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Short, sharp shock

The Days Ahead: Busy economic numbers but no corporate updates

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Please check out our 119 Years of the Dow chart  

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Hedge fund manager sorry but lost all your money

--Christian Thwaites, Brouwer & Janachowski, LLC

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

All charts from Factset unless otherwise noted.

Thank you 

Don't forget Dividends

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

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

 --Christian Thwaites, Brouwer & Janachowski, LLC

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

All charts from Factset unless otherwise noted.

Too much news not enough direction

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

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

 This is what is hanging over the markets:

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

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

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

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

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

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

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

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

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

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

  3. It holds another referendum

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

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

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

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

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

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

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

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

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

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

Please check out our 119 Years of the Dow chart  

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Drunk raccoons

 --Christian Thwaites, Brouwer & Janachowski, LLC

 

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

All charts from Factset unless otherwise noted.

Year of living dangerously

Normal Service for a while.

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

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

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

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

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

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

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

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

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

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

Here’s a very good description.

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

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

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

  2. They bought them

 Now it’s

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

  2. They pile them into an index

  3. Set up an ETF to track the index

  4. The ETF buys the stocks

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

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

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

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

  3. Add a new sector called Communication Services

  4. Move more companies from tech to the new sector

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

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

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

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

 Please check out our 119 Years of the Dow chart  

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Changing the way we remember

 --Christian Thwaites, Brouwer & Janachowski, LLC 

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

All charts from Factset unless otherwise noted.

Once upon a time…

Look back in anger

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 And here it is:

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

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

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

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

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

What would change their mind? In order:  

  1. Economic growth stalling badly.

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

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

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

  5. Commodity prices fall.

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

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

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

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

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Ugly mansions

 --Christian Thwaites, Brouwer & Janachowski, LLC

 

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

All charts from Factset unless otherwise noted.

 Clyde

October flash backs

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

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

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

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

Here’s a deeper dive:

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

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

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

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

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

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

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

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

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

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

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

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

  1. Do nothing

  2. Buy

  3. Sell

  4. Get defensive

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

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

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

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

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

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

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

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

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

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

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

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

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

Please check out our 119 Years of the Dow chart  

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Pile of leaves, pile of leaves

 --Christian Thwaites, Brouwer & Janachowski, LLC

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

All charts from Factset unless otherwise noted.

Brian Protheroe - Pinball

Stocks can't make their mind up

The Days Ahead: Earnings again. ECB decision.

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

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

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

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

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

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

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

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

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

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

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

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

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

 Existing home sales are also down:

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

 What’s going on and should we worry?  

  1. Mortgage rates are up sharply.

  2. Lending standards are tighter.

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

  4. First-time buyers are holding back.

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

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

 Please check out our 119 Years of the Dow chart  

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Escaped pig lured back by Doritos

 --Christian Thwaites, Brouwer & Janachowski, LLC

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

All charts from Factset unless otherwise noted.

Chunga’s Revenge 

That was the drop.

The Days Ahead: Earnings and trade news, especially China as manipulator

 One-Minute Summary: It’s difficult to pinpoint the catalyst for the market sell-off this week. Most of the culprits were known for weeks. Trade, China, rates, tech problems, October seasonals. We knew all that. No central bank said or did anything they hadn't said already.

So what was it? We'd point to two factors. One, technical. There are plenty of algorithm strategies. They see a price break and start dumping stocks to protect the positions. So, when Nasdaq broke its 200-day moving average on Wednesday, a lot of trading strategies kicked off. Don't expect great numbers from quant or hedge funds this year.

Two, rates. Tuesday was also a day when the U.S. Treasuries fell.  There were some big Treasury auctions that didn't help. But markets panic when investments meant to move in opposite (stocks and bonds) directions start tracking together. Treasuries rallied later in the week so normal service resumed. We'd also point out that our own “Fear” measures (gold, Yen, Swiss Franc and the 2-Year Treasury) barely moved so this wasn't a wholesale rush to safety. 

We think most of the recent 25bp increase in the 10-Year Treasury is catch up. It was clearly over sold and the rally on Friday brought that back to only a 10bp increase. Many investors have played the inverted yield curve story…that, yes, short rates would increase but longer rates would remain anchored because the economy was going to peak soon. We feel that's broadly true but the 10-Year hadn't moved enough to adjust. The economy, after all, will probably grow around 3% this year, which is close to its 70-year average. Yet Fed Funds are at their lowest since 1964.

There was no major economic data. Inflation came in low and consumer confidence dipped a little. We would not consider either relevant to the week.

 1.     How can you tell if the market is overvalued? You can't. Sure, you can say that valuations seem high by standards like the CAPE Shiller ratio, Price to Book Value, Tobin’s Q, yield, narrow leadership or any number of metrics. None are thoughtless. None infallible. One may be very good at calling an overvaluation but, as we've pointed out in our recent “16 Lessons” blog, being right and early is the same as being wrong. What we try to do is balance out the risks of being in a successful, but perhaps long-in-the-tooth bull market, with diversification and protection. Clients know we’ve been investing in structured notes recently, and while they take a few years to mature, they at least put a band around performance results.

As for diversification, we’d also note that a 60/40 portfolio of stocks and bonds has had a very decent risk return for many years. Here's the chart:

The black line is the 60/40 portfolio. Above it is the S&P 500 and below it a widely followed bond index. As one would expect, the 60/40 portfolio weathered the severe draw-down in the two (shaded) bear markets better than a stock-only portfolio. Mind you, twice in the last 20 years, stock-only investors were enjoying some spectacular highs in 1999 and 2018. But the 60/40 portfolio has done very well and we'd expect it to serve investors well.

Back to the vexed question of valuation, one set of data that has been a useful guide is the real earnings yield. It’s not complicated. It’s the reciprocal of the widely used price earnings (PE) measure deflated by the CPI.

The logic behind it is:

  1. Stocks should return more than bonds because they're riskier.

  2. We can define a return to shareholder as the company’s earnings divided by its value...the earnings yield (above at 6.36%).

  3. But because we want real returns from stocks (bonds provide the nominal returns in our portfolios), this needs to be adjusted for inflation (above at 3.65%).

 We can also compare that yield of 6.36% to the 10-Year Treasury but it gives the same answer. Stocks were expensive for most of the 2004-2006 period and very cheap in 2011-2012.

 So where are we now? Stocks are not cheap but they are certainly not in the danger territory where the black line is below 3%. That fits with our opinion for most of this year. We think stocks still have some upside. After all, earnings are in good shape, the economy thriving and the Fed’s actions, while tightening, are predictable. We do, however, expect some of the quality and dividend aristocrats to perform better than some of the high-growth names (step forward FANG gang) that recently rolled over.

 2.     Have stocks suddenly become more volatile? Yes, compared to recent history. No, compared to long-term averages. We just experienced a week where stocks fell 3.3% on Wednesday and 1.5% on Thursday. Days on either side had intraday peak-to-trough downdrafts of 0.5% to 1.5%. That’s a lot when 1% is equal to $230bn these days. The decline since the September 21st peak is around $800bn or 4% of GDP. Here's the daily percent change of the S&P 500 over the last few years:

So two things stand out. One, last week’s price action was big. We've only had daily price swings of that size four times in five years. But, two, note the shaded area. That’s 2017, when stocks had a strong year, up around 20%, with no set back. It was about as calm as we've ever seen. Compare this to the same chart using the halcyon days of the 1980s, when the market powered ahead by 150% in six years.

That was a period of falling rates, strong earnings and reduced political risk. Not much to worry about in hindsight. Yet, the daily swings were much greater. In the last five years, the average daily move was 0.04% with a standard deviation of 0.77 (in other words, it would vary most of the time from down 0.74% to up 0.81%). In the ‘80s it was 0.06% and 0.87, which was 13% higher.

 The reason that we've had such low volatility is mostly down to interest rates being low. Stocks had no real competition. Now they do, especially as U.S. rates are increasing. The week was also notable for how nearly all stocks were caught in the sell-off. Last week, only 19 stock were positive and most of those were stocks that had an awful year-to-date performance, so were more in the nature of a short-term bounce.

 Followers of this note know we've argued that we’re in a higher volatility regime. Certainly higher than we've seen but not unusual in stock market history.

 Bottom Line: Fundamental buyers should return soon. Some will like the new prices and some will rebalance portfolios. Earnings will take most of the news flow. There are still 470 companies to report in coming weeks. We would still look at protecting the portfolio where we can and are currently looking at Treasury FRNs.

 Please check out our 119 Years of the Dow chart  

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Sommeliers are stripped of title

 --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.

Ronnie Lane - The Poacher

The Lift then the Drop

The Days Ahead: Inflation and a short week for the bond market

One-Minute Summary: U.S. equities fell for the second week. This hasn't happened since last June and we would note that too was a quarter-end trade. We expect some recalibrations of portfolios.

Small caps came under some pressure. They’re down 6% over the last month but still well up on the year. We also saw corrections in the Consumer Discretionary, Tech and Communication Services sectors. We’d put that entirely down to the new sectors that came into being a few weeks ago (we wrote about it here), where tech companies moved around and probably threw off sector allocations for managed and index funds.

The market has faced some pressing issues recently. Trade talks, some hawkish Fed talk, Italian bond yields, QE tapering in Europe, oil. Take your pick. Caution is called for while we go through the next few months.

 1.     Jobs, less than expected but more than enough. The number was less than expected at 134,000. There are two surveys in the monthly employment numbers and the differences are important when bad weather strikes.

One, the household survey (basically people answering a phone survey), which is taken the 12th of the month and counts anyone employed full time, even if they didn't work because of bad weather. Two, the establishment survey (businesses answering a questionnaire), which asks about average weekly hours and will record fewer hours if employees can't get to work. So, in the first, weather has no real impact on full time workers but does on part-time and in the second, the amount of work can change and throw off the trends.  

 And that was the case with the September numbers. Florence hit between September 10 and 13, and so the official numbers would not have caught part timers who could not work because of the storm. Similarly, while the average hourly workweek did not change, it fell for high labor intensity industries like wholesaling and construction. Overtime hours also fell which you would expect if you can't get to work. All in all, the low headline number probably underestimates the strength of the labor market.

 Putting this all together and we get this chart:

Unemployment fell to a near 50-year low, annual wage growth fell a little on a base effect (it rose this time last year) and the broader measure of unemployment rose and is not close to its multi-year lows.

The headline numbers are strong and won't dissuade the Fed from moving rates up again in December. We don't totally buy into the increase in earnings because a) it’s all employees and so is skewed by high-end earners and b) it's not inflation adjusted so doesn't really tell us if purchasing power is increasing (it's not).

 2.     The Bond Market corrected. Last week we wrote about how the Fed seemed to be all on the same page. Steady growth, slowly tightening and inflation behaving. This week we saw a speech from Chair Powell that revived the whole Phillip’s curve debate which suggests they are more worried about the low unemployment rate leading to increased wages. Hey, he even put in a nice equation:

 Inflation(t)=−BSlack(t)+CInflation(t−1)+Other(t)

Which looks impressive until we dig in and see that a) slack is notoriously difficult to measure b) Cinflaiton (sic) is the tendency for inflation to linger, so also tough to measure and c) Other, is, well, “unspecified factors”. Clear? No, nor us.

We're not there yet with increase wages and, to us, that relationship seems so very 1970s.

But along with good numbers from the Manufacturing and Service Industry surveys (the latter at a record high), the 10-Year Treasury yield spiked from 3.08% to 3.23% for about a 1% capital decline. Some of this may be technical…weird stuff happens at quarter end...what with window dressing and rebalancing.  The 2-Year Treasury only moved up 8bps and for the issue that we’ve been buying recently, the price fell $0.05 from $99.13.

It seems one of two things must happen as rate hikes continue.

Either, the yield curve inverts, and that can be any part not just the popular 2s/10s, and the economy weakens.

Or, the curve shifts upwards as growth and inflation take off.

The market shifts between the two and last week the latter had the upper hand. The employment and ISM numbers supported the second version. The disappointing trade number (the deficit with China was at a record level…we’ll leave it at that), supports the first.

We'd also keep an eye on this. This shows the spread for U.S. Investment Grade Corporate bonds over Treasuries:

It’s fallen in recent weeks. Now, call us cautious but it does not seem that U.S. corporate debt became less risky recently. It’s 90% industrial and financial companies and 50% of the index is BBB rated: one notch above junk. One thing we know about this cycle, is that companies have rushed to load up on debt at low rates. Normally, around 7% to 15% of companies are downgraded at the end of a cycle. Assume it will be at the top end of the range this time, then we’re looking at 15% of BBB bonds will be junk. And then ETFs and Funds will be forced sellers at the bottom. That’s not a good place to be and keeps us firmly overweighting short term Treasuries.

Bottom Line: There is a collection of exacerbating factors driving capital markets right now. Most of these are known but sometimes the market stops, weighs them all up, takes some profits and rethinks it all. Nothing major happened but some traders are getting out of positions that didn't work last quarter. We'd continue to buy insurance for our long equity positions. China was closed all week so there may be some catch-up on Monday.

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Oddly satisfying videos

 --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.

Dario G - Voices 

18 Lessons from 40 years of investing

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

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

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

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

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

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

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

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

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

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

  3. Markets do not correct by going sideways.

  4. Every market has excesses.

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

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

  7. Fear is stronger than long-term resolve.

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

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

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

  11. Bull markets are more fun than bear markets.

  12. Never trade on headlines.

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

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

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

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

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

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

Please check out our 119 Years of the Dow chart  

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 --Christian Thwaites, Brouwer & Janachowski, LLC

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

All charts from Factset unless otherwise noted.

 

 

Fed on the same page

The Days Ahead: Jobs number on Friday. PMIs on Monday.

One-Minute Summary: No drama from the Fed. Rates and bonds barely moved. Most stock markets were lower with economic sensitive sectors like financials and materials down 4%. China and America agreed not to talk for the time being. The Mexico trade deal looks good and Canada may join up in the next few weeks. We're often asked why trade is not a bigger issue for the market. It is a big deal but nothing irreversible or financially catastrophic has happened yet. Frayed patience and tempers for sure. But we've not seen many large companies come out and say i) it’s a major problem and ii) we don't know what to do about it.

Another good quarter for U.S. equities. The rolling 1, 3, 5, and 10-year performance are all in double digits and the 10-year rolling return is now 11.5% compared to 10.1% at the end of the second quarter. That would turn a $100,000 investment into $293,000 and $261,000 respectively…a 12% improvement. Yes, time and small differences matter.  

1.     The Fed met and… Raised Fed Funds rate by 25bps to 2.25%. To no one’s surprise. Fed watching used to be a nuanced inspection of language. They meant to keep markets on the back foot. As Alan Greenspan famously said “I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I said.”

 Things are very different now. The Fed embraced “forward guidance” some years ago, and now talks openly about what’s going on and what’s going to happen. That’s all fine. The only trouble is that it may delay policy changes (because they won't have communicated it) and give the Fed less room to maneuver. That's not a problem right now. But in the next few years, there’s going to be a time when what they say they're going to do and what they must do will be very different.

 Here’s what we think was important:

  1. Growth: revised up for 2018 and 2019. They now agree with the Administration that we’ll see 3% growth in 2018. But they also expect growth to peter out sometime in 2019. In other words, very different from the Administration. We'd certainly agree on that point. It’s difficult not to see the current growth spurt as merely bringing purchasing decisions forward by a quarter or two.

  2. Unemployment: has bottomed out for this cycle. They don't see any further improvements

  3. Inflation: coming in lower than they expected a few months ago

  4. Rates: will top out at 3.5% in 2020, implying three more hikes in 2019 and two in 2020.

 On the dot plots, we compared forecasts made in March and the latest one. Here it is:

It’s a bit hard to read (the Fed doesn't like graphic designers) but you can see i) the Fed Funds rate moving up by some 50bps more than they thought a few months ago and ii) more agreement among the Fed members. Back in March, the dots were more dispersed. Now they're clustered. The Fed Governors are singing from the same hymn sheet.

 Two more interesting points. One, Fed policy is still accommodative, in our view, even if they removed the actual word.

The top lines show the Fed Funds rate and, in blue, the real Fed Funds rate (i.e. deflated by inflation). Anytime that's below zero, it’s an easy monetary policy. Two, the danger for the stock market is when tight policy starts to go easy, as in 2000 and 2008. We're a way off from that happening.

 So bottom line? Good for equities and a smooth upward rise in rates. We’ve been advocates of the front end of the curve. The 2-Year Treasury yields 2.83%. You only get paid 13bps more for investing in 5 year and 22bps for 10 years.

 2.     How’s the Japanese stock market doing?  Is something you need not have asked in the last 27 years. As readers know, Japanese stocks had a spectacular 1980s, peaked in 1990 and have been on cyclical ups and downs ever since. An investor putting money in at the top would still be nursing a 50% loss today.

Japan has faced demographic challenges. Its population peaked 12 years ago, its labor force 20 years ago and it has a labor force participation rate some 20% below the U.S. Things move slowly. But in recent years we've seen:  

  1. Real attempts at labor market and business reform

  2. Very loose monetary policy, low rates and a weaker yen. The yen is a haven currency…tough to break the habits of flight investors

  3. Rejuvenated business sector

 Put those together with trade, ahem, talks, that mostly ignore or benefit Japanese companies, and we’re looking at a good outcome. Here’s the long term chart on Japan. In the short term, it tends to move with the yen: weak yen, strong market. And that's mostly what’s happened since 2013.

So far this year, Japan stocks are up 5% compared to the broad MSCI-EAFE market of -3%. It’s up 18% in local price and 8% to U.S. investors since the March lows. Japanese business is very competitive right now. It has become a major force in global M&A. Japanese companies have bought Shire (a major pharma company), Uber (through SoftBank), Irvine Scientific and Integrated Device Technology as well as our neighbor, Glassdoor. Japan’s small companies have done well…up 50% in the last two years and outperforming large caps by 18%. Small caps tend to reflect the domestic economy well. They're less dependent on the exchange rate.

Did we mention, things move slowly in Japan? This isn't one of those rush-in-now-and-buy stories. But it does reinforce our confidence in Asia ex the China is-all-that-matters, which has not worked well in recent months.

3.     “We've fixed U.S. trade.”  Possibly but it’s not showing up in the numbers. The revised Q2 GDP numbers came through. They were unchanged at 4.2% of which Net Exports contributed 1.2%. By comparison, they have not contributed more than 0.3% for more than six years. So the latest trade in goods number looks like this:

The deficit jumped from $72bn to $75bn, and way more than the $71bn consensus. This is enough to hold GDP back by 1% in Q3. The problem is that the tax cuts created demand which the U.S. cannot fill. No amount of tariffs will change that for the time being. Trade is set to look worse in coming months.

Bottom Line: Facebook and Tesla had a very bad week. In each case, it’s management not macro or business issues that did it for them. That’s a risk with some of the biggest tech stocks. Bonds will probably stay in narrow ranges for the next few weeks. Only a very bad employment number would upset the market.

Please check out our 119 Years of the Dow chart  

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Self-solving Rubik’s cube

 --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.

Nick Drake - Northern Sky

Record Highs. But elections coming

The Days Ahead: Fed meets and will raise rates.  

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

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

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

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

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

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

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

There are a few ways to get a pay increase:

 1.     You're paid more

2.     You're paid the same but work less

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

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

4.     You're paid the same but inflation falls

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

  3. Drawdowns in Emerging Markets are common.

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

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

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

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

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

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

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

 Please check out our 119 Years of the Dow chart  

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Instagram can kill you

 --Christian Thwaites, Brouwer & Janachowski, LLC

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

All charts from Factset unless otherwise noted.

 

Karl Hyde - 8 Ball 

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

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

1. The annual change in US inflation

2. The real rate of 10-Year Treasury bonds

3. The names and start dates of the Fed chairs

4. Highlights from each year that influenced inflation

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

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

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. 

10 Items to check on your Statement

10 Items to check on your Financial Statement

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

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

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

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

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

3.     Tickers: U.S. listed ETF and stock tickers are straightforward. They're usually two to three letters. A lucky few have one. If they have “ADR” after them, they're foreign stocks listed in the USA and will usually end in "F" or "Y", so NSRGY for Nestle in the US. If the ticker has three or less letters, it means the stock is listed on the NYSE. If it has four, it’s listed on NASDAQ. (Note 2) 

Mutual fund tickers can be tougher. They will have five letters and an “X” at the end (e.g. POAGX). If they're a money market fund, they will have two Xs (e.g. AJLXX).

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

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

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

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

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

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

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

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

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

Useful websites

Everything you need to know about CUSIPs

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

Understand option tickers

Notes

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

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

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

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

While Away...

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Please check out our 119 Years of the Dow chart  

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Five lessons from the ultimate innovators

 --Christian Thwaites, Brouwer & Janachowski, LLC

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

Summer Sun (Plein Soleil)

What's up with emerging markets

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