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10 Items to check on your Statement

10 Items to check on your Financial Statement

 Brokerage and investment statements can be tricky to read. This is a quick read. The mantra is check, check, check and ask. It's your money. Here are 10 things to look for:

1.     Mutual Fund Share Classes: There are many! Check the five letter ticker. The last letter is always an "X". What you don't want to see are any “B” or “C” or “R” class shares. They're expensive and probably pay the broker a trail or 12b-1 fee. How can you tell? Well, one clue is that a B, C or R will be the penultimate letter in the ticker just before the “X.” What you do want to see is “A” or “I” in the ticker and, preferably, with “LW” or Load-Waived at the end (e.g. AGTHX.LW). (Note 1) 

If in doubt call and ask “Am I invested in the cheapest available share class?”

2.     ETFs: Most tickers will be three or four letters. There are some with clever ticker names, which are marketing driven and possibly geared more towards traders. So EEM is iShares $32bn Emerging Markets Fund. It carries an expense ratio of 0.7% and has underperformed its index. IEMG is another Emerging Markets ETF from iShares but it costs 0.14% and has outperformed its index. If you have an ETF with a cute name (AMPS, MOO, BLNG, CAFE) just, you know, double-check it.

Some ETFs are ETNs. This means that they invest in derivatives and they will probably incur roll costs. Some ETNs and ETFs will also have “ultra” or “2x” or 3x” which means they're leveraged. We won't touch these and you shouldn't either. Look in your statement under the ETPs (Exchange Traded Products) section.

3.     Tickers: U.S. listed ETF and stock tickers are straightforward. They're usually two to three letters. A lucky few have one. If they have “ADR” after them, they're foreign stocks listed in the USA and will usually end in "F" or "Y", so NSRGY for Nestle in the US. If the ticker has three or less letters, it means the stock is listed on the NYSE. If it has four, it’s listed on NASDAQ. (Note 2). If the ticker ends in a “Q” it means the company is bankrupt so, unless you’re into protracted legal dealings, don’t buy it.

Some tickers have cute names too but they don’t carry the same concerns that we have for ETFs. So, SAM is Boston Beer (from Sam Adams beer), TAP is Coors, Mammoth Energy is TUSK and Nordstrom is JWN, the initials of the founder John W Nordstrom. FIZZ is the National Beverage Corp. The list goes on.

Mutual fund tickers can be tougher. They will have five letters and an “X” at the end (e.g. POAGX). If they're a money market fund, they will have two Xs (e.g. AJLXX). The first letter usually shares the first letter of the fund company’s name. So, Vanguard funds start with a V, Fidelity funds with a F, and so on.

Option tickers are a different animal. The company ticker may not be the same as the regular ticker. Additional letters indicate the strike price and the month of the option. 

4.     And what if it's a bond? Then it won't have a ticker but a CUSIP (pronounced Q-SIP), which is a string of nine numbers and letters. The first four or six numbers identify the bond issuer, so 9128 means it's a U.S. Treasury, 13062 means it's the State of California, 037833 means it’s Apple and so on. The next two identify the actual bond and the last one is an accuracy check system.

5.     Cost Basis: Not all statements have these but you should know where to get them. The cost basis on mutual funds, ETFs and even stocks will change constantly if you have elected to have dividends or capital gains reinvested. You should also ask your broker or financial institution what basis calculation they use. They should ask you at the time of any sale of securities.

6.     Yield: For equities this is simply the latest quarterly dividend multiplied by four, divided by the share price. It’s a current yield and probably won't be the same as you have actually received in the prior twelve months.

For bonds, it’s more complicated. The yield is the annual coupon on the bond but if it’s a premium bond things can get tricky. First check if the price you paid for the bond was more than $100. If it is, you have a “premium” bond. Now you have a choice. For example, a bond that you paid $11,000 for will redeem in 10 years at par so you can either amortize the premium of $100 a year or you can pay income tax along the way and take a capital loss. (Note 3) 

7.     Transactions: In the back of the statement you will find a list of transactions. Some will reflect reinvestment of dividends and capital gains. We're not concerned with those. But look at other transactions for stocks, bonds, ETFs and funds. Transactions are not free. Many brokerage firms charge for a purchase or redemption of a security and even if they don't, you will still incur the cost of a bid/ask spread. Add up all the transactions on your statement and divide it by the market value. If the transactions amount to more than 30% of the market value, you may want to find out why.

 8.     Fees: If you use a broker or adviser, the statement should show the management fees. If it’s a quarterly statement, multiply the amount by four to get an annual rate and divide that by the total market value. Anything over 1% is high.  

 9.     Income: Every line item on your statement should have an income number. Even if it's a stock that pays no dividend, there will typically be a dash (“-“). Income should also be consolidated with your account summary. Check it. It's one of the most important numbers of your investments. Review the maturity dates of your bonds. The capital will usually be reinvested but, again, check. Don't confuse 1) yields with total investment returns or 2) estimated annual income (EAI) or estimated yield (EY). These are only an estimate and will change.

10.     Current Price: All investments should have a current price as of the date of the statement. Some illiquid stocks may have an old price from a prior date and some (and this is bad) will have a n/a, which means it's no longer traded. Also, check the prices of a security you don't recognize against an older statement. If the price hasn't changed much, it may indicate it doesn't trade. (See Note 4) 

Useful websites

Everything you need to know about CUSIPs

Investopedia: Wikipedia for investing. Generally (but not always) good.

Understand option tickers

Notes

1. Also look to see if you are invested in more than one share class of the same fund. This can happen if you have a consolidated or household statement, which combines multiple accounts (e.g. IRA, Roth, Trust, taxable). You want the one with the highest price because that will be the cheapest.

2. If you see something like LON, SWX, MEX, WBO or BATS after the ticker, it means the stock is listed overseas (so London, Switzerland, Mexico or Austria) or on multiple exchanges (BATS is an electronic exchange).

3. Here's where your CPA and the 1099-INT IRS form comes into play. Worst case is that you end up paying full income tax on the fixed income yield and end up with an undeclared capital loss. So, pay attention to those bond prices.

4. A good rule of thumb is that the longer the company name (e.g. Vantage Drilling UTS, INTL STPLD C/O Ord SH & 1%/11/2% Step up SR SECD), the more likely it's an illiquid stock.

Stocks up and Government Closed

The Days Ahead: Europe industrial production and U.S. housing. Earnings start.

 One-Minute Summary: A better week. Year to date, 442 companies in the S&P 500 are up and 63 are down (confusingly, the S&P 500 has more than 500 companies). It’s early days, of course, but the S&P 500 is up 3.6% this year and there’s only been one trading day where the market didn't close higher than its start. If you think that over the last month, we've had the longest government shutdown, the threat of a national emergency, the President threatening the Fed chair, tough trade talk with China and more tariffs on EU products, then the market seems a lot more robust than the gloom of late last year.

The government shutdown will start to affect economic numbers soon.

  1. The January unemployment data, for publication on February 4th, was collected last week. In the last shutdown in 2013 and 1996, claims rocketed up as government employees became eligible for unemployment insurance.

  2. Some economic data is no longer available. It started with the Census Bureau and the trade report last week and looks to continue with the BEA and GDP estimates. It means we’re all flying a bit blind.

  3. The GDP forecast for Q1 2019 is for 2.1% compared to an estimated growth of 2.8% for Q4 2018. One respected analyst thinks that every two weeks of the shutdown reduces GDP by 0.1%. That’s $20bn which seems about right.

So it was good news to read the Fed minutes last week and see it confirmed that they intend to remain patient and watch the data. That takes the odds of an early Fed cut pretty much off the table for March and probably June as well. A lot hangs on whether there will be a trade deal. And the answer very probably, is yes. We know that both sides have an incentive to close a deal. Both economies are hurting and the U.S. deficit is widening the longer this goes on. We have no idea if this will be a token deal (as in the Canada and Mexico deal) or something substantive that addresses thorny issues like intellectual property and market access. But we think something will break to the upside.

1.     Nothing happening with inflation.  We have to remind ourselves that inflation is the other Fed mandate (along with employment) and while the Fed looks at core PCE inflation, the familiar CPI is also important. It drives things like TIPS bonds, social security, pension benefits and some wages. It’s all been a bit of a yawn lately:

The headline number came in at 1.95%, primarily because gas and other energy prices fell by nearly 10% in December. Rent and home ownership costs are running at 3.2%. That’s an especially important line item because at 24%, it’s by far the largest index component. For the next few months, we’re unlikely to see core inflation much above 2.3% (h/t Pantheon Economics) partly because the base effects from a year ago start from a high level. Real wages were up 1.2%, which is not enough to tip the Fed’s hand.

So, all in all, as forecast and not a market mover. Given all the other stuff that's moving markets these days, that’s one less thing.

 2.     Should I stay or should I go? We've been saying for years that wage inflation is barely a factor in the economy. Despite lower labor force participation, employee wage gains seem stuck around 2%, about in line with inflation. There are times when it runs higher, especially in deflation periods which give the illusion of real wage gains, and in tight labor markets. But tight labor markets are difficult to define. In the 1980s, the Fed thought any unemployment rate below 6% was inflationary. In the 1990s that fell to 5.5%. It's currently 4.5%. But we’re still not seeing much wage inflation.

Yet the labor market is healthy and that’s a good thing. More people are quitting their job than at any time since the 1990s. That’s tough if you're an employer but people don't quit unless they feel they can land another job, so it’s a straightforward confidence indicator. Moving employer also generally means higher wages. So for years, job switchers saw higher wage growth than job stayers. Standard career advice to those wanting a pay increase was “change job”. There were other downsides but we’ll keep those for another day. Here’s the difference between the two:

The blue line is the switcher, running consistently above the stayer. But now job stayers’ wages are increasing at their highest rate since 2007. For years, employers kept staff with better work conditions, vacation, benefits, awards, and training. Anything but actually pay more. That seems to be changing and it should be good for confidence. More here.

Bottom Line. There is a lot of bad news priced into markets. The economy is not nearly as weak as the stock market suggests. It’s growing at a slower rate but that is not the same as no growth. It won't take much to reverse sentiment.

Please check out our 119 Years of the Dow chart  

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Please start smoking again

 --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.

Teddy Afro - Anbessa 

Meet the New Year, Same as the Old Year

The Days Ahead: More Fed speakers should echo Powell’s comments. Inflation numbers out.

One-Minute Summary: We're always suspicious of market moves over prolonged holidays. Many traders and investors are away and some markets, like Japan, were only open for three days in nearly two weeks of business.  Europe checks out for nearly 10 days. So “small news makes big impact” or “worst day since last one” are headlines you see a lot. This is what we think is going on:

  1. Economy weaker but not stopped and not near recession.

  2. The inverted yield curve story is overdone but that doesn't stop people talking about it.

  3. Volatility is normal. But if you haven’t seen it in a while it feels awkward.

  4. The government shutdown, impasse and partisanship should not be a major problem.

  5. 2018 was a bad year for multi-asset investors. The only markets not in correction or bear territory are Brazil and India.

  6. Earnings and dividends are both likely to continue to grow 10%. There are no major profit warnings.

  7. U.S. Treasuries have done well but they may be too pessimistic about a recession.

  8. Trade and China are the very big elephants in the room. And will remain so.

1.     The Fed moved the markets again. The last time was in December when the market fell 12% peak to trough. Many thought the weaker signs in the economy, such as trade, industrials, government shutdowns and the general tightening of financial markets, should have meant the Fed passed on its fourth hike of the year. We didn't. It’s not the Fed’s job to bail out the stock market and there were no signs of credit stress.

 But Chairman Powell came through on Friday when he announced that the Fed intends to be patient when coming to further increases and will respond as needed. That was the equivalent of throwing a massive bone to a very hungry market. It means they're going to take into account things like China trade deals, profit warnings, the global economy and any housing softness.

 We're somewhat nervous that one announcement can make such a difference. But markets are feeding off headline risk right now. They were down 7% in the days before Christmas on nothing more than a few throwaway headlines and they're now up 3.5% on not much more than soothing noises. But that’s the way markets play out at this end of the cycle.

 Meanwhile, government bonds have been on a tear and are due for a correction. They’re clearly anticipating a recession but they may have overdone it. That move down in the chart is equivalent to a 5% price gain on a 10-Year Treasury.

2.     How were the jobs numbers?  Great. No, really great. After a disappointing December, the market was all about a slowing economy and employment growth. There was plenty of news to support the view: trade, slower industrial production, and some weaker Fed surveys. But the 315,000 new jobs announced Friday were the best since the launch of the tax cuts last February and the third best in the last five years. Here’s the chart:

By now, you’ll know that we take a rather jaundiced view of the labor market. Sure, the numbers are there but things like labor participation, the underemployed rate (the black line) and part-time work are all not what we would expect. Yes, the nature of the labor force has changed: lower participation by women, marginalized workers and demographics but we'd cork the champagne before declaring it the best jobs market ever. Some points worth looking at:

  1. The labor force grew by 419,000. That’s more than the growth in the population.

  2. The number of employed rose by 142,000 while the number unemployed rose 276,000. We'd suggest that’s a good sign that more people are coming back into the work force.

  3. Average hourly earnings rose by 3.1%. This may be distorted. People out of work in prior months because of hurricanes and California fires will have reentered. Their wages thus came back on stream and changed the underlying trend.

  4. Average weekly hours didn't change.

  5. There was a net loss of jobs for those with a college education and they’re 57% of the workforce and 67% of the over 25-year-old workforce.

This all puts the Fed in a bit of a quandary. They recognize the stressed financial conditions of the last two months and see weaker growth numbers. But they also watch wages very closely. There’s a very clear link between the Fed Funds rate and wage growth (h/t Pantheon):

The Fed won't move for now. But if the wages keep growing, then they’ll probably hike in June.

3.     How important was the announcement by Apple? Not very. The fourth quarter is a big quarter for Apple. They typically realize one third of their annual revenue between September and December. They revised sales down by 8% and margins to 38%, which is exactly what they've been for five years. The problem with Apple in the short term is China, which is 18% of sales, and the iPhone price point and saturation. Even after the price drop, Apple sells at a 20% discount to the market and 50% discount to Microsoft. As in the past, if it falls below 10x, it seems like a very good buy.

 

 Bottom Line. Trade related headlines will keep traders on their toes. We feel confident with the Fed’s obvious patience with the data and willingness to listen to the markets. Any breakthrough on trade will push the market higher very quickly.

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Top apps of 2018

Short selling explained

--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.

One of these things first - Nick Drake

Crikey, what did the Fed say to move the markets?

The Days Ahead: The last of the year’s economic data. Not a week to trade.

One-Minute Summary: Yes, that was nasty. All the fears of the year came through last week. The Fed said it saw slower growth and was not as dovish as people would have liked. No light on the political issues. So that's Brexit, Italy, government shut down, resignations and trade all lurking in the background. A disappointing core inflation report. Lower business activity in some Fed regions.

Yet the market is not on a “fear trade”. For that we would have to see a rush into gold, the Yen, Treasuries and a big spike in the VIX. What’s happening is a correction to a slower growth, normalized rate environment. There is nothing particularly wrong with the U.S. economy. All this would hardly deserve the market pessimism we’re seeing. But if we add the trade and China tensions, then market nerves make more sense.

We'd go further. If we see a trade deal with China, which is almost certainly likely even if the details won't be as impressive as the headlines, and some wage growth, we’ll see a snap back in the market and the economy.

1.     Crikey, what did the Fed say to move the markets? Pretty much what everyone thought a month ago.

Look, the Fed was always going to raise Fed Funds in December. They had four planned for the year and it was going to take serious deflation or deterioration in financial conditions to stop them. A 10% correction in stocks simply did not count. And a good thing too. It’s time the Fed stopped underwriting stocks every time they have a perfectly normal correction. The President’s advice merely hardened their resolve. What Fed Chair want’s to go down doing the bidding of a mercurial economist-in-chief?

The Fed changed two items in the announcement.

First, that the Committee “judges that some” further increases will happen. Last time it was that the Committee “expects further” increases.

Second, they added that they would monitor economic developments…which means nothing more than “look, we know markets have sucked and we’ll keep an eye on it, but we don't need to do anything yet”. 

All fine and pretty innocuous. But then came their economic projections in the famous dot plots. Here they are in December and three months ago:

I know it’s tough to read but the bottom line is that 1) they lowered growth and inflation expectations and 2) they expect two increases in 2018, not three. The Fed said what everyone knew but didn’t want confirmed: the economy is slowing. The bond market’s reaction was entirely logical. Short term rates up, long term rates down. The 10-Year Treasury is now at 2.78%, up 3% over the last month and the yield curve is at its lowest for the cycle.

Stocks wanted a bail out and didn't get one so promptly sold off 2%. It didn't stop there. By week’s end, the S&P 500 was down 7%. But there was a lot of other bad vibes in the air of which we would list as:

  1. Turmoil in the White House

  2. No end to trade tension

  3. Prospect of a government shutdown and

  4. Some stock specific hits at Johnson and Johnson, Xerox and FedEx, the biggest stock in the Dow Jones Transportation index.

All the Fed did was provide the timing.

2.     FedEx on trade: For those interested, here’s the full quote from Fred Smith CEO and founder of FedEx. He should know a thing about trade, politics and its effect on business.

“And I'll just conclude by saying most of the issues that we're dealing with today are induced by bad political choices, making a bad decision about a new tax, creating tremendously difficult situation with Brexit, the immigration crisis in Germany, the mercantilism and state-owned enterprise initiatives in China, the tariffs at the United States put in unilaterally. So you just go down the list and they are all things that have created macroeconomic slowdowns.”

3.     It feels like a bear market. Is it? No. But it sure feels like it.  We asked this question last week but we’re down again. Not to pile it on, but the S&P 500 is down 8.5% this year. That's a weighted average, of course. The average share was down 9% and the median share was down 10%. But this was a year of the market coming in strong, a fall, a slow recovery to peak and two legs down, one in October and one in December. So the drop in the S&P 500 from the all-time high is -15% but the average stock (i.e. not cap weighted) is down 26% from it’s 52-week high. There are only four companies within 3% of their all time high and 65% of the stocks in the S&P 500 are in their own bear market i.e. down more than 20%. No stock is at it’s all time high.

This is not quite a capitulation. We'd need a wider, deeper and longer fall for that to happen. But it does mean some bargains are beginning to appear.  As we've mentioned before, there is no single way to gauge the over or under valuation of the market. If there were, we'd all be following it. But one we like is the earnings yield. This flips the traditional PE (price earnings) measure and tells you how much a company earns, expressed as a yield. It’s not the same as a dividend because a company does not pay out 100% of their earnings. Then you take that number and compare it in real terms. Here’s the chart:

It’s the yellow and black lines we’re interested in. Both have moved sharply upwards, showing the market is around 30% cheaper than a year ago in nominal terms and 40% cheaper in real terms. More, the earnings yield is at its cheapest in nearly 6 years and in real terms in two years.

This doesn't mean jump in with both feet. But there is no way companies will report 30% lower earnings in 2019. In fact it's more like a growth of 8%. For now the market is living on fear and stocks are getting cheaper. That feels uncomfortable but may be a very good set up for 2019.

4.     Is Brexit any better? No.

Bottom Line. Stocks will finish the year at about the 25th percentile of historical performance. That means a 2018 happens 25% of the time. For volatility it's at a 66th percentile, meaning it’s above median but not alarmingly so. As we've said before, 2018 feels bad because 2017 was so good. We had a year of low volatility and high returns followed by somewhat higher volatility and flat returns (source AQR) . Our guess is that in a few years, we’ll barely remember this year. Treasuries did fine. Here’s to a better 2019.

Please check out our 119 Years of the Dow chart  

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A drone shuts down a very large airport

Movie remakes

 --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.

Goin’ Back

Last full week…at last

The Days Ahead: Fed meeting. They’ll raise.

One-Minute Summary: The on-off trade talks dominated market sentiment. But nothing substantive. Job openings were up. Inflation came in as expected. The budget deficit for the first two months of the fiscal year, increased from $201bn to $305bn. But, hey, everyone knew that was coming. It will come up in around 6% of GDP. Remember France and Italy? They’re arguing whether their deficit can go up to more than 2.5%. We’ve shown this chart before but we want to stress just how unusual it is:

Normally, deficits go up as unemployment rises…think unemployment benefits and lower income taxes. So, you know, they tend to move with each other until 12-months ago. This is now the biggest non-recession deficit in 70 years.

Oil went sideways and European stocks rallied when the ECB announced the beginning of the end of its four-year QE program. They have neither achieved their growth or inflation targets of 2% so they're going to keep reinvesting maturities for a while. U.S. industrial production grew but the manufacturing component peaked three months ago. For those following housing, here’s an excellent summary of what’s going on and why Robert Shiller is probably off. It’s one reason why we don't believe in the Cassandra-like calls for a 2019 big recession.

And on that note, there will be many such 2019 forecasts vying for attention in the press, Twitter and Facebook feeds. Even in the more sober press. On the Bloomberg site alone, one can find conflicting outlooks for 2019. The more outlandish the more clicks. We’re here for our clients and try to keep things in perspective. Send any articles our way that you think we should read to cthwaites@bandjadvisors.com

 1.     It feels like a bear market. Is it? No. The definition of a bear market is a 20% fall from peak to trough. The S&P 500 fell from its September peak of 2940 to last week’s intraday trough of 2598. A 13% decline. But it didn't close there so the record books will show a 9.5% loss. Year to date the market is down around 1.6% in price but up 0.5% including dividends. Both numbers are changing daily.

If the market feels worse, it’s because of more volatility. In the last 10 days (we’re writing this on Friday) we've seen six days where the intraday move was more than 1.8%, with three up days and seven down.

It also feels worse than the headlines because in 2018, 130 companies in the S&P 500 are down 20% or more and another 73 are down between 10% and 20%. A full 301 companies (so 60% of the S&P 500) are down for the year. Only 60 stocks are up over 20%. For 2017, 240 stocks were up over 20%. Here's what the top 10 winners and losers look like in 2018:

And in 2017

The axes are not the same. The top-10 winners in 2017 were up between 87% and 366% while in 2018 they were up 46% to 82%. So yes, it all feels much worse than the headline change in the S&P 500.

Macro or political events have driven markets in 2018. Corporate earnings were strong and, while they may have peaked for now, most forecasts are for growth of 10% or more in 2019. The economy is softer, rolling down from a peak growth of 4.2% in Q2 to 2.4%, but not close to recession. Unemployment and inflation are close to all-time lows. They may edge up but not by much.

So what caused all the problems? Trade, Brexit, Italy, France and, most important of all, China. All are events that markets cannot price. They create general uncertainty and all round derisking. It’s one reason why top-quality sovereign (so US Treasuries, Japanese and German) bonds have done well in the last few months.

We think 2019 will be better if only because the market is now nearly 20% cheaper than a year ago. But we'll need some relief on those macro issues.

2.     How are banks doing? Not well. Normally banks chug along with the economy. Loan growth goes up as more people take out more mortgages and companies take out loans for expansion. Margins are low but predictable. Regular dividend payments.

Wait, no, nonsense. That was half a generation ago.

Banks discovered leverage and all sorts of high-margin businesses like securitization, investment banking and prop trading desks. It was grand for a while. It all crashed and new regulations were meant to take it back to the old boring days. So why have financials in general (the black line which includes insurance companies and asset managers), the big banks and the regional banks (the other two lines) fallen by over 25% in the last few months?

What's been the problem?

  1. Credit quality: business debt, including commercial real estate, is at record levels. But the quality of a loan taken out when rates were 2% is a problem when rates are 5%. Most corporate margins are very low. There are 92 companies in the S&P 500 with margins less than 3% and the average debt to equity ratio is 165%. The same numbers for small cap are 228 companies and 204%. Higher interest payments simply mean bigger headaches for banks.

  2. Capital Markets:  trading volatility, equity underwriting and M&A have all been weak and are highly cyclical.

  3. Net Interest Margins: tend to come under pressure if yields flatten

  4. Cost of deposits: much higher in the world of fintech and cross selling

We could go on. Regulation and capital constraints have also played their part but we feel those are less important. Financials still count. They're 13% of the S&P 500 down from a peak of 22%. But they don't look like they're going anywhere.

3.     Is there anyway Brexit can turn out well for the U.K.? No.

Bottom Line. We still think the market is over-playing the economic slowdown. Treasuries are holding up well and outperformed equities by 2.25% last week. It’s certainly been a year for stretching patience but patience is generally well rewarded in the stock market.

Please check out our 119 Years of the Dow chart  

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History of Gritty

 --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.

‘Cos we all need a Guiding Light right now.  

 

Wait and see but don't trade

The Days Ahead: Small business optimism indicator. Fed will be in slient mode.

 One-Minute Summary: We're writing this the day before the jobs number. This is typically a major data point for traders but we’re not traders and there’s probably no number that would lead us to change our outlook. Why? Well the estimate is for around 190,000 new jobs, compared to 250,000 last month but these numbers are subject to very big revisions…as much as 50,000 either way. We know the unemployment rate will remain around 3.7%. The only item that may move the market is if there’s a big jump in average hourly earnings. But, if you've been following us, you’ll know we think real wages are unlikely to move much.

The markets had a very busy week. Much of the trading action is prop desks, algos and macro funds closing trading positions towards year-end. It’s not a time to react to headlines. Any view one has is likely to be mown down by stop loss trading. In the last 10 days, we've seen five days where the intraday move was more than 1.5%, six consecutive days of rises and one where the days started very badly and closed up.

Or as Leon Cooperman said “[quant managers] have created a tremendous amount of volatility in the market, scared the public, [and] effectively raised the cost of capital to business”. Yep

Clients have been asking:

Is this the start of a bear market? No. Yes, to corrections and some big moves on stocks but no, to stocks being way overbought and in need of a wide spread sell-off.

Is it the start of a recession? No. The housing market is soft and some leading indicators like trade, oil, and chemical shipments are down. But they're not collapsing. Growth will slow but not stop.

Why is the Fed raising rates? Because of the unemployment numbers. Inflation and wage inflation are not a problem. But it seems likely the Fed will not raise as much as people thought. A few months ago, we said yes to a December hike and two to three in 2019. Right now, we think yes to December and one to two hikes in 2019. The futures market has only one hike priced in for 2019, but that's not hugely reliable.

How are Treasuries doing? Well, thank you for asking. The 10-Year Treasury yield fell from 3.05% to 2.85% last week. That would be a 2% price increase for a bond maturing in August 2028. We expected Treasuries to perform well in times of stress and they did.

 1.     The Yield curve inverted. Should I be worried? No. Let’s take a quick look at what we’re talking about. Here’s a graph of the yield curve today, a month ago, a year ago and the dark days of 2006.

A year ago we had a nice, normal-as-you’ll-ever-see yield curve. Short rates were around 1.25%, the 10-Year Treasury at 2.4% and the 30-Year at 2.8%. But then 1) the Fed committed to more rate increases in 2018 and 2) the government passed a late-cycle, fiscal stimulus package that dropped corporate and personal taxes. If you're a believer in the “tax cuts solves all problems” school, you would have expected 1) rapid growth in Q2 and 2) a bump in tax revenues as more people went back to work, earned and invested more.

But, ha, they only got the first.

And if you're a believer in “don't cut taxes at the back end of an economic cycle when the Fed is raising rates” school, then you weren’t surprised by what the market did next. The front end of the curve rose, because the Fed increased rates, but longer yields rose and then fell back. The market was basically saying, yes, the economy is growing for now, but it won't last and the Fed will have to ease in the next year or so. And that’s when the yield curve inverted (the “Now” line). Except it only inverted at the three and five year line (here). That's part of the yield curve. And only by 2bps. That’s why the “Now” line has a little kink in it at the 3 and 5 marker on the X-axis.

But suddenly we saw a lot of headlines about a how a yield curve is a recession indicator, so look out.  But, you need a lot more information to worry about imminent economic woes. See the top line, from September 2006? Now that’s an inverted curve. Every single rate was above the Federal Funds rate of 5.25%. Back then the Fed was busy raising rates but long-term rates refused to move. And that spelled big trouble.

We’re not there yet.

And how good is the yield curve inversion as a recession predictor? Not very. Here’s the data going back to the 1950s.

When that blue line falls below the zero it turns out a recession follows in as much as four years (the 1960s) to as little as one year (2007). And many times it throws off a false signal, as in 1995.

We'd take the yield curve as one measure but there are much better indicators of a weakening economy. Claims, auto sales, housing, industrial production and some Fed indexes have a much lower error rates. 

As for the bond market, we’re already positioned for lower growth by investing in the middle of the curve (so 7-10 years) and Floating Rate Notes.

So, when somebody says “Aha, the yield curve is inverting” you can say, up to a point.

 2.     The trade talks. That's all settled, right? No. Well, yes for about half a day when the talks seemed to bring about a delay in the tariffs and some commitments from China to buy more stuff. But take a look at the two statements from the White House, here, and the Chinese Foreign Ministry, here. Here’s a quick side by side:

Microsoft Word - B&J60secondiinsights CT1 12-5-18.docx copy 2.jpg

We could go on but were these guys even in the same room? The markets understand the issue of tariffs. It’s not so much that they're a tax on consumers (they are), or that the U.S. is a chronic low-saving, high-cost service producer (it is), so will always run a goods deficit (it does)…it’s that it creates a heck of a lot of uncertainty for companies in managing their costs and demand.

Right on time, the trade deficit announced on Thursday (last week was just goods…this one has services like air travel in it), ballooned out to a near record high. As one of our favorite commentators put it, “pumping up domestic demand with fiscal easing and picking fights with trade partners does that”.

Bottom Line. The market is over-playing the economic slowdown. We're still at 3% growth for the year but with some slowdown coming. Trade remains front and center. Expect more headlines about the yield curve but remember the news cycle is 24 hours and we’re investing for years.

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Should index funds be illegal

Best jokes of 2018

 --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.

Beth Ditto - Fire 

18 Lessons from 40 years of investing

When markets correct, it’s worth revisiting why we like stocks.

When you buy an equity, whether a single stock or basket of index stocks, you become an owner in the company. As a shareholder, you receive what’s left after the company pays its employees, suppliers, overhead, debts and loans. These costs tend to stay fixed. Revenues, however, fluctuate.

If revenues go down, because of a recession, competition or less demand, the amount left for shareholders will fall.

If revenues increase, because of higher prices, new products or general growth, the amount left for shareholders will rise.

It’s what makes equities potentially rewarding but frustrating in the short term. Stocks try to anticipate the changes to revenue and earnings. Because these are difficult to forecast, equities tend to overshoot in both directions. Sometimes they rise too fast too quickly. Sometimes the gloom is overdone.

Here’s a long view of the annual returns of the S&P 500 since 1929. These numbers do not include dividends which add somewhere between 1.5% to 2.5% a year.

The average return is 7.3% a year. The average up year is 17.6% and the average down year -14.4%.

Note that real rates of interest don’t seem to correlate well with stocks. Sometimes stocks do well in low real rates (early 1950s) and in high real rates (1980s). And sometimes the other way around as in 1945 and early 1930. It’s the rate of change that probably matters more.

Here are some of our lessons from decades of investing. We don't claim them as all original. Better and smarter men and women have come before us and will follow us. Nor is this list complete but generally we think about these things when markets start to move.

  1. Markets tend to return to the mean over time.

  2. Markets go up by the stairs and come down in the elevators.

  3. Markets do not correct by going sideways.

  4. Every market has excesses.

  5. There are no new eras, so excesses are never permanent.

  6. Everyone buys the most at the top and the least at the bottom.

  7. Fear is stronger than long-term resolve.

  8. Markets are dangerous when they trade on a handful of can't lose names.

  9. Bear markets have three stages: sharp down, a rebound and a drawn-out downtrend.

  10. When all the experts and forecasts agree, something else will happen.

  11. Bull markets are more fun than bear markets.

  12. Never trade on headlines.

  13. Being early and right is the same as being wrong.

  14. Prices change more often than the facts. Don’t confuse the two. (h/t David Ader).

  15. You are either an owner (equity) or a lender (a bond).

  16. There’s no such thing as an alternative investment. Just variations of #15.

  17. It is very rare that drastic market events require immediate action (See#12).

  18. Intelligent people do stupid things, especially if it’s easy to do those things.

Please check out our 119 Years of the Dow chart  

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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.

 

 

Markets don't like waiting on announcements

The Days Ahead: New jobs numbers. Unless it’s a shocker, the Fed will raise in December

One-Minute Summary: We never like markets when they depend on a single outcome or announcement. It makes for very nervous trading whenever you hear “markets are waiting on X for direction”. Last week it was Chair Powell on the outlook for rates and, of course, the President on whether there would be progress on trade talks with President Xi. That’s fine. The trade talks are front and center of any discussion about the direction of global trade and economic well-being. But just as these problems took many years to develop, they’re unlikely to be solved over a dinner. We can hope for some sort of delay on the January tariffs. Markets would like that. If it's “no deal”, we would expect risk assets to take a step down.

Just for the record here is a quick summary of trade positions coming from the Administration in the last week or so:

  • Trade Representative Lighthizer: says he would be surprised if China dinner fails

  • National Economic Council Chair Kudlow: China must do more

  • National Trade Council Director Navarro: If Wall Street is involved and continues to insinuate itself into these negotiation there will be a stench around any deal that is consummated

  • Treasury Secretary Mnuchin: Trying to reach a resolution

  • President Trump: ready to take it to a more serious level

So, we’re all clear then.

Generally, we feel the stock market over corrected in October. This was partly because Chair Powell said on October 3rd, that “we’re a long way from neutral”. Wham. The S&P 500 fell 10% in two weeks, NASDAQ fell 12% and growth small caps 13%. That was somewhat corrected this week when Powell made an excellent speech about Financial Stability but also mentioned rates were “just below the broad range of estimates”. That made all the difference. The 10-Year Treasuries fell below 3%, down from its oversold high of 3.23%. And stocks picked themselves up. The S&P 500 was up 4.8%.

It was a good clarification but doesn't change our view of the markets. The Fed Fund Rate is 2.25%. It’s going to 2.5% next month. The Fed’s range of estimates is 2.5% to 3.5% so there is going to be somewhere between none to four hikes next year. It will also depend on the data. So far the early data, such as housing, trade, yield curve, the lower oil price, ISM Manufacturing are all pointing lower. But the Fed is not responsible for those. They watch unemployment and inflation. Unemployment is lower than they would expect and inflation is not a concern. Our view is that rate increases will come only gradually in 2019.

 1.     How is trade with China going? Not well. We saw preliminary trade numbers for October and the deficit reached $77bn, the highest it’s been in years and 20% above a year ago. Remember that net trade was a drag of 1.9% on GDP in Q3 so it looks like the trend will spill into Q4. Tariffs cannot fix this problem. The trade account is a subset of the current account and the current account, in turn, is just the difference between what a country spends and what it saves. The U.S. spends more than it saves and so runs a deficit. Tariffs may change the deficit level but only at the expense of higher prices for consumers or lower margins for businesses.

Meanwhile, this is what has happened with the goods trade with China:

The top lines show U.S. exports to China. They're down 10% on the year. The green line shows China’s exports to the U.S. They're up 10% over the year. The bilateral trade balance is at a record monthly high of $40bn. The overall trade deficit is running at $869bn, with China at $480bn or 55% of the total. At the end of 2017 it was $810bn, China at $375bn and 46%.

2.     How important are bond spreads? Very. Many investment blogs tell of the dangers of interest rate increases to bonds. Rates go up. Bonds go down. Why would you buy bonds if rates are increasing? But in our view, interest rates are a distant third when discussing bond risks.

First, is liquidity. The bond market may be very large. Treasuries alone are $14 trillion and there’s another $15 trillion in corporate bonds, munis, mortgages and various asset-backed securities. But individual bond issuances are not large. As an example, take John Deere (DE). It's a well-recognized borrower with a solid A rating. Its market cap is $48bn and it has some $38bn in outstanding bonds. But those are made up of different coupons and maturities. Each one of those is small. The 3.45% of 2023 is only $300m and we’d bet half of that is held by buy and hold investors. If an investor has to sell under pressure, they will find liquidity very difficult to come by.

Second is credit. Most bonds trade as a spread over Treasuries and the size of the spread depends on the creditworthiness of the issuer. That Deere bond trades 75bp over its Treasury equivalent. But GE recently went through a downgrade to BBB and its bond spread jumped from 140bps to 600bps in a month. The price meanwhile fell $110 to $85. So credit quality can wreak a lot more damage to a bond portfolio than an interest rate hike.

 Why is this important? Well the credit cycle is beginning to turn, especially in High Yield. Here’s the spread of High Yield bonds over Treasuries:

They have rocketed up from 350bps to 420bps in less than a month. Some of that is the concern about a general economic slowdown, and thus ability to pay, some down to big mergers (companies are usually downgraded if they pay for mergers with debt) and some due to the bond market catching up with stocks.

The lesson, of course, is to make sure to invest in very high credit at this point of the cycle and that’s why we continue to like Treasures and Treasury FRNs.

3. Microsoft. Microsoft took over from Apple as the world’s largest company. Here’s a chart from the time of Microsoft’s IPO in 1986.

Apple was a go-nowhere stock for much of the ‘90s while Microsoft quietly took over the corporate world. It was the other way round in the 2000s. But Microsoft has come a long way since the Zune and annoying clippies . It’s now a powerhouse in corporate cloud services, databases and its Office suite. It really is a testament to technology, capitalism and free markets.

Bottom Line. Trade. The market is considerably cheaper than a few months ago. We would expect some recovery before the end of the year but we’re not going to do better than low single digit returns in stocks for the year.

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83 year old takes on robbers

Shiny rock on Mars

 --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.

Massive Attack 

Short, sharp shock

The Days Ahead: Busy economic numbers but no corporate updates

One-Minute Summary: Anyone hoping for a quiet week was disappointed. The market suffered a 3.5% two-day loss before recovering on Wednesday. For most investors, this year has not left much to be thankful for. Nearly all asset classes we know have weakened: gold, commodities, large cap, international, emerging, credit and even Treasuries. The S&P 500 is up for the year but by the thinnest of margins. There were no new problems last week nor were there any resolutions to the problems. We'll restate these because they're important and none really lend themselves to quick fixes:

  1. China trade: all eyes on the G20. So far, no breakthrough

  2. Peak earnings:  companies may face higher wage bills or just decide not to expand

  3. Economic slowdown: this week it was lower industrial production and soft, but not deteriorating, numbers in housing.

  4. Fed rate hikes: no hint that the Fed is concerned about the weaker economy and will let up on rates  

This week also saw another indicator that the Kabuki theatricals on trade are hitting home. Here’s a story about farm produce rotting because of collapsing Chinese demand. And here’s a chart showing declining Chinese import of manufacturing components and the decline of U.S. durable goods orders. We advanced the China data by three months so it’s clear what’s going to happen to U.S. orders in the next few months:  

Markets settled on Wednesday. Volumes were low and Treasuries moved less than 2bps.

Tech takes a hit.  We've been nervous about the FAANG trade for a while. For those not familiar, this was the name given to Facebook, Alphabet-Google, Amazon and Netflix, which had a phenomenal run in 2017 and most of 2018. Other companies came along for the ride, including Microsoft, Nvidia, Tesla and Alibaba. Together they became the driver for much of the S&P 500 in 2018 and were around 18% of market capitalization at the September peak.  They're now  14% and the S&P 500 is 9% lower. What happened?

  1. Valuations: most of the big tech stocks traded on premium multiples and were around 40% more expensive than the market average. At those levels, they're priced to perfection. Every earnings call must beat estimates with bullish outlooks for sales and costs. One slip and the momentum investors bail.

  2. Regulatory: most of the tech companies live under a very benign regulatory environment. U.S. competition policy is hopelessly outdated and unless there is a price impact to consumers, they're left well alone. EU takes a different approach and looks at privacy usage, bundling and threats to new entrants. The EU has taxed, fined and warned many of the tech companies for some years now. The U.S. may now follow suit.

  3. Management: Facebook’s cavalier attitude to privacy and trolling is beginning to irritate politicians and the public.

  4. Sector realignment: we discussed here about the new S&P 500 sectors, which moved companies to and from tech and into the new Communication Services sector. It’s all a little opaque but we’re pretty sure the rebalancing has not finished.

The news from Apple fits the above but the main story was about “peak iPhone”. The company has made much out of its ability to command a price premium. The new iPhone X started out well but Apple sources 18% of its revenues from China and there are indications of some pushback from customers. Apple revised its volume estimates and its suppliers were hit badly. Here's an ugly stock chart of some of those suppliers over the last three months:

We expect Apple to recover. It’s fast becoming cheaper and it has a fortress balance sheet. Its glory days may have peaked but as many investors learned to their cost, it’s not a company to underestimate.

Bottom Line. We think most of what has happened is a healthy correction, although on any one day it sure as heck doesn't feel like that. There is some speculative blow off (tech), some genuine geo-political concerns, and some reevaluation of stocks. We don't see big leverage causing a problem, aside from stuff like leveraged loans but that’s a market unto itself. Nor do we see unfathomed optimism, although, again bitcoin has certainly trapped the unwary. For now, we’re defensive.

Please check out our 119 Years of the Dow chart  

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Hedge fund manager sorry but lost all your money

--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.

Thank you 

Don't forget Dividends

Dividends are a very important part of successful investing. The chart shows the S&P 500 price return and the S&P 500 total since 1988. Starting with $100 in 1988, the investor carefully reinvesting dividends would now have $2,107, a 10.7% compound return. The investor in the price only S&P 500 would have $1,046 or 8.1%.

The difference of 2.6% a year meant the dividend investor retired with almost double the amount.

 --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.

Too much news not enough direction

The Days Ahead: A short week and welcome break. EU and Brexit.

 One-Minute Summary: U.S. stocks held up well for a very eventful week. We often talk in macro and market sentiment terms here but sometimes specific stock stories can change markets. We'd point to GE, down 15% and down 55% in the last year. Its bonds are even down 27% and it was recently downgraded to one level above junk. There’s a likelihood that the company is about to go into freefall. Next was Apple and fears that we’ve reached peak iPhone. Suppliers have been put on notice and Apple-related stocks (e.g. ,Dai-ichi, Hon Hai, Foxconn) have been hit hard. The $175bn market-cap loss in Apple is greater than all but the top 25 companies in the S&P 500. And then there’s Goldman Sachs, which is the third largest component of the Dow Jones Industrials simply because it has a high price stock. Goldman is caught in the middle of one of its periodic scandals.

 This is what is hanging over the markets:

  1. Fear of peak earnings: corporate America’s margins are threatened by higher import costs, trade and possibly higher wage bills

  2. Trade: last week we had China trade talks are on (Trump), the tariffs are on hold (Lightizer), on again (Ross), talk tough to China (Navarro) and no don’t, it’s all going fine (Kudlow). One may forgive the market for thinking it’s all a bit up in the air.

  3. Fed and rates: Powell and other Fed governors are talking up rate increases in December and into next year. Yet Treasuries have rallied.

  4. Economic data: retail trade, industrial production and inflation all slowed from prior peaks.

  5. Geo stuff: China, Italy, Brexit, Mexico, Brazil. All out there and with no clear path.

Stocks are probably over estimating the weakness in the economy but all the signs are there. It’s going to be tough to see a positive sentiment for risk assets coming. We still like Treasuries especially as some cracks are beginning to appear in credit.

1.     How’s Brexit going?  We've stayed away from this painful subject pretty much since the vote in the summer of 2016. Painful because it seemed like the U.K. was throwing away 40 years of trade advantage and close EU integration in return for promises of more growth, better healthcare for all and a return to imperial glories. It was a divisive vote and pitched experts against populists culminating in a Tory minister saying, "I think people in this country have had enough of experts".  Ok, then. The vote went through, the Prime Minister resigned, a new Prime Minister took charge and quickly realized that the EU had very much the upper hand in negotiations.

 Much of the discussion centered on treatment of the Irish border. The Republic of Ireland is in the EU. Northern Ireland, part of the U.K., is not. Both sides wanted freedom of movement between the borders and an agreement was hammered out that was shown to the U.K. Parliament this week. It did not go well. As of writing, the Prime Minister has lost several cabinet members, Parliament is furious and many feel that the whole deal is “Brexit in name only” or BINO. There are now three options:

  1. The U.K. accepts the terms, pays an exit fee and keeps many of the trade agreements or…

  2. It rejects the agreement, which means no deal will conclude before the hard exit option comes into play in March 2019, or…

  3. It holds another referendum

We have no idea which way it will go. Meanwhile sterling has fallen. It’s down 13% since the referendum. So have stocks. Here’s the performance of the U.K. stock market for a U.S. investor over the last two years relative to the S&P 500:

And so has the economy. The IMF shows the U.K. economic growth falling from top of the G7 list to bottom; see their report in “U.K. outlook in six very ugly charts”

The most common international benchmark for U.S. investors is the MSCI-EAFE index. It has about an 18% weight in the U.K. down from 25% ten years ago. We've avoided the U.K. for over a year now and there’s not much to entice us back.

Unfortunately, this is not just a local affair. The U.K. is still the world’s fifth largest economy and a major trading partner. Combine Brexit with Italy, trade, China, Mexico, Brazil and general tensions and the whole global growth story looks shaky.

 2.     What’s the oil price telling us?  We're not commodity experts but a moving oil price will come down to a demand or supply question (I know, duh, as the teenagers would say). It’s not clear right now. The supply guys say, well, the Iran sanctions are leaky, Saudi will pump to keep in with the U.S. and eyes away from Khashoggi, Mexico and Russia can’t reduce supply and U.S. shale is back on line. The demand guys say look at world output, China slowdown, energy alternatives, slower economic numbers and there is your answer.

We saw wild swings in the oil and natural gas prices last week. Here’s a chart of both and the ratio between the two over the last 12 months:

Oil is now in a bear market and that matters for the U.S., which produces 12m barrels per day, compared to Saudi Arabia at around 9m. The big moves last week were probably large positions being unwound. The price of natural gas does not normally climb 20% and then fall 10%. The ratio between the two had also settled into a range of 22:1 for the last few years and suddenly halved to 11:1.

So, we’re not sure that last week tells us as much about the state of the economy as it does about volatility in asset classes. Make no mistake, traders and hedge funds have not had a great year and the oil/gas spread is a classic risk trade (h/t Cameron Crise). It looks like some of those trades went badly wrong. We’d give it more time to settle down.

On a very rough guess, it looks like the oil price fall drops oil production revenues in the U.S. by $60bn a year. The U.S. consumer spends about $45bn a month at gasoline stations (not all of it on gas, we know) so it may free up some additional $5bn of increased spending. Over on the corporate side, we’d say that the lower prices come at a very good time for businesses.

Bottom Line: The Fed is clear that there is nothing standing between them and rate increases. Speeches last week made no concessions to stock market weakness, slowing U.S. or overseas growth or trade.  That could change but then Powell could be seen to be giving into Trump pressure. That’s a heck of a dilemma for the Fed and it will play out in the next few weeks.

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Drunk raccoons

 --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.

Year of living dangerously

Normal Service for a while.

The Days Ahead: CPI, Europe economic indicators, which will show how much trade tariffs hurt.

 One-Minute Summary: Nearly all sectors were up except the new Communication Services, but see our explanation below. We had felt that the October sell-off was overdone. It was pricing a recession, which is not going to happen for some time. Buyers came back to the market and the election removes a very big overhang. No surprises from the Fed but short-term rates came within a whisper of 3%. There’s now only a gap of 46bps between two-year and 30-year bonds. We don’t see that changing.

Oil is now officially in a bear market having fallen from $76 to $59 in a month. China remains a big concern on the trade issues and on how much the economy is slowing (see here for a very interesting read of how the middle class is economizing).

 1.     Did markets care about the mid-terms? Not really. Markets read polls and the outcome was pretty much as expected. Generally, markets are fine with split government. Nothing much gets done. Nice and predictable. But there were some early polls suggesting the Republicans would keep the House and the bond market, even in after-hours trading, took a sharp turn for the worse. The concern? That fiscal policy would ramp up and the already deteriorating debt position would head into even wider deficits.

We’ve talked about the deficit. It's a story that’s going to be with us for a while. Start with the deficit in the fiscal year just ended. It was $780bn, up $113bn, and would have been $823bn if spending in 2017 had not been brought forward (i.e. it ended up in last year’s deficit when it really should have been in 2018). Personal and payroll taxes rose $105bn in 2018 but corporation taxes and revenues from fines matched that almost dollar for dollar, falling $99bn. Meanwhile government spending rose $173bn.

So we saw the 2-Year Treasury climb to 2.98% on Tuesday night. It settled to 2.92% but it may not be too long until we see a 3% handle on the two year. Meanwhile, the Fed all but confirmed they will raise rates in December and the expected slowdown in the economy is already happening. It was 4.2% in Q2, 3.5% in Q3 and will probably come in at 2.7% for Q4. The concern on Tuesday was simply that with the economy slowing, a full-on Republican administration would add further fiscal stimulus.

2.     The Fed met and… didn’t really say much other than confirm the economy is growing nicely. They did point out that “Business Fixed Investment” or capital expenditure, slowed. They didn’t indicate whether this was i) noise ii) concerns about trade iii) the money was better spent on buybacks or iv) lower demand. We’d go for i) and ii). To be fair, the Fed would never really talk about buybacks so that was unfair.

 The interesting story at the Fed is away from rates. It's this:

It’s the Fed’s balance sheet and it started the year at around $4.2 trillion (the blue bars). It’s now $3.9tr. You can see how much it's down and the annualized rate of decline is in the green line. It's around 18%. This is the Fed selling the securities it bought in five years of QE. Except they don’t sell them. They let the bonds mature and do not repurchase. But unlike a regular Treasury, they don’t get their money back from the U.S. Treasury. The money just disappears in the same way it was created when they bought the Treasuries.

But the U.S. Treasury still needs the money (because we’re running the deficits up there in section 1) so now they have to borrow more than they would if the Fed just held onto their bonds. Think of it as when the Fed buys bonds, they disappear. When they sell them, or don’t reinvest, they come back to the market.

Here’s a very good description.

 Bottom line? Fed monetary policy is much tighter than it appears from watching interest rates. Hence, we like the U.S. Treasury Floating Rate Note (FRNs) for the short end of the curve. 

 3.     How ETFs distort markets. We’re big fans of ETFs but there are a few rules to follow if you want to get the best out of them. One key thing to remember about ETFs is that they are not passive. Every ETF tracks an index and that index is comprised of stocks selected by the index provider. It used to be that investment management worked like this:

  1. A fund manager made a list of stocks that they thought would go up

  2. They bought them

 Now it’s

  1. Fund manager makes up a list of stocks they think will go up

  2. They pile them into an index

  3. Set up an ETF to track the index

  4. The ETF buys the stocks

 Even the grand old S&P 500 index is not just the 500 largest companies listed on the stock market as S&P excludes companies they feel don’t meet their standards of probity, governance or profitability.  But index providers are big and powerful these days so when they make a change to an index it can leave ETFs scrambling to keep up.

And that just happened. Back in the summer the folk at S&P decided to update the various industry sectors (Called GICS or Global Industry Classification Standards). Fair enough. There used to be a steel sector, mining and railroads sector…you gotta keep up with the times. They decided to:

  1. Eliminate the Telecom sector, which had only three companies left in it and AT&T and Verizon were 90% of that sub-index

  2. Reduce the number of companies in the tech sector and move them to Consumer Discretionary

  3. Add a new sector called Communication Services

  4. Move more companies from tech to the new sector

Now, a rough guess tells us that index funds make up around 20% of the S&P 500 and another 25% of active managers use it to benchmark their performance. So, cue lots of money moving around. This is what the market sectors looked like on the day the changes went live:

The tech sector fell from about $6.8 trillion and 28% of the index down to 20%, while the newly named Telecom sector rose from $500bn to $2.3 trillion or 2% of the index to nearly 10%. There are, of course, sector ETFs that track all these and it seems that investors did not sell down their tech ETF and rebalance. That meant there were a lot of forced sellers of tech shares like Google (was tech, now Communicating Services) and Netflix (was Consumer Discretionary and also now Communication Services) but there weren’t enough buyers on the other end…indeed there were no Communication Services ETFs to take up the slack (h/t John Authers).

 Anyway, we think this along with the share buyback blackout, accounts for some of the recent weakness in tech. It will rebalance in time but meanwhile we must live with the distortions created by passive funds.

 Bottom Line: As we’ve noted before the stock market has become considerably cheaper this year. Companies have reported around a 25% increase in earnings, with another 8% at least next year, but stocks are mostly flat and the market trades at around 15x times next year’s earning. That means valuations have fallen around 20%. We would not quite count on a rerating back up to 18x but we think the rest of the year will trend up. The two big risks: China trade (who tweets first) and the pace of the economic slowdown.

 Please check out our 119 Years of the Dow chart  

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 Other:

Changing the way we remember

 --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.

Once upon a time…

Look back in anger

One-Minute Summary: We, for one, are very glad October is over. See below for what we think has gone on. When all markets correct, we usually find it’s a good idea for the dust to settle and see what has fundamentally changed. As we’re fond of saying, prices change more than facts and the last few weeks have seen investors hitting the sell button and asking questions later.

The markets finished higher for the week but still had one of their worst months for some time. Earnings were phenomenal with the weighted average growth rate at 24%...that’s up from 19% a week ago but that's what happens when big index weightings like Google, Apple and Facebook turn in 30% to 40% growth rates. The market looks very oversold to us. Expect healthier markets once November elections are done.

 1.     Look back in anger:  October was not kind to investors. The S&P 500 was down 7%, small caps down 11%, the Dow Transportation down 8%, the NASDAQ down 8% (and at one point down 12%), most Asian markets down 9% and most European markets down 8% to 9%. The best performing market was Switzerland, down 0.5% and the worst Korea, down 14%. The first is all about haven status and the second is a bellwether for global trade.

Was it better in bonds? Yes, but still negative. The U.S. broad bond market fell 0.9%. U.S. corporates and High Yield and international bonds were down nearly 2%. The best bond market was German Bunds where 10-Year yields fell from 0.5% to 0.3% but that was all a flight to quality as Italian spreads widened out.

Now what does it mean when all asset classes are hit?

  1. A few misplaced remarks. In this case, renewal of the China tariffs and Powell’s hawkish talk on the natural interest rate.

  2. A few missteps on the geo-political stage. In this case, the killing of Jamal Khashoggi, with all Saudi oil market at risk and the midterms, which are, you know, different.

  3. A few highly leveraged trades. In this case, U.S. tech index, which had been a no-lose proposition all year.

  4. A few missed earnings. We already mentioned companies like CAT and MMM which narrowly missed revenue or earnings, or cautioned on the 2019 outlook.

  5. A few missed economic numbers. In this case, ISM manufacturing, trade, capital goods.

  6. No “Fear” trades. In this case, markets did not head to the classic safety trades of gold, yen, Bunds and T-Bills. So, it wasn't a move from “risk to safety” but a general rout.

It's Pelion on Ossa and the best thing to do is step out of the way. Not every market twist requires action and decisions made at heated times rarely turn out well (see #17 here). Here’s what we know:

  1. Company earnings: are strong. They're near the peak but that means they won't grow as much, not that they're about to swan dive. Corporate repurchases will start again soon.

  2. Economy: also strong. Low unemployment and low inflation. But the twin deficits (trade and budget) are about to get worse. That’s a concern not a disaster.

  3. Leverage: in some areas like leveraged loans and High Yield. But not really in banks, consumer (yes, we know the student debt story).

  4. Corporate America: not happy with import prices and uncertainty (see some of the comments in the latest ISM report here). But also still moving ahead, not shedding labor (quite the opposite) or reducing capacity.

  5. Slowing growth: the economy can not handle 4% growth and S&P 500 companies can not turn out 20% earnings growth year over year. That’s an adjustment not a hard recession. And it’s generally good for bonds.

  6. Monetary policy works with a 12-24 month lag: the increase in rates in the last 12-months is now showing up as a slower economy. Slower, not stopped.

We put all those together and would expect more volatility…as we've said before, volatility was way too low in 2017 and most of 2018….what we have now is normal. The numbers will change very quickly. Two days ago, we had a YTD performance of the S&P 500 of 1.4%. Today it's 2.5%. Once we get through this month we fully expect quieter markets and Treasuries to steady.

We’re fans of history so we’ll use that as an excuse to pull out an important chart.

For the last five years, a 60/40 equity to bond portfolio returned 6.5% or 70% of the S&P 500 but with 40% less volatility. Longer numbers give an even better trade off.

Market volatility may produce opportunities for tactical traders but preservation of financial and mental capital is more important in our world (h/t Cameron Crise).

2.     Jobs.  The October jobs numbers were going to surprise because the last two months saw hurricanes that distorted the numbers. The way the BLS calculates the people in work is to ask, “were you paid anything last week?” If you weren’t, you're not counted as employed. This is fine if you're paid semi-monthly or monthly. There is no change to the numbers employed. But it's different if you're paid hourly. If you miss a few days because you’re trying to get out of the way of a storm, you fall off the payrolls. If you then come back to work the following week, it counts as a new job. It sounds confusing but what it means is that the new job numbers tend to score first, lower and then higher than trend in the months around hurricane disruptions.

 And here it is:

We think the trend growth in employment is around 200,000 a month so at first this looks like a continuation of a trend rather than a break to new higher levels. Labor participation rose a little, but as we wrote last week, it’s not about to hit any new highs.

The one data point that caught the press’ attention was the white line, showing Average Hourly Earnings up 3.1% over the year…the fastest wage growth since 2009.

Yes, okay, but last October saw wages decline in nominal terms so the year-over-year comparison is highly distorted and we don't think for a second that wages are about to break out into some new sunny upland. Earlier in the week, we saw a much better indicator of wages and salaries and it looks like this:

That blue bar is the real increase in wages and benefits. Sometimes it goes up not because employees are paid more but because inflation dropped. As we mentioned before, there are lots of ways to get a pay increase but the only one we’re really interested in is if compensation grows significantly higher than inflation. It hasn’t.

Look, nothing here is going to change the Fed’s mind about December. Some even think the Fed may raise rates at their next meeting on November 7th. The tradition of only announcing rate increases when there’s a scheduled presser is new…we remember the days when the Fed opened its doors at 8:30, told you what the rate was and closed up. But, no, they’re not going to do anything on election day. We're all set for a December meeting.

What would change their mind? In order:  

  1. Economic growth stalling badly.

  2. A big equity market correction…more than 20%.

  3. Politics (the President rattles Mr. Powell).

  4. A big international event, say, an Emerging Markets melt down.

  5. Commodity prices fall.

Which is another way of saying, it ain’t gonna happen.

 3.     Peak Apple: No, probably not. Yes, it lost its $1tr market cap (so did Amazon but by a much bigger miss) but it's still up 22% this year, earns a 40% return on equity, and will spend around $100bn in share buybacks, which is enough to buy any of 450 companies in the S&P 500. Those of you so inclined will note that it has been a great timing investment when it falls to 12 times earnings (shaded area) but it's not there yet.

Bottom Line: As last week, we would still look at protecting the portfolio where we can and invested in Treasury FRNs. We think there will be some restoration of confidence in coming weeks and would expect the bond market to stabilize and recover first.

Please check out our 119 Years of the Dow chart  

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 Other:

Ugly mansions

 --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.

 Clyde

October flash backs

The Days Ahead: Earnings continue. Also look for wage news and jobs.

One-Minute Summary: Another roller coaster week. Stocks managed to recover earlier losses and on Thursday halted a six-day losing streak. Economic numbers were generally slow but investors weren’t paying much attention to the macro. The pullback was wide-spread. Some 40% of S&P 500 companies are now down 20% from their highs.

Treasuries were stronger. Overseas markets were down too for many of the same reasons: geopolitics, tighter financial conditions (the ECB said it would start to raise rates in 2019) and some weaker earnings.

U.S. earnings have been in line and…remarkably strong, especially if we use year over year numbers. Companies reporting so far have shown a 22% gain in earnings. But investors focused on peak margins, the dollar, weak housing and a fear the Fed will make a policy mistake i.e. hike rates too soon. Bear in mind, too, that we are in a blackout for share buybacks. Companies cannot buy their shares in the weeks leading up to earnings. So a notable buyer has been noticeably absent for some weeks. That will change soon.

Here’s a deeper dive:

1.     Psych 101 – Stock Markets: Ha, just joking. We don't know anything about psychology. But we do know markets…how they mess with you, and are your frenemy. The news cycle obviously loves this stuff. Quoting Dow Points because “Dow down 1000” is way more dramatic than “Dow down 6% and back to August levels…but readers, please be aware that the Dow is a deeply flawed price weighted index and should not be used for performance measurement purposes”.

And while we’re on the subject of hyperbole, verbs like plunging, collapse, panic, rout and bloodbath (OKfelev, we know you can use a thesaurus already) and pictures of exhausted stock traders really don't help. By the way, all those verbs were in Bloomberg last week…and they're meant to be a voice of reason.

We know investing is tough. As we like to say, stocks go up by the stairs and down in the elevator and the emotional cycle looks like this:

We'd say that we’re somewhere between the two circles. And we’re not trivializing the emotions that come with losing money but here are some things we know.

  1. All major asset classes have fallen: that usually means it’s a broad, sweeping move. The down days are not driven by analysts reading through Caterpillar’s 10-K and concluding their business is worth 30% less today. It’s a large push-one-button trade.

  2. U.S. Treasuries rose: that’s the way it’s meant to work. A typical 10-Year Treasury note rose about 1% in price last week.

  3. Defensive sectors outperformed: Staples and Utilities. Again that’s the way it’s meant to work…a move to relative safety.

  4. Tech was hit: about time. It was a one-way trade for nearly two years. Google beat earnings by 30% but revenue missed by $160m, which sounds a lot until you realize that Google’s daily sales are $360m so they missed about 10 hours of sales. The stock fell 3%. Same story with Amazon. We' think tech had got well ahead of itself and profits were there for all to sell.

  5. Volatility felt bad: but that’s only because of the extraordinary calm that preceded it. We've written at length about the lack of volatility in 2017. We only had two days from 2012-2017 when stocks fell 3% and so far in 2018, we've had four such days and two of those in October. But, this is normal for equities. And we’d expect more volatility as interest rates rise.

  6. The market is not behaving irrationally: the Fed said they think rates should be higher than they are today (and they said it again last week, here) at the same time as the housing market slowed, the trade deficit shot up, the budget deficit widened and retail sales were off. Higher rates and lower growth mean lower earnings.

  7. Rotation: some of the biggest gainers in the nine months to September have corrected the most since mid- September. On the other hand some of the biggest gainers in the last month had a torrid 2018. Again, we'd expect that. A company like LBrands, a fine company but right in Amazon’s cross hairs, is down 50% this year but up 20% since September. Investors were simply seeking out bargains.

 So what do we do? It comes down to four choices:  

  1. Do nothing

  2. Buy

  3. Sell

  4. Get defensive

We've already made a move to #4 earlier this year. Because it's a lot easier to make decisions under calm than duress. We like the dividend payers and the fortress balance sheet types, like Berkshire. We also invested more in Treasuries. We may trim some positions where the fundamentals have really changed but there aren't many of those.

 Finally, we'd share a chart in which we take some comfort.

The black line is the S&P 500 price. It's had some pretty big swings. See 2015 to 2016 and, of course, this year. The blue bars and green line are the earnings and dividends of the S&P 500. There is an unmistakable upward slope to both and a surprising lack of volatility. Prices do indeed change more than fundamentals. Forward price-earnings ratios are now at their lowest since 2016. It doesn't mean there won't be more corrections but corporate America is generally in good shape.

2.     The mystery of lower job participation. Labor participation has fallen by 5% since 2000 and never recovered from its pre-crash highs. Some said that was all down to demographics. The baby boomers were retiring in big numbers…some 10,000 a day.

Well, that’s correct up to a point but it’s not the main reason. Turns out the biggest decline in labor force participation is in the 25-54 age group. The peak workers and earners. Here it is:

The blue line is the biggest cohort of prime-age workers. It’s the same size it was 12 years ago. The other line is workers aged 55 and over. That's up by 10m or 42%. We get that older workers may choose to stay employed for financial or lifestyle reasons and that service and non-manual jobs mean workers can stay employed longer.

But the decline in prime age workers is more concerning. We think one economist we know has put his finger on it (here but behind a paywall). It’s the opioid crisis. It kills 70,000 a year so there are probably around 1.2m to 1.6m people using opioids (no one keeps count). They have dropped out of the labor force. If they were in, participation would be around 1.5% higher.

Aside from the sheer human misery of it all, it means there is a smaller and tighter labor force than there should be. The 55 and over group will retire and that will lower the country’s growth potential. Not this year but certainly in two to five years.

3.     GDP. Great quarter guys. Yes the third quarter estimates of GDP came in at 3.5%. Here it is:

It’s lower than Q2, as everyone expected. As we’ve noted before, the tax cuts were front-end loaded meaning they put immediate cash in hand for the corporate and personal sectors. That showed up in Q2 with higher investment and spending. There was also the boost from trade as exporters rushed to fill orders before the tariffs kicked in.

All those rolled over in Q3. The numbers would have been worse but companies rebuilt inventories and government spending rose 3.3%. The net trade position also fell sharply, as we thought it must. We look forward to the spin on this as the trade deficit is now $40bn worse than the beginning of the year and $100bn worse since the tariffs.

All told, there is nothing in the numbers to prevent the Fed raising rates in December.   

Bottom Line: October has been rough. Midterm elections have usually been a good time for stocks. In the last 13 midterms, back to 1966, there has been only one down market in the October to February period. The average return is 12%. Credit is also holding up well. We'd be a lot more nervous if we saw things like leveraged loans, banks, credit defaults swaps or High Yield having problems. They're not. And that’s a good sign.

Please check out our 119 Years of the Dow chart  

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 Other:

Pile of leaves, pile of leaves

 --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.

Brian Protheroe - Pinball

Stocks can't make their mind up

The Days Ahead: Earnings again. ECB decision.

 One-Minute Summary: A roller coaster week. Stocks manage a 0.11% gain, which is the first weekly gain in four weeks. But it was hard won. We had a 1.5% gain, followed by a 1.8% correction but with late afternoon rallies every day. We think what’s happening is that we have the good news of earnings, jobs, inflation, China “not a currency manipulator” and the not-so-great news of the Fed, housing (see below) and retail sales. Throw in some geopolitical problems and the Italian budget and it's clear markets are nervous.

If there was a market story this week, it was the usually dry as toast Fed minutes. All that happened was they said rates may have to rise above the longer run levels. Eh? That means simply that if they feel the longer term, equilibrium, neither-accommodative-nor-restrictive rate is, say 3%, then rates may have to rise to more than that to offset inflation or “financial imbalances” (which usually means asset-price inflation somewhere in the economy). That was enough to see rates spike for a day and leave the 10-Year Treasury yield up 5bps for the week. We're not too concerned. One, we feel rates may settle higher for a while as we go through a heavy refunding period and two, the Fed won't do anything rash.

Elsewhere it was a heavy reporting week. Netflix showed good numbers, rallied and then lost it all. It’s pretty much the same price it was three months ago and, as a founding FANG member, reflects some disappointment in the tech story. The best sectors for the week were the classic defensive stock of utilities and consumer staples. Telecom used to be one of those sectors but is now the Communications Services sector with the likes of Google and Facebook…so is definitely no longer a defensive play.

 We've seen stellar earnings. About one-fifth of S&P 500 companies have reported with an average earnings gain of 19%. Stocks sell at 15.9x next year’s earnings, well below the five-year range.

 1.     How are the tax cuts coming?  Fine if you pay corporation tax. For the average S&P 500 company, taxes fell from an average (very few paid the old top 35% rate) of 28% to 21%. Unlike credits or other fiscal stimulus, these dropped immediately to the bottom line and probably account for around half of the 20% annual increases in S&P 500 earnings we’re seeing now.

It was meant to create jobs…but the momentum behind job growth hasn't really changed in the last year. Sure, it’s positive at around 180,000 a month this year but that’s only up from 175,000 in 2017. Wages, no…not much to see. Capex? Some. Buybacks? A lot.

 So it’s all fairly elusive until we get to the budget deficit and there it’s very clear indeed. Last Monday, the Treasury issued a presser on the deficit. It rose $113bn to $780bn in 2018 (the government fiscal year ends in September) or just under 4% of GDP, up from 3.6% in 2017. Here’s a slightly different way to look at it but you can see the trend.

The bottom line shows the deficit as a % of GDP. It slopes sharply down from the beginning of 2018. The upper line is the unemployment rate. Normally these lines should be in sync. High employment, lots of tax revenues, low deficit. And when the economy enters recession, the government picks up the demand slack by increasing deficit spending. At the end of the go-go ‘90s, the budget was in surplus and unemployment roughly where it is today at around 4%.

In the financial crisis, unemployment more than doubled and the deficit grew rapidly. And just as rapidly, it began to improve. Today’s number is the highest it's been in 70 years outside of a recession.

The worry today is that we have a high and deteriorating deficit at almost full employment. Rates are going up. The net interest payable on the public debt is $332bn, making it the fourth largest budget item behind Social Security, Medicare and Defense. So more debt at higher rates will certainly put some pressure on public finances. There are even more revenue losses to come.  Most expect the deficit to hit $1 trillion next year. And that assumes no recession or slow down.  

Some day, funding the deficit will be harder. We still like Treasury bonds, however, because most of the new issues are coming at the short end. There was even a brand new type of Treasury Bill issued last week. We now have a 2-month bill to join the 1-month, 3-month, 6-month and 12-month bills. That helps for now. But one way or another, the bill for those tax cuts will come due.

2.     Housing market, all good? Well, not so much recently. The housing market is special in America. It’s the biggest beneficiary of middle-class tax breaks and the government spends a lot of money subsidizing and backing residential mortgages. We won't revisit the nightmare of 2007 but the housing market is showing some signs of a rollover. We look at housing starts, permits, refis, mortgage applications and new and existing home sales (six in all). One feature of the post-crash “start” market is that i) it’s still about 40% below its peak and ii) there are a lot more multi-units, up from around 20% of all starts to as high as 40% and now around 26%. That should mean more inventory and lower rents and may explain why that part (the OER) of the inflation index has been so low.

And yet….last week we saw two key housing indicators flash red. Housing starts and permits were down. Starts are usually volatile…weather and labor shortages can affect the start process. Permits are not...you just file with the municipality and you're on your way. But those are down 10% this year.

 Existing home sales are also down:

That's a big drop and the lowest number since 2015.

 What’s going on and should we worry?  

  1. Mortgage rates are up sharply.

  2. Lending standards are tighter.

  3. The limits on tax deductibility have kicked in, especially in high price areas. Sales in the Northeast are down 20% this year.

  4. First-time buyers are holding back.

Should we worry? No. Housing has peaked for this cycle. But it's not about to crash. A combination of sober lending standards, weak consumer recovery and slow wage growth have stopped the market from getting too far ahead of itself. Our best case is that the economy slows for the remainder of the year and the Fed does not ratchet up rates too aggressively in early 2019.

Bottom Line: There is an end-of-year feel to the market. Some so-called crowded trades (i.e. there is lots of money in them) like Nasdaq and the dollar, have done well and we’d expect some profit taking. As last week, we would still look at protecting the portfolio where we can and are currently looking at Treasury FRNs.

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Escaped pig lured back by Doritos

 --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.

Chunga’s Revenge