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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.

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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

Apple adds a zero

The Days Ahead: Big 10-Year Treasury auction. Inflation numbers.

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

One-Minute Summary: One of those weeks when you think lots of stuff happened, markets must be going bonkers. But stocks had a good week. Earnings continued to do well and of course, Apple, had a strong week. It’s now 4% of the S&P 500 and $1 trillion. It’s an even higher weighting in 8 out of 10 of the largest ETFs, ranging from 4% for an S&P 500 tracker and 15% in the Technology Sector fund (ticker XLK). Not to spoil the party, but we’d remind readers that Altria has been a much better stock since Apple’s IPO back in 1980. One hundred dollars invested in Apple back then is worth $55,000. For Altria it’s $88,000. The slow and steady increase in Altria along with dividends was a better investment than the long no-dividend policy of Apple and the 17 wilderness years. Still, great company and justifies much of the run-up in the S&P 500 in the last few weeks.

Trade was front and center again. The U.S. Trade Representative raised the stakes by increasing tariffs on $200bn of goods from 10% to 25% but not until September. The Chinese shot back announcing yet unspecified tariffs on $60bn of U.S. imports. The U.S. exports around $120bn of goods to China every year so, yes, the Chinese may be running out of retaliatory measures.

There’s a sort of trade truce with the EU right now so expect more on the China trade for a while. If markets seem numb to the trade issues it's because there’s still a big gap between what’s been threatened and what’s been implemented. However, the Yuan/$ rate is getting a lot of attention. The Yuan has weakened by 8% since April, negating much of the effects of higher tariffs. That's one reason why we’re a little cool on Emerging Markets right now and taking protection.

Elsewhere, the job numbers were lower than expected and average hourly earnings didn't move much. The numbers won't change the Fed’s mind on a September hike. The 10-Year Treasury broke through 3% for one day and settled back to 2.95%. If a 3.9% unemployment rate isn't enough to push yields higher, what is? We'd say earnings and wages (not increasing), a better trade deficit (no), more confidence from the Manufacturing and Non-Manufacturing sector (no), more aggressive talk from the Fed (not there either), or higher inflation (see next week but probably not).

1.     Should we care about the budget deficit? Yes, but not yet. One of the ironies of the last year is that the normally fiscally disciplined politicians signed on to a very big tax cut in the last stages of an economic cycle. The argument for such a move was that lower taxes would spur investments spending, growth, productivity, all sorts of good things and, of course, lead to higher tax revenue. So:

Step 1: Cut taxes

Step 2: Wait

Step 3: Higher growth and more tax revenue

Tax revenue is down $150bn in Q1. It will be more in Q2. Corporate tax receipts are down 48% and, as a percent of GDP, at a 70-year low. The OMB announced that the deficit in 2019 is now $1 trillion or around 5% of GDP.

We'll stay away from the soundness of such a policy and point to two things.

First, here’s a chart of the deficit and unemployment since 1948.

We've inverted the unemployment rate to show the relationship. As the economy enters a recession (the shaded bars), unemployment rises and deficit spending increases to make up the shortfall. There’s a drop off in tax receipts, of course, but the general approach is to smooth out demand when the economy most needs it. Once the recession eases, stimulus is removed and the deficit improves.

What's remarkable about the last year is that the two lines have gone in wildly different directions. This means that if there is a recession, there’s little scope to increase spending when it's most needed.

Second, there’s the increase in borrowing. The Treasury just announced funding needs for Q3 and Q4. It’s a very big number. In Q3 the Treasury expects to borrow a net new (i.e. after funding maturing debt) amount of $329 bn, up $56bn from April estimates. And in Q4 it expects to borrow $440bn. Again, net new. That compares to $72bn in Q2 and $192bn and $204bn in the same time last year.

The Treasury is doing all it can to help the process. They're introducing 2-month bills for the first time. They’ll come in November at a rate of $25bn for seven weeks. They increased the amount of 5-Year Treasuries by $1bn a month and the amount raised from bills (so less than 12-months) from 18% to 27% of the total. That should make it easier to absorb and keep longer-term rates from rising as fast.

What does it mean? One, we like the short end of the Treasury market. It’s a strong risk adjusted place to be in the yield curve. Two, we also like medium term (7-10 year) Treasuries as we think rates will peak some time in 2019 and not affect the middle of the yield curve.

2.     Why are asset managers not good investments? I mean, you know, they manage money for a living so you might say to yourself, “these guys know what they're doing, I’ll buy the stock and get a nice alpha-laden return on the S&P 500.” But no. The public fund companies have been pretty awful investments. Here’s a composite of some of the biggest (we left out Invesco and Blackrock but they are not the exception…we just ran out of names):

Over the last 10 years, an investment in some leading asset managers underperformed the S&P 500 by about 45%. It doesn't get better if we change the dates. Year to date, three, five and 15 years are no better. Are they just bad managers? Erm…no, but they're in a tough business. What has been investors’ gain in the form of low cost index funds has been asset managers’ loss. Many are caught between low cost providers, like Blackrock, State Street, American Funds and Vanguard and specialist hedge, private equity and venture funds. ETFs and low cost funds are now around 20% of all managed funds and take an even greater share of flows.

Many will adapt. Either by merging, shrinking or finding new areas of growth. But for now, it’s probably more disruption and declining margins.

 Bottom Line: Earnings are still doing well. The Yuan, trade and  macro numbers will drive sentiment. Meanwhile, stocks, as we’ve mentioned, stocks are trading on forward P/E of 16.6 cheaper than all of 2016 and 2017.

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Charlotte takes on the world

 --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: DIscover India

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.

Please check out our 119 Years of the Dow chart  

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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

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.

Please check out our 119 Years of the Dow chart  

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Other:

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

Tech saves the day

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

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

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

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

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

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

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

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

Here’s an important chart we look at:

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

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

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

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

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

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

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

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

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

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

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

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Mount Trumpmore

Elon Musk does not like questions

Beating Harvard with index funds

--Christian Thwaites, Brouwer & Janachowski, LLC

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

 

First, check your index

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

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

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

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

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

A few things jump out:

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

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

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

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

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

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

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

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

How do they do it? Here’s a rundown:

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

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

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

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

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

 

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Robert Mercer and the police

Theranos still misbehaving

 --Christian Thwaites, Brouwer & Janachowski, LLC

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

 

 

Excuse me, have you seen the Budget Deficit?

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

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

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

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

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

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

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

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

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

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

Does it matter? You tend to get three answers:

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

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

3.     It's complicated.

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

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

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

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

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

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

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

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

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Takahata Isao and Grave of the Fireflies

And Gillian Ayres died

--Christian Thwaites, Brouwer & Janachowski, LLC

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

 

Always something happening and nothing going on

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Berkshire Hathaway is now the country’s second largest realtor

--Christian Thwaites, Brouwer & Janachowski, LLC

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

 

And it all came right

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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McDonalds celebrates women

Another take on share buybacks

Mute don't block

--Christian Thwaites, Brouwer & Janachowski, LLC

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

All charts from Factset unless otherwise noted.

 

Steel your face

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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T. Boone Pickens now has an ETF

Facebook censors

Mrs Musk  

--Christian Thwaites, Brouwer & Janachowski, LLC

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

 

Back in sync

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Beagles found a single mouse in a one-acre field in under a minute

Why the new tax policy will suck in imports

 --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.