few weeks. This is what’s going on with the two:

As you would expect, Flexible prices are volatile with prices swinging from -3.0% to 3.5% in the last year. Sticky prices are moving much more slowly and haven’t changed their rate of growth much in the last four years. We think it's likely to stay that way. And as for wages?

They're not keeping up with inflation (black line). To some, this is a puzzle. Low unemployment, low participation and a tax change trumpeted as good for workers and their wages should lead to wage increases. But, no. There has been some increase in hours worked, so take-home pay is up. But it's by a very small amount. For us, real wages have to increase to push inflation up meaningfully and, so far, ‘aint ‘appening.

Bottom Line: More good earnings numbers coming up. Stocks are within a whisper of all time highs but, if companies report concerns about tariffs, expect some weakness. We still favor small company stocks

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SEC drops whistleblower prog

Young billionaires

 --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.

Detectorists

Vacation Week Trading

The Days Ahead: Corporate earnings kick off. It’s going to be another strong quarter.  

One-Minute Summary: U.S. Treasuries had a good week with the 10-Year Treasury at 2.82% and the 30-Year Treasury well under 3.0%. The gap between the two is now 11bps, the lowest in 11 years. Stocks had a good week and we’re now in positive territory for the S&P 500 year to date with small company and tech stocks way ahead…up over 11% in both cases. International markets recovered but Emerging Markets again struggled.

On the one hand, yes, the trade issues continued but markets have had plenty of time to adjust to the threats so nothing really new. On the other, international markets stand to lose more from trade so will take longer to adjust. Things got a little better when a story went round that Trump’s Ambassador to Germany offered zero tariffs on all auto trades. Could happen. And on the other (see what we did there), the dollar weakened and bonds rallied on an employment report that showed no increase in wages and more people looking for work. That would seem to shut the door on the whole wage inflation, labor shortage argument.

We'd remind readers that summer trading can be very thin and misleading. The short holiday week and a heat wave on the East Coast meant volumes were light. Markets can and will overreact to news. And as we say, “prices move faster than fundamentals… don't confuse the two” (h/t David Ader)

1.     "Trade wars are easy to win". You might say to yourself, if you measure the country’s trade deficit since the phony trade war started in January and moved into a more serious phase a few months ago. And if you were into charts, you would point at this and say, let’s Make American Exports Great Again.

Because of the way the BEA calculates GDP, the improvement from January to May would account for about a 0.7% improvement in GDP. Pretty good work. What shall we solve next?

But this month’s trade figures give us the excuse to bring out one of our favorite charts: U.S. soybean exports. And here they are:

The U.S. is a big exporter of food. Around $150bn a year out of $1,400bn in total goods exports. The U.S. sells a lot of soybeans, corn and meat products and imports wine, fish and fruits and vegetables. They tend to balance each other out. But one big export earner is soybeans. And they all go to China. The green line shows the trend. They rocketed from $2bn to over $4bn. That’s a very big change on an annualized basis, which is how GDP will measure it.

They have spiked before, notably in 2016 when there was a poor harvest in Brazil. But this increase is even bigger and there’s no mystery why. Chinese importers were buying ahead of the tariffs imposed today, which were in retaliation to the $34bn of Chinese goods targeted by the Administration. We certainly don't expect these numbers to improve in coming months.

So, the headline looks good for now and will help the Q2 GDP numbers for sure. But by the middle of Q3 the deficit will start to worsen.

Look, we know U.S. trade is a mess right now. Companies don't know whether to change suppliers, move overseas, expand or prepare for price increases. The ISM data on manufacturers’ prices paid has risen for 28 straight months and is by far the highest indicator in the dozen metrics tracked by the ISM. Trade talk is going to continue to dominate capital markets for the rest of the summer. We think that eventually businesses, politicians and consumers are going to protest at higher prices and the overall disruption. But it’s only the last constituent that counts for this Administration. And they have yet to feel the pressure.

2.     Are bonds good value? We'll preface this timeless question with the normal “it depends.” But by one measure, yes. We looked at the yield on the S&P 500 and compared it to the 10-Year Treasury. Here’s the chart:

The black line is the 10-Year Treasury yield at 2.84%. The blue line is the yield on the S&P 500 at 2.04%. When equities yield more than bonds (which is not often), they tend to be very good times to buy stocks. When bonds yield 200bps more than equities, it tends to be a good time to buy bonds. We're not there yet. It’s only around 80bps. But here’s the point. Stocks these days don't offer a great dividend payout. Some 100 of the S&P 500 don't even pay a dividend. Many would rather use buybacks to boost share prices because they're more tax efficient and tied to executive pay (color me skeptical, I know).

So, bonds at around 3%, which they were a few months ago, seem very fair value against stocks. We've seen a lot of the bond bears reverse position in recent months. Some of that is shorts caught out but some is down to bonds, especially Treasuries, just representing good value right now. As clients know, we've been investing in the mid-part of the Treasury yield curve for some months now and we’re inclined to remain there.

 Bottom Line: Good earnings numbers coming up but export traders (BA, CAT etc) will remain under a cloud. Large cap will probably remain in the 2600 to 2800 trading range. It closed 2750 on Friday.  Emerging Markets remain the weak point.

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Drone over Tesla, Fremont

 --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.
Friday on my Mind
 

100 Year of Inflation and Real Rates - Updated July, 2018

We looked at 100 years of inflation. This chart shows: 

1. The annual change in US inflation

2. The real rate of 10-Year Treasury bonds

3. The names and start dates of the Fed chairs

4. Highlights from each year that influenced inflation

Our takeaway is that inflation remains low by historical standards and that it has not been much of a problem for nearly 30 years. The level of real rates looks very low and suggests more deflationary than inflationary forces.  

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.

Hog Wash

The Days Ahead: Employment report and probably some trade talk. Shorter week.

One-Minute Summary: Markets lost their patience with the trade issues. Ye gods, on Friday the rumor was that the U.S. will withdraw from the WTO. That actually require an act of Congress so no immediate threat. The market recovered from its lows but there was a general risk-off theme.

The 30-Year Treasury had a good week, with yields falling from 3.08% to 2.96%. Why? Well, we’re in the middle of a great quarter for growth. We know this because 1) first quarter GDP was revised down to 2% 2) since the crisis, there are some very weird seasonals not captured in Q1 that flow through to Q2 and 3) with things like a lower trade deficit, the GDP now model is flashing around 4% growth.  There have been some quarters of 4% growth since 2009 but they have very quickly rolled over to the lower average growth of 2.0% to 2.5%. We think that’s going to happen again. The decline in the 30-Year Treasury yield tells us the market is not convinced growth will last.

A rough week for Emerging Markets, which are dominated by the dollar, interest rate and trade issues. We're watching to see how China reacts. They may impose more tariffs. But they could just 1) weaken the Renminbi 2) sell U.S. Treasuries or 3) go after U.S. companies doing business in China from China. Apple has 18% of its sale in China and another 18% in Asia Pacific. Any iPhones sold there are made there. If China was to start making life difficult for firms selling in China, then goodbye Queensberry and hello cage fighting.   

1.     Markets are jumpy – maybe because there are fewer defensive stocks around. Stocks feel like they're volatile but the standard deviation and VIX numbers are pretty much in line with levels from two years ago. It’s only against the unusually low 2017 levels that it feels more risky.

 But in some ways the market as a whole is a more risky animal than in past years.

 We looked at the classic defensive sectors of the S&P 500. So, that’s utilities (e.g. DUK, SO) telecommunications (T, VZ) and consumer staples (PG, WMT, KO, MO). We took their combined market capitalization as a percent of the S&P 500 market capitalization. Here it is:

Defensive stocks have indeed fallen to a near all-time low of 12% of the market from 21% in the pre-crisis era. Some of that is because these companies face more competition and they’re just not great businesses. But some is because big companies keep getting bigger because, well, they are good businesses and there has been little to no anti-trust enforcement.

So, Amazon is 25% of the Consumer Discretionary sector and accounts for 35% of the gain in the S&P 500 this year. The top 10 growth companies account for 100% of the gain. And the top four tech companies (AAPL, GOOG, FB, MSFT) are 42% of the tech sector.

It’s going to get worse too. In the fall, S&P will create a new sector called “Communication Services” by taking some stocks away from tech and consumer sectors. When that's done, the top five stocks of each of those three sectors will account for 50% to 70% of those sectors.

So, yes, the market has become less defensive which means the market is more vulnerable to any correction in non-dividend paying, momentum stocks (h/t David Ader).

2.     Bought a washing machine lately?  So how much will the tariffs cost us in the end? We're more concerned about the on/off mixed messages of the tariffs. If we take a more or less worst case scenario and all imports from China are taxed at 25%, we would see a about a $125bn cost to the U.S. economy. Sometime in the second quarter of this year, the U.S. economy passed $20 trillion. So that’s a 0.6% hit to GDP. The economy will grow around 3% this year. A drop from 3% to 2.4% does not remotely qualify as a recession. Of course, we can play with even bigger numbers. How about 25% on all auto imports? That’s 0.2% of GDP. Or the EU throws a 20% tariff on all U.S. exports? That’s 0.3%.

But of course, it’s much more than keeping score on who can raise the most or who blinks. The real problem is in the complex global supply chains of modern companies and flow of intellectual property. So, if Harley Davidson, which was in Twitter’s sights last week, faces a 20% increase in its prices in the EU and higher steel prices in the U.S., it must divert production to its existing overseas plants. To do otherwise would surely be a breach of its responsibilities. The stock (HOG) is down 25%.

We don't really know yet what the impact of the trade disputes will be. We do know that tariffs are a tax. Someone has to pay the tax. If companies pay the tax, margins are squeezed. If consumers pay the tax, prices go up. Back in January, the administration imposed a 50% tariff on washing machines and 25% on solar panels. Consumers ended up paying for this one. This is how washing machine prices have changed:

That top green line shows prices accelerating by 83% in the last few months. That's after many years of price declines. This tariff was targeted at LG Electronics and Samsung. Both companies’ share prices fell 13% to 25% this year and showed up in South Korea’s exports to the U.S. (in the blue bars).  

So, all together, tariffs hurt consumers. The question now is how will consumers, businesses and politicians respond to the trade talks? If there’s enough of a blow-back, we might get less bluster and more thought. But it will take at least six months to show up in the data. (h/t Ian Shepherdson at Pantheon Economics)

Bottom Line: Large cap will probably remain in a trading range. The S&P 500 should remain above its 2700 support level but expect some rapid moves.  Emerging Markets remain the weak point.

Please check out our 119 Years of the Dow chart  

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NIMBYism San Francisco style

Rodents in ATM

 --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.

Dreams

Summer trading starts in fits

The Days Ahead: Some durable goods orders. But trade will dominate as a problem.

One-Minute Summary.  We were unchanged on the week but had some odd days when the market fell at the open but closed higher. That seems to be a lot of quants at work (h/t Cameron Crise), which is leading to higher volatility.

Markets are trying to make sense of the increased taxes coming their way. They're in the guise of tariffs, of course, but they have exactly the same effect as a tax. Take steel. It’s up 53% from a year ago and 25% since March (the date the first tariffs came out). Someone has to pay the tariff. It will either come in higher prices to importers, which are then passed on, or in margin compression. Or both. The market doesn't know how all this will work out yet but last week’s Philadelphia Fed survey suggests there are price pressures around the corner. 

Meanwhile the U.S. will have another strong quarter ending in a week’s time. Most earnings estimates are for a near 20% annual gain. At least half of that is down to the lower corporation tax but a 3.5% GDP rate is certainly helping. Small caps and the NASDAQ index (confusingly it’s not the NASDAQ exchange but a warehouse for tech stocks) reached record highs. Europe is struggling with politics in Germany and, of course, trade concerns. The 10-Year Treasury marked time at the 2.85% to 2.95% range. Every time it tries to break through 3%, it rallies.

1.     Markets are jumpy – Emerging Markets edition: Not a great week for Emerging Markets. It’s nearly all tied to trade and the escalating tariffs. First, it was the U.S. imposing 25% tariffs on $50bn of Chinese imports (here’s the full list). Second, China came back with an unspecified tariff on $50bn of U.S. imports. They’ll probably target agriculture and autos. Third, the U.S. thought carefully and said they would charge a 10% tariff on another $200bn of goods. Fourth, the U.S. (well the White House) said, fine, we’ll charge the EU 20% on tariffs on all cars coming into the U.S. It’s true the U.S. can hurt China more than the other way round, for now, simply because imports from China are four times greater than exports to China.

Chinese large cap stocks fell around 11% (in thin markets, there was a national holiday). But Chinese small cap stocks “only” fell 7%. It’s the same story in much of the developed and emerging markets: small cap, domestically focused and non-financial companies have done much better than the large export, headline companies. This makes sense. They're more insulated from the trade problems and benefitting from domestic growth.

A good example of the complexity of the situation is Daimler Benz, Germany’s fifth largest company. It gave a profit warning not because of the U.S. threat of tariffs on cars from Europe, but China’s tariffs on imported cars from the U.S. because…Daimler makes a lot of cars and trucks in the U.S. for the Chinese market. So, it’s a roundabout Emerging Market story. And it's a good example of trying to target one trade sector and not knowing the complex global supply chain of a major U.S. employer.

There’s some short-term uncertainty in Emerging Markets right now. Not just trade. There’s an election in Mexico that will bring in a reformist administration that may not be good for business. The U.S. dollar is still strong and oil still high. Both will hold Emerging Markets back. Again, small caps are doing well, which is why we like the exposure. But we’re investing in protection for our large cap exposure.

2.     Why is everyone talking about the yield curve?  When you buy a bond, you're a lender. You want your money back. Lending overnight should be cheap and safe. Lending for 30 years should be more expensive and riskier. There’s a lot of discussion about what this “term premium” should be. For a five year bond, should it be an extrapolation of the 2-Year note? Or with some adjustment for inflation? Or other macro risk? If so, how much? The number has declined in recent years. We think it’s because investors don't require a lot of premium to lend long because they feel rates will ultimately settle at lower levels. And that the economy won't grow at the rate it used to. Think of it as a sentiment indicator.

A hard indicator, however, is the yield spread between two bond maturities. The most commonly used is the 2-Year Treasury and 10-Year Treasury. Here it is:

That spread is down to 36bps from 130bps at the beginning of 2017 and 71bps in early 2018. That means an investor only paid an additional 0.3% for lending money for five times as long. Why? Well, here’s a quick summary:

  1. The Fed is raising rates at the front end. It’s the only rate they control. The market sets all others.
  2. The market thinks that short-term rates will go up but either that or other things (think trade) will slow the economy, so…
  3. The Fed will start lowering rates long before that 10-Year Treasury matures, so…
  4. The spread or premium will be back to where it should be because short-term rates will fall, while the 10-Year Treasury will not change.
  5. In 2018, we think it means i) yes, the economy is growing gangbusters now, but ii) the Fed is worried about tight labor market so iii) will continue to hike but iv) trade/budget deficits/length of cycle/debt will slow the economy and v) we’ll be back to a Fed cut cycle.

In the past, when short-term rates rise above long-term rates, a recession is just around the corner (the shaded parts in graph). But here’s the thing: you can have a low or inverted curve for a couple of years before the recession hits. It’s all up to the Fed. If they wait too long to cut when the spread inverts, the worse the recession.

We think the rate hike cycle may stop in 2019 and it’s one reason why we’re cutting exposure to corporate credit, and using a short bar bell strategy of 2- Year and 10-Year Treasuries. Or simply, we're unconvinced this late cycle boomlet is going to run for long.

So, here’s a reminder:

h/t Macro Market

Bottom Line: U.S. large cap stocks will struggle to break out of a trading range. European stocks should recover from some of the trade shocks this week.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

GE out of the Dow

Senegal’s triple fist bump

 --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.
Football's (ok soccer's) best actor awards

Why the markets are now interested in trade

This is a recording of our June 2018 conference call. If you want to join us live next time or get future updates about new episodes, subscribe to our email newsletter: bandjadvisors.com/subscribe

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Hike but no spike

The Days Ahead: Fed meets Wednesday. Yes, they will raise rates. Bonds won't move much. New dot plots will be important

One-Minute Summary.  After flirting with crossing below its 50 and 200-day moving average (better known by its Wagnerian title, The Death Cross), the S&P 500 had a solid week and is up 4% for the year. The Small Cap world of the S&P 600 and Russell 2000 reached all-time highs and are up around 10% this year. Bonds hung in the 2.90% to 2.95% range. Pretty much unchanged for the last month.

Europe is still worried about the Italian politics, debt and bond world. Italian banks were down over 6% and even the news of a merger of Unicredit with SocGen was not enough to stop a 2.5% drop in the share price. The trade news was not good. One would expect the markets to freak out at the retaliations, a very grumpy G-7 meeting and rate pressure. But the trade war has not changed the generally good narrative. Why? Well 1) the devil is in the details on trade and until we know what they are, it’s tough to put a number on growth and 2) perhaps markets are in the “take it serously, but not literally” world.

Something very definite came in last week from Commerce Department on Chinese steel flanges. You know, the things that look like this. If it goes ahead, U.S. customs will charge importers around $50m. But imports would quickly take up the slack so the final cost to consumers will be negligible in a $20 trillion economy.

Meanwhile, the U.S. ISM numbers were good. Job openings were up. The trade deficit narrowed. The FANG basket of tech stocks has outperformed the S&P 500 every month this year except April and have done it again in June. This won't continue but there’s a trend in place.

1.     Markets are jumpy (Part 3): This week was the turn of the Brazilian stock market.

The basic story was that the government imposed fuel price controls following the trucking strike, which has been going on for weeks. The central bank stepped in with some aggressive currency swaps to try to prop up the Real. But inflation is on the rise (hence the price controls) and there’s an election in October. Throw in trade problems, the Emerging Markets (EM) debt problems, and one wonders why it took so long for the market to wake up.

We think the EM story is solid but the recent weakness is because:

  1. Core yields have risen in developed markets and EM’s track the increases. We think these will moderate.
  2. The dollar has strengthened which hurts EM’s debt management. We expect the US dollar to soften over time.
  3. Crude has been on the rise which hurts more EM economies than it helps. We think that’s about to end.
  4. Trade tensions are high. They will remain so but we don't expect them to affect intra-EM and EU trade.

So, it’s been a test of resilience for sure but Emerging Markets remain an excellent asset class for solid growth.

2.     There’s an awful lot of debt. Yes, but not in the usual places. If we’re looking for the next bear market, one place you can pretty well know is that’s it’s not going to be in the same place as the last time. So, as we said last week, don't go looking at the MBS world. In fact, don't even go looking at consumers. The new snappily-titled Z.1 report came out this week. It was called the Flow of Funds report, which describes exactly what it is. But, hey, I’m not a branding expert and someone came up with Z.1. And who can blame them? It’s a ton of information that gives us plenty of blog subjects if the markets aren't really doing anything or we need a break from tweets and headlines like this.

Here’s what caught our eye:

The blue line is household debt. That’s all the mortgages, credit card, auto loans, and home equity lines thrown in together. You can see the peak of 120% of GDP a few years ago. Since then, households have taken the message of running down debt very much to heart. It even fell more last quarter. So it seems consumers are a) not following through on the confidence they say they have and b) not using the tax cuts to borrow more.

The other line is non-financial corporate debt (we need to exclude banks who need debt for capital and loan growth). It’s at an all-time high. Now we know one of the themes of the last few years was for companies to borrow at low rates to offset cash held offshore and pay for share buy-backs. And we know that we should probably adjust the number for cash and cash equivalents held by companies (remember Apple’s $100bn cash pile).

But still, that’s a fair amount of borrowing and we think it’s one of the main reasons why stocks have been tepid in recent weeks. Yes, the tax cuts have helped a lot. Estimates for S&P 500 earnings in 2018 made in early December were $146, up 11%. By January, they were $158, up 19%. The difference was entirely due to the lower tax rate. So in a high-leveraged world, companies with lots of pricing power (think software, personal products, pharma) do well. Companies with less pricing power and leverage (think energy, transportation, autos) will not. And there are a lot more companies in that second group than the first.

So what? We're keeping a close watch on the leveraged companies. We’re out of some of them (like REITs) and expect more sideways market action until the story is clearer.

Bottom Line: Yield curve is flattening again. This time in the 5s and 30s. Europe will struggle with the trade news. Volatile but sideways stocks.  

Light blogging only next week. Heavy travel. Back in two.

Call 415 435-8330 or email at cthwaites@bandjadvisors.com if you need anything. 

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Why farm-raised salmon are deaf

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--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.

Weekend Music: Band Apart

A lot of action but not much change.

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The Days Ahead: Quieter week for big economic numbers. Watch for trade and updates on the Eurozone.

One-Minute Summary.  When markets crack, we know two things. One, the problems don't come from the last crisis (so no need to look in the MBS world). Two, they come from things you barely notice. Last week it was Argentina and Turkey. This week, it was Italy (see below). U.S. bonds promptly rallied 4.5% and the 10-Year Treasury yields, which many predicted would soar to 3% and beyond, fell to an intra-day low of 2.79%. Bonds got medieval on Tuesday and one Bond King had a very bad day.

Domestic and international stocks and U.S. bonds finished more or less unchanged on the week. But there was plenty of action along the way. Small caps had another good week (they tend to not get riled by trade stuff) and are now some 500bps ahead of the large caps so far this year.

The trade talk is not good. The U.S. went ahead with tariffs on steel from Canada, Mexico and the EU. We don't think they're going to take this one lying down. In past years, the parties would have taken the issues to the WTO and talked about it for a couple of years. This time Cecilia Malmstrom, the very accomplished EU Trade commissioner fired right back with, “When they say American (sic) first, we say Europe united.” So far markets have tended to view the trade talks as bluff followed by climb down. That’s worked. So far. Still, expect a lot more disconcerting headlines.

1.     Markets are jumpy (Part 2): Here’s something you don't see very often. A G7 sovereign bond crashing in a single morning’s trade. As everyone knows by now, Italy is trying to form a government on a coalition of two parties. The Northern League (secession, pro-Russia, anti-GMO, lower taxes, Eurosceptic) and the 5-Star Movement (guaranteed minimum income, Green, unsure about immigration and mostly Eurosceptic) tried, failed and tried again to form a government. In Italy, winning parties must present their cabinet and government candidates to the President. He has veto power. And he used it. The fear then was another election in the fall with both parties running on an explicit “out-of-Euro” platform because…that’s the only thing these guys really agree on.

Now we've seen Italian governments come and go and, with 42 Prime Ministers since 1945, a change of government in Italy passes as a Cabinet reshuffle elsewhere. And we don't really think this time is different. A government will form, it will make a few changes and it will argue with the EU about debt, growth and bond restructuring.

So why did this happen?

That spike on the right is the spread between Italian (BTP) and German bonds (Bunds). Both Euro sovereigns. Both have never defaulted in 70 years. Both with rapidly improving current account surpluses. But the spreads “blew out” (technical term) from 120bp to 270bp which meant the price of an Italian bond dropped from €102 to €89. Stocks took a smaller hit and investors dumped Italian banks, who, of course, must hold BTPs for capital. Some of the big-name stocks were down some 25% from their late-April peak.

By week’s end, things had settled down. The 5-Star and League parties will get their people in. The problems from the Berlusconi years (see famous Economist cover) will remain. Italy’s GDP per capita hasn't risen in 20 years. It seems unlikely a rancorous split from the EU will achieve much. And markets probably don't expect Italy to take it that far.

We don't own foreign bonds and this week was a good reason why. You can lose much more of your principal on a spread-widening event than you can on rising rates. To us, fixed income allocations should reduce the risk of a portfolio, not increase it. But expect this to play for a while.

2.     Jobs, jobs, jobs: Yes, the numbers were good. So good the President leaked them an hour before they were released. Which, I dunno, suggests why he may give Martha Stewart a pass. Here they are:

The headline unemployment number is now at a 20-year low. Last time it was this low, the 10-Year Treasury was 6.5%. So why is it only 2.8% now? And didn't even move on the day? Sure, some is because of the Fed’s QE and low inflation. But we think the market is not wholly convinced about this labor market. We've touched on some of these in the past but here goes:

  1. The uninsured part of the labor force is the lowest it’s ever been. If you're not insured to receive benefits, you don't register for them.
  2. Wage inflation is barely moving in nominal terms and flat in real terms.
  3. Quit rates have not reached their pre-crisis level. You tend to quit a job if you're sure you can get another, so it's a confidence thing.
  4. The U-6 (underemployed) rate is nowhere near a 20-year low.
  5. Participation in key age cohorts is way down.

To which, critics respond, well the labor market has changed, if you want a job you can get one and look this week’s Beige Book says St Louis is even hiring convicted felons. So, it's  a tight labor market.

Fair enough, but nearly six months into the stimulus we’ve yet to see big consumer spending numbers, even though people are paying a little less tax (in aggregate, not in California). As one of the best analysts put it, “the longer the stimulative benefits of those particular policy changes [tax cuts] take to show up, the less likely it is that they will.”

Bottom Line: The Spain and Italy markets support our belief that U.S. Treasuries will remain well-bid and the 2-Year Treasury looks attractive above 2.5%. U.S. economic numbers last week were good but seemed more to be catching up with a run of less-than-great reports.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

Musk: public safety too important too important to abide by the government’s rules.

Robo advisors web sites don't work

--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.

Something for the weekend