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Small Caps deal with rising rates

The Days Ahead: Fed minutes but otherwise a quiet week.

One Minute Summary There is one stock index at a record high. Take a bow, U.S. Small Cap stocks, which are up 6% this year and climbed over their January 24th record high. We actually prefer the S&P 600 as a small cap index, for reasons we explained here.  That has also hit an all-time high and is up 7%, mostly because it excludes speculative, blowout companies that don't make money. Why the small cap love-in? Well, put most of it down to recent dollar strength. Small companies don't have the same overseas exposure of the S&P 500 large cap so are less affected by a strong dollar.

Stocks had a sideways week. We kind of expected that because economic news has been fair to middling and the trade stuff is very much in the background. Total containers moving from the Port of Long Beach jumped 16% in April. We think that’s down to exporters and importers trying to get ahead of the announced trade restrictions from March 1.

Housing, retail sales and industrial production all came out. They were steady, not spectacular. We think we've reached the peak in housing for this cycle. It’s at 1.26m compared to the pre-recession record of over 2m. Higher mortgage rates will keep housing demand flat for a while.

European markets struggled mostly with the news from Italy. Italian stocks had been one of the best performers but investors sent bond yields up by 40bp in less than two weeks. It’s all down to politics. U.S. bond yield also climbed. The economic news seems to confirm the Fed outlook. Steady growth and interest rate hikes.

1.     How are the tax cuts going?  Well, one area you’d expect to thunder ahead would be retail sales. Lower taxes, more take-home pay, more discretionary income, stable inflation, more confidence. Personal consumption is 68% of the $19.9 trillion U.S. economy. Knock out some essentials like food, housing and health care and there is around $7.5 trillion of spending. We were waiting for the April numbers because the tax refunds were done, the new withholding sorted and the distortions caused by the hurricanes (where people bought forward purchases of furnishings and autos) were over.

Surely the new confidence was at hand? Last month’s retail sales (blue column) were up 4.6% YOY, which was down on the prior month but marginally better than the start of the year. We also took a look at what people spend on necessities.

That number was also up 4.6%. What stood out was the 12% increase in spending at gasoline stores (the lower chart). Now, we know, not all sales at gasoline stores are of gasoline but neither are they big-ticket sales reflecting solid confidence. Our read is that basic household items absorb much of the increase and that discretionary spending remains weak.

We're in the minority in thinking these retail sales were pretty meager. The Atlanta GDP Now model raised its estimates for Q2 growth and the 10-Year Treasury bond yield rose 8bp to 3.08%. We're going with around 3% GDP in Q2, less than most. But there is still half the quarter to go.

2.     Does the run up in bond yields change our outlook? No. We fully expected three hikes from the Fed this year. It may even be four. So, two or three to go. Our view on rates is built on inflation, growth and credit demand.

We also look at simple break-evens that measure how much yields would have to rise in a year to lead to an annual return of zero. Low yield and high duration numbers (which we had in January) mean lower break-evens and vice versa. An example is the current on-the-run (i.e most recently issued) 10-Year Treasury, which has a yield to maturity of 3.01% and duration of 8.41 years. The break-even is 3.01/8.41 = 36bp. So the 10-Year note yield would have to rise to 3.37% for the bond to return zero over the next 12 months.

The shorter the maturity the lower the duration. So a 2-Year Treasury yielding 2.55% with a 1.9 year duration has a break-even of 134bps. At the other end, a 30-Year Treasury at 3.13% and 19.19 years is only 16bp.

There’s always a risk of continued curve flattening (where there is not much difference between 2-Year and 10-Year rates) as this shows.

In an expanding economy the difference between a two and 10-year rate is more like 200bp, not the 49bp we see now. A flattening yield curve would mean long term bonds don't change much as front-end yields rise.

So what? Well this all means that we prefer the short to medium end of the curve, at the 7-10 year maturity or six-year duration. The break-evens are higher and the risk/reward looks attractive.  And that’s where we've positioned most of our bond portfolio.

3.     Women in the workforce. We talk a lot around here about demographics and the economy. One sure thing about demography is that you kind of know what’s going to happen. Today’s twenty somethings will, in 20 years a) still be alive and b) buying life insurance, savings products and sensible stuff. It gives you some idea of the overall direction of the economy. But one data item that really strikes us is this:

The top section shows labor force participation by sex in the U.S. The female work force has declined pretty drastically since the recession after years of climbing up. Japan is on the lower chart. That upward slope on women working is impressive. Japan has a real demographic problem. Its population has declined and the average age has crept up. Nearly 30% of the population is over 65. The government has put a lot of effort into attracting women into the workforce. And it’s working. We like where Japan is going for a number of investment reasons and this week’s slip in GDP does not overly concern us. The increase of labor participation seems a very good forward indicator.

Bottom Line: We'll be looking at news from Europe. Growth has stalled but we think it’s temporary. Next week will tell us more.

Please check out our 119 Years of the Dow chart  

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Stealing owls

--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.

 

 

Back to light again

The Days Ahead: Housing and retail sales  

One Minute Summary Low inflation numbers from both consumers and producers meant bonds rallied from the 3% level. We haven’t seen the 10-Year Treasury decisively break 3%. We don't put a lot of store in that number. It’s a nice round number but it’s not really relevant to the average Treasury buyer. We were pleased to see the bond market absorb a very large refunding week of $166bn in bills up to 30-year bonds.

There are a few technical moves going on. Small Cap stocks had a good week. They’re up about 5% this year compared to the S&P 500 at 2%. The S&P 500 also managed to bounce off its 200-Day Moving Average. Emerging Markets tracked sideways. The combination of dollar strength, some highly indebted companies and Argentina and Turkey trying to salvage their currencies by ramping up short-term rates, sentiment took a hit. Turkey’s weighting in the Emerging Markets index is only 1.3% but it’s enough to give some concern.

The biggest winner of the week were energy stocks, up around 4%. We think stocks are still trying to gauge where bonds are headed and where the next big catalyst will come from. We're not entirely sure ourselves except we’d say (stop us if you've heard this) growth is not particularly robust, inflation is low, the Fed’s going to raise rates slowly and all that can be undone with a single Tweet. We're still looking at protection and getting paid for some months of a sideways market.

1.     What's going on in with inflation? Not much. The Fed thinks inflation is easing up hence the well-telegraphed three to four rate increases this year. We had a minor scare in January that Average Hourly Earnings (AHE) were rising too fast. But subsequent reports put paid to that notion and the January number was revised down.

Inflation is probably the single most important driver of bond yields. Obviously, if you're paid a fixed coupon and fixed maturity, inflation eats into real returns. Equities, of course, are a very good inflation hedge until inflation gets out of hand and consumer demand flattens (the 1970s). Treasury Inflation Protection Bonds (TIPS) are also great hedges and we use them. But they don't provide much current income.

The inflation story since 2009 has mostly been “it’s just around the corner.” Half the Fed thinks that way and most sell-side economists enjoy a healthy living predicting inflation surges. The given reasons boil down to:

  1. Unemployment is low. Wage inflation must come soon.
  2. QE flooded the market with M2 money and there’s a decent and lagged connection with money supply and inflation.
  3. The twin trade and budget deficits will push up prices.

But inflation just seems to be stubbornly in the 2% range and has had trouble even breaching that in the last decade or so. Here’s the latest inflation numbers reported on Thursday:

The core CPI (so take out Food and Energy) is up 2.1% and headline inflation is 2.4% with a lot of that driven by higher energy prices (up 13% to 20%) and the base effects of very low cell phone and medical expenses a year ago. We talk about this a lot but the story hasn't changed.

What does this mean? We ran some very long inflation numbers here  and would stick with our view that inflation will not take off and that the current 10-Year Treasury rate, which has flirted with 3% for a few weeks, will stay in a 2.8%-3.1% range for a while. The bond bull market may be over but there is no big uptick in yields coming.

2.     “Good earnings, guys.” So you’re a CEO hanging up on a great earnings call (unless you're Elon Musk in which case you send them over to YouTube) after you reported a 25% earnings increase. You’re looking ahead to a permanently lower corporate tax rate, lower cost of capital and pretty friendly regulations. So your choices are:

  1. Pay higher salaries or bonuses
  2. Hire more people
  3. Kick up the capex
  4. Go do some M&A
  5. Increase your dividends
  6. Announce some share buybacks

Now there are some pretty fierce arguments about the merits of each of these, especially the last one. In the “they're great, stop complaining” camp there’s Cliff Asness at AQR and in the “they kill prosperity” camp there are, well pick your number, but one of the more rational ones is William Lazonick at UMass.

We'll not get into the merits because we're only really concerned about how the choices affect stock prices. And here, there is a clear winner: stock buybacks. Apple was the latest to announce a $100bn buyback and its stock rose 14% in a week. Not all share buybacks are received with the same enthusiasm. Some stock buybacks are basically self-liquidation exercises, with IBM being the most famous example. It spent $50bn of its $130bn market cap on buybacks and the stock fell 29%.

What we don't see is much hiring. We watch the NFIB survey, which asks employers if they're going to hire more people in coming months. Here’s the chart:

Last week’s NFIB report was a cracker. Optimism increased, profits up and nearly 60% announced hiring plans. But recently those plans have not resulted in increased employment. Usually when that green line (good time to expand) goes up, employment growth follows soon after. But not in the last few years. In 2017, the “good times” line jumped very high but there’s been no follow through in bigger job numbers.

What this means to us is that companies are keeping margins and profits as high as possible and are very reluctant to add to fixed expenses. The tax fix was meant to change all that but for now the benefits are mainly accruing to shareholders.

Bottom Line: Eyes on the dollar. It has reversed in recent week and is now pretty much unchanged year to date. More strength will be bad for Emerging Markets and U.S. stocks. Bad news on the trade front will send it up.

Please check out our 119 Years of the Dow chart  

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Other:

China is changing the way trade is shipped.

--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.

 

Tech saves the day

The Days Ahead: Inflation number and the tail end of earnings.  

One Minute Summary A run of not-so-great economic news but there were good reasons for most of them. The trade deficit narrowed a bit, which lends support to the arguments that lower import demand would follow from the unusually high levels after the hurricanes last fall. The ISM Manufacturing and non-Manufacturing indexes both fell and, worryingly, in the employment sections of the reports. It just seems that employers are very unwilling to start hiring in big numbers. The core (PCE) inflation numbers inched towards 2.0% but there’s a big base effect going on from low hospital services (now up 7%) and energy prices (now up 8%) this time last year.

The Fed met and acknowledged slightly higher inflation but slower growth. There was no press meeting but we feel they must be twitchy about trade tensions and some slower growth in the world economy. We'll know more the next time they hold a press conference in mid-June. We feel the Fed will be fine with a few months of the core PCE at 2% and will wait until late summer for any signs of lasting inflation. We think inflation will remain low, which is why we like bonds at these levels.

Stocks were mixed but had a big Friday. Apple had a monster week announcing another $100bn share repurchase and a 16% increase in the dividend. It rose 12% in the week and it's now worth $900bn. U.S. stocks are up 1.6% this year but there’s no momentum or theme. Nearly all U.S. and foreign markets are around plus or minus 1.5% so far. The only outlier is China, which is trying to solve some of its own trade issues.

1.     How about those new jobs?  Not as well as expected. Non-farm payrolls came in at 164,000. Most people were expecting closer to 200,000. But the prior month was revised up. Here’s the chart: 

We're less focused on the absolute numbers these days and more on the hourly earnings and labor force participation. Why? Well, the reported unemployment numbers are about as low as they can go but that alone doesn't mean there is full employment or wage pressure just around the corner. Hourly earnings rose 2.6% (the lower line in the above chart). Given that non-core inflation is only just below that, it means real earnings are flat. And average weekly hours worked was unchanged. Participation slipped a bit.

All in all, nothing for markets to run on in any direction.

2.     Are U.S. stocks expensive? About 6% less than they were a few months ago. What we've had is a run of very strong earnings. The blended earnings growth in Q1 was 24% and that's the highest since 2013. The energy sector grew earnings by 93%. They're still important to the economy at 6% of the S&P 500 but with 10% and 8% of the S&P 500’s sales and earnings.

Here’s an important chart we look at:

It shows the earnings yield of the S&P 500 at 6.3%. We then reduce that number by the level of inflation. The higher that lower black line, the cheaper the stock market relative to inflation and bonds. Right now it’s cheaper than it was for most of 2017 but not as cheap as it was in the 2012-2015 period.

No one stock market measure is infallible, of course, more’s the pity. But we think the market is adjusting to the gradual rate rise as well as the less than stellar global macro news.

3.     How’s the Treasury doing? Meh. So, every year the Treasury tells the markets how much it’s going to borrow. The amount is basically refinancing of maturing debt and raising of new debt. Early estimates are for $950bn in 2018.

This should be fairly straightforward except the forecasts of what the budget deficit varies by who’s doing the talking. A few weeks ago, we highlighted the CBO’s estimates and they had a chart showing the deficit like this:

But the Treasury recently put out deficit estimates and their graph looks like this:

They both agree the number was about 3.5% for 2017 but then, you know, they kind of take different roads. Basically, the Treasury says growth will rip along at 3% and more and raise lots of tax revenues with no recession and the CBO says, er, probably not. The CBO is a pretty independent, bi-partisan and objective body. Steven Mnuchin runs the U.S. Treasury.

So we’re dealing with a bit of a movable number here and the markets were surprised when the Treasury announced they would only borrow $75bn in Q2 compared to an estimate of $176bn a few months ago and $488bn borrowed in Q1. So that was a bad day for Treasury bears and the 10-Year Treasury rallied some 10bp (or up 1.5% in price).

Does this mean tax receipts are in great shape and the deficit okay? No. The Treasury prefunded some of its needs and April brings in a lot of tax payments, so we don't get to sound the all clear. It demonstrates the seasonality of Treasury bonds (and therefore the bond market). They tend to be weak in the first quarter of the year. Why?

  1. Inflation tends to come early in the year. If businesses raise prices, they’ll get it done as soon as they can.
  2. Japanese investors repatriate dollars by selling Treasuries ahead of the end of the fiscal year in March.
  3. High refunding needs ahead of tax deadlines (h/t David Ader, IFI Research).

Anyway, with all this, we would expect the 10-Year Treasury to stay well below 3% in the near term, despite the expected Fed hiking in June. So, we’re okay with the level and sentiment in the bond market right now.

Bottom Line: We don't expect any break out from the range bound market we've had for three months. We'd be worried about another round of big and leveraged M&A activity (looking at you T-Mobile/Sprint). That tends to typify late cycle activity.  We'll probably look to reduce portfolio volatility again soon.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

Mount Trumpmore

Elon Musk does not like questions

Beating Harvard with index funds

--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.

 

100 Year of Inflation and Real Rates

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

1. The annual change in US inflation

2. The real rate of 10-Year Treasury bonds

3. The names and start dates of the Fed chairs

4. Highlights from each year that influenced inflation

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

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

A look at some bubbles

The Days Ahead: More earnings and jobs numbers.  

One Minute Summary: A lot more economic news to feed off this week but not a lot of action. GDP numbers were soft with consumer expenditures and almost every category weaker than the last quarter of 2017. The high point was a build-up in inventories, which makes sense because consumers went on a mini spending binge last year and companies then had to build inventories back up. Anyway, the market yawned as they did with disappointing factory orders and lower home sales.

The S&P 500 was flat. Some oversold sectors like staples and telecomm did well. Europe was mostly flat but we think they're likely to outperform this year. Emerging Markets were flat but off 2% in dollar terms as the dollar rallied, particularly against the Euro. The 10-Year Treasury hitting 3% was not unexpected and soon retraced.

What we’re seeing with earnings is a pattern of selling on the news. Some of the biggest moves this week were companies that reported perfectly fine numbers but gave weak outlooks. Caterpillar (CAT) was a good example…down 9% on multiyear margins and net income. 3M (MMM), Teradyne (TER) and Freeport McMoRan (FCX) were the same. What’s going on? A lack of the next big thing. Earnings are good, economy okay, inflation ticking up gradually. These are all fine but there’s no big catalyst in the wings so stocks are taking a breather. No reason for any portfolio changes

1.     Bubbles: The problem with bubbles is that they're difficult to spot when you're in them (post hoc is a piece of cake). Having gone through two out of the three worst market corrections in the last 80 years, let's just say we’re on the lookout for any signs of exuberance, rational or not.

Two areas that have given us some concern are commercial real estate and (some) tech and we’ve written about both at length. The two came together spectacularly in a bond offering from WeWork, a company that creates a world where people work to make a life, not just a living. It’s basically shared office space for the tech firms, the gig economy with a lifestyle twist (like free beer and foozball) and has raised plenty of equity money to value it at $20 billion, which would make it the 150th most valuable company in the S&P 500, if it were listed. But to get into the S&P 500 you kinda have to make money, which WeWork does not. The 342 offices are all over the world and in some pretty nice locations too.

They came to market with a 7.85% seven-year $500m bond, with a rating B+, which is pure junk or as S&P put it, has:

“Adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments.”

No kidding. You’d think with all those offices, it would be an asset intensive business. But WeWork doesn't own the properties, it leases them. So it’s more of an operating real estate company and should be asset light.

Why, then, does it need the money? Because it's tearing through cash. In 2017, it had revenues of $822m and lost $883m. At that rate, it will eat up its cash assets in two years. It has no equity cushion, unless SoftBank chips in another $4bn. Its EBITDA is so awful that the company has to adjust it like crazy:

Source: WeWork Prospectus via FT Alphaville

GAAP says you must produce a real, accountant certified earnings number. That’s around $771m in the above. But GAAP also says you can restate EBITDA if there are one-off expenses (like stock options you grant once), or you expect some earnings to come through for a full year (instead of a partial year). You don't have to disclose exactly how you got there but, from the above, all that gets WeWork to a $193m loss.

They then put in a “Community Adjusted EBITDA” to get it to a $233m profit (the bit in yellow). How did they get there? By adding back in all the sales and marketing expenses saying, in effect, they won't happen again. No investor has ever heard the phrase “Community Adjusted EBTDA” before or quite so aggressive an income restatement. Neat trick: turning a $933m loss into a $233m profit. 

Enough on accounting. But suffice to say it’s a very dodgy way to report your expenses but because it’s a private company, you have to go with it. So how did steely-eyed irascible bond investors take it? They over-subscribed and the company looks set to raise $702m.

So why are we concerned? Mainly because it's:

  1. A hunt for yield
  2. A basic business model (it's a landlord) masquerading as something new age
  3. A ton of debt sitting on a ton of debt because the properties they lease don't belong to them but leveraged real estate companies.
  4. An eye watering valuation

So, leverage on leverage, novel accounting and demand at-any-price is not a great combination. Add in that seven of the world largest tech companies are tech and that never before has one sector dominated the large cap universe, that tech is now 27% of the index (it was 33% at its peak) and, you know, the general euphoria around tech, and well, color us skeptical.

It's another reason why we focus on quality, dividends and companies with management discipline.

2.     ETF Screens: We attended a meeting with a major index provider and asset manager the other day, somewhat under Chatham House rules. The topic was social investing and index managers. Blackrock has made a big splash about corporate responsibility asking that companies account for their societal impact or risk the ire of the world’s largest asset manager. But Blackrock is the largest shareholder in multiple firearm manufacturers and doesn't have much of a choice except to invest in them as long as they are listed companies.

On the firearms side, we ran the performance of the four listed manufacturers (there are others but they're mostly private or foreign) against the Russell 2000 small cap index. They're terrible investments but that’s not really the point.

Most of them are small market capitalizations and together they're only 3 basis points (so, $15 for every $50,000) of the index. The lower line shows the performance of the four companies and, clearly, they have not performed well at all.

What we wanted to explore was whether we could use an ETF that excluded either i) firearm manufacturers ii) retailers of firearms or iii) some broader definition of societal good and responsibility. We'd like your thoughts and please let us know either here and jump to the comments section or here.

Bottom Line: We're in a range bound market for bonds and equities. We expect it to stay that way. We'll be looking for wage and hourly earnings increases in the job numbers. We don't expect to find any.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

Stuffed anteater disqualified

--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.
 

Budget Deficits and Trade

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First, check your index

The Days Ahead: Big earnings week.  First look at Q1 GDP.  

One Minute Summary: A quieter week on the economic front but what there was uninspiring. Housing starts were fine but most of the increase was in multi-family housing. Industrial production was up but flattered by energy and mining, which are 20% of the index.  We saw new nominees for the four (!) open positions at the Fed. We like them so no drama there.

The S&P 500 was up for the week. Small company stocks, Emerging Markets and International all had a better week and all three are ahead of the S&P 500 year to date. The best market was the U.K. It’s by no means out of the Brexit problems but the stock market has a heavy 22% weighting to mining and commodities, which have been on a roll recently.

Earnings were positive. But the market has distinguished between “bad, good earnings” which would be better net income mostly due to lower taxes and “good, good earnings” which would be better because of margins or volume. In the first camp put Philip Morris and IBM (down 17% and 8%) and in the latter, Netflix and industrial supplier Grainger (both up around 6%). Generally, earnings are having a barn- storming quarter with companies showing 18% annual growth. The 10-Year Treasury rate rose to 2.95% but some of that is because of a heavy refunding week coming up. We don't expect it to continue to rise.

1.     How’s that curve flattening going?: We know, pretty much, that the Fed will raise rates another two or three times this year. But this is not the risk in the market. The main concerns are will the Fed Funds rate exceed the 2-Year Treasury and how will the market react? Here's a chart showing the Fed Funds policy rate and the S&P 500.

A few things jump out:

  1. A rising rate environment need not harm stocks. See the period of the 1980s, early and late 1990s and 2003-2004
  2. If the Fed Funds rate catches up with the 2-Year Treasury, stocks will begin to correct or at least tread sideways.
  3. he Fed has for the last 30 years, had a “put” in place. It started with Greenspan and continued right through 2016. Basically, if the market stalled, the Fed cut rates.

We think the Fed “put” is unlikely to happen this time.  As one of our favorite commentators put it,  “The Fed will accept a recession before it allows high inflation.” What we’re seeing now is the gradual flattening of the yield curve and that means the economy is slow and money is tight. The Fed seems ready to pounce if we get a few reports of accelerating inflation. They're unlikely to be concerned if the market swoons. Providing, of course, the Fed can keep its independence.

What does it all mean? Slower growth and range-bound rates…and probably stocks.

2.     What's in an index? Quite a lot actually. We're big fans of indexing but perhaps the most important decision, even before fees, is what index are you going to use? Most indexes are built by:

  1. What stocks do you think are going up?
  2. Decide if you want to rank them by market cap or not
  3. Build an index.
  4. Launch an ETF

But step 1 is kind of important. The classic example is the U.S. Small Company index from Russell or S&P. The Russell is by far the better known and older, arriving in 1984 and just in time for when the small-company effect was identified. Some 93% of the $1 trillion in small company funds and ETFs are benchmarked to the Russell 2000. But a few years later, S&P came up with their version of a small-company index. This is how the two have done since then:

We're interested in the blue bar, which is the S&P 600 and you can see it outperforms the Russell 2000 in 17 of the 23 years since 1994. It gets even better because its margin of outperformance on the downside is larger than its upside performance so the volatility, risk and things like Sharpe ratios are also superior.  

So how much more did one earn using the S&P 600 versus the Russell 2000? Well, a $10,000 investment made in 1994 would be worth $131,000 in the S&P 600 and $86,000 in the Russell 2000. Now S&P knows their index is better so they charge for it. But that cost is absorbed by the ETF provider and doesn't show up in the expenses paid by the shareholder.

How do they do it? Here’s a rundown:

B&J60secondiinsights 4-20-18 LECH edits.jpg

Basically, the S&P 600 has a quality bias and because it rebalances more frequently it’s less prone to front running. This happens because an active manager can identify what companies are likely to fall out or be included in the Russell 2000 and start to trade it ahead of the July 1st date knowing that, on that date, some $750bn of funds will be forced buyers and sellers. In fact the rebalance effect alone accounts for 0.6% of the 1.9% annual outperformance.

So if the S&P 600 is so much better, why is it still around? Well, two reasons. First, there is a place for an index that just takes all the listed companies and basically says “this is what’s available, use it if you want.” Second, it's an easy index to beat so active managers tend to like it.

The lesson? Indexing is great but always ask how the index works. There are many ways to construct an index and, as you’d expect, some are distinctly better than others.

Bottom Line: There is profit taking going on as well as some sector rotation. Energy is a favorite sector right now. At the risk of sounding like a broken record (what’s the digital equivalent?), the tweets and politics could unsettle the market very quickly.

 

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Robert Mercer and the police

Theranos still misbehaving

 --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.

 

 

Excuse me, have you seen the Budget Deficit?

The Days Ahead: Earnings season starts up. Financials and Energy stocks should be good.

One Minute Summary: The Fed published the minutes from its March meeting. They think growth will accelerate later on this year and made the usual cautionary noises about inflation. The bond market ignored it. Bonds were also unfazed by the inflation report (see below). Markets were also not terribly surprised by the CBO report, which calculated that the 10-year cumulative deficit will rise 32%. Most economists had worked that one out.

The market was mesmerized by tweet storms. Some historians went back to the Cuban missile crisis to see what happened there (a 7% drop then recovery) or with the NATO bombings in Yugoslavia in 1999 (the market rose 12%). The placatory remarks from President Xi Jinping helped. Stocks rose 3.2% through close on Thursday. It was a good week for most sectors except utilities and REITs, which tend to be rate-sensitive.

U.S. small cap, Emerging Markets and International are all ahead of the S&P 500 year to date. Russia had a bad week, down 14%...which happens if you get hit with sanctions. Russian stocks are only 3% and 2% of the Emerging Markets equity and bond indices (we don't use Emerging Markets bonds).

There has been no direction to the market for over a month. Some of this is because of a news cycle that's more noise than signal. Earnings season starts soon and it will be good. Expect big numbers across the board and especially energy. No changes to our portfolios.

1.     How’s the CBO doing? Pity the staff at the Congressional Budget Office. They have a hard-earned reputation for non-partisan work but had to rush through an analysis of the tax cuts in December 2017, days before the bill was passed. Their best estimate at the time was that the bill would add some $1.4 trillion to the deficit over 10 years.

But it's actually quite a bit worse. This time last year, the CBO report said that the 10-year projected deficits would be $9,422bn (here, page 89). Fast-forward to December and it was, well, if you go and cut taxes, it will add $1,454bn to that number.

Last week, they had a chance to run the numbers again and it's $3,000bn more than this time last year. So, now instead of the 10-year deficit being $9.4 trillion, it’s going to be $12.4 trillion, Oh, and debt held by the public (which is all the federal debt except that owned by trust funds like Social Security, Medicare and Retirement funds) will grow from 75% of GDP to 95%.

Anyway, here’s the chart of budget deficits as a percent of GDP to 2028, heading up to 5% of GDP from a 50-year average of 3%. In fact, the deficit has only been over 5% of GDP five times since 1946 and four of those were in the depths of the 2007-2009 recession.

Why are deficits growing? Well, it comes down to lower revenue from corporate taxes of course which are permanent, and lower income taxes up to 2026, after which they jump because they expire in 2025. And it’s also because of mundane things like higher interest rates on the higher deficit.

Does it matter? You tend to get three answers:

1.     No. We owe it to ourselves. See Japan etc.

2.     Heck, yes. No family budget can go on spending like that.

3.     It's complicated.

 There were an awful lot of people who were on the side of #2 but they've gone to ground/retired recently. Answer #1 can be true if you have a nation of savers and don't rely on outsiders to finance your debt. As for #3, the CBO puts it best:

 “Such high and rising debt would have significant negative consequences, both for the economy and for the federal budget”

We've had deficit panics in the past. But then we had higher growth and higher inflation (which reduces the real cost and value of debt). Today we have neither of those. Put it all together and we would say this is another reason to expect low growth for many years.

2.     Do we have an inflation problem? Not yet. We had two major inflation reports, Producer (PPI) and Consumer (CPI) prices. The headline numbers were 3.0 % and 2.4%. On the CPI side, we’d note that there’s a “base effect” especially in three areas. First, in energy. This time last year, prices for gasoline and energy were flat or down. But oil is now 26% higher than a year ago (lucky California drivers are paying 30% more than 18 months ago), so energy prices are up 7% but from a low base. Second, cell phone prices dropped sharply last year (we wrote about it) but now they've stopped dropping. Third, medical care expenses rose from a year ago when the ACA had negotiated lower hospital costs. Those too have started to rise. Together these three are around 15% of the index.

Here’s the chart with the cell phone expenses at the bottom now rising.

Take some of these base effects out and we’re looking at core CPI at 2.1%, which is unchanged. Over on the wages side there is no real movement either. Any increase is in more purchasing power not increased wages. Remember the BLS puts you down for a wage increase if your wages don't change but prices fall.

So we remain in the camp that inflation won't really take much hold although the Fed will talk about it.

Bottom Line: We don't think business and consumer confidence is running very high. Stocks are going to react and overreact to very bit of news. Look for what CEOs say in earnings calls. We feel we’re well positioned for a rough few weeks.

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Takahata Isao and Grave of the Fireflies

And Gillian Ayres died

--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.

 

Letting the trade waters go by

The Days Ahead: US inflation. Watch for German and China trade.

One Minute Summary: Markets were slow. Many traders and investors were off for the week. Europe was all but closed. The trade and political stuff makes for big jumps in volatility. This is good for bank trading desks and option writers. For long-term investors it’s not a problem unless they react to it. As we’ve mentioned before, this volatility feels unsettling because it’s been quiet for much of 2017. In fact, volatility is bang in line with its long-term average. Welcome back my friend, to the show that never ends.

U.S. Treasuries were up. Bond spreads ticked up. That's the credit worries at work. The S&P 500 was down 1.2% for the week. It’s down 2.5% so far this year but up 11% on the year. Small caps have done comparatively well this year. Tech was down again. It’s mostly fear of regulation because we don't expect earnings to be hit soon. We would still buy the protection we put in place for clients recently.

Europe and Emerging Markets were positive and have outperformed the U.S. by around 2% this year. Japanese exporters had a tough week. They're in the trade crossfire. Last year, Prime Minister Shinzo Abe gave President Trump a hat with a logo reading “Donald & Shinzo, Make Alliance Even Greater.” He may ask for it back.

1.     What a mess with China:  You may have noticed there was some chat on trade with China last week.  Some 99.99% of economists believe trade wars hurt the world economy. The others don't. We found it useful to try and unpack some of the talk, ‘cos , you know, you might think we have a $500bn trade deficit with China. (Skip to the end if numbers are not your thing). 

1.     The U.S. has a $375bn goods trade deficit with China. That is made up of $506bn of stuff we buy from China and $130bn of stuff we sell to them

2.     The U.S. has a massive $38bn surplus in services with China. Bigger by far than any other country. It's mostly travel, IP licenses and business services (do a consulting gig for Alibaba without even leaving your San Francisco office and it shows up here)

3.     The trade deficit is thus $337bn. Still large but not $500bn.

4.     Most of what the U.S. sells to China is food, aircraft, cars and capital goods. They're 52% of all exports.

5.     Most of what China sells the U.S. is cell phones (some $65bn a year), computers and telecomm equipment and toys.

6.     The U.S. has 25 products that account for more than $1bn in sales to China. China has 68 coming the other way.

Now it would seem that China is in a very good position here. The U.S. has targeted 25% tariffs on some $50bn of goods coming in from China.  So that's $12.5bn. Here’s the full list, starting with Thorium. They left off the cell phones because because that “Designed in California, assembled in China” on the back of your iPhone means exactly that. Apple and others would have a fit if those were part of the deal.

China, of course, retaliated last time on the steel tariffs with 25% tariffs on $3bn of stuff from the U.S. That's the wine, ginseng and pork products one. So, that’s $750m. This time, they've targeted the big ones like soybeans, aircraft and cars. They floated a tariff rate of 25%, which would cost U.S. exporters around $22bn.

Put this all together and we’re looking at around $45bn of cost for U.S. exporters and U.S. consumers. That’s around 0.2% on a $20 trillion economy. If the U.S. goes with the $100bn increase we heard about last night, then add another $25bn for a total of 0.3% of GDP.

But this is not the point. What worries businesses is how far this can go, whether supply chains will have to be redesigned or business strategies rethought. So Boeing, John Deere and Caterpillar were all down around 12% recently. The stock market reaction, down some $1.5 trillion since February, is way out of proportion. But then it nearly always is.

The foreign exchange market, however, is not rattled. If markets get really scared about this, expect the dollar to strengthen and the Yen and Renminbi to weaken. It’s been the opposite.

Anyway, here's the trade deficit with China. It’s 50% of the U.S.’ entire trade deficit. If I were a betting man, I’d say the U.S. will have a tough time winning this one.

2.     How about those jobs numbers? Meh, not so good. It was just 103,000 compared to 326,000 in February. We have a kind of love-hate relationship with the jobs numbers. On the one hand, they're a big, market-moving event. The Fed follows them because it’s part of their mandate. And you’ll occasionally hear an administration mention them. But they're subject to huge variations from initial to final, have weird seasonals and tend to over or under report against consensus by 50,000. Yes, a 100,000 estimate produces a 50,000 to 150,000 result. And that's considered fine.

Anyway, here they are with the bottom line showing average wage increases.

That’s the number that got everyone worked up two months ago when it spiked. We thought then it was a seasonal thing and it certainly looks that way now. Average earnings were up 2.7% but these are nominal not real increases and skewed to supervisory workers. The non-supervisory workers saw a much smaller increase and lower weekly earnings.  Which means they had a modest pay rise but got to work less.

The market had other things on its mind and gave the numbers a big yawn. It was mildly bullish for Treasuries with rates at 2.78%. It all supports our low growth low inflation outlook.

Bottom Line: Expect markets to react a lot to bellicose trade talk. Mr. Zuckerberg will visit Congress. Probably best to stay clear of big tech for a while.

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Tearing up Econ 101

--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.

 

Always something happening and nothing going on

The Days Ahead: The European long holiday keep things quiet. Jobs number on Friday.

One Minute Summary: We had three out of four trading days where the market moved by more than 1.3%. But there was no change over the week. Bonds had a good week. European markets were up but Asian stocks are still trying to figure out what the trade talks do for them. Companies like Toshiba, Sharpe and Nintendo were down 6% to 8%. The Euro and the Yen took a break from their steady rise this year but that was probably due to some cross-currency funding needs of major banks (the rule on overnight funding changed with tax reform).

Stock volatility feels high. But it's no different from its long-term average. Stocks have gradually got cheaper these last few weeks. We've seen no downward revision of earnings. While the economy is not quite the tear the tax cut crowd thinks, we’re a long way from recessions and economic downturns. Sentiment is shaken but if that flushes out some of the fast money especially at a quarter end, then… good.

1.     Tech Wash Out. When companies grow big and dominant they attract attention. In Europe, it tends to come with taxation. In the U.S., it's regulation. The driving themes of tech in the last few years were a mix of i) almost measureless scalability ii) the network effect (i.e. the more people use something, the more valuable it becomes to the community) iii) growth and iv) real oligopoly. These are exactly the same arguments in the last tech boom, the IBM and BUNCH stocks in the 1970s and all the way back to the Bell System in the 1900s.

It was perhaps inevitable that one or more of the current tech leaders would trip. It happened to be Facebook. It wasn't the first to break the rule of corporate communication (don't let the lawyers run your PR) but it did an outstanding job of going to ground and coming up with a sort-of-sorry mistakes-were-made-apology. But when investors are looking to sell stocks that had massively outperformed the market over the last three years, then any news becomes a reason to sell. Europe thinking about imposing a sales tax on tech companies. Sell. Tesla’s debt downgraded. Sell. Nvidia, a stock that has risen 700% in two years, said it won't be testing autonomous vehicles for a while. Sell. Twitter and privacy. Sell.

Tech has had phenomenal run. And it’s not nearly as overbought as in the 1990s. Here’s a chart showing the performance of tech against utilities, the ultimate defensive sector, in the 1990s and in the last 10 years.

It certainly looks like a bubble but on a much smaller scale. What concerns us is that many investors have left conservative investments and put an awful lot of faith in a few growth stories. For the last five years, tech has beaten utilities hands down, up 150% against utilities up 54%. But since the 2000 tech peak, it’s a very different story. Tech has risen 78% and utilities by 224%. It took 14 years to get back to break-even if you’d bought tech in 2000. For utilities it was just over four years.

So? Well we’d just reiterate the theme that diversification is very important. And we’d expect this period of volatility to continue.

And from the history rhymes library, here’s a pretty fierce response from the head of AT&T when the government started the breakup of the Bell companies in 1981.

2.     What’s the bond market saying? That growth isn’t going to last. And that inflation won't be a problem. We feel pretty confident about the second. Primarily because we think there’s more slack in the labor market than many realize. We wrote about it here. On the first, though, you've probably heard about the yield curve flattening. This is when short-term rates increase but long term rates stay sticky. There are lots of ways to measure it but here's the spread between 3-month Treasury bills and 10-Year Treasury notes.

Even at the height of QE when the Fed bought every Treasury and MBS in sight and so pushed yields down, the spread was 2.25%. After the election, in the heady days of growth, deregulation and tax cuts, it steepened sharply. But it's been falling ever since and especially so this year. It's now down to 1.02%.

To us, the market is saying that i) tough trade talk may sound good but there is probably nothing economically constructive that can come out of them ii) the twin deficits are going to need financing and the financing is going to come at the short end of the market and iii) the markets are nervous about growth. So, why not hold longer term Treasuries because they're not going to change…only the short end will.

That's our view certainly. We really don't believe in the “bear market for bonds” hype. We think rates are pretty well underpinned at the 2.7% to 3.0% range and will stay there for much of the year.

Bottom Line: Another short week. Asian markets grappling with the trade tariffs. As clients know, we’ve placed some protection on U.S. stocks. Expect volatility to remain high.

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Berkshire Hathaway is now the country’s second largest realtor

--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.

 

Fed makes it the first of three

The Days Ahead: Shorter trading week and Europe will be very quiet. Asian markets on watch after the trade news.

One Minute Summary: Trade issues hung over stocks again. The Fed was generally hawkish and clearly thinks “gradual” increases are on the way. So, another two this year and maybe three. Tech came under tremendous pressure. The sector was down 8% with Facebook down 14%. It’s now the cheapest it’s been since the IPO. Financials had a bad week too. Normally, they do just fine as rates increase. This time there seems to be a funding problem and overnight rates climbed sharply. This might be a result of changes to how banks fund themselves post tax reform.

We're now in a higher volatility era for equities. So far this year average volatility has been 17 and it closed at 23 on Friday. It's long term average is 18. In 2017 it was 11. That’s clearly the outlier. Our list of things to worry about now includes tech, trade and earnings in addition to the normal phase of the cycle, U.S. politics and rates.

European and Asian markets performed better than the U.S. Emerging Markets held up well despite the trade issues. The dollar weakened again. It’s down about 3% this year.  

1.     Meet the New Fed.  The Fed met for the second of its eight meetings this year and the first with Fed chair Powell leading. The Fed holds a press conference in four of those meetings, which tend to fall two weeks before the quarter end. One feature the Fed has developed in the post-crisis era is that it has given very clear forward guidance on its thinking. The idea being that markets could afford few surprises. So, it was no news that they announced a 25bp increase in the Fed Funds Rate range to 1.50%-1.75% from 1.25%-1.50%.

But what the market was hanging on to was the “dot plots” and economic projections. And answers to the big questions: does the Fed see the economy growing, is there inflation and will there be more rate increases? Well, the short answers are “a bit”, “not really” and “possibly”. Here's the most important graph, the dot plot, which shows where the FOMC thinks rates should be in coming years.

A couple of things jump out:

1.     The wide dispersion of views. In just a few months, the range for rates in 2019 jumped from 1.2% to 3.5% to 1.5% to 3.8%. There was an even broader dispersion for 2020. Clearly the board thinks the tax cuts and stimulus are going to work and will need correcting.

2.     The Longer Run. The Fed sees the cycle peaking in the next two years and sees the long term Fed Funds Rate at near 3%. This seems wishful thinking to us. The economy would have to show a growth or inflation spurt that’s been absent for a year.

There is a dot for each member of the FOMC and the regional Governors. But one declined to vote and there are four Fed Board Governors still to be confirmed. And, to us, that's important. This Fed is woefully understaffed right now and new members could easily change the Fed’s outlook and hawkishness.

Other standout points were that the Fed acknowledged growth had slowed in the first quarter (so, points to the doves) but that the economic outlook “has strengthened”. They also saw inflation as benign and, in the Q&A, as far as bubbles go:

“So, in some areas, asset prices are elevated relative to their longer-run historical norms. You can think of some equity prices. You can think of commercial real estate prices in certain markets. But we don't see it in housing, which is key. And so, overall, if you put all of that into a pie, what you have is moderate vulnerabilities in our view.”

Which is good.

The takeaway is that this is benign for the markets and we saw 10-Year Treasuries rally after the meeting. We don't see this Fed as wanting to raise rates dramatically and so hold to our view that rates will stay in the 2.75% to 3.00% range for a while.

2.     More on Trade: The latest round of trade tariffs hung over the market. While we’re not sanguine about the whole trade war talk, the latest news on the steel tariffs is better. Remember just two weeks ago? It was a full on/bring it on global 25% tariff on all steel. Now, there are reprieves and exemptions on six of the ten top steel importing counties, and 28 members of the EU. That’s 56% of the total imports or around $5.2bn of additional annual costs. Of course, that’s now. It will change.

 So it may be the same with China. Rattle the sabre, invite retaliation, wait for other industries to lobby, wait some more and quietly climb down. Of course, China is a bigger game than steel:

The U.S. exports around $185bn of goods and services to China. It imports round $523bn. That blue bar is the monthly deficit in goods and that’s what the Administration has in its sights. It's around $35bn a month and was $375bn in 2017. Again, there was some pretty fierce talk about the theft of American prosperity and they targeted around $50bn of that $375bn. It’s not the whole amount. It’s tariffs of 25% on about $50bn, so $12.5bn of costs. Still, China came out swinging and will probably target Republican sensitive districts. They've already started with food products, wine and some steel but those were in retaliation for the steel tariffs, not the latest ones.

No wonder the likes of Apple, Microsoft, Starbucks, GM and Nike are in the firing line and will probably remain so. If we just do the math, the two announcement amount to around $19bn. That’s 0.1% of GDP. But the fall in stocks has been more like $1 trillion.

Bottom Line: Short week. We're looking at how Asian markets react to the escalation in the trade tariffs. As clients know, we’re placing some protection U.S. stocks right now as we expect volatility to remain high.

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Now would be a good time for Zuckerburg to resign

John Bolton at Yale

--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.

Political headlines dominate but little market impact

The Days Ahead: Fed meets. Look for any change to their economic projections.

One Minute Summary: Trade issues hung over stocks. The administration lined up China, which runs a $35bn monthly trade surplus with the U.S. It's quite a lot less if services are included but many businesses are annoyed at China’s freewheeling IP (Intellectual Property) transfers. The President asked for a $1bn a year reduction in the trade deficit but given that the deficit is more like $380bn and some 40% of the U.S. total, he probably meant $100bn. As for the new Chief Economic Advisor, Larry Kudlow, I’m hard pressed to remember anyone in that position who had much influence. But he seems like a decent enough fellow.

Small company bank stocks rallied. The Senate passed the snappily titled Economic Growth, Regulatory Relief, and Consumer Protection Act, which raises the threshold for enhanced supervision by the Fed from a $50bn threshold to $250bn. So, that’s nice if you're a Key Corporate, Fifth Third or State Street. You now no longer have to provide a liquidation plan. In fact, only 12 of the 43 banks with over $50bn in assets will come under enhanced supervisory rules. All others get a pass. And yes, they all took TARP.

Bonds rallied. Stocks were lower but small companies had their best two weeks of the year. They're now just ahead of large caps year-to-date. Europe recovered. It seems to be out of the trade crosshairs right now. Japan and Emerging Markets rallied some 2%. The dollar barely moved.


1. How’s the economy doing?

Not as well as the administration thinks. The most important assumption of the tax package, and the one that presumes there won't be a trillion dollar deficit in the next few years, is that the economy will grow at 3%, or 50% faster than the post crisis level. If it doesn't, the whole Laffer curve, animal spirits, trickle down economics falls to the ground.

Now some funny stuff has gone on with first quarter GDP growth for the last few years. It’s nearly always lower than the rest of the year. Why? Well, the economists are busy writing PhDs about it but it probably boils down to faulty seasonal adjustments. If retailers, for example, start holiday discounting earlier, then sales will be brought forward and there’ll be more of a New Year slump. Statisticians try to adjust but it’s a fiendishly difficult task.

But this quarter’s revisions look particularly severe. The Atlanta Fed puts out a nifty report that tracks GDP in real time. Here’s our version of it:

The February projections were for 5.5% growth. Since then, it has steadily fallen as manufacturing, trade, inflation and retail sales numbers have all come in below expectations. The latest number is for 1.9% and the two lines show the street and administration expectations. The street is revising its numbers now and we expect them to come in lower.

Does it matter? Well, it’s the direction not the magnitude. So, yes, if growth is less than expected and consumers are not buying into the tax-cuts and higher take-home pay story, then the interest outlook changes. Treasuries rallied this week, as we would expect with lower growth. The peak on the 10-Year Treasury on February 21 at 2.94% now seems quite a way off and we feel very comfortable with our position in 7-10 year part of the curve.


2. ETFs, easy, right?

We like to talk around here about how not all ETFs are created equal. Some are great, the VOOs and SPYs of the world. Some are patently dopey, some dangerous. And some you really need to understand. One of those is the S&P 500 equivalent of the bond market, the Bloomberg Barclays Aggregate Bond Index (AGG).  

The S&P 500 is, mostly, the largest quoted companies in America sorted by size. The biggest component is Apple at $900bn and the smallest is Frontier Communications at $0.5bn (it’ll get bounced out at the next semi-annual rebalancing). Own the S&P 500 through something like Vanguard’s VOO and you’ll experience 3% turnover.

But a bond index gets tricky. You start with all the bonds that meet your criteria of quality, maturity and size. Then you need to constrain it somehow or else a big corporate borrower like Ford will dominate your index. You then have to take bonds out that repay, or mature, or are downgraded, or if a new issue comes along. Then you ignore some bonds altogether like Treasury Inflation Bonds (TIPS), floating rate note bonds, or step-up bonds. This all gets busy and so the index rebalances every month. Own the AGG through something like iShares AGG and you’ll experience 250% turnover.

So what? Well something interesting is about to happen. The AGG excludes Treasuries and MBS that are held by the Fed under the QE program. Fair enough. They're out of circulation so no need to count them. But the Fed is selling them and they're going back into the index. At the moment, the AGG has 37% of its assets in Treasuries. By most estimates, it's headed to 45%.

We also know that Bond Index ETFs are growing. They have at least $1.0 trillion today and are expected to grow to $1.5 trillion in a few years. That's a lot of demand. Numbers are hard to come by but we think ETFs, as forced buyers, will buy some 30% of Treasury issues in the next few years. It’s one reason why we think there will be a smooth run up in rates. (H/T David Ader).

Bottom Line: We'll see the new Fed at work. They'll be looking at this, which is the spread of 10-Year Treasuries to 2-Year Treasuries. The lower it gets, the more likely an economic slow down.

It took another dip last week. No major changes to portfolios. Growth should come from International and Emerging Markets. We're lightening up on real estate and other rate sensitive stocks. We continue to like investments providing downside protection on the S&P 500.

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Vanguard says no to genocide free investing

Time up for the Blood Unicorn

--Christian Thwaites, Brouwer & Janachowski, LLC

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

All charts from Factset unless otherwise noted.

How damaging are the tariffs?

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And it all came right

The Days Ahead: The market is inflation sensitive right now. Tuesday’s CPI number will be important

One Minute Summary: Mixed economic numbers. Blow-out job numbers (but yes, some caveats). The trade deficit widened, although there may be some relief on the oil side in coming months. Productivity stalled. The Fed’s Beige Book, a report that lives up to its title, was mostly more of the same “modest to moderate” (mentioned 193 times in a 32-page document) growth from the 12 districts. There were some reports of compensation increases but we put that down to state minimum wage increases coming into effect in January. Some 29 states have minimum wages above the Federal level (which is unchanged for nine years) and 18 of them raised them for 2018.

The week started with major concerns on the Administration’s policies but markets settled down mid-week. We're not out of the woods, of course. Thursday’s decision to limit steel tariffs to non-NAFTA partners means those issues now become part of the NAFTA discussions. The ECB said it would keep buying bonds for “as long as necessary.” That weakened the Euro.

Bonds were flat. Stocks liked the jobs number. The S&P 500 and European stocks were up around 3% to 3.5%. We're still 3% down from the market peak on January 26, but up 7% from the lows. The dollar took a round trip…down and then up.

1.     Blow-out job numbers. We've been cautious on the jobs market for a while. Yes, good headline numbers but low labor force participation, low wage growth and high growth in low wage and part-time jobs. This month was different.

The headline number was the best since November 2014 and the third biggest since 2000. The unemployment rate was flat because the participation rate ticked up to 63%, which is good, but the same as a year ago. And the types of jobs? Construction, specialty trades did well but there were still the same mix of temporary and low-level service jobs. No argument or change there.

The last set of job numbers set up a storm about Average Hourly Earnings, which showed a big jump and had all the “here comes wage inflation” experts humming. But it proved another false start. Earnings growth slowed to 0.1% from 0.4%. Hours worked increased.

What’s it all mean? There is more labor slack in the market than assumed. More sidelined workers are coming into work. This is good for activity and the economy. Wages are not growing. Which is good for stocks. Mind you, this is only one month of data. So, you know, lest we get carried away.

2.     How are the steel companies doing? Quite well, thank you. Steel production peaked in the early 1970s, halved in the next decade and has been flat since 1988. As stocks, you would think they’d be hammered as old industrials but they've actually done quite well. Here’s a composite of the 10 largest steel companies in the S&P 1500.

In the last three years, the top five steel stocks have outperformed the S&P 500 by a whopping 31% and by 5% in the last year. The long-term results of 20 and 30 years are equally impressive. Of course, they are highly cyclical stocks so an investor would have had to stomach a 70% loss in the 2008 recession.  But, basically, they're in good shape and for the 134,000 employees in the steel industry, wages are about 35% higher than the national average.

So what does all that mean? Well, the tariffs were not really about steel or aluminum. The U.S. did not accuse any country of dumping, which will get you a hearing at the WTO. Instead, the Department of Commerce used the national security argument (pretext?...hey, I’m not a lawyer). That opens up all sorts of retaliation opportunities because it's a spurious and hard-to-prove rationale.

Meanwhile the Fed’s Beige Book mentioned that “Four Districts saw a marked increase in steel prices, due in part to a decline in foreign competition.” And the survey was taken mid-February. So, you know, barn door…horses.

If the purpose of the tariff was to “stick it to the foreigners” and send a strongman message, then job done. But if this escalates into tit-for-tat, then we’re in serious trouble. As of midweek, the market was leaning to the former.

Bottom Line: The trade issues are going to be lurking for a while. We don't know what policy will come down the road. It's somewhere between speak softly…big stick and improv. We don't think this is a game changer yet. We hold Treasuries for a risk-off market. We'll increase our growth exposure in international and Emerging Markets. We're lightening up on real estate and looking at some downside protection on the S&P 500. It was a good week.

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McDonalds celebrates women

Another take on share buybacks

Mute don't block

--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.

 

Steel your face

The Days Ahead: Italy heads to the polls. Non-farm payroll numbers. More fall-out from trade.

Jerome Powell did rather well in the semi-annual report to the House and Senate. His comments were slightly hawkish. Two points stood out.

One, he said that the Fed will “continue to strike a balance between avoiding an overheated economy and bringing PCE price inflation to 2%.” No argument on the second but the Fed’s mandate is employment and inflation not avoiding growth. So, yeah, that was odd. Two, he said he finds "rule prescriptions helpful”, which is something the Fed has not pursued (thankfully) for the last few years. Otherwise Taylor rules and Philips curves would have led to much tighter policy.

On balance, I think this means he’s seen the new fiscal policy coming at a near fully employed economy and that it might tip the balance towards more cuts this year. We expect three cuts, which would take the Fed Funds Rate to nearer 2% by year-end.

But we like the bond market and especially Treasuries. Why? Well, first, much of the recent economic data has not been that strong. Yes, bad weather, New Year interruptions and so on. But more disappointment than elation. Second, they're going to be first in line to buy in time of anxiety. And what have we had this last week? A lot of anxiety and increased volatility. Meanwhile:

1.     Steel your face: Steel tariffs were announced on Thursday. Stocks took a dive. The tariffs amount to 25% on steel and 10% on aluminum. How big is the industry? Well, in the graph, the top line is monthly imports of steel, at about $3bn a month, and the bottom line is steel exports, at around $1.1bn a month.

So, a quick calculation would suggest that steel imports will cost around $9bn more a year, which assumes that domestic producers i) don't fill the demand and ii) prices don't change. We don't know the answers to the first yet, but the share prices of Nucor, AK Steel and U.S. Steel all rose by between 7% and 11% so one assumes more demand is coming their way. Steel prices are up 32% this year and jumped 4% on Thursday…although we’ll admit delivery and futures prices may not be well connected.

On the demand side, stocks like Caterpillar, Ford, GM and Boeing all had a very bad day. The steel industry is not particularly big. It employs around 85,000 and is about 0.05% of the workforce. Both numbers are a third of what they were 25 years ago. Companies that use steel employ many, many times more.

Here's the full Commerce Department findings. The announcement came under Section 232 of the Trade Expansion Act of 1962, which cites national security as a reason for tariffs. The largest source of steel imports are from Canada and Mexico, which, I dunno, don't normally come to mind when thinking of security risks.

And that’s the rub. This is the sort of irresponsible policy markets fear. For many years, we have not seen any major policy errors. This may be the market adjusting to a new reality.

2.     Buybacks in the news: Again. Some 75% of companies have reported for Q4 and the lower corporate tax and other tax-related savings were much on their mind. The most common responses for how they would use the savings were i) invest for growth and ii) “cash return to shareholders,” which will almost inevitably be share buybacks. Now, we have a problem with buybacks, namely:

  • Management says they're going to do it but don't
  • The timing is nearly always off
  • It adds no value

On the first, management can announce a big repurchase program but is under no obligation to carry it through. On the second, there were no buybacks at the bottom of the market in 2009 and plenty on the way up. For insiders, they're none too good at valuing their own companies. And on the third, shrinking the float by 10% may increase the share price but a firm’s value remains unchanged. No surprise, CEOs tend to be paid on price return h/t to 13D Research.

It’s a very big part of stock-market action. There have been some $4 trillion of buybacks since 2009 on an average market capitalization over that period of $14 trillion. It's accounted for some 70% of earnings-per-share growth since 2012 and it explains a lot of the higher levels of debt that companies carry to finance the buybacks.

Some 305 companies in the S&P 500 have repurchased shares in the last year and since the tax changes, they have announced another $215bn worth. In February alone, this was $153bn or nearly three times the January level.

How’s that worked out? Well, we looked at the performance of some of the largest dollar buybacks (green line) and the largest as a percent of market cap (black line, where the winner is Sealed Air, which bought back some 7% of its stock).

Over three years, both groups have underperformed the S&P 500 by a considerable margin. Even the ETF specializing in buybacks (you knew there'd be one) has underperformed the S&P 500 by 50% in the last few years. And that's not all:

  • Some 125 of the 305 companies bought at a premium to the current price, in effect wasting shareholder money by buying a falling stock
  • The average discount was only 2%, which suggests a lot of fire power to achieve very little
  • Financials accounted for 26% of the total, or 29% if one excludes Apple’s monster $10bn buyback. And if you're like me and think banks should be well capitalized all the time, this should worry you

Many of the companies took on additional debt to pay for the buybacks. We would expect lower levels of buybacks if market volatility continues and rates increase. Meanwhile, if you hear more about increased buybacks from the likes of Cisco, Metler Toledo and Amgen, well, count us skeptical.

Bottom Line: With earnings over, we’re now at point of anxiety. We expect the trade issues to become front and center for a while. Stocks are now flat for the year. At the end of January they were up 8%. Emerging Markets are still positive. Get to know the name Cecilia Malmstrom, the EU trade commissioner, because the EU will almost certainly challenge the U.S. at the WTO and impose counter tariffs. Also, mug up on these guys.

And in some good news. Carol Kaye will be 83 next week. You may not know her but you've heard her many times. Happy Birthday, Carol.

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T. Boone Pickens now has an ETF

Facebook censors

Mrs Musk  

--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.

 

Smart Counsel: For our Attorney Clients

We have worked with attorneys and their financial needs for many years. Attorneys have a unique career trajectory. Typically, this means peak earnings come later than other professions but can also last longer. It's also a profession which never lets up. Hours are long and challenging. So creating financial independence as soon as they can. See the attached for a quick review of what we do

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. 

8 Things You Should Know About ETFs

Investments in U.S. Exchange Traded Funds (ETFs) have grown far quicker than mutual funds over the past decade and now hold approximately $2.22 trillion in assets. Retail and institutional investors alike have poured into ETFs in recent years, lured by the promise of low costs, enhanced tax efficiency and unmatched trading flexibility.

7-Things-You-Should-Know-About-ETFs-graph-002.jpg

While it is undeniable that ETF fund issuers have managed to provide investors with benefits, they have also proven adept at marketing ETF offerings. In order to balance the ledger, here are eight things you should know when you buy an ETF.

1.Trading Costs on ETFs are not insignificant. Normally investors will incur a commission when purchasing an ETF in addition to paying the inescapable bid/ask spread, which is essentially the amount by which the ask price exceeds the bid price. Currently in the ETF universe the asset weighted bid/ask spread is 0.07% (higher than a lot of expense ratios!).

2. Dividend Reinvestment is generally more efficient in mutual funds than in ETFs. On average, ETFs take two or three days longer than mutual funds to reinvest dividends, which can result in a significant performance drag. An investor may also incur bid/ask costs again upon the reinvestment of dividends. Why "may"? Becuase it depends on your brokerage terms. 

3.Premium or Discount Costs arise when trading ETFs because the market price for an ETF deviates around its net asset value. If you purchase a mutual fund you will always buy it at net asset value. This is not the case for ETFs.

4.ETFs have experienced temporary periods of extreme mispricing. In the past, market volatility, bouts of illiquidity in underlying securities and trading halts have all caused scenarios where ETFs have traded tens of percentage points away from net asset value.

5. Securities Lending is a common practice amongst ETFs and in some cases ETF fund issuers take a sizable portion of securities lending profits for themselves. As an investor you are likely to bear all of the risk associated with this activity and yet won’t necessarily receive all of the return.

6. Sampling or Optimization strategies are utilized by most ETFs in order to more efficiently track an index. This can often lead to better performance for investors, however, it is worth knowing if 20% of your money in a U.S Large Cap ETF is invested in non-index positions.

7. Average ETF Turnover is approximately 870% and 4 times greater than the average turnover of U.S. Stocks. One of the largest ETFs, SPY, has an annualized turnover rate of 3400%. Many ETFs are utilized by hedge funds and other short term speculators to jump in and out of the market on a daily basis.

8. Check the index. Some indexes have lower licensing fees than others so the cost to the ETF provider will be lower. But some indexes are better than others. The S&P 600 (SML), a small cap index, has outperformed the cheaper Russell 2000 (RUT) small cap index very significantly over many time periods 

All ETFs are not the same and some may prove to be more expensive and expose investors to greater risk than others.

We appreciate the flexibility of ETFs and use them in our client accounts. But we believe extensive research is necessary when comparing ETFs to one another and mutual funds.

- Christian Thwaites & Curtis McLeod

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.

The Twins at Work

The Days Ahead: Second round of Q4 GDP. Italy heads to the polls.

Bonds are grappling with higher expected growth (even though we had some disappointing existing home sales, retail sales and Industrial Production) and the reawakening of the twin deficits story. For those of you of a certain age, this was a big deal in the 80s and 90s. It’s basically a fear that growth will suck in imports and the, ahem, reformed tax regime won't bring in as much revenue as they hoped because, you know, “tax revenues are going down”.

How bad are those deficits?

Well we already have one of the highest federal deficits at a time of low unemployment. We expect them to go up when recessions take hold but this time they've stayed high despite the halving of the unemployment rate. We also now have a much weaker dollar and the fear is that the two lower lines (the deficit and trade balance as % of GDP) will grow as the dollar weakens (the black line going up). It’s a messy chart and we’d warn about interpreting it too literally but it’s in the background and we expect it to come up in future Fed meetings.

Meanwhile the bond market rallied and moved further away from the key 3% on the 10-Year Treasury. We're very comfortable with this move and don't expect any major pick up in rates. Meanwhile: 

1.     Long-term investments returns:  We're pretty comfortable with long term investing. We don't market time, we keep turnover low, avoid the fads and keep to your asset allocation targets. So it’s nice when we see Credit Suisse’s Global Investments Returns Yearbook, which measures returns from 1900 to 2017. Here are some highlights:

  • The U.S. equity market was one of the best in the world, returning 6.5% in real terms. South Africa and Australia were better probably because of their commodity bent.

  • Equities were a way better asset class than anything else. Better than housing (0.3%), collectibles (2.9%) and bonds (2.0%) and, of course, cash (0.8%). Gold and other precious metals failed to keep up with cash.

  • Emerging Markets lagged the U.S. here:

  • But the Russian and Chinese revolutions er…redistributed those assets and the Second World War hit most of SE Asia hard. Since 1950, the annualized returns for Emerging Markets were around 12% vs 9% for the U.S.
  • The U.S. is dominant. At its 1990 peak, Japan accounted for almost 45% of the world index, compared with 30% for the USA. It fell to just 8%. The US regained its dominance and today comprises 51% of total world capitalization. Here: 

Where does that leave us? We appreciate that no one has a time horizon of 117 years and that some periods have been very painful to investors. If you invested in the market peak of 2000, it took 13 years to make any money. Japanese investors from 1989 are sitting on a 40% loss. But we would say:

  • Equity returns may be lower in coming years, mainly because of low interest rate
  • The case for equities is that, over the long term, stockholders have enjoyed a large risk premium over cash. On average it has been 7.5%
  • Even with a lower equity premium of around 3½%, equities are still expected to double relative to cash over a 20-year period.

2.     A funny thing happened on Thursday, which is sort of a modern parable on corporate governance. SNAP, the disappearing photo app, fell some 17% on the news that one of the Jenner/Kardashians didn't like the new look. Here’s the chart:

Ms. Jenner has 24m Twitter followers and 325,000 of them hearted the comments. That was enough to wipe $2bn off the value of the firm. At the same time, the founder sold stock under SEC Rule 10b5-1, which basically says an insider can sell stock on a pre-determined schedule and avoid running into material non-public information rules…which most of us know as insider trading. How much did he sell? Some $620m making him the highest paid CEO of a public company by a very large margin. It was around 3% of the company’s worth and Snap lost $3.4bn last year. Tim Cook earns around $12m or 0.00001% of the company’s value. And they make a great deal of money.

Now, I’m the first to admit I’m not Snapchat’s target market either for their app or stock. And we made fun of Snap last year.  But a number of things come to mind:

1.     A company like Snap trades on very thin air. It’s one of those winner-takes-all and network effect businesses. You probably only have time in your life for one disappearing app so the company either makes it big or is copied and left in the dust. And if one unhappy client can send your stock plummeting, it seems to me like it’s a very risky business. It’s should not be like the Department of Defense calling United Technologies and saying, “Hey, we don't like your Black Hawks any more.  Or is it just me... ugh this is so sad."

2.     The governance at Snap reached a new low. The Class A shares have no vote, the Class B have one vote and the Class C have 10 votes. Guess who owns the Class C? There are plenty of other companies who issue dual share classes (Berkshire for one) but this seems one step too far for the index providers who ganged up on Snap and said “you can't be in our index”, which turns out is a problem because index funds own some 15% of the S&P 500.

3.     On a higher level, it complicates the IPO market. There are plenty of Unicorns playing in Silicon Valley’s magic forest but they seem content to stay private. And who can blame them? The public markets are going to ask awkward questions like “do you make money?” We need a healthy IPO market for stocks. There have only been around 100 in the last six months and many of those are small or relaunches or spin-offs.

Bottom Line: Earnings are winding down. It’s been as strong quarter with growth at 15% compared to estimates of 11%. Emerging Markets remain very well supported.

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Credit Suisse yearbook on investments returns

Berkshire Hathaway annual report out this week

 --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.

 

Back in sync

The Days Ahead: Markets closed Monday.  Not a big news week but, hey, early days.  

Stocks rose every day this week. At the worst point this year (February 8th) we were down 11% from the S&P 500’s all-time high. It's now less than 5%.  We'd like to see stocks take a breath for a while.  Some of the action is short-covering and profit taking. We get that. But how do you manage around a company like Netflix, which is up 45% this year, fell 13% and rose 11%? And what can one make of Berkshire buying even more of Apple and Teva? Is that a confidence vote in tech and pharma? Or lack of M&A opportunities for Berkshire?

Either way, we’re in a period of rapid descents and recoveries. Meanwhile, bonds were flat, which was better than people expected.

1.     Why volatility had to come back.  Markets become accustomed to events very quickly. For a number of years, portfolio managers had very decent returns from stocks and bonds without the normal downside risk. “This is the new normal” they thought. “How can we make money from that [think, think...] aha, we will put more volatility into our portfolios and earn even more.”

And if you're a Harvard alum or government employee in Hawaii, that’s what you got and that’s why Harvard’s endowment returned a total of 11.9% from 2015 to 2017, while a standard 60/40 mix of U.S. equities and bonds returned 21%. Now, it's fun to laugh at Harvard but the real point was that a 60/40 portfolio had extraordinary gains over the last three years and even beyond that…

Over the 20 years, a 60/40 portfolio (the black line) returned 97% of a full equity portfolio (blue line) with a worst drawdown of 29% against 57% for the S&P 500. In 2017, the 60/40 did not have a single month of negative returns and captured 70% of the market’s 20% return. In the words of our friends at Goldman Sachs, a 60/40 portfolio had “…one of the strongest risk-adjusted returns since the 1960s as bonds and equities went up together, with very low volatility.” And they would know.

Why? Put it down to a generous mix of growth expectations, low rates, low inflation and predictable central bank policy. That has now changed. In less than six weeks, the budget put a very large hole in the deficits. Here’s OMB director, Mulvaney:

 “And yeah, you’re going to see a spike in the deficit over what we had originally expected this year because we — tax revenues are going down (sic). ”

To which one might reasonably ask, “And you're okay with trillion-dollar deficits?” and he would reply,

“There is a way out of this.  By the way, we do all of this, okay, without changing Medicare — or at least the benefits that people get with Medicare. We’ve always talked about the drug stuff…(again, sic).”

At which point, one might reasonably face plant and conclude they're making this stuff up as they go along.

Now last year, the budget deficit was $665bn or 4% of GDP. Interest payments were around $503bn but net interest was $360bn (because the Fed remits interest earned on its Treasury holdings back to the Treasury). The new tax bill adds $1.5 trillion to the deficit, over 10 years, and then the new budget deal (the one that increased defense spending from $630bn to $686bn) adds another $320bn, over two years. It all doesn't look good and some pretty sober people think that $665bn could be $1 trillion next year. Buy, hey, we've always got that drug thing.

Of course, a lot can happen in one year and 10 years so it’s no good playing the doomsday machine yet. But you can see just how much uncertainty the market now has to price in. And uncertainty means more volatility. Expect that black line to get a little more choppy in coming months. We'd remind clients that’s why we’re long international and emerging markets. The dollar is likely to continue to be a casualty.

2.     The markets puts on its beagle nose: As regular readers know, we’ve been very sanguine about inflation for a number of reasons mostly because deflationary forces are large, secular and demographic. But there is a whiff of higher inflation in the air and for the first time in a quite a few years, we had a CPI report that the market actually cared about. The headline looked like this:

These are all year-on-year numbers and there’s really nothing to see. Core inflation was unchanged at 1.8%, headline also unchanged at 2.1% and the biggest (24% of the index) component of the CPI, owner’s rent, was also unchanged. Yay, on lower cell phone charges.

But closing in on some of the details, such as apparel and gas (because of tax increases) and there are some pointers that the core inflation may edge up to around 2.5% which is consistent with the Fed’s PCE target of 2.0%. We would stress that this will all happen very slowly. But the market is a bit more wary these days and that's one reason interest sensitive stocks like Real Estate had a bad day (and year).

3.     The stock market is not the economy (Part Many). As stocks hit more turbulence, you will now hear politicians complain the market ignores positive fundamentals. That's true because the market is a predictive machine. If it was a coincident indicator it would offer rather dismal returns. But here's a reminder:

Stocks on top. The economy below. Stand-out years are i) the 1980s where the economy had great back-to-back years but the market had two big corrections and ii) the post 2010 period where very slow growth was matched with outsized stock gains.

There are many reasons, of course, starting with the simple fact that S&P 500 companies only employ around 11% of the U.S. workforce (and some of those are overseas employees….not all companies break them out)…the S&P 500 is more export dependent than the U.S…stock market earnings can be changed with share buybacks and so on.

Last week, we saw weak retail sales, industrial production and so-so consumer confidence numbers and housing starts. We think the market is slowly adapting to, yes, higher growth, but with a lot more long-tail risk. Throw in an untested Fed and tensions rise. But, all together now, the stock market is not the economy.

Bottom Line: The FOMO (Fear of Missing Out) trade is now the FOBL (Fear of being long). That's not an original point…I stole it from somewhere. We're still in a market finding its feet in a new world where deficits matter. There’ll be more surprises to come and, again, that's the reason we like Treasuries.  

Here's the link to the Mulvaney (OMB Director) interview. For some reason the WH chose not to update it. https://www.whitehouse.gov/briefings-statements/press-briefing-omb-director-mick-mulvaney-president-trumps-fy2018-budget/

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

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