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Big talk from bond bears

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The Days Ahead:
More earnings and so far all good.

The bond bear story continued with the backdrop of the debt ceiling and a government shutdown. The 10-Year Treasury rose to 2.63% from 2.40% a few weeks ago and the 2-Year Treasury to 2.05%, its highest since 2008. But the last time the 10-year yield was at 2.6% was late 2010, summer 2011, summer 2013, summer 2014, late 2016 and a year ago, so we’re not in new territory. A Google search of “bond yields rising” produced 26.5m hits, so someone is worried.

We're not because there’s no real news. China buying, Fed hikes, tax cuts and deficits, oil up and many more are not anything new. We do have to worry about some of the cash coming back from overseas holdings but the likes of Apple with a $270bn bond (not cash) portfolio, will merely move those from one custody account to another. And we'll watch growth and inflation to see a sustainable uptick. Even with that, it’s hard to see rates moving solidly above 3%. Remember also the Treasury is borrowing much more at the bill market (under one year) and at the five years and under note market than the long bond. So supply will still be constrained.


1. Rally right across the board:

Er... no. Stocks may have risen quickly these last few months but it has by no means been an indiscriminate rise. Three out of the 11 sectors are down YTD: REITs (-5%), Telecomm (-3%) and Utilities (-5%). Some of this is because they tend to be interest rate plays, are  highly leveraged and pay a premium yield. REITs, for example, pay a yield of 4.9% but run debt ratios that are 6x to 7x EBITDA. For Telecomms it's 2x and Utilities 4x. For the S&P 500 as a whole excluding those three and Financials, it’s 2.2x. So all three will do fine in a low rate environment.

That perception is beginning to change. Many companies borrow long so you’d think they would be immune to short-term rate changes. And they are. But the market is a forward looking animal and the concern is that borrowings taken out a few years ago, say by a REIT at an average LIBOR spread of 3% at 3.5%, are now going to cost 5.1%. All things equal (they’re not but bear with us), interest payments will climb 54%. Their rents may climb 5% to 10% if they're lucky but commercial rents as whole are not rising nearly as much.

Anyway, it’s one of the risks in the market, along with valuations, rates, politics, debt ceilings, earnings and taxes. These are of course, the classic bricks in the “wall of worry”, which stocks must always climb. They are the same issues as last year and every year. Here’s the chart of the three sectors for the last year.


2. How’s Russia doing?

Is not a question we’re asked very often. Its  stock market has been a bit of a wasteland for years. From 2008 to the end of last year, it fell 53% against the S&P 500 of +135%. Since the beginning of January, it's up 10% (USD).

Now the Russian stock market is a bit weird. There are only 64 companies with a market cap of over $500m and it has an energy weighting of 44% and another 21% in financials, which probably lend mostly to oil companies, so you know, not exactly diversified. There is only one tech company that specializes in e-mail services (here you go, but not advising you sign up). The stock market capitalization is only $677bn, or around 3% of the S&P 500. You could buy it with one Facebook and have some change to spare.

But oil is coming back. Its average price was around $50 for most of last year and it's  now been well above $60 for a month. The record price was $145 in 2008. But in Russian roubles, it's never been higher and has risen 40% in six months. Of course, this means the rouble has devalued a lot up to 2016 but that has reversed recently and budget deficits are being repaired (they were hammered by the sanctions). Many of those sanctions remain but a key one, extending to sovereign debt, may be lifted, which will lower interest rates.

Most Emerging Markets indices don't hold more than 4% in Russia and we’re even below that. But it’s nice to see the market come back. It remains well below its all-time highs and is absurdly cheap, trading at 6x forward earnings compared to the U.S. at 18x.


3. Dow at 26,000:

Prepare yourself for more breathless "another thousand" stories. The latest breakthrough happened on Wednesday. It was less than two weeks since it crossed 25,000. Of course, that's only a 4% increase and there are plenty of times when the market has risen 4% in two weeks. The next gain to 27,000 will only take 3.8% and it will only take 2.8% to go from 35,000 to 36,000.

But as we’ve said before the Dow is a rotten index and no one should use it for performance purposes or bragging rights for how well stocks are doing. The problem is that the Dow is price weighted. So, companies with a high stock price have more pull on the Dow than companies with low prices, even though they're worth a lot less. The second most “important” stock in the Dow is Goldman Sachs (GS) simply because its stock is $250. But by market capitalization, it’s one of the least important because it’s worth $95bn compared to Apple at $915bn (biggest company in the Dow, but only sixth in the weighting).

If all this sounds obtuse, compare the fortunes of Boeing (BA) and GE.

Blog 3 1-19-18BA GE 2_GE-USA.jpg

Boeing had a great year. Higher orders, better margins and lower pension costs. It's up 120% in the last year. GE had a miserable year. High costs, insurance losses, restructuring, new management and breakup talk. It's down 44% over the last year (top part of chart). BA has a high stock price, $340, and is the most important stock in the Dow. GE has a low share price, $17, and is the least important stock in the Dow. So, the Dow goes up.

But if you add the two companies’ market capitalization, or value as in the lower chart, you can see that value dropped from $385bn to $349bn, which on careful examination, is a lower number and an 8% loss. And that's the way the team at S&P would calculate it. The Dow would calculate it as an 87% gain. Anyway, as long as the Dow is calculated in this way, it's going to throw up some weird numbers (h/t John Authers).


Bottom Line: Big industrial earnings next week. So far, outlooks have been very solid.

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--Christian Thwaites, Brouwer & Janachowski, LLC


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

All charts from Factset unless otherwise noted.