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Small Company Stocks

The Lift then the Drop

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

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

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

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

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

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

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

 Putting this all together and we get this chart:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Oddly satisfying videos

 --Christian Thwaites, Brouwer & Janachowski, LLC

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

All charts from Factset unless otherwise noted.

Dario G - Voices 

Record Highs. But elections coming

The Days Ahead: Fed meets and will raise rates.  

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

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

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

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

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

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

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

There are a few ways to get a pay increase:

 1.     You're paid more

2.     You're paid the same but work less

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

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

4.     You're paid the same but inflation falls

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

  3. Drawdowns in Emerging Markets are common.

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

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

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

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

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

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

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

 Please check out our 119 Years of the Dow chart  

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Instagram can kill you

 --Christian Thwaites, Brouwer & Janachowski, LLC

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

All charts from Factset unless otherwise noted.

 

Karl Hyde - 8 Ball 

Not the longest bull market

The Days Ahead: Second estimate of Q2 GDP and Personal Income.

One-Minute Summary: There are indications that markets are becoming inured to tweets. What would have shattered confidence a few years ago now passes for normal. The noise-to-signal ratio in investments is always high. What seems important at the time, probably doesn't count very much for long term investments. We look at the economic cycle, inflation, earnings and rates. Data on most of those fronts didn't change much.

Stocks had a good week, especially small caps. Emerging Markets were up 2.5% but the news from China (trade) and Turkey (currency) was unchanged. Put it down to summer volumes. The main story was the dollar, which weakened by 1.6%, its worst week since February.

1.     Is this the longest bull market ever? No, except when using a very arbitrary measure. So, last week the S&P 500 recorded a 410% gain from the March 2009 low, without a 20% drop. Cue, “longest bull market” headlines. But the definition of a bear market requires a 20% drop. A “correction” requires a 10% drop. Both definitions are nonsense. What about 19.5% or 9.9%? When you’re talking markets, it’s as much about sentiment as numbers.

 In the 1970s, stocks fell 53% over two years and took another five years to recover the losses. We would argue that was a more painful and meaningful bear market than the short-lived 30% bear market of 1987. The 1970s were a slow, grinding and persistent sell-off in the face of inflation, oil supply shocks, bank failures and property crashes. The 1987 sell-off was a by-product of an investment fad called portfolio insurance (as in, it claimed to but didn't).  

Similarly the 1990s bull market was a steady, all-round improvement in earnings, multiples and productivity. The current bull market from 2009 is a painful recovery from devastated financial markets. In the first, people made money. Market rose 405%. In the second, investors took nearly four years to make back their losses. Yes, stocks rose 316% from the bottom but investors made a less impressive 86% after getting back to break-even.

The previous “longest” bull market was from October 1990 to March 2000, when the market rose 405%. But that includes two 20% sell-offs that were relatively short. In our view, the real bull market was from summer of 1982 to March 2000, when the market rose 1,300%. We measure the current bull market from its 2000 peak, in which case returns are also around 86%. For a full 13 years, from 2000 to 2013, the market returned 0% excluding dividends. (We might add that an investor making consistent investments over that time would have experienced much better results given the many opportunities to buy low.)

The recent gains in the market mean that for 1, 3, 5 and 10-year rolling periods, we now have double-digit gains for all four of those reporting periods for the first time in 18 years. The 20-year number is less impressive.

So can the market keep going? Certainly. Price earnings ratios are quite high but have leveled off in recent months. Stocks are cheaper than they were in 2015. Dividend growth is strong. Earnings are up. The longest post-war bull markets were well over 18 years each. By those standards, the current one has some way to go.

2.     What’s the Fed up to? Not much. There were some fears that the President’s er…comments on the Fed chair may compromise its independence. We think that's highly unlikely. The Fed minutes were published last week and Chairman Powell delivered a speech at Jackson Hole. Our takeaways:

  • They see the problems in Emerging Markets but don't feel the need to act

  • They're thinking about moving policy from “accommodating” to “neutral”

  • Trade and fiscal policy may have downside risk

  • Inflation is not a problem

  • They have their eye on financial instability…to a degree much more than prior Feds

The bond market has barely reacted. The main concern is the yield curve:

That line at the top is rapidly pushing to zero, which means that two and 10-year rates pay the same. That’s usually good for medium and shorter bonds…the first for total return, the second for yield. And that's where we’re focusing our bond portfolio.

We don't think the inverted yield curve is quite the harbinger of recession that popular commenters believe. So, you won't see us reacting much if it does fall further.

3.     Are we looking at a housing bust again? No. Property and banks. That’s where we look for a systemic blow-up in the economy. It's mostly because unfettered credit extension reaches rapidly across and down the economy. There are credit problems today. Corporate and government borrowing are high and the latter is set to rise further. But they don't have quite the same reach as the first two.

So, we’re quite relieved to see some of the recent numbers on housing. The ones we watch are housing starts (down 12% from a few months ago), new home sales (down 5%), mortgage delinquencies (12-year low) and existing home sales (down 5%). Here’s the existing home sales chart:

Sales have stalled and we think it’s to do with the lower lone, which is the 30-Year mortgage rate. It’s 80bp higher than the beginning of the year and would increase a mortgage repayment by more than 10%...in a flat real wage environment, that's enough to push demand back. The new limits on tax deductibility haven’t helped either.

Anyway, it's also an illustration that monetary policy works with a lag. The Fed tightening this year may not show up for two to three quarters. Those housing numbers are the result of policy steps taken nine months ago.

4.     How bad are political crises for markets? We care about politics in our real life but markets are dispassionate. Let’s look at four examples:

  1. Nixon: from February 1974 to the resignation in August 1974, stocks fell 10%

  2. Clinton: from December 1998 to January 1999, stocks rose 6%

  3. Brandt: German Chancellor and spy ring in 1974, stocks fell 22%

  4. Chun Doo-hwan: drawn out saga of corruption in South Korea, stocks rose 25%

The trouble with any of these and more is that exogenous influences probably had a far greater effect on the markets. The purely political ones are very difficult to isolate. We think company profits, the Fed and trade will influence markets more than politics. For now, those are all on a steady path.

 Bottom Line: Stocks are trending up but with no big stories or conviction. We don't expect the political  noise to influence markets much.

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.

Karl Jenkins: The Armed Man

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

Please check out our 119 Years of the Dow chart  

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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

Vacation Week Trading

The Days Ahead: Corporate earnings kick off. It’s going to be another strong quarter.  

One-Minute Summary: U.S. Treasuries had a good week with the 10-Year Treasury at 2.82% and the 30-Year Treasury well under 3.0%. The gap between the two is now 11bps, the lowest in 11 years. Stocks had a good week and we’re now in positive territory for the S&P 500 year to date with small company and tech stocks way ahead…up over 11% in both cases. International markets recovered but Emerging Markets again struggled.

On the one hand, yes, the trade issues continued but markets have had plenty of time to adjust to the threats so nothing really new. On the other, international markets stand to lose more from trade so will take longer to adjust. Things got a little better when a story went round that Trump’s Ambassador to Germany offered zero tariffs on all auto trades. Could happen. And on the other (see what we did there), the dollar weakened and bonds rallied on an employment report that showed no increase in wages and more people looking for work. That would seem to shut the door on the whole wage inflation, labor shortage argument.

We'd remind readers that summer trading can be very thin and misleading. The short holiday week and a heat wave on the East Coast meant volumes were light. Markets can and will overreact to news. And as we say, “prices move faster than fundamentals… don't confuse the two” (h/t David Ader)

1.     "Trade wars are easy to win". You might say to yourself, if you measure the country’s trade deficit since the phony trade war started in January and moved into a more serious phase a few months ago. And if you were into charts, you would point at this and say, let’s Make American Exports Great Again.

Because of the way the BEA calculates GDP, the improvement from January to May would account for about a 0.7% improvement in GDP. Pretty good work. What shall we solve next?

But this month’s trade figures give us the excuse to bring out one of our favorite charts: U.S. soybean exports. And here they are:

The U.S. is a big exporter of food. Around $150bn a year out of $1,400bn in total goods exports. The U.S. sells a lot of soybeans, corn and meat products and imports wine, fish and fruits and vegetables. They tend to balance each other out. But one big export earner is soybeans. And they all go to China. The green line shows the trend. They rocketed from $2bn to over $4bn. That’s a very big change on an annualized basis, which is how GDP will measure it.

They have spiked before, notably in 2016 when there was a poor harvest in Brazil. But this increase is even bigger and there’s no mystery why. Chinese importers were buying ahead of the tariffs imposed today, which were in retaliation to the $34bn of Chinese goods targeted by the Administration. We certainly don't expect these numbers to improve in coming months.

So, the headline looks good for now and will help the Q2 GDP numbers for sure. But by the middle of Q3 the deficit will start to worsen.

Look, we know U.S. trade is a mess right now. Companies don't know whether to change suppliers, move overseas, expand or prepare for price increases. The ISM data on manufacturers’ prices paid has risen for 28 straight months and is by far the highest indicator in the dozen metrics tracked by the ISM. Trade talk is going to continue to dominate capital markets for the rest of the summer. We think that eventually businesses, politicians and consumers are going to protest at higher prices and the overall disruption. But it’s only the last constituent that counts for this Administration. And they have yet to feel the pressure.

2.     Are bonds good value? We'll preface this timeless question with the normal “it depends.” But by one measure, yes. We looked at the yield on the S&P 500 and compared it to the 10-Year Treasury. Here’s the chart:

The black line is the 10-Year Treasury yield at 2.84%. The blue line is the yield on the S&P 500 at 2.04%. When equities yield more than bonds (which is not often), they tend to be very good times to buy stocks. When bonds yield 200bps more than equities, it tends to be a good time to buy bonds. We're not there yet. It’s only around 80bps. But here’s the point. Stocks these days don't offer a great dividend payout. Some 100 of the S&P 500 don't even pay a dividend. Many would rather use buybacks to boost share prices because they're more tax efficient and tied to executive pay (color me skeptical, I know).

So, bonds at around 3%, which they were a few months ago, seem very fair value against stocks. We've seen a lot of the bond bears reverse position in recent months. Some of that is shorts caught out but some is down to bonds, especially Treasuries, just representing good value right now. As clients know, we've been investing in the mid-part of the Treasury yield curve for some months now and we’re inclined to remain there.

 Bottom Line: Good earnings numbers coming up but export traders (BA, CAT etc) will remain under a cloud. Large cap will probably remain in the 2600 to 2800 trading range. It closed 2750 on Friday.  Emerging Markets remain the weak point.

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Drone over Tesla, Fremont

 --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 on my Mind
 

Small Caps deal with rising rates

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Stealing owls

--Christian Thwaites, Brouwer & Janachowski, LLC

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

 

 

Back to light again

The Days Ahead: Housing and retail sales  

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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China is changing the way trade is shipped.

--Christian Thwaites, Brouwer & Janachowski, LLC

 

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

 

First, check your index

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

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

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

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

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

A few things jump out:

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

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

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

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

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

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

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

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

How do they do it? Here’s a rundown:

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

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

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

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

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

 

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Robert Mercer and the police

Theranos still misbehaving

 --Christian Thwaites, Brouwer & Janachowski, LLC

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