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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)

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

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

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

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

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

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

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

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

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

  • It's a term loan, which means it’s a loan originated by a bank and then sold to investors.

  • It's not tied to LIBOR but to ABR (Alternative Base Rate), which is a mix of LIBOR, Fed Funds and the prime inter-bank rate.

  • It’s not rated. This doesn't mean it's a bad credit just that given the amount of the loan, at $725m, a credit rating was probably too expensive.

  • It comes with covenants, which lower the payment to investors if the company’s EBITDA falls below a certain ratio.

  • It's thinly traded and is a Level 3 asset. This means there is no observable price (like a trade) so values can only be calculated using estimates or risk-adjusted value ranges

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

  • It’s backed by individual Adjustable Rate Mortgages or ARMs and by FNMA

  • It has a floor rate of 0% and is based off LIBOR 1-month. They can change the index any time

  • It's subject to the normal pre-payment risk and the experience of the underlying mortgages.

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

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

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

FRNs_BFRIX-USA.jpg

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

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

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

frns table.jpg

So what can we conclude?

  • FRNs should have a stable price but many don't especially if the credit cycle is deteriorating or rates are rising fast

  • Stretching for yield often means credit quality declines.

  • Many of the securities are illiquid or use Level 3 pricing.

  • The higher the quality of the FRN fund, the more it's likely to concentrate on financial stocks. The Bloomberg Barclays FRN <5 Year index has 65% invested in financials.

  • FRN funds seem not to have performed better than high quality bond funds in both rising and declining rate environments despite taking i) more concentration and ii) credit risk and iii) less interest rate risk.

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

Other information:

Fannie Mae on floaters

Quick definitions

How it's taught at business school

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Take me to Attorney Briefs

 

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. 

Whiff of Contagion

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Please check out our 119 Years of the Dow chart  

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Other:

Pastafarianism is not a thing

--Christian Thwaites, Brouwer & Janachowski, LLC

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

Closing note: Aretha and Chains

Retirement Checklist - Are you on track?

Your Retirement Checklist

Saving and investing enough for retirement is daunting. Here’s a Checklist to help you stay on track. Don't worry if you can't do all of these. These are all good habits but none of us are perfect. 


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

If you're a lawyer…3 Threats to Your Retirement

Threat 1: The law firm structure

The collapse of the venerable San Francisco-based law firm, Heller Ehrman, reminded us of the risks inherent in law firm structures. In the last few years, there have been other high-profile firms that have dissolved, such as Howrey and Dewey & LeBoeuf.

1.     The LLP structure: Many law firms are limited partnerships where the people (or “members”) are partners. Corporations can not own any part of the firm. If they do, they're an LLC. The liability is limited which means that, as a partner, you can lose your capital but no more than that.

Except...in some cases the doctrine of fraudulent transfer kicks in. This dates back to 1571 and basically says you can't move assets around to avoid creditors. For a law firm partner, this may mean that creditors demand the return of compensation made in the months before a bankruptcy. So, if you made $100,000 in January and the firm tanks in June, creditors can lay a reasonable claim on your earnings. This creates a huge incentive to get out early, which speeds up the death cycle.

2.     Why firms go bust and you lose your capital. Mostly it’s bad management. In some cases (Heller Ehrman, Brobeck Phleger & Harrison, or Thelan), a high revenue producing team leaves. In the case of Brobeck, eager M&A attorneys took company stock in tech IPOs in the late '90s. They ended up with worthless shares. Dewey Le Boeuf offered rich employment guarantees to incoming staff. Dreier was pure fraud.  

3.     The death spiral: In each case, two things happen.

1. The firm can't cover its expenses, more teams leave, and the firm blows through the terms of its line of credit (which is the only real asset). Liquidation follows.

2. Partners started to depart and the death spiral began.

Banks go down where there is a run on the bank. Law firms go down when there is a run on the partners. Bankruptcy is usually swift. There is no Chapter 11 workout route. More often, it’s a debtor-in-possession process, where your new boss is not like your old boss. She’s working for the creditors.

The common denominator is over reach and inability to manage top revenue providers. Throw in some stretched and under-capitalized finances, and many of these firms go fast. Many of the above firms were over 100 years old but folded in months.

4.     What are the warning signs?

  • High senior to junior lawyer salary ratios. In Dewey’s case it was 15:1

  • High amounts of long term debt or lines of credit…

  • And what it's secured against. In the case of Dreier it was against yachts and an Aston Martin.

  • Big reallocations of income within the firm

  • Deferred contributions to qualified plans

  • Unusual ways to define net income

  • High guarantees to incoming lawyers and teams

  • Series of big mergers

  • Firms borrow to pay partner draws

5.     So there is a “run on the bank” and I’m left as a partner: When a law firm dissolves, partners are faced with the following issues:

  • What happens to my capital?

  • Will creditors come after me?

  • Should I switch to another firm or retire now?

  • If I switch, can I transition my clients to my new firm?

  • How do I access my old retirement plan assets?

  • What benefits are provided by my new firm?

  • Should I go over to the new firm as a partner or not?

None of them particularly palatable. But this is a time when standing still is not an option. The first thing we advise is to revise the planning and retirement analysis for those clients. We presume that the capital accounts of our clients will be frozen and ultimately lost. The same for Deferred Compensation plans.

Qualified plans are, of course, protected. In the case of the Heller failure, the plans were eventually transferred intact, although with some delays and difficulties.

6.     Aftermath of a Failure: In the aftermath of a law firm failure, we re-visit retirement planning and analysis, which have to be re-done. Certain assets such as capital accounts are almost certainly no longer available. Other changes will occur. Assuming the affected partner moves to a new firm, the entire benefits and compensation structure will be different and a new capital account must be funded.

7.     What Can You Do? Focus on factors you can control. First, if you have not done so already, create a financial plan customized to you and your family (age, retirement date, spending plans, college education needs). Second, ensure your financial plan accounts for the known threats and risks you face, including those unique to your profession. Third, re-read the warning signs above.

Always, always make full use of your personal and retirement savings starting with your 401(k) plan and other retirement accounts. These will be the primary source of retirement income for you. Remember, attorneys generally do not have a business asset to cash in upon retirement. There is no capital event. What you earn is what you will need to retire on.

And a final check: invest your assets profitably and productively. And that means:

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. 

 

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Tesla, Turkey, Treasuries.

The Days Ahead: Earnings mostly over. Productivity report

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 And wow, what a difference that makes.

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

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

So, dividends matter.

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

Please check out our 119 Years of the Dow chart  

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Best not to provoke bison

 --Christian Thwaites, Brouwer & Janachowski, LLC

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

Friday Music - Nils Lofgren

The Lawyer's Financial Stages - Stage 1 - The Early Career

We work with many associates and partner attorneys in large firms. There is often a professional and financial lifecycle as lawyers progress. Here’s what we see:

Early Career: Congratulations! Graduating fresh out of law school and passing the bar exam is an accomplishment. You start at a leading firm in a practice you always wanted. Starting salaries are generous and there are usually annual bonuses of up to 30% of base. Expenses are high. Some of that is setting up a new house, often with a new spouse, and becoming familiar with regular household expenses. Housing, travel and food expenses can run as high as 50% of income (more if you’re in New York, the Bay Area or Washington).

And there’s one big and often intimidating expense. Yes, student loans. It’s best if you can consolidate these (but be careful you don't run afoul of the community property commingling principles) for nothing else than ease of repayment. You may also pay a lower rate.

Start with the basics. Create a budget. Stick to it. Start saving some cash reserves. Three months of expenses is a good number to start with. That’s mostly so you can pay for emergencies or any time off work without having liquidate investments.

Set up a low cost investment savings account. Use ETFs or low cost index funds. Invest $100 a month. Saving $100 a month at a 5% return can grow to $80,000 in 30 years and $192,000 at 10%. So save more if you can. Get into the habit of “paying yourself first”.

You’ll never miss $100 but it can grow considerably with time. If your firm offers a 401(k), invest as much as you can. It's a gift from the IRS and they are not in the habit of gifting. Do not borrow from your 401(k).

Investment and saving success is about time, discipline and patience. You may get Facebook at $5 and retire early. Or you may get Yahoo at $125 and retire late. But with either, you hear about it more than you see it. Most of what we see is consistent saving and staying in the market. So start now.

And watch your expenses. Yes, again with the expenses. You will be working 60 hours a week so simplify your life where you can. Stuff like expensive phone plans, dining out, Uber, cable bills and club memberships can run into hundreds of dollars a month. Get into the habit of managing all expenses. Sweat the small stuff.

If you have any questions on these, or would like to discuss further, please feel free to e-mail us or call 415 435 8330.

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

The Lawyer's Financial Stages - Stage 2: The Associate, On and Up

Senior Associate: Work is familiar but not easier. The hours don't let up and you now know the pressures of keeping clients happy, the price pressures and workloads. You may have looked at moving to the corporate world. But maybe a corporate legal department is not for you. Not enough variety.

You like your firm. It’s big enough to attract corporate clients and interesting litigation. You’re now known in your specialty and you’re starting to be cited and published. You may even start helping on the recruitment drive, which is a good way to keep in touch with your school and alumni friends. You know some senior partners who you respect and start to work with more. You like your team and the cut and thrust of big law.

You should now be on your way to financing your first house, apartment or condo. Try to pay at least 20% as a down payment so that your mortgage runs to an 80% loan to value. Do not borrow from your 401(k). You're not paying yourself back. You're stealing from your future retirement. That might be a pipe dream in the Bay Area or metro New York but at least try. Don't fall for ARMs unless you really intend to sell inside of four years (or inside the adjustment period). Also try not to use interest-only repayment periods. It just takes longer to pay it all off.

Now is the time to start a basic financial plan. What you spend and what you save. You're already maxed out on the 401(k) because, well, we covered that in Stage 1 and if you're not, then stop reading now. Remember this is a financial plan. Not a document that you prepare once and stick in a drawer. Just like a business plan, you need to check that you’re on track. Are your assets growing? Do you have the right allocation? Is your credit score strong? Grade yourself. This is a test.  

By now, you should have a low-cost index fund investments strategy well under way. By your mid 30s try to have your savings amount to around 100% of your annual earnings. You can include your 401(k). Buy your life insurance at work. It’s a group rate and cheap. Check to see if it’s portable. Still sweating the small stuff? Good. Because you're about to enter your peak earnings years.

If you have any questions on these, or would like to discuss further, please feel free to e-mail us or call 415 435 8330.

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

The Lawyer's Financial Strategies - Stage 3: The Partner and Quest for Time

Partner: You’ve made it. It’s a heck of an achievement to make partner in a major U.S. law firm. It’s competitive and mostly an “up or out” culture. You're now one of the decision makers in the firm so it’s not just your own practice area you're looking out for. You think about the firm. You're an owner.

You are probably in your 40s now and have 10 to 15 years of peak earnings ahead of you. You could work longer but age 60 to 65 seems a reasonable time to dial back and you want to build options. You will have to make a capital contribution to the firm. It’s at-risk capital and probably funded by a loan. Nevertheless, you know about firms that went under and where you stand in the capital structure so it’s a gulp when you sign on the line.

But the firm’s remunerations are generous. You should now be eligible for a Defined Benefit Cash Balance Plan (see here for recap), which should start you at about 5% to 10% of your annual income. Remember these plans have a capped balance but it will take some years to get there. You should also be eligible for a separate partner-level 401(k), which provides more firm contributions and allows you to get close to the maximum of $54,000. There may also be deferred compensation plans or venture funds that you should review.

Yes, these are peak earnings years. But they are also peak spending years. You may have resisted the temptation to upgrade to a large house but school, college and any extracurricular activities cost money. You may also have other dependents, with parents high on the list. And a spouse may no longer be in full-time work. Always check in with your plan. Are you on goal for assets, investments and paying down debt? The big wealth destroyers are divorce, losing your job and a family illness. You can't plan for those but you can put some defenses in place.

By now your low-cost index fund and ETF investment program is well underway. You never missed the $100 a month you started with 15 years ago and you don't miss the $2,000 a month you invest now. You never went for the private equity and hedge fund pitches that came round the office so you're way ahead. Your net worth, excluding residence, should start to climb to four to five time your income. It should ramp up quickly in your late 40s and 50s.

That empty nest is coming up but it’s bittersweet. Yes, the tykes cost you an arm and a leg but you're justifiably proud. The money is good but the hours don't let up. But now you have options.

If you have any questions on these, or would like to discuss further, please feel free to e-mail us or call 415 435 8330.

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

The Lawyer's Financial Strategy - Stage 4: Senior Partner and choices

Senior Partner. You are a senior and seasoned leader…how did it all creep up so quickly?  But your colleagues certainly think of you as the expert in your field. You probably have many junior partners who seek you out for your wisdom. You may have spent time on the Executive Management Committee so you know how to run a professional and complex firm. Your clients know you well and reach out when they need help, advice and guidance. You have become everything you admired in the legal profession. Respected, focusing on people and their needs, a communicator and always intellectually curious.

The law is your domain. Sure the pressure on fees and billing never seems to let up. You’ve been through several recessions when companies start to hire in-house legal talent. But for the thorny, difficult cases and complex settlements, they turn to you. It’s not an easy profession but it keeps you mentally alert and sharp. Where you need to be.

You have had a decade or more in your firm’s partner-level 401(k) and cash balance plan. These have been good for $75,000 to $100,000 a year. These balances make up most of your liquid net worth although that low-cost index fund and ETF investment program that started years ago and you tell all junior associates to start, is looking pretty good. Recently you may have contributed to the firm’s deferred compensation plan. It’s not a lot because you still have at-risk capital in the firm. But you understand the firm’s finances and appreciate the prudent financial management of the firm. You earned enough to pay for your kid’s college without extensive loans and the mortgage has an end in sight. Your net worth is more than you imagined when you started out. You may not have the “capital event” of a stock plan coming up but you have earned well. But those hours...however much you delegate, you're still in charge of the team and responsible for its direction and results.

You have options. Maybe teach or join Some non-profit boards. You also can choose to be “at counsel” which means some free-up of your capital and more control on your time. You may want to work for another year or three years. You're not quite sure what you will do with your time. Travel, time with the family, perhaps some writing all sound good. But you don’t have to make that decision yet and there’s enough money so no need to rush anything.

By now, you are thinking of legacies, drawing down your savings and working out when and how you take from your 401(k) and qualified assets. There are a lot of moving parts and you're also rethinking your asset allocation. It was fine to have risk assets when you were earning…you were saving every month and buying on every dip. But now you probably need less volatile assets because who wants to be withdrawing funds at a market bottom. Some expenses you never paid much attention to can now play a big part in your life. Healthcare for you. Perhaps still for your parents.

So there’s lots to do. Manage the money, make sure it’s there when you need it and watch the small stuff. But you have played the game of life and won. Your finances weren’t everything in your life but they’ve given you the freedom to make your own choices.

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.

Attorneys: Your Red Flag Insurance Issues

Attorneys: Your Red Flag Insurance Issues

Ok, we have to talk insurance. Not life or health insurance. Hopefully, you're well covered there and they are both relatively straightforward compared to the world of Property and Casualty (P&C) insurance. With life and health insurance, you're insuring against having to pay for something you may not have the money for. But the liability is mostly known. With P&C insurance, you’re insuring against something you may cause and the liability is almost certainly unknown.

As a lawyer, you're particularly at risk. There are plenty of good plaintiff attorneys out there, so you need sound policies to protect your assets and family. And let’s be candid. Litigants don't go after massive damages if there’s nothing to collect. As a successful lawyer, you have a big target on your back. They know you have assets. Here's a quick review:

1.     What’s insurable? What do you want insured? The chart below is a quick way to review the frequency and severity of losses. This is entry level P&C stuff but shows how insurance companies assess risk. It’s the top left corner we’re worried about. The others are either minor, and so losses relatively easily absorbed, or are essentially uninsurable because of adverse selection or the potential loss size. As a successful professional, we need you to concentrate on the top left where, if not covered, you can quickly find your assets at risk, particularly around liability. The good news is that this is exactly the quadrant where the insurance industry works well.

2.     Excess Liability Insurance:  Does your insurance coverage exceed or match your net worth? If a lawsuit puts your assets at risk, you don't want to be running out of insurance. Make sure your regular homeowners, rental and auto insurance covers you adequately and that you carry umbrella insurance.

3.     Personal Umbrella Insurance: Protects you against claims and lawsuits above the limits of your personal auto or homeowners insurance. It can also protect you from claims like libel, slander and liability coverage on rental units. And from events like these:

·      A guest trips on the ottoman in your home and develops sciatica

·      A friend drinks in your home and causes an accident on the way home.

·      Your dog causes that annoying jogger to take a header into the curb

·      You hit someone’s 1955 D-Type Jaguar

·      You chaperone a class field trip and Sebastian breaks his foot kicking a tree stump

·      Your child damages college property (sure you can disown them later but…)

·      Your neighbor sues you for mental anguish over that drone you haven’t quite got the hang of yet

·      Your cat pees on a priceless Persian rug

Sure, some of these can be frivolous, but we saw the second one happen and cause years of anguish. Discovery, depositions and documents all take time and you don't want to represent yourself. An insurance company will have an obligation to defend you in court. That alone can be a primary benefit for the policy. So, umbrella insurance is not really an option for our lawyer clients. It’s a must.

4.     How much and how much? Premium costs will depend on many things (don't they always). If you have a pitbull, children under 25 with access to your cars, a bad driving history, firearms, a swimming pool…you're going to pay more. Most of the major insurance companies offer umbrella insurance, even GEICO. Some require that you carry your home and auto insurance with the same company (which is a pain and messes with your no-claims history) but many do not (which is better). Rough cost? Start at $200 per $1m of coverage and work up.

One million dollars of coverage will pay for litigation defense and all the nuisance lawsuits. But if the claim is larger, you don't want to be in a position where wages are garnished or inheritances diverted. A reasonable amount of coverage is one-for-one of the family net worth up to around $5m. Settlements can be higher but it’s rare and the insurance cost can start climbing fast. It’s a self-selection problem.

5.     The Three Quick Questions on Umbrella Insurance: You can buy most insurance direct but this is one case where you should talk to a broker. And not a tied broker, who represents one company, but a full service, multi-carrier broker who can provide multiple quotes. Make sure the insurance company is rated at least “A+” from A.M.Best.  And it’s the “claims paying” rating you're looking for, not the credit rating. You're a policyholder not a creditor.

And the Three Questions are:

1. What are the risks you face? Consider your risk as a homeowner, the risk of causing an accident while commuting and any potentially dangerous activities you participate in that could put those around you at risk. Its not your personal risk at question here it’s your risk to others. That’s why riding a motorcycle may cost you less than driving a car. Sure it’s more risky to you, the rider, but not to “Joe Texts while Drives”.

2. What is the value of your assets? These include properties, possessions, stocks, bonds, savings and retirement funds. And in your law firm, it will be your deferred compensation and your capital. The more assets you have to protect, the higher the umbrella policy limit you need.

3. What's your potential loss of future income? Liability lawsuits can result in loss of both current assets and future income, so even those early in their law career may want to consider the consequences of a serious claim.

So while you may not have many assets now, if you’re on track for a high paying career, you could be involved in a lawsuit that can target money you haven’t earned yet. Fun, isn’t it?

6.     D&O Insurance: if you or your spouse serves on a non-profit board, make sure your general liability insurance (for example, your umbrella insurance) carries a D&O and E&O rider. They’re not expensive but if something happens in that non-profit, for example an accounting, investments or employment problem, you don't want the plaintiff coming after directors’ personal assets. Those assets are likely to exceed those of the non-profit.

7.     Consolidate: You may have acquired assets over time and so insured them in different ways. So, your fine art, second home or jewelry may have separate policies. You don't want to wait until claim time to find out what’s protected.

8.     Staff: You may have a housekeeper/cleaner, part-time gardener or babysitter. All could be deemed employees. You should review Employment Practices Liability Insurance. This will cover wrongful dismissal, discrimination or visa problems.

9.     Travel: A worldwide travel protection plan is a good idea. Not for cancelled trips (Amex can do that) but for medical emergencies and flights back home if you put your back out on that Provence bike-trip-of-a-lifetime. (That one cost a client $75,000.)

10.     Make sure the insurance policies sync with the estate plan: Many wealthy people own property in LLCs or trusts. Not all insurance providers enable policies to reflect alternative ownership structures so these should all be aligned. Again, not something you want to deal with at claim time.

Brouwer & Janachowski, LLC

Mill Valley, CA

415 435-8330

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.

Five tech hand

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

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

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

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

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

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

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

Moving on.

This is how GDP looked:

Good news

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

Not so great

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Astronomy photographs of the year

 --Christian Thwaites, Brouwer & Janachowski, LLC

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

Friday Music: Valerie

Not happy about it but…

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

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

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

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

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

One item that got our attention was this:

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

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

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

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

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

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

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

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

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

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

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

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

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The last time a President pushed around a Fed Chair

--Christian Thwaites, Brouwer & Janachowski, LLC

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

Sophie Hunger

Stocks staying ahead despite trade

The Days Ahead: More corporate earnings. Industrial production.

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

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

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

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

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

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

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

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

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

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

Corporate debt is a different story. Here it is:

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

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

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

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

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

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

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

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SEC drops whistleblower prog

Young billionaires

 --Christian Thwaites, Brouwer & Janachowski, LLC

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

Detectorists

Hog Wash

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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NIMBYism San Francisco style

Rodents in ATM

 --Christian Thwaites, Brouwer & Janachowski, LLC

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

All charts from Factset unless otherwise noted.

Dreams