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Coming up to May. Now what?

The Days Ahead: Jobs numbers, Fed meeting, more big earnings

One-Minute Summary We mentioned last week that it was going to be a bottoms-up sort of market, trading on stock stories rather than macro. And so it was. Boeing (biggest stock in Dow, which is one reason that index didn't reach record highs), suspended guidance. Facebook did its thing of record sales and fines. Anadarko, a $35bn oil E&P company, was put in play. SAP, Germany’s largest company by far, up 18%. Microsoft, at record highs and, as of writing, back on top as America’s biggest company and sole member of the $1tr club. And so on. All good solid stuff, which is what we wanted to see as we start hitting a tougher time for year-over-year comparisons.

Stocks hit a record high. They've now fully retraced the near 20% correction, which started last February and reached bottom in December. Those who look at the S&P 500 total return index (the one that includes dividends) or used a 60/40 portfolio, reached all-time highs a few weeks ago…yes, dividends are important. The Dow Jones Industrials and Dow Jones Transportation indices, neither of which should be used for portfolio measurement, are about 1% and 3% off their record highs.

What's holding stocks up? A very favorable yield environment.  The Fed won't do anything next week. After that, the market will look for a more definite trend. We're in an abnormally low volatility phase right now. You would think with trade, Washington, embargoes, Brexit and all, we’d all be nervous. But for now investors are taking the Fed’s lead.

Breaking news on GDP: we wrote most of this on Thursday night thinking the Q1 GDP sneak peek would be a “hold the back page” story.

So, doncha know, it came in at 3.2% when everyone, including us, thought it would be a 1% affair. You would think if it was the “blockbuster report [showing that] policies are unleashing the vitality of the American economy” (yes, the Commerce Department said that), the 10-Year Treasuries would plummet. But they rallied.

Why? Well one reason is that the report is not all that it appears. Trade and inventory growth accounted for half the growth. We see inventory builds as essentially borrowing growth from the future. It’s unlikely that companies will be happy to keep high inventory on hand. Housing, personal consumption and the core PCE inflation were all weak. So, we’ll have to see if this can continue.

1.     Housing on recession watch. No. This is a bit of an ongoing theme because a few months ago, the warning lights were on for a recession. We've covered some of the early signs of a recession here, with claims, and here with some other major indicators.

Housing is always a prominent recession indicator. The way we think about it is to separate housing sales from housing starts and new sales. That’s because while home sales are a very big number, the most recent was 5.2m, down 5% on the month and 5.5% from a year ago, sales don't create much economic activity. Yes, people redecorate and earn commissions but that pales against the economic output from building, fitting and equipping a new house.

So, it’s housing starts and new home sales that interest us.

After some concerns back in December, it looks like housing is firming up again. Here are the new home sales from early in the week.

New home sales on the rise

The level of 692,000 (it’s an annualized rate) is a near peak from the recession lows and was well above forecast. We'd also note that the median price is down nearly 10% from a year ago. But i) prices are volatile and may rebound and ii) the SALT limits hit high-price areas like the Northeast and overstate the national trends.

This is good news. Sure, low rental vacancies are helping but normally people don't buy a new house unless they feel pretty secure about jobs and pay. We also like the fact that new home sales are still catching up with existing home sales. After the crash, distressed sales were everywhere, which meant home builders focused on higher priced units. But now, there is more affordable housing especially in the Southeast, which accounts for 58% of all new sales (h/t  Calculated Risk).

So, housing is one area of our recession watch that is on solid ground.

2.     How’s that inverted yield curve going? Well, as the song says, I just looked around and it was gone. Back in December there were real concerns the curve was inverting and that suggested a recession. Our point was that, yes, inverted curves preceded recessions but the timing was way off and, as we like to say, “being early and right is the same as being wrong”. So we didn't think it meant much. But now look at it:

Yield curve not inverting any more

Yield curve not inverting any more

The spread has more than doubled since its 8bp low back in December, when markets were pricing in a full recession. It’s the 2-Year Treasury, which has fallen in yield, from around 2.6% to 2.3%. That suggests there is i) more deflation in the air (certainly possible given recent dollar strength) or ii) the Fed will cut later this year (unlikely) or iii) the recent economic data has been poor (it hasn't) or iv) the 2-year is pricing off German bunds, which are back below 0% (possibly).

You can see we’re not exuding unqualified confidence on this one. We'd say some of it might be seasonal (always a good copout) or that the market is just pricing in a prolonged Fed-on-hold and doesn't expect much move in long-term rates. But for sure, it shows a fast fading of recession fears.

Bottom Line: Despite the recent rise in stocks, valuations remain solid. Some 204 of the S&P 500 companies trade 20% or more below their all-time highs and despite a stock market average valuation of 17x, there are 160 companies trading below 14x. The top 10 companies, with a heavy tech weighting and 22% of the market, trade at an average of 22x. That's a good indicator for the next year.

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Man sailed around the world with a chicken

 --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.

 Time of the Season

Earnings one day at a time

The Days Ahead: More earnings; first sight of Q1 GDP.

One Minute Summary The market definitely had other things on its mind last week. It was a short one to begin with and by Thursday, most eyes were on The Report or the long weekend. We're reminded that financial markets tend to ignore political events unless they’re really going to disrupt things. But the bar is high these days and a divided Congress and polarized opinions is really nothing new.

Healthcare stocks were down around 5% especially the big insurers who stand to lose most from any move to universal access. Somehow, we think they'll still be standing post any reforms. Economic data was better than expected including the consumer sensitive retail sales. Growth in China seemed to stabilize. Companies continue to report decent earnings but there were mostly modest beats and no big moves. The market liked the Apple/Qualcomm patent deal resolution. Qualcomm was up 42%. Not bad for a $96bn company but only back to where it was in 2014.

1.     Recession Watch. As we've mentioned several times, we don't think a recession is around the corner. But Wall Street economists, academics and the Fed all have pretty dismal records when it comes to recession predictions so we’ll not claim special insight. Our thinking is that we've seen modest, slow growth since the Great Recession with no big consumer-led credit bubbles. That kind of pattern is more in line with a slowdown than outright recession. Of course there are a ton of variables that can change things quickly. Trade, budgets, China growth, tariffs. Name it and there’s some chance that it could happen.

But we do know that the Fed looks at the big ones like GDP, change in nonfarm payrolls, PCE inflation and the unemployment rate. These are all lagging or coincident indicators. So they also look at forward-looking indicators including retail sales, industrial production, durable goods and the ISM surveys. We'll look at these in coming weeks but the short version is that none are critical right now.

We view initial claims as important, simply because if you're laid off, you have every incentive to file an unemployment claim. They also come out weekly and tend not to have revisions unless there are things like natural disasters. The recent claims numbers are around 192,000, which are the lowest for 50 years even when not adjusting for population growth. And if we adjust for workforce growth, we see claims are 0.14% of all workers, which is the lowest it’s ever been. Recession peaks for claims and claims as a percent of workforce were 680,000 and 0.4%. So, yes, we've come a long way.

But two things make us cautious. One, the number of people eligible for unemployment benefits plummeted. Put another way, the insured unemployment rate, here in the green line, is only 1.2%. That means two thirds of all unemployed receive no benefits at all.

Very low rate of insured unemployed

That may be because of i) the gig economy or ii) people have not built up enough time in the workforce or iii) workers have reached their limits.

And two, (h/t Capital Economics), is that states have changed eligibility rules drastically in recent years. Some states simply exclude certain professions from unemployment benefits. So hard luck if you’re a real estate or insurance agent, student nurse, intern or part time in some states. You're not covered. Also, some reduced the duration and eligibility of benefits. In the case of NC, for example, claims fell 80% following benefit reductions compared to a national average of 50%.

So what? Well, claims may not be the reliable indicators it was. We feel that the labor market is weaker than it looks, hence our position that wage and price inflation will remain low.

2.     Germany. Any news? Germany is very important in the global economy, where it’s number four in the world, but less in stock market terms, where it's not even in the top 10. In fact, the top three companies in the U.S. have a higher market cap than the entire German stock market, with some change to spare.

But the market is important not least because it serves as a bellwether for the EU block. Last year was rough for German stocks. U.S. trade tariffs, Brexit, low interest and new EU auto emissions all hit the auto companies and banks, together over 40% of the index, hard.

This year, it’s been a much better story. The market is up around 16% for U.S. investor, outperforming the U.S., and is one of the strongest in Europe. It’s not because all has turned around. More that things stopped getting worse. Major indicators like industrial production, capital investment and exports bottomed out in the last few months and that’s after the economy narrowly missed a technical recession in 2018.

The market has always traded at a discount to the U.S. That’s more to do with the sector make-up of the index. The U.S. market has around a 30% weighting to tech. With Germany it’s less than 2%.

German stock market cheap

Current valuations of German stocks are 74% of the U.S., less than the long-term average of 80%. At these levels, we think they’re worth holding.

Bottom Line: It’s a micro, not macro market right now. And we wouldn't have it any other way. It's clear the economy is slowing but not halted, the Fed is hands-off and Treasuries low and stable. We'd like to see solid earnings with stable margins and no surprises.

Please check out our 119 Years of the Dow chart  

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 Other:

Dog swims 130 miles out to sea 

 --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.

LP - Lost on you 

Uber: Market Top or Big Nothing

The Days Ahead: More earnings, some Fed speak and a short week

 One-Minute Summary There were lots of tradable events last week: claims, inflation, producer inflation, Fed minutes, the ECB meeting, job openings. But bonds moved only 5bp up and the yield curve didn’t send out any more recession signals. All quiet. Stocks had a good week. Up around 0.5% and now, wait for it, up 16% this year. Riskier assets like small cap, tech and growth are up even more. It seems strange that stocks would rip when the economy is slowing but it’s all to do with dovish language from the main central banks. The Fed confirmed its “patient for longer” decision with the publication of the March minutes. No real dissent and expectations that the Fed balance sheet will soon be a source of demand for Treasuries.

Earnings season is just getting started but JP Morgan (JPM) posted some good numbers on Friday, which helped. JPM is the biggest bank in the financial sector part of the S&P 500. It’s all been a good run on stocks. Disney announced a new subscription service which sent the stock up 13%. So good news from 2 of the 20 largest companies in the S&P 500. Stuff that did badly last year is coming back and we have a different type of leadership than the tech giants. Volatility is very low. We're not saying that things will roll over but some caution is due.

1.     Where’s the inflation?  Not in the headlines that's for sure. The Fed has a model that says low unemployment means wage pressures means higher prices. Nothing wrong with that, it’s an easy-to-understand sequence. Unemployment is way down and last week’s claims numbers reached the lowest level since 1969 when the population was around 35% smaller. But inflation? Not there. Here’s the latest:

Inflation low everywhere except rents

There’s the headline in blue columns at 1.8%. Gas prices rose in the last few months, so that pushes the core CPI up to 2%.This all makes it unlikely inflation will reach the Fed’s 2% target, which in turn makes it unlikely they’ll hike rates. The Fed also tracks real rates so we now have a curious position where real rates as measured by Fed Funds are at their highest point in 10 years and against the 10-Year Treasury, their highest since mid-2016. That’s a de facto tightening which was not in the script. Whoops.

There are those who feel that earnings must start to increase but we haven’t seen it yet. Real earnings are up just 1.3% over the year which, sure, is better than a year ago but still pretty modest given how wonderful the tax cuts were going to be for wages.

One concern is rents.

Rental vacancies at 30 year low

This shows rental vacancy rates at 30-year lows and, in the bottom chart, the relentless growth in rents. Since 1988, they've grown 50% faster than standard inflation. They account for 33% of the CPI and 42% of the Core CPI. So put together higher living costs, low unemployment, low wages and you either get a break in one of those series or just low 2% growth. Which is what we have now and what we see happening.

2.     Uber? Sure, why not? Here’s the prospectus. It’s 395 pages long and the “risk factors” start on page 25 and go on…and on….for 48 pages. There’s the usual stuff about competitors, expenses and acquisitions but then it goes into a weird world of deaths, criminal activities and incarcerations. And that tricky one where courts say their employees are employees and not contractors. And that they may never make money. We'd say on that last point, they're world class because on $11bn of revenue they lose $3bn and they say 25 times that they may “never achieve profitability”. It must have been a blast as an investment banker coming up with all that risk stuff.

So no complaining if your investment goes to zero because the lawyers will point to the document and say, “see, we told you it was dodgy”.

Uber has a bit of a reputational challenge but no worries, the Chairman is a serious bloke who ran Northrop Grumman, is Canadian and says “world class governance will be our north star”, which is a bit tricky if you live in the Southern Hemisphere but full marks for trying. The price tag for all this great technology which allows you to, er, call a cab and have it take you where you want to go is…well, to be determined, but most think it’s around $100bn which would make it #54 in the S&P 500 and #499 in profitability. GE holds the wooden spoon for that because it’s busy writing down bad insurance policies from 20 years ago.

The bigger point, well made by Matt Levine over at Bloomberg, is that Uber is one of the unicorns emerging from the enchanted forest where profits don't matter and first-to-scale wins. There are more to come like Slack, Palantir, Airbnb and Pinterest. Some could be the next Facebook or the next Snap (-45%), Blue Apron (-88%), GoPro (-92%) or Dropbox (-34%). If they go well, put it down to top of the market exuberance (a bad thing). If they go badly, put it down to healthy investor caution (a good thing).

Anyway, "Uber is the defining tech start-up of its generation" which may be true if you're measuring it in dog generations (h/t FT) and they have a picture of a bloke to reassure us that they're nice guys.

And a killer slogan.

So, yeah, no profits, no growth, regulatory difficulties and increasingly intense competition. Awesome. Sign me up.

Bottom Line: We're reminded that last time the market was this high was in August and the 10-Year Treasury was 3.25% not 2.5%. We've swapped high rates and high stocks for low rates and, well, still high stocks.  Markets tend to overreach themselves in each direction so we’re still sticking with our call to have some Treasuries around in case it all comes undone.  

Please check out our 119 Years of the Dow chart  

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San Francisco most expensive city in 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.

 Pinball

The Fed and Politics

The Days Ahead: U.S. inflation and start to earnings

 One-Minute Summary Stocks were up 2% in the week after a barnstorming first quarter of 13.6%. With all the ballyhoo about record markets, if you compared your portfolio six months ago to now, not much changed. If you got your timing wrong, then it was a very different story. Last year, nearly all asset classes moved down together, except for Treasuries later in the year. This year, it’s been up across the board. This is what a humble 60% Equity/40% bonds looked like in the first quarter, the best level since 1998 and the third best quarter in 30 years.

The market liked the latest on trade talks (“any day now, going well’) which makes us a little wary about how many times the market can rally on the rumor. Most of the economic news was better than expected (U.S. manufacturing) or seems to be touching lows from which they’ll rebound (German manufacturing). European stocks climbed to a seven-month high on expectations trade will improve.

 U.S. Treasuries lost some ground but ended the week at 2.5% or just 6bps up on the week. We don't think anything changed that would cause Treasuries to break out of their 2.4% to 2.7% range.

 1.  How exciting were the jobs numbers?   Not very. New jobs came in at 196,000 after February’s weak 20,000 number. The unemployment and underemployment (those who would like to work more but can't) were unchanged. Service jobs (71% of the workforce) increased by 170,000 and 61,000 of those were in healthcare. Now, when the BLS says healthcare, please don't think of nurses, technicians, doctors and EMTs. Most of the jobs are home and community care and office service workers and the point about those jobs are they’re i) part time and ii) pay very little. The average home care worker earns $11 an hour, or 40% of the average, and works 20% less.

Look, we get it. Jobs are jobs. But many jobs just aren't that well paid and pay rises stalled again. The Average Hourly Earnings, which popped by 3% in January, is now down at a 0.1% growth and 3.2% over the year (white line below).

The curious thing about wages is that the NFIB consistently talks about the difficulty of finding workers. If that's the case then you would expect wage increases to start coming through. But they haven’t. If they do start to rise then we’ll see margins compressed and a feed through into inflation. If we don't, then we’ll continue to see the economy eke out 2% growth rate with low productivity.

Either way, these numbers won't have changed the Fed’s mind about holding off on rates.

2.     Is the Fed becoming politicized? Not yet. The Fed enjoys a well-earned reputation for independence. A couple of things happened last week, which caused concern. One, the President upped the pressure on the Fed to drop rates and let the “rocket ship” run. The Fed can ignore this. Two, Herman Cain and, two weeks ago, Stephen Moore, were nominated to fill the two vacant spots on the Fed’s Board of Governors. You can read about it here and here but the summary is that both are hacks, ignorant of monetary policy and run an overt political agenda with a history of disastrous calls on the economy, inflation and markets. And they’re not economists.

All of which is true. But taking this one step at a time, we don't think it’s quite as dire. First, there are five permanent members of the FOMC, and only two are economists. The other three are lawyers. Rotating groups of Regional Fed Presidents make up the rest of the ten members for a total of six economists and four non-economists. So the non-economist is not a problem. And there’s an army of highly qualified economists at the Fed if you're a Governor who’s intellectually curious.

Second, not all nominees make it through the process. Two very good nominees, here and here, were just dinged for no particular reason.

Third, just because they're on the board doesn't mean anyone pays attention to them. The Fed statements back in 2008-2009 regularly had two policy dissenters and no one gave them a second thought. Sure, they can take to the airways right after the meetings but that won't change things.

So at this point we’d say the possible outcomes are:

  1. They’re voted down by the Senate (like Nellie Liang and Marvin Goodfriend)

  2. They’re voted in and cause havoc

  3. They’re voted in and marginalized

  4. They're voted in and grow up

  5. The regional governors run the show

People are rightly worried about #2 but we’d put it at less than a 20% probability. 

3.     What can we expect in earnings season? There is a bit of a ritual in forecasting earnings that goes like this:

Analyst (shows number on paper): I’m putting you down for this.

CFO (sucks teeth): Er, bit high, we had that recall thing.

Analyst (scribbles down a number): Gotcha. This?

CFO (looks out the window)

Analyst: This?

CFO: That does not look unreasonable.

Three months later:

CFO: We beat estimates

Analyst: Good quarter guys. Solid beat. Trebles all round.

That’s why 75% of companies “beat” earnings because everyone lowballed them to begin with. Anyway this quarter, analysts are busy revising down earnings. According to Factset, they revised them down 7% during the quarter, which means as the quarter progressed, they slowly pushed estimates down. Earnings will still be up year over year but far short of the 20% levels we saw throughout 2018.

That 7% is a big number. Normally it’s more like 4%. It makes us a bit nervous what businesses will say about sales and the rest of the year. And it will probably reduce the number of times we hear “beats”.

Bottom Line: Inflation numbers next week. This is the one measure the Fed has consistently overestimated and got wrong. We're looking closely at the earnings announcements with the big banks all due next week.

Please check out our 119 Years of the Dow chart  

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Oreo Game of Thrones

--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.

 David McWilliams

Does the yield curve really predict recession?

The Days Ahead: Jobs numbers and durable goods

One-Minute Summary We're writing this Wednesday mid-week so either something big will happen that will render all below irrelevant or it may have a two-day staying power.

We had a week where the broad economic numbers were still weak: housing, trade and consumer confidence. Markets traded off but much of the news was anticipated so there were no grand meltdowns.

1.     You're not going to talk inversion again, are you?  Afraid so. So, let’s be clear. The yield curve has not inverted. Parts of the yield curve have inverted. The most cited curve is the 10-Year Treasury and 2-Year Treasury (or 2s/10s because bond types love shorthand) and that has not inverted. The 10-Year Treasury yields 2.37% and the 2-Year Treasury yields 2.25%. Next we go to the 2s/30s, so now we’re at the 30-Year Treasury, which yields 2.82%. So that's not inverted either.

Where’s the inversion? In the belly of the curve, so-called because if you hold it vertically it looks like, well, a belly (here take a look, section 1, blue line). Ok, so where we have inversion is in the 90-day bill, yielding 2.45% and the 5-Year Treasury at 2.19%. And at the Fed Funds Rate of 2.5% and the 90-day bill.

We’re unlikely to see the entire yield curve invert because

a) the 30-Year Treasury is very popular with pension funds with long-term liabilities and no-one issues bonds that long with that quality, so if you have ‘em, hold ‘em and

b) post-2008, banks must hold safe assets and the long Treasuries don't tend to be sold much.

And that means? Now that's where the long knives come out. Some say “harbinger of recession, tin hat and New Zealand time” , others, meh. We're in the middle and take the view that a) tax cuts brought forward growth b) the tax cut effect has faded c) growth everywhere is slow and d) that the bond and stock markets saw this coming six months ago. So, will everyone please calm down.

Yield curves in developed markets started to flatten a few months ago.

All those lines sloping down measure the difference between 10-Year and 2-Year sovereign bonds in Germany, Japan and the U.S. The U.S. one is still above zero, just. The others are at their lowest levels in two years, although note that in the case of Germany and Japan all four bonds (so two at 10-Years and two at 2-years) are at negative rates.

As we’ve noted before, a yield curve inversion does precede a recession but not all the time and even when it does, it can lead by 9 to 23 months. And, as we’ve also said, being early and right is the same as being wrong.

Where does this lead us? That economies are weak, growth is slower and that any upturn, here or overseas looks far from certain. So with that we're fine with our Treasury allocation and focus on the front-end of the curve.

2.     Recession Watch So having relegated the yield curve as the recession signal, what works? What's the single best, sure fire, back tested to the nth and reliable recession indicator? Well, no surprise, there isn't one. Here are some ones we look at and recent trends:

Looking at the list, there are no resounding, ding-dong highs or sepulchral lows. Nor we would expect them at this stage of a very long cycle. Slowdown it is then. Will the Fed cut rates? Perhaps but they've never cut rates with claims this low:

The absolute level is around 220,000 and as a percent of the labor force, it's never been lower. So, we’ll change that “perhaps” for “no” and watch the claims numbers.

3.     Are earnings slowing? Yes. First, it’s down to lower growth of the economy. Second, wage pressures, while very low, do affect margins. Third, year over year comparisons are hit hard by the base effects of a year ago, when U.S. companies had 20% earnings growth, half of which was courtesy of the tax cut. The earnings slow down is worldwide:

The S&P 500 is still ahead, showing around 7% annual growth in earnings. Europe is the worst hit because of banks, which are not only badly managed but have bad loans and assets and low rates to contend with. Japan is suffering from trade problems and low growth.

So, there is the earnings growth: weaker and probably due for some downgrades but probably priced in.

Bottom Line: We're probably done with the low rates news and its immediate effects on the market. We'd like to see equities trade sideways but we don't always get what we want and would expect some correction unless earnings surprise to the upside. Treasuries seem like a continued good allocation.

Please check out our 119 Years of the Dow chart  

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Other:

Double your revenue double your losses

--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.

Magic Bus

Fed still rules the game

The Days Ahead: PCE inflation and housing. Slow corporate calendar.  

 One-Minute Summary The surprise was the Fed’s very dovish move to lower growth forecasts and to say they're done for the year (see below). That sent the 10-Year Treasury down to 2.44% and below the 3-month bill. That’s the “inversion” we and others discussed before (here and here). We’re not sure it’s the recession indicator people say it is but it’s definitely corroborating the slowdown in the economy. For good measure, German and Japanese 10-Year government bonds traded below zero.

Low rates are all well and good but they’re a disaster for financials. No bank can make money borrowing at the Fed Funds window for 2.4% and make a five year commercial loan at 2.3% with a traditional 200bps spread. In Europe, bank depositors get 0% but it costs the bank -0.4% to borrow from the central bank. The worse outcome, here and overseas, is that low rates push up financial assets but kill risk taking by banks (h/t Cameron Crise).

Major indexes were down on the week. We hope it’s all part of a healthy consolidation but when markets make their targeted annual gain in 10 weeks, expect some profit taking.

1.     Has the Fed turned dove?  Yes, in a very big way. Most expected the Fed to confirm its “patient” stance from January. After all the slowdown in January was expected (it was there in the trade and housing numbers back in December) and the seasonal problems with January are well known (they tend to understate growth). So most investors expected “halt until June then one, possibly two hikes”.

No more. The Fed sounded very cautious on growth, spending and investment and noted no change in inflation. Then with the “dot plots” they effectively forecasted that there would be no rate increases for the rest of 2019. Here are the dot plots:

We'll save you squinting and head to the bottom line. In December, the Fed thought the Fed Funds rate would be 2.72% in 2019 and 2.94% in 2020. Those are now down to 2.37% and 2.54%. That implies no more increases in this year and maybe one in 2020.

What's also noteworthy is that they're also saying they're not going to raise Fed Funds, currently at 2.5%, above their long-term neutral rate of 2.79%. That's curious because that's what a central bank would have to do to deliberately slow the economy. We don't have an answer to that.

They also made some changes to the “balance sheet”, which is the stock of Treasuries and Agency (i.e. mortgage) securities from years of QE. These peaked at around $4.3tr in 2016 and dropped by an average of $24bn a month from 2018 to reach $3.7trt this month. You would think the Fed would want to keep running the balance sheet down, after all it was less than $1tr in 2009. But no, they're going to keep reinvesting coupons on Treasuries and Agencies into Treasuries. So the Fed will become a net buyer of Treasuries again this fall.

This whole meeting is a bit of puzzle if only because the Fed seems to have boxed itself in. We see the following possible outcomes

  1. Economy continues to weaken. Rates drift lower. The Fed looks like they're ahead of the game.

  2. Economy bounces back later in the year. Rates steady. Fed has given the cycle a second wind.

  3. Economy comes back strongly. Rates drift upwards. The Fed will have to reverse quickly.

We think the biggest issues around right now, China, Brexit and global growth, will all improve later this year. But for now the Fed is very dovish indeed.

Market reactions were fairly predictable.

  1. 10-Year Treasuries dropped to 2.52%

  2. 2-Year Treasuries to 2.38% (six month ago it was 2.96%)

  3. 3-month bills increased a bit to 2.46%

  4. The front end of the curve inverted more…the 3-month bill now yields more than the 10-Year Treasury

  5. Dollar weaker

  6. Emerging Markets up

  7. U.S. stocks sold off in a classic case of “buy the rumor, sell the news”

  8. Financials were hit (they don't like low rates)

 We had put many of these investments in place a few months ago so we don't feel the need to adjust portfolios.

And because today’s yield curve is one for the grandkids (yes, it's that unusual), here it is: 

The blue one is from Fed day, with a big sinkhole in the middle and well below the yellow line from January. The black line is from a year ago. That’s a normalish yield curve. Since then all the action and gains have been at the front end of the curve.

2.     How’s the German stock market doing? Not well. From mid-2015 to January 2018, it was up 42% in local terms and 60% for a U.S. investor and handily beat the S&P 500 by 7% in 2017. It was all driven by the global synchronized growth and higher rates story. Since its peak, it’s down 21% but has rallied 8% this year.

Why? Germany was caught in the U.S. and China trade, er, talks. The German stock market derives 72% of its sales from outside Germany (S&P 500 around 40%) and exports are 35% of GDP (U.S. is around 12%). The stock market is also very dependent on financial, industrials and autos, which are 52% of the market, compared to 30% for the U.S. The top 10 companies in the German stock market are 40% of the index and the big three autos are 11%. You get the picture, big companies, no tech and very dependent on overseas demand.

The result is Germany is very much unloved right now, which means it’s very cheap

The blue line below is a rough measure of valuation. For the last 15 years, the German market has traded at about a 20% discount to the S&P 500. Today that number is around 28%. The market also yields around 2.7% compared to the S&P 500 at 1.8%. None of these are sure things. We know markets can get cheaper, dividends cut and more bad news can come out. But Germany seems very unloved right now and on a two to three-year horizon, that might not be a bad entry point.  

3.     Unicorns are coming to town. Yes, it’s time for the Lyft, Uber, Pinterest, Slack, Palantir, WeWork, RobinHood (your kids use it), AirBNB and Peloton to enter adulthood and the big bad world of the public company.

  1. There are a few things different from the last time a bunch of IPOs came along.

  2. There are more dual classes of share, which means they won't be in some leading indexes.

  3. They lose money. A lot.

  4. Pricing may be very aggressive. See companies like SNAP (down 60%) and Blue Apron (down 88%).

  5. Some of these companies are already owned by mutual funds and the like as private companies (yes, ‘40 Act funds can own private companies, just not very much) so there may not be a big queue of buyers on day 2.

Still, they'll get some attention.

Bottom Line: So the market got what it was looking for, lower rates, and…sold off. We know the economy is slowing right back to its 2% normal and inflation is slipping lower. We're almost back to the 2-2-2 world we talked about a few years ago. Inflation, growth at around 2% and the 10-Year Treasury  with a 2 handle.  

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Surprising nominee for the Fed. And not a good one.

 --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.

 Days of Pearly Spencer 

A shot across the Dow

The Days Ahead: Fed meeting.

One-Minute Summary A steady drip of lower but not catastrophic economic numbers helped push the S&P 500 up every day this week. Yes, it’s one of those “bad news is good” things because the Fed is on hold and lower rates make stocks look better. The S&P 500 seems reluctant to broach its September highs but we’re only 4% off the record and up 14% from December.

To us it looks like an asset and technical trade. The asset side is just the relative attraction of equities. To oversimplify, lower rates allow equity discount models to throw off higher valuations. The technicals are just resistance lines for moving averages. We'll leave both to those who know what they’re talking about.

But what we don't see is bullish, confident, “great quarter guys” talk coming from the corporate sector. It’s all a bit wait-and-see if the cycle can keep going. We think it can and see this as the pause that refreshes.

And in an update on the tenth anniversary of the market low, we’d remind investors that the S&P 500 rolling 10-Year return is 16.5%. It hasn't been above 15% since 2001 so the 10-Year numbers are about as good as they get. What can we expect? Somewhere between the rolling 20-year number of 6% and 5-year of 11%.

 1.     How low can rates go? Don’t know. They’re already way below what we thought they would hit in 2019. This week we had a run of weak data, starting with retail sales, lower new home sales and Friday’s industrial production. The 10-Year Treasury tracked lower every day and hit 2.58% on Friday morning.

The yield curve is fully inverted in the belly of the curve with 10-Year Treasuries yielding only 7bp more than 1-Year Treasuries and 15bp more than a Treasury FRN. The latter has no duration risk. The 10-Year Treasury has a duration of around 8. The curve isn't yet the alarming shape it was back in 2007 but here, in the blue line, you can see the kinks in the curve.

We think the following dynamics are at play:

  1. Fed is on hold and there’s talk of only one rise this year. A few weeks ago it was a pause until June and then two.

  2. The ECB talked a grim book last week and announced a new LTRO (a sort of bank lending subsidy). No chance of rate changes there either.

  3. The German and Japanese 3-month bills are at -0.5% and -0.1. The U.S. is at 2.43%. On a relative basis with global money movements, the U.S. trade is a no-brainer.

  4. Brexit and Venezuela creates a fear trade. The U.S. retains haven status

For what it’s worth, rates have declined steadily since the December FOMC meeting. There is much discussion about the level of the  R* rate (the neutral rate where the economy neither expands or contracts). What is clear is that it’s lower than thought a few months ago. And we’ll probably see confirmation of that at next week’s FOMC meeting.

2.     Is there any sign of inflation?  No. The Fed talks about inflation all the time. It’s one of their two mandates: promote maximum employment and stable prices. They do not provide more specifics. Maximum employment could be unemployment of 2% (it’s never 0%) or 4% depending on the cycle and circumstances. The inflation target is usually held to be 2%. It’s relatively easy for the Fed to kill inflation but very hard for them to increase it. But, my, how they have tried. Years of QE, forward guidance and low rates should have stoked the inflation fires. But they haven’t. Not in the U.S. or in any other leading economy. Here’s the long-term trend in U.S. inflation.  

Inflation tends to rise going into a recession. No surprise there as the Fed chokes off any inflation uptick very quickly. But you can see that inflation has barely stayed above 2% since the recession or indeed going back to the 1990s.

The latest inflation measure looks like this:

That’s shows housing at 3.2%, core inflation at 2.1% and, because of soft gas prices, headline inflation at 1.5%. There are still deflationary forces at work…the bottom graph shows things like TVs and cell phone prices falling.

What’s next for inflation? Banks and investments houses pushed TIPS earlier this year on the basis that the Fed would allow higher inflation. That hasn't worked out. Expected inflation was as high as 2.1% in October but slipped to 1.9%. We think there is some risk of wage inflation coming though in the back end of the year. But there’s also the force of a strong dollar and lower import prices if a trade deal comes through. On balance, we don't see much inflationary pressure. Neither does the bond market.

3.     We're not alone in rubbishing the Dow as a lousy indicator of market sentiment, direction or performance. It's price weighted which means that the higher the stock price, the more that stock moves the Dow.

The five most valuable stocks (MSFT, AAPL, JPM, JNJ, XOM) in the Dow are 38% of the index. But the five highest prices are Boeing, United Health, 3M, Goldman Sachs and Home Depot. They’re 12% of the value but 32% of the prices. So, when Boeing tumbled on Tuesday from $450 to $358, it had an oversized influence on the Dow and greatly overstated stock market weakness.

So what does the Dow have going for it? Longevity and the sound bite value of “the Dow fell 400 points” rather than “the S&P 500 rose 0.8%”. But as a market measure? Nothing.

Bottom Line: Expect the news and macro events to keep stocks going. We think one of the big catalysts will be for news out of Europe to stop worsening. Expectations are beaten down. A small respite could help European stocks a lot.

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Lyft’s IPO filing. Yes, it loses gobs of money

 --Christian Thwaites, Brouwer & Janachowski, LLC

 

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

All charts from Factset unless otherwise noted.

 

 

China? What return would you like?

The Days Ahead: Inflation and headline risk on trade and tech 

One-Minute Summary:  Ouch! Those payroll numbers were 20,000, down from back to back months of 300,000 new jobs. If you're Chair Powell, your call on staying patient back in January looks like mighty fine timing.

So is this the economy weakening? Yes. Are the recession bears right? No. There’s a lot of noise in any one-month print and the new jobs number has an over/under deviation of 75,000…so this number may be 95,000 or a loss of 55,000. What we’re looking for is are people worried about job security and will that cycle into declining spending? There is no sign of either. Hey, look, there is no doubt the economy is slower. You can see it in housing, manufacturing and trade. But a full tip into recession? No.

As for wage gains, yes, average hourly earnings increased 0.4% over the month and 3.4% over the year. But if your employer gives you an hourly wage increase at the same time as fewer hours, you're not ahead (although the BLS says you are). And that’s what happened. The average workweek fell.

So there’s something in the numbers for the bears (low numbers) and the bulls (wages) but we’d stay our hand until there are clearer trends. Treasuries rallied. The 10-Year Treasury is at 2.63% compared to 3.2% in November. It’s likely to stay at these lower bands. At the start of the year, we expected the Fed to postpone any further rate hikes until June. But if we get another few months of this, the Fed’s next move may be to cut, not raise.

Stocks were down every day this week. It was mostly a global growth story. Slower in U.S., China and Germany and a very accommodative (bearish) statement from the ECB. This is fine. We think the market was oversold last December and over bought up until a few weeks ago. I mean how many times can the market rally on “hopes for a China trade deal” headline?

1.     Did the trade policy backfire? Well, it ain’t over but if you're looking at the halftime score, then, yes. Here’s the full report. A quick way to look at it is with 2018 and (2017) numbers:

  1. The U.S. ran a $891bn ($807) goods deficit. 

  2. It ran a $271bn ($255bn) service surplus (things like transport, travel and financial services)

  3. And an overall trade deficit of $620bn ($552bn)

 The big changes were:

  1. A much narrower petroleum deficit of $53bn ($61bn) but that used to run over $300bn as recently as 2012

  2. A much bigger deficit of $129bn ($110bn) in technology parts

  3. A deteriorating trade deficit with China at $419bn ($375bn)

There's no real mystery to this. One, last year’s tax cut was equivalent to a fiscal stimulus while at full employment. You do this and demand leaks into imports almost straight away. Two, dollar strength. Three, trade tariffs. We'd argue that the third was probably the least important but it did lead to a big drop in food exports. Anyway, here's the goods part. A rising blue column means the deficit is worsening.

The U.S. started to talk tough on trade in early 2018. There was an immediate improvement as importers of U.S. goods brought forward purchases to avoid tariffs. But since the low in mid-May, the monthly deficit has grown 23%.

We don't know where it’s all going to end. But the U.S. cannot simultaneously enjoy tax cuts + low unemployment + low inflation AND a smaller trade deficit + dollar strength. Something has to give and for now, it’s the trade deficit.

 2.     Are China stocks up and away?   What answer would you like? The headline indexes are up 25% to 30% this year but are still down 10% to 15% from last year. The main reasons are a feeling that the trade talks will go China’s way, that the worst is over and a rally from very low valuations…the China market traded at 10x earnings in December or 35% cheaper than the U.S.

Another reason was the power of the index. MSCI, a leading index provider, announced it would start to increase the weighting of China shares in its Emerging Market Index, which is the benchmark for $1.6tr of assets. It will increase China weight in the index from 7% to 10% and the greater China weight (so include Hong Kong and Taiwan) from 42% to 46%. That means around 40% of all Emerging Markets investors must increase their buying of China stocks. They have no choice in the matter.

This matters very much, because, as we've said many times, while we’re big fans of indexing, it really matters what index you use. Here’s the performance of leading China equity indexes over the last two years.

The returns range from -14% for the Shenzhen Index to +23% for the China 100 index. Why the difference? Well the indexes range from Hong Kong listed but China domiciled Blue Chips, Nasdaq type stocks, small caps, all cap stocks and stocks registered only in China with limited foreign ownership rules. The S&P 500 is towards the top at +16%. But you’ll also note how volatile China stocks can be. The peak to trough drop in most of the China indexes was 47% compared to 20% for the S&P 500.

But the biggest lesson? Choose your index carefully.

Meanwhile, we think some of the rally in China is overdone and so like to have downside protection on our Emerging Markets positions.

3.     Did the equity melt down in December hurt households? Yes. By about $4 trillion.

That's the first decline since 2015 and meant that growth in net worth fell to 0.8% from around 5%. But we’re not concerned.

  1. It’s probably temporary. High net worth households holds a large part of the equity holdings. Their propensity to spend is less than the average household.

  2. We'd note from the same report, that net corporate borrowing was flat for most of 2018. Many commentators only cite the gross number. U.S. corporations are not heavily indebted.

  3. Consumer borrowing (so credit cards and mortgages) is around 130% of compensation, down 1% from last year and from a peak of 170%. U.S. households de-levered post 2008 and stayed that way.

  4. Overall debt grew 4.5% but household debt grew 3% and the Federal Government debt grew at 7.6%. Nominal GDP grew 5.2% and as long as debt grows slower than income, we don't have a problem in the household sector.

The Household Financial Accounts report rarely generates market-moving news. But we like it because it confirms that we’re looking at modest debt growth in the corporate, household, state and local government sectors. The Federal Government is another story.

Bottom Line: Some 442 of the S&P 500 companies are up this year and 305 have outperformed the S&P 500. But, in contrast to 2018, performance of the 10 largest companies accounting for 22% of the index has been way below the S&P 500. We'd wait on the sidelines for now.

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The broken patent system that kept Theranos afloat

--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.

Dexter Gordon - One Flight Up  

Berkshire’s Change and some very good 10 Year Returns

The Days Ahead: Job numbers.  

One-Minute Summary:  Most of the economic data was weak. That includes the ISM Manufacturing, pending and existing home sales and personal income. But these were all very much expected. The Fed’s move back in January (“we’re patient”) looks exactly right. It's not often that expectations and results are so finely tuned. But this time we knew the tax cuts would run out of steam and uncertainty around China, Europe, trade and government shutdowns would lead to lower numbers. Jerome Powell repeated them all in his talks with Congress last week.

Two points. First, slowing, not a recession. A recession is not two quarters of declining GDP. It’s a far more complicated run of data that includes GDP, employment, claims, hours worked and trade sales (full list here). And those are not flashing red. Second, this should keep rates low for a while. The 10-Year Treasury is at 2.75%, only 20bps higher than two years ago.

It’s been a stunning start to the year. In the first two months, the S&P 500 is up 11.5%, small and mid caps up 15%, China up 27% and Europe up 11%. We'd like to see a pause but would remind ourselves that markets do not correct by going sideways. So having some protection in place seems fine.

As 2009 begins to run off the 10-year returns , we’d like to celebrate that the 10-year compound rate of return in stocks is now 16.75% (see below).

That’s a remarkable number that only comes along every couple of decades (h/t Dan Wiener). So, yay. But a year ago, the same number was 9.8%. The big improvement is because the horrendous 2008 year falls off. The lesson? Stay invested, ride through painful downturns and don't trade the headlines.

1. What did Warren Buffet just do?

Change the bar for measuring Berkshire Hathaway. New accounting rules forced his hand.

There are two ways to think of buying Berkshire. One, a portfolio of companies selected by a legendary stock picker. Two, a group of businesses assembled by a legendary manager. For many, it’s the first. So, when you buy Berkshire you get a bunch of great performing stocks. They're here on page 12. It's like the world’s best-known mutual fund. The biggest holding is Apple but the most famous is Coca-Cola where Warren Buffet has made a 19x return. They amount to $170bn of a $497bn company.

The other $327bn is $127bn of cash and $200bn of operating companies managed out of Omaha. Companies like Geico, BNSF (the U.S.’ third largest railroad), Precision Castparts, an aviation parts manufacturer, reinsurance, energy and other. The “other” includes companies in distribution, mobile homes and retailing (see page A-1). Together they make around $24bn, although this popped to $45bn in 2017 due to tax cuts.

One accounting rule change later and losses on the stock portfolio run through the income statement. In 2018, stocks went up, down and up, and Kraft Heinz had a bad year. Berkshire reported a loss of $1.1bn in the first quarter, then a $12bn profit, another $18bn profit, and a $25bn loss in the fourth quarter. Add those together and the company reported $4bn for the year compared to an average of $26bn for the prior five years. Buffet used to tout book value as the way to measure Berkshire. That was fine if you didn't have to account for swings in the portfolio companies. You got a nice steady increase in book value and could ignore market values. Now you can't because they hurt/flatter the income account every quarter.

So what’s the new measure? Share price. Seems simple enough and on that measure Berkshire does just fine. The rolling five-year returns (below) aren't what they were but they still comfortably beat the S&P 500.

We like Berkshire simply because it has solid growth and well managed, conservatively financed businesses that are worth more than their carried cost. Its value is $495bn with cash and stocks. Take those away and it’s earning some $24bn on a market value of $196bn or a PE of around 8. That looks compelling.

2. How’s U.S. growth doing?

Slowing. It's no surprise the U.S. economy eased in late 2018. For the entire time after the 2009 crash, the norm was 2% growth. Yes, there were flurries of higher and lower growth and there were brief times in 2011 and 2014 when the economy contracted. The tax cuts were exciting but merely brought forward purchases. It wasn't until later in the year that people figured out the cuts were mostly for companies and high-end income earners.

So, Q2 growth was 4.2%, slowed to 3.4% and 2.6% for the final quarter. For calendar 2018, the economy grew 2.9%, so above prior years but not by much and, dare we say, not as much as the tax cutters promised. Here’s the chart, with the slowdown in the bubble on the right.  

What were the drivers? On the plus side, defense spending and investment in intellectual property (which is basically capex for tech companies) were very strong and inventories rose. But on the downside, consumer spending grew less (and savings went up), net exports worsened and Federal and state and local government expenses slowed...a lot.

Going into Q1 2019, there are a number of headwinds including a sharp drop off in capital goods, gas prices no longer falling, government employees who almost certainly cut back spending and some seasonal problems which have made the Q1 GDP numbers a problem for the last decade.

So, there’s the slowdown. We knew it was coming. The start to the year is even slower….the Atlanta GDPNow folk have us at 0.3% for Q1. There’s no evidence that the tax cuts have done anything to raise the capacity of the U.S. economy. We're back to the 2% world. That should keep rates low for a while and the Fed on hold…which is good for Treasuries.

Bottom Line: The market feels overbought. Just as the downturn in late 2018 was overdone so too this rebound all feels headline driven. The macro news is moving markets. We'd rather see bullish comments from companies but they’re not in that sort of mood right now.

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City seizes pug and sells it on ebay

 --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.

Mark Ronson

Highs in the Slow Lane

The Days Ahead: First estimate for Q4 GDP

One-Minute Summary:  Man, it was slow this week. The U.S. Treasury market hasn’t seen this low level of volatility since late 2017 and it's at its fourth lowest level since 1988. It’s all because we know the economy is slowing and the Fed on hold. Until either of those expectations shifts, we don't see much reason for a breakout. What news there was, lower capital good orders and home sales, confirmed the slow down. The Fed is making it good for risk assets and equities continue their rise. The S&P 500 is up 11%, Small Caps up 17% and even European stocks, which had a tough 2018, are up 8% to 10%. 

The market is getting used to an earnings slowdown. After growing at 22% in 2018, most expect around 4% to 6% in 2019. That makes the market reasonably priced to us and no portfolio changes.

 1.     How are we going to fight the next downturn? Er…good question. This came up at one of our recent client meetings. So, if the Fed Funds rate is at 2.5% and the deficit at 5% of GDP and growing (thank you tax cuts) what do you do if there’s a recession? Because rates are already low and the deficit grew $1.2 trillion last year. It’s a fair question. Let's start with what happened in the past.

Here’s the last nine recessions from the last 61 years. The current expansion is 127 months old, beating the record of 120 months in the 1990s by a few months. But two points.

 One, the 1990 recession was relatively shallow and quick so the expansion was more like 1982 to 2001 or 212 months (not all agree with this!).

Two, as we've said many times, we've had a not-so-great recovery since 2009. There was nothing like the snap back we saw in earlier recoveries. That suggests a mild recession when it does come (which is not yet).

The average expansion and recession since 1857 is 38 and 17 months. Since the 1940s, it has been 58 and 11 months. And since the 1980s it’s been 95 and 11 months. Generally, expansions are longer and recessions shorter. That may be because the Fed is Johnny-on-the-spot when it comes to managing the recessions. The amount the Fed has cut its rate on average is 400bps and, in the case of a sharp recession, as in 1980 and 2008, as much as 550bps (that's the right hand column).

Here’s a long term graph with the Fed Funds rate.

Clearly, with Fed Funds at 2.5%, over there on the right, the Fed cannot cut anything like the amount it has in the past. So what to do?

There’s a lot of debate but we’ll focus on the stuff which we think effects investments.

Monetary Policy

  1. The Fed could go to zero and negative rates. Not great for savers but would probably work.

  2. Quantitative easing again. It worked before and there could be scope for more especially, in equities and private bonds

  3. Targeting interest rates or yield curve targeting. Japan targets the 10 –Year bond at 0%, from which every other rate takes its cue

  4. Inflation targeting: the Fed could raise its inflation target

  5. Macroprudential management: include managing bank capital or mortgage loan ratios

  6. Forward guidance: telling the market the Fed would hold rates down for specific and long periods.

 Fiscal Policy

  1. Project and infrastructure planning. A missed opportunity in 2009 but perhaps next time.

  2. Relaxing lending restrictions.

  3. Easing of employment laws.

  4. Changes in regulation

  5. Distributive tax cuts with time limits, to encourage spending over saving
    Extension of unemployment benefits. Again, worked in 2009.

  6. More borrowing. As we've discussed the U.S. has considerable and unique borrowing rights

  7. Global coordination.

Of course, many of these would require a political will not currently in evidence. Nor is the list remotely complete. Good economists could generate many good ideas in double-quick time. But our point is that despite debt and low rates, policy options abound. We are not at all worried about low rates. We think they’re the norm. We'd prefer not to have the level of deficits but a downturn is very manageable.

We’re not preparing our portfolios for a recession. While possible, it’s unlikely. We like our current Treasury, fixed income and equity allocation.

2.     What did the Fed minutes say? Ha, no, no-one asks that. But it was a slow week for news so more people read them than normal. Also, the Fed delayed publication because Washington had snow, which counted for a big news day.

But what was on people’s minds was whether the “we’re going to be patient” announcement in January was shared by the whole Fed or was just Chair Powell gone rogue.

So, they not only said they were going to be patient but said it 13 times and started to use the word “strong” a lot less. Our takeaways are:  

  1. Inflation for both price and compensation is low

  2. The Fed is well tuned into the equity and credit markets (more than we thought). This means a market slide would trigger more easing.

  3. Shrinking the balance sheet (the opposite of QE) will probably stop….that’s more indications of easier policy.

The market barely moved. We've been a in a range of 2.65% to 2.75% since January after the very big move down from 3.2% in November. We think it will stay around here. By historical standards, rates remain very low in real and nominal terms.

Bottom Line: The broad narrative is unchanged. Some of the best performing stocks in 2019 are those that cratered in 2018. Our own PG&E is one (down 83% in 2018, up 175% in 2019). Exxon, Philip Morris, Haynes, Xerox are some others. The big leaders in 2018, especially the big tech stocks, have lagged the S&P 500. Most of the news will be on lower economic numbers, which is priced into the market, and trade, which is not.  

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Cat ladders

 --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.

 Nouvelle Vague

Everyone take a breather.

The Days Ahead: Shorter week. No major economic news.

One-Minute Summary:  When the Fed announced it would stay patient a few weeks ago, some tired punters thought, “Aha Trump got to them.”  But, the Fed was actually spot on. The economy is weakening (no, not recession). This week we saw a low CPI report at 1.6%, the NFIB (a proxy for small businesses) optimism index plunged, retail sales came in very low and on Friday, industrial production (IP) fell 0.6%. The last one is all about China. As the China index falls, so does the U.S. The business equipment sub-component of IP was down 1.5% and automotive down 15%. That’s all trade war related. The folk over at the Atlanta Fed revised down expected growth for Q4 2018 to 1.5%. It had started at 3.5%.

So growth is slower and one of our favorite Fed Presidents (here she is), reiterated the China, European, Brexit, trade and growth risks and underscored the whole “patient” mode. The 10-Year Treasury traded in a very narrow and bullish range. It’s now 2.67% and yielding only 25bps more than 3-month bills. A year ago, that was 120bps. That’s why we’re in the Treasury FRNs.

Hey, look, it’s all on trade right now. How are the talks going (“great”)? Are there concessions and commitments from the Chinese (probably)? Will the tariffs be delayed (yes)? The market feels a little nervous for sure and most indicators of liquidity are well below 2018 levels. That feels like a market wanting to go up but worried about being caught out. We're still 5% below the ding-dong highs of August but up 11% from the December lows. Again, Small Cap has outperformed by even more and Emerging Markets are up 8%.

For the record, we’d like to see a consolidation. But as we've learned along the way, “rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”

There are lots of problems with government shutdowns. One is that the IRS missed 16 days of tax refunds. So far this year, there has been $21bn of tax refunds compared to $29bn at the same time last year. It may continue. The IRS thinks only 10% of taxpayers itemized in 2018 compared to 30% in 2017. It seems fewer people over-withheld so the normal March-April boost in retail sales may not happen (h/t Cap Eco).

 1.     The war on buybacks. It’s a tough life being a S&P 500 CEO.  You know, you go along for years doing things that shareholders like. You announce a share buyback and everyone claps and say’s “Yay, this guy read his Jensen and is returning cash to us in a tax efficient and orderly way”. Actually, they probably stop at “Yay” but you get the picture. And for a while, all was good in the land of investors. Heck, they even built ETFs around it: IPKW and SPYB but please don't buy. But of course, buybacks lost favor, both ETFs went pear shaped and underperformed the S&P 500 by very big amounts.

We're often rude about buybacks because one big problem is “are they buying back stock because they really can't find anything else to invest in or is it just to increase earnings per share without increasing earnings?” By the time you find out, it’s too late. IBM, Foot Locker, Yahoo, Halliburton and many others made very large buybacks and never saw much change in their share price.

This is how they work. The company below, Tweeyelp, makes $50m a year and has 100m shares in issue. It decides to buy some shares. It buys 10m shares for $100m. Now there are fewer shares (90m) with the same earnings. All things being equal (they never are but stick with us), the price is now 11% higher. Yep, that's all it is.

Anyway, people don't like them as much anymore. The 2018 tax cut aimed to increase capex, wages and employment (any day now) but a lot went to share buybacks instead. No surprise really, the same happened with the 2003 Bush tax cuts when buybacks more than doubled in the next two years.

There is a small but growing “buybacks are bad” crowd and it just recruited a new member on Wednesday.

Marco_Rubio___marcorubio____Twitter.jpg

Stocks reacted immediately.

That move was worth about $101bn. Which tells us two things. My, this market is nervous. A small thing like that was enough to upset investors. Two, expect more talk about corporate governance and some rollback on the corporate tax front. It may not happen soon but I suspect there’s more bipartisan agreement than meets the eye. And if this all keeps bad buybacks at bay (there’s a bumper sticker there), then…good.

2.     Is the big increase in the deficit going to be a problem for Treasuries? No. Sure there are some very serious people who think that all debt is bad. Last week the total amount of U.S. public debt reached $22 trillion (here's the debt clock and here’s the Treasury’s more sober view). For those who worry about these things, this was a bad number as it now exceeds U.S. GNP. You would think that if the U.S. keeps running deficits and issuing more Treasuries, that investors would demand ever-higher rates.

You would think but it ain’t necessarily so. In Japan, public debt is 220% and has doubled in the last 20 years. But the yield on the Japanese Government 10-Year bond has fallen from 2% to 0% and it hasn't moved for three years. The debt in the green line and the 10-Year bond in blue.

Now there’s a vigorous debate about all this. On one hand, there’s the “we owe it to ourselves don't worry” school and MMT has found some fans in Congress. On the other, there’s the belief that high government borrowing crowds out other investments and threatens basic freedoms.  

Without getting into the theory, here’s why we like Treasuries right now even though supply is growing:

  1. Compared to other major high credit sovereign borrowers, the U.S. provides a very attractive rate of interest. The 10-Year Treasury is now 2.7% compared to Germany at 0.1%, Switzerland at -0.3% and Japan at 0%.

  2. The Treasury is very good at managing auctions and has come up with a number of innovative ways to sell debt. These include inflation protected and Floating Rate bonds and Cash Management Bonds. There is talk of a 20-year bond (there’s only 10 and 30 year bonds at the long end), zero coupons and bonds indexed to health care or college inflation.

  3. The ratio of public debt to GDP is overstated. The headline number is 104% but really, it’s 74% because Social Security and various government pension funds hold about $6 trillion of the debt (Schedule D on the attached if you're interested). Nearly every commentator omits this point.

  4. Inflation is low. If a risk free bond yields more than inflation, we’re off to a good start.

  5. Demand for risk-free securities remains high. If you’re a bank, insurance company or pension fund, a guaranteed, liquid non-callable investment looks pretty good. Especially with new capital ratios.

  6. Non-financial corporate debt rose to 46% of GDP last year up from 40%. There’s no sign that they're being crowded out.

We could go on. But for now, the easing off of the economy, a patient Fed, tame inflation and low global growth all make Treasuries a very attractive investment. And we’ll argue all day against the debt doomsayers.

Bottom Line Earnings are coming in well. Up around 13% so far. Fewer companies issue guidance these days (a good thing) but those that have tended to guide lower. That’s to be expected. Valuations are fine. We've set the portfolios up for downside.

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How to wreck a pension plan

 --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.

Daniel Hart - Theme

Markets ignore the Whatabouts.

The Days Ahead: Inflation and flash Europe GDP. Government shutdown on Friday?

One-Minute Summary:  One week after the Fed’s “patient” speech and we’re in very quiet markets. Stocks moved within a 0.1% range or about one tenth of what they’d done in the first few weeks of January. The stuff that lingers in the background hasn't changed. An upcoming border/budget dispute, government shutdown, a March 1st deadline on the trade talks, Brexit, slowdown in Europe.

But, as we said last week, the Fed is on hold. For what? Housing, industrials, the ISMs, trade, consumer, GDP. Most of that group has yet to catch up from the government closure so we’re probably not looking at any change for some months. We're encouraged that even Janet Yellen doesn't know where rates are headed.

Meanwhile earnings are positive with good news from retail stocks like Estee Lauder and Ralph Lauren and large companies like Boeing, Apple and Exxon. It seems like 2017 all over again with the S&P 500 up 7%, Small Company up 11%, international and Emerging Markets up 7% and even the Dow Jones Transportation index up 12%. That's the one with highly cyclical stocks like railroads, trucking, barges, airlines and FedEx/UPS giants. If they’re doing well, the rest of the economy may be slow but it’s not anywhere near recession.

 1.     Are we winning the trade war? Well not if you use the trade balance as a guide. So, if you're buying stuff from the U.S. and your government says “right, everything you buy from them will cost you 25% more” or if you're importing stuff from China and your government says, “right everything you buy from them will cost you 25% more”, then you're really going to question how much you want that stuff.

And that’s what’s happened to the goods trade balance in the last 12 months. Food exports from the U.S. fell from $14bn a month to $10bn. Soybeans have undeservedly become a major news item in the last few years. The U.S. used to sell around $3bn a month, with a peak of $4.3bn in 2012. Now it’s $875m. The U.S. used to sell $14bn of autos overseas. That’s now $12.2bn. The overall trade deficit in autos is now $19.7bn, up from $16.3bn.

Trade with China is down. Exports to China fell 32% from a year ago. The bilateral trade deficit will probably come in at around $416bn compared to $375bn in 2017.

It would seem that the current strategy is not working except to push the world to the brink of recession judging by a range of business surveys  (h/t John Kemp). The most important date on the calendar is March 2nd when the U.S. tariffs on $200bn or Chinese goods takes place. We think there will be a deal of some sorts. But we doubt it will solve the thorny issues of IP, tech transfer and services.

The overall November figures were slightly better than previous months but imports were down sharply, reflecting weaker U.S. demand. There is lots of noise in the monthly numbers so nothing definite yet. But we believe trade will drag on growth in Q1 2019. For now, these numbers confirm our decision to lighten exposure to overseas risk assets.

2.     How bad is it? It’s not. It’s tempting in this business to exercise caution. After all, bad news reads well and it’s easier to sound smarter when forecasting recessions, corrections and imminent price drops. But bears don't make money. There are ETFs for those bold enough to call market tops. One that’s been around for a while is the ProShares Short S&P 500 ETF which was launched in 2006 at $138, had a brief time in the sun peaking at $190 in late 2009 and now trades at $30. The press calls but our line of “yes, the news is terrible but investors should stick to their plan and ride this through” is met with an uninterested thank you.

There’s always data to support a recession but it’s usually wrong. One that's in the news recently is the inverted yield curve. This simply measures whether long-term bonds yield less than short-term bonds. Normally any investor is going to demand a higher rate for long term loans. “Lend me money for one year at 3% for one year” seems reasonable. “Lend me money for 10 years at 2%” less so. Because, you know, you might default, lose the piece of paper or just decide not to repay. So, when you get a chart like this, there’s a lot of harrumphing:

This is the 10-Year Treasury yield less the 3-month Treasury yield. One is at 2.7%, the other at 2.5% (bottom) for a difference of 0.2% (the 19.95bps line). Commentators show it with a 10 or 20-year chart and say something like “an inverted yield curve has predicted the last three recessions.”

Well yes, but it didn’t predict the ones in 1953 or 1988 and gave off plenty of false signals in 1959, 1960s, 1979, 1988 and 1994 to 1998. And so on. It may be better than a coin flip, we don't know. But we do know that if you acted on it and came out of the stock market every time it dipped towards zero, you missed some very hefty gains.

So what does it mean this time? Well, we like the Occam Razor principle. Don't make this complicated. It just means that short-term bonds look attractive and will probably remain so if the Fed pauses and the economy ticks along at 2%.

Bottom Line There is nothing wrong with a little market consolidation. You know, take a breather knowing that the Fed is on hold. Analysts have cut earnings estimates by around 4% for 2019 but the market seems fine with that. We'd make no changes having positioned for just this kind of market a few months ago.

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British national bird in China

 --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.

Catch a boat to England…maybe to Spain

The Fed calls the Shots

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The Days Ahead: Economic data back on line, but may not be reliable for a few months.  

One-Minute Summary: January was a good month. Stocks up 8%, small company stocks up 11%, international and Emerging Markets up 6% to 9% and bonds trading in a narrow and bullish range.

More data confirmed that China trade talks weigh on people’s mind. The Chicago PMI index dropped from 65 to 56 in a month. We don't usually talk about this index much but it’s Chicago and Boeing is headquartered in Chicago and Boeing sells a lot of aircraft to China…2,000 in all and 1,000 in the last five years at $350m each. So when we look at the New Orders component of the Chicago PMI and see it at a two-year low, we know how sensitive things are to the trade, er, talks.

The Fed announcement (see below) did more to drive stocks than earnings. Earnings were generally good and are up 12.4% YOY. But the hard comp numbers are coming up as 2018 had all the tax cut benefits so analysts are looking at low and perhaps negative growth for Q1 2019. We're not concerned. The market has priced in the slowdown and it mostly comes from energy and tech stocks.

We're also seeing a bounce back from bombed-out stocks. There are 38 stocks up more than 20% this year but the same stocks were down 25% in 2018. This seems a good sign as the market leadership is broader and investors are not just bidding up tech names. The best sector this year has been Energy, which peaked in 2015 and fell 38% to its December low. It’s up 13% since then.

We're in an easy money phase right now. That won't last too long because the data is going to start improving. The market overdid it on the downside in 2018. It may be overdoing it on the bounce back in 2019.

1.     Jobs: great numbers or what? What. The headline number was 304,000, way above estimates. But the December and November numbers were revised down by 70,000 and the unemployment and underemployment, or U-6, rates (the black line) ticked up. The government shutdown may well account for the jump in the U-6 rate as it reflects discouraged workers who want, but were unable to find, full-time work. Which describes a furloughed government worker quite well.

Analysts pointed out that hourly earnings growth (white line) was weak (here’s a particularly bad offender at Bloomberg). But they're still running at 3.1% and in line with the employment cost index, which counts benefits and salaries and is a much better guide to wages. Overall, this is a solid report but not building any pressures that the Fed needs to worry about.

2.     Did the Fed blink?  Yes. Last December the Fed completed the fourth rate rise for 2018. Even though the government was in shutdown. Even though parts of the economy were rolling over. Even though the China trade problem was front and center. It seemed as if the economy, the labor market and inflation were all where they wanted them. This time, they said they would “be patient [when determining] future adjustments to [rates].” It was the “patient’ part that the market liked.

So what changed their mind? In our view, it was the stock market. Since the last meeting, we saw the market correct by 8% and then rally by 15%. That put a strain on financial conditions and, along with weaker numbers, was enough for the Fed to not just stay its hand but also hint that rate increases are off the table until June.

They also removed the phrase that risks were “roughly balanced” and referenced “global and economic developments”. We'd be careful not to read too much into this, other than to say that if a trade deal was done, government stayed open and Brexit concluded, the Fed would reverse its position very quickly. But for now, we have a return to easy monetary policy.

As if to confirm the Fed remains the only game in town and can outdo China, the government or any other pretender any time it wants, stocks rallied hard and are now up 15% from the December lows. The 10-Year Treasury also rallied to 2.62%. Remember it reached a high of 3.25% last year and is almost back to where it was two years ago.

And the yield curve? Now looks very odd:

The black line is where it was a year ago. It’s steep, as one would expect with a Fed just getting to grips with tightening and tax cuts. The blue line is where it is now after four rate hikes. The front-end (up to one year) is all up but beyond five years, barely changed. This tells us two things:

  1. The place to invest is between three months and one year. You earn 10% less yield with a 3-month bill over a 10-Year Treasury, but with 96% less risk.

  2. The market expects the economy to slow and sees no inflation risk.

 And that’s why we’re still using the Treasury Floaters and the 7-10 year Treasury bonds.

3.     More Aristocrats.  There are 53 companies in the S&P 500 Dividend Aristocrats index. That’s all the companies that have increased dividends every year for 25 years. S&P just added four more that made the cut: Chubb, People’s United Bank, Caterpillar and United Technologies. This is how the four of them have done since 1994:

It’s a remarkable record. If you bought one stock of each back in 1994, they would have cost $412 and you would have received a $2.12 dividend. They're now worth $5,191 and paying out $41.45 in dividends. And would have outperformed the S&P 500 by around 140%.

Now, we like dividends.  When a company pays a dividend, it’s real cash. There’s an old stock market saying that “dividends are like getting married, share buybacks are like dating”. One is a hard commitment and the other more like “ Yeah, I might when I get around to it”. Share buybacks have three problems:

  1. Management buys stock at market tops

  2. What they announce (wow, great) is more that what they actually do

  3. It’s nearly all tied to management compensation (so some moral hazard, no?)

The Dividend Aristocrats contain few pure growth stocks and almost no tech. They're not all perfect. Franklin Resources, the parent company of Franklin Templeton funds, peaked four years ago and is down 38%. They also tend to be large cap and underperform the wider market in a broad rally. But over time, they've outperformed the S&P 500 by around 2% and we would expect these latest additions to continue the trend.

Bottom Line. Solid earnings but tough if you have any meaningful exposure to China. The Fed changed everything last week. They’ll probably regret sounding quite so accommodative especially if there’s a fix on trade or shutdowns. We'd exercise some caution coming into February. The market is up as much in a month as we expected for the year.

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World’s loneliest duck

UCLA students and Uber

 --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.

Don’t think twice

Another shutdown over…maybe.

The Days Ahead: Jobs numbers and Fed meeting

One-Minute Summary: At the time of writing, equities were in a good mood. Seven out of the last 10 trading days were up and the S&P 500 is up 6.3% this year. That's roughly back to early November levels and up 12% from the miserable December days. Small Cap is up even more…up 15% from the lows.

The White House announced the end of the government shutdown but it was conditional and we could end up with the same problem two weeks from now. In the last nine shutdowns going back to the 1970s, stocks haven’t reacted much. You can barely find them on a graph of the S&P 500. This time stocks have risen around 9% so we’re not expecting a big rally.

We thought markets had over-reacted to recession fears last year. What we’re seeing now is the market retracing some of its losses and preparing for a slow down, a neutral Fed and low rates. It's not a signal that we’re all back to happy 2017 and early 2018 days but more of a measured response to an orderly slow down. There’s no good news from Europe and China and that places the U.S. in front for growth and upside.

Earnings season is going well. They're up 11% for the 100 or so S&P 500 companies that have reported. They might be guiding lower but markets expected that. Last year’s tax cuts were meant to lead to a capex boom, more domestic investment, wage increases and more jobs. That was nonsense. But it led to very large stock buybacks. They won't be around in 2019 but markets expect as much.

U.S. Treasuries have had a good three months with the 10-Year Treasury falling from 3.25% to 2.75%. That's about a 6% return excluding the coupon.

 The three big things on our mind are:

  1. Government: new rapprochement or ongoing divisiveness (not really a question) and a China deal

  2. Fed: on hold for three months, six months or more?

  3. Economy: how much of a slow down?

We think these are all manageable. So we continue to like Treasuries, the U.S. and some protection on risk assets.

1.     How’s’ Europe doing?  Not so good. European stocks had a very strong 2017 but a torrid 2018. The U.K. dominates European stock markets. It’s nearly one third of the all-European index. Germany, Switzerland, France and The Netherlands make up another half. We tend to invest in the Eurozone-only stocks, which excludes the U.K. (handy while Brexit drags on), the Nordic counties and Switzerland. The case for Europe some 12 months ago was:

·       Pickup in activity and global growth

·       Ongoing easy monetary policy from ECB

·       Politics calmed and labor market reforms

·       Relatively cheaper stock markets

·       Brexit would work

Fast forward and we had 1) Italian elections and a huge row with the EU over the budget deficit 2) the “gilets jaunes” or Yellow Vest protests in France which took aim at just about every reform President Macron had in mind 3) trade tensions with the U.S., especially autos at 20% of the index, and 4) banks, another 20% of the index, which struggled with low rates and bad loans.

The ECB announced this week that the outlook had weakened and would keep rates low. But rates are already 0% and the central bank charges negative rates on its deposit accounts. It has stopped buying bonds through the QE program mainly because there are fewer bonds to buy.  So what next? They'll keep reinvesting coupons on the bonds they own and keep the guidance low. They can use the TLTROs, which are incentives for banks to lend.  And they can switch QE back on gain. So, they have plenty of options.

 Meanwhile, we've also seen some slow pickup in inflation and wages:

That lower green line is a sign that wages are increasing and could feed into more consumer growth. We also like the relative value of European stocks. They yield nearly twice as much and trade at a 25% discount to U.S. stocks. According to one respected street analyst, the share count of European stocks was negative late last year. That's a good sign as it means companies are buying back shares and not issuing new equity finance.

We’re somewhat cautious on Europe. Its ties to the U.S. and China are strong so it’s getting caught in a very uncomfortable middle. We're looking at some protection strategies. Watch this space.

2.     Long View on the bond market. There are two important themes in the bond market, which we think investors should know.

 Treasuries. We know that 2017’s tax cuts increased the deficit and that the Fed is drawing down its balance sheet. So that's two important sources of Treasury supply. Right now, U.S. Treasuries are about 40% of the broad bond market indexes. It’s going to rise to around 50%, according to one very respected strategist. More and more bond assets are in ETFs. Those ETFs match an index and must buy Treasuries. They will be a steady source of demand. They have no choice, unless the index compilers re-write the rules.

It’s a weird inversion of normal supply and demand rules. There are other reasons we like Treasuries (low inflation, Fed on hold, relative yield, safe haven etc.) but this index thing is a real force and we wouldn't underestimate its impact.

BBB Bonds. BBB bonds are one notch above junk. They've also grown to be a very large part of the bond market. They were 35% a few years ago and they're now closer to 50%. There are worries that in a recession, many borrowers will be downgraded and tip into junk status. So what, you may ask? I liked it at as a BBB and I like it at BB. But many investors, including our friends the index providers, cannot buy or hold junk bonds. So, yes this is genuine concern. A bunch of bonds that were considered good credit but slip into bad credit means a lot of forced sellers. Which, you know, is usually not good.

But, many of these BBB borrowers are banks with better capital than they ever had. Citibank, Barclays and JP Morgan alone account for 21% of that growth from 35% to 50%.  Another 50% comes from four companies: GM, Ford, AT&T and Verizon. These may not be the greatest companies around but it tells us that “the whole bond market is about to implode” story is very over done. It's not a system wide problem. It's about five companies that have plenty of financial clout.

So, we’re not worrying about non-junk credit and you shouldn't either (h/t Columbia Threadneedle).

3.     Are flash crashes still a thing? Yes. These are unexplained sudden and very large price movements. There are post-hoc diagnostics, which never make much sense other than “stuff happens”. Last week, Jardine Matheson, one of the largest companies on the Singapore stock exchange had an 80% pre-opening drop.

 

It’s a bit difficult to see because, well, being a flash crash, it was all over in minutes. But a mighty, blue chip stock closed the previous evening at $69 and was traded at $10 just before the open. The actual trade loss for one investor was $9m. It doesn't seem as if any ETF or mutual fund was affected and certainly no investments that we held. The Singapore authorities reviewed but did not cancel the trades.

Sure, these things are rare but if you're caught in one, you could be wiped out.

 Bottom Line. Another good week despite the dearth of economic data…mostly because the various agencies were closed. The Treasury market should stay in recent ranges of 2.7%.

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A guide to technical analysis

Your odds of dying from opioids are greater than a car crash

 --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.

How Come - Ronnie Lane  

Farewell Mr. Bogle

The Days Ahead: More earnings. Many government stats aren't available because of the shutdown.  

 One-Minute Summary: Another good week. Year to date, 459 companies in the S&P 500 are up and 50 are down. That’s an even better dispersion than a week ago. Only two companies are down more than 8% and they are Macy’s and the hapless PG&E. Neither is a surprise. Some of the biggest rises are in companies that were hit badly in the last two years and are on a bounce from record lows.

 Which reminds us of financials. They had a good week after earnings from Citibank, JP Morgan and Bank of America. The bar was very low. The market turmoil of the fourth quarter had everyone braced for bad news so when management gave more upbeat forecasts the sector rallied by 6%. Financials have had a rough time in the last 10 years. New regulation, higher capital, low interest rates and fines have taken their toll. As an investment, they peaked in 2007 and have yet to make back their highs. They’ve underperformed for the last five and one-year periods. They’re never going to be exciting investments again but at least some confidence is finally back.

 The market was driven by three things.

One, the Fed again urged patience with rate hikes. What was interesting was that the latest call for waiting came from the most hawkish member of the FOMC, Esther George from the Kansas Fed. Since 2011, she’s been on a crusade to raise rates, so this was a big turnaround.

Two, trade progress. Well sort of. You know how news comes out from the White House. Long on promise. Short on details. Anyway, it seems as if China is nearer to a deal and even committed to bring the U.S. trade surplus to zero. To do that they would have to buy all their aircraft from Boeing, all their soybeans from the U.S., double their auto purchases, use U.S. fabricated semi-conductors, move a lot of plants offshore and the U.S. would have to stop buying cell phones. Could happen.

Three, a very benign bond market with 10-Year Treasuries around their lows for the last 12 months.

It’s one of those markets shrugging off bad news and jumping all over good news. The reverse of three months ago. But the basic themes are stocks holding up, earnings OK and an easier Fed.

1.     Oh, no they didn't.  Yes. Surprisingly, the White House underestimated the economic impact of the government shutdown. No problem calculating 800,000 furloughed workers. That works out at 0.01% of GDP for a two-week shutdown. But we’re at a month now and they forgot to calculate the 4m or so Federal contractors who, while not government employees, are out of work. Here’s the top White House economic advisor saying workers are actually better off because they're not working. Now, I don't know from under what stone crawls the idea that not working improves people’s economic well-being, but suffice to say, no, Kevin, it doesn't work like that.

So what’s the real number? Tricky but here are some things we know:

  1. The 2013 shutdown was 13 days and it cut GDP by 0.3%

  2. Federal government employee compensation, for around 2.8m workers, is around 2.1% of GDP. That’s $420bn.

  3. Around 380,000 of the 800,000 are furloughed without pay. That means they don't get paid for when they're off work. The others will have pay reinstated for the time off.

  4. So about 20% of all workers are without pay, which they'll never get back, which is about $76bn. Another 20% will be paid when it all ends.

  5. Put all that together and we’re looking at a 0.9% decline to GDP

  6. Add in private contractors, government purchases and a multiplier effect and we’re at -1.1%

All those numbers are reductions from trend growth, so that means 1.1% less than what would otherwise have been a 2.5% quarter.

So, what about the actual level of growth?

We know that Q1 GDP has displayed some weird seasonalities since the crisis. For 8 of the last 10 years, Q1 was the weakest quarter of growth for the year, although in 2013, it was later revised up. The first estimate of Q1 GDP is not due until late April but we think we're headed for a negative number. That’s assuming the shutdown has ended because the BEA, which runs the GDP data, is, you guessed...closed. That will put the Fed very much on hold.

 2.     So, consumer confidence holding up? Er,...no. The latest report on consumer confidence took a nosedive and is at its lowest level since the election in October 2016.

The decline was due to…well the University of Michigan said it best, so we’ll hand over to them:

“…to a host of issues including the partial government shutdown, the impact of tariffs, instabilities in financial markets, the global slowdown, and the lack of clarity about monetary policies”

Now, the reason the stock market hasn't freaked out is because:

  1. Sentiment and spending are not the same

  2. The market corrected a lot in 2018 and, as we said at the time, it was probably overdone

  3. Inflation expectations remain low, so the Fed is likely to stay its hand.

Of course, that may all change but for now it’s steady as we go and avert your eyes from the government and political train wreck.

3.     Jack Bogle. Died. The pioneer of index funds. There are plenty of good obituaries, here, here, and here.  The story is well-known by now. How he took a simple concept, just buy all the stocks in the S&P 500 weighted by their size, hold on and don't pay high management fees. Initially it was all a failure. The original S&P 500 fund from 1976 only raised $11m. Today it's $420bn. Back then the average fee for a managed fund was around 1.2% and you had to pay 5% upfront to buy it. So, a $100,000 investment would cost you around $26,000 over 10 years. With Vanguard it now costs $740.

No other person has done as much for personal investing as Mr. Bogle.

Bottom Line. It’s been a great start to the year. But so was 2018, so no counting yet. The S&P 500 is back to October levels so anyone who went to cash back then has missed a 14% bounce.  Small company stocks have done even better and international and Emerging Markets have kept pace with the S&P 500 over the last few weeks. The Treasury market has held up well. And will remain so. The Fed has no real data to work with and so will stay on the sidelines.

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Federal Reserve: student debt hurts housing market

--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 forever now. The Passengers.

 

Stocks up and Government Closed

The Days Ahead: Europe industrial production and U.S. housing. Earnings start.

 One-Minute Summary: A better week. Year to date, 442 companies in the S&P 500 are up and 63 are down (confusingly, the S&P 500 has more than 500 companies). It’s early days, of course, but the S&P 500 is up 3.6% this year and there’s only been one trading day where the market didn't close higher than its start. If you think that over the last month, we've had the longest government shutdown, the threat of a national emergency, the President threatening the Fed chair, tough trade talk with China and more tariffs on EU products, then the market seems a lot more robust than the gloom of late last year.

The government shutdown will start to affect economic numbers soon.

  1. The January unemployment data, for publication on February 4th, was collected last week. In the last shutdown in 2013 and 1996, claims rocketed up as government employees became eligible for unemployment insurance.

  2. Some economic data is no longer available. It started with the Census Bureau and the trade report last week and looks to continue with the BEA and GDP estimates. It means we’re all flying a bit blind.

  3. The GDP forecast for Q1 2019 is for 2.1% compared to an estimated growth of 2.8% for Q4 2018. One respected analyst thinks that every two weeks of the shutdown reduces GDP by 0.1%. That’s $20bn which seems about right.

So it was good news to read the Fed minutes last week and see it confirmed that they intend to remain patient and watch the data. That takes the odds of an early Fed cut pretty much off the table for March and probably June as well. A lot hangs on whether there will be a trade deal. And the answer very probably, is yes. We know that both sides have an incentive to close a deal. Both economies are hurting and the U.S. deficit is widening the longer this goes on. We have no idea if this will be a token deal (as in the Canada and Mexico deal) or something substantive that addresses thorny issues like intellectual property and market access. But we think something will break to the upside.

1.     Nothing happening with inflation.  We have to remind ourselves that inflation is the other Fed mandate (along with employment) and while the Fed looks at core PCE inflation, the familiar CPI is also important. It drives things like TIPS bonds, social security, pension benefits and some wages. It’s all been a bit of a yawn lately:

The headline number came in at 1.95%, primarily because gas and other energy prices fell by nearly 10% in December. Rent and home ownership costs are running at 3.2%. That’s an especially important line item because at 24%, it’s by far the largest index component. For the next few months, we’re unlikely to see core inflation much above 2.3% (h/t Pantheon Economics) partly because the base effects from a year ago start from a high level. Real wages were up 1.2%, which is not enough to tip the Fed’s hand.

So, all in all, as forecast and not a market mover. Given all the other stuff that's moving markets these days, that’s one less thing.

 2.     Should I stay or should I go? We've been saying for years that wage inflation is barely a factor in the economy. Despite lower labor force participation, employee wage gains seem stuck around 2%, about in line with inflation. There are times when it runs higher, especially in deflation periods which give the illusion of real wage gains, and in tight labor markets. But tight labor markets are difficult to define. In the 1980s, the Fed thought any unemployment rate below 6% was inflationary. In the 1990s that fell to 5.5%. It's currently 4.5%. But we’re still not seeing much wage inflation.

Yet the labor market is healthy and that’s a good thing. More people are quitting their job than at any time since the 1990s. That’s tough if you're an employer but people don't quit unless they feel they can land another job, so it’s a straightforward confidence indicator. Moving employer also generally means higher wages. So for years, job switchers saw higher wage growth than job stayers. Standard career advice to those wanting a pay increase was “change job”. There were other downsides but we’ll keep those for another day. Here’s the difference between the two:

The blue line is the switcher, running consistently above the stayer. But now job stayers’ wages are increasing at their highest rate since 2007. For years, employers kept staff with better work conditions, vacation, benefits, awards, and training. Anything but actually pay more. That seems to be changing and it should be good for confidence. More here.

Bottom Line. There is a lot of bad news priced into markets. The economy is not nearly as weak as the stock market suggests. It’s growing at a slower rate but that is not the same as no growth. It won't take much to reverse sentiment.

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Please start smoking again

 --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.

Teddy Afro - Anbessa 

Meet the New Year, Same as the Old Year

The Days Ahead: More Fed speakers should echo Powell’s comments. Inflation numbers out.

One-Minute Summary: We're always suspicious of market moves over prolonged holidays. Many traders and investors are away and some markets, like Japan, were only open for three days in nearly two weeks of business.  Europe checks out for nearly 10 days. So “small news makes big impact” or “worst day since last one” are headlines you see a lot. This is what we think is going on:

  1. Economy weaker but not stopped and not near recession.

  2. The inverted yield curve story is overdone but that doesn't stop people talking about it.

  3. Volatility is normal. But if you haven’t seen it in a while it feels awkward.

  4. The government shutdown, impasse and partisanship should not be a major problem.

  5. 2018 was a bad year for multi-asset investors. The only markets not in correction or bear territory are Brazil and India.

  6. Earnings and dividends are both likely to continue to grow 10%. There are no major profit warnings.

  7. U.S. Treasuries have done well but they may be too pessimistic about a recession.

  8. Trade and China are the very big elephants in the room. And will remain so.

1.     The Fed moved the markets again. The last time was in December when the market fell 12% peak to trough. Many thought the weaker signs in the economy, such as trade, industrials, government shutdowns and the general tightening of financial markets, should have meant the Fed passed on its fourth hike of the year. We didn't. It’s not the Fed’s job to bail out the stock market and there were no signs of credit stress.

 But Chairman Powell came through on Friday when he announced that the Fed intends to be patient when coming to further increases and will respond as needed. That was the equivalent of throwing a massive bone to a very hungry market. It means they're going to take into account things like China trade deals, profit warnings, the global economy and any housing softness.

 We're somewhat nervous that one announcement can make such a difference. But markets are feeding off headline risk right now. They were down 7% in the days before Christmas on nothing more than a few throwaway headlines and they're now up 3.5% on not much more than soothing noises. But that’s the way markets play out at this end of the cycle.

 Meanwhile, government bonds have been on a tear and are due for a correction. They’re clearly anticipating a recession but they may have overdone it. That move down in the chart is equivalent to a 5% price gain on a 10-Year Treasury.

2.     How were the jobs numbers?  Great. No, really great. After a disappointing December, the market was all about a slowing economy and employment growth. There was plenty of news to support the view: trade, slower industrial production, and some weaker Fed surveys. But the 315,000 new jobs announced Friday were the best since the launch of the tax cuts last February and the third best in the last five years. Here’s the chart:

By now, you’ll know that we take a rather jaundiced view of the labor market. Sure, the numbers are there but things like labor participation, the underemployed rate (the black line) and part-time work are all not what we would expect. Yes, the nature of the labor force has changed: lower participation by women, marginalized workers and demographics but we'd cork the champagne before declaring it the best jobs market ever. Some points worth looking at:

  1. The labor force grew by 419,000. That’s more than the growth in the population.

  2. The number of employed rose by 142,000 while the number unemployed rose 276,000. We'd suggest that’s a good sign that more people are coming back into the work force.

  3. Average hourly earnings rose by 3.1%. This may be distorted. People out of work in prior months because of hurricanes and California fires will have reentered. Their wages thus came back on stream and changed the underlying trend.

  4. Average weekly hours didn't change.

  5. There was a net loss of jobs for those with a college education and they’re 57% of the workforce and 67% of the over 25-year-old workforce.

This all puts the Fed in a bit of a quandary. They recognize the stressed financial conditions of the last two months and see weaker growth numbers. But they also watch wages very closely. There’s a very clear link between the Fed Funds rate and wage growth (h/t Pantheon):

The Fed won't move for now. But if the wages keep growing, then they’ll probably hike in June.

3.     How important was the announcement by Apple? Not very. The fourth quarter is a big quarter for Apple. They typically realize one third of their annual revenue between September and December. They revised sales down by 8% and margins to 38%, which is exactly what they've been for five years. The problem with Apple in the short term is China, which is 18% of sales, and the iPhone price point and saturation. Even after the price drop, Apple sells at a 20% discount to the market and 50% discount to Microsoft. As in the past, if it falls below 10x, it seems like a very good buy.

 

 Bottom Line. Trade related headlines will keep traders on their toes. We feel confident with the Fed’s obvious patience with the data and willingness to listen to the markets. Any breakthrough on trade will push the market higher very quickly.

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Top apps of 2018

Short selling explained

--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.

One of these things first - Nick Drake

Crikey, what did the Fed say to move the markets?

The Days Ahead: The last of the year’s economic data. Not a week to trade.

One-Minute Summary: Yes, that was nasty. All the fears of the year came through last week. The Fed said it saw slower growth and was not as dovish as people would have liked. No light on the political issues. So that's Brexit, Italy, government shut down, resignations and trade all lurking in the background. A disappointing core inflation report. Lower business activity in some Fed regions.

Yet the market is not on a “fear trade”. For that we would have to see a rush into gold, the Yen, Treasuries and a big spike in the VIX. What’s happening is a correction to a slower growth, normalized rate environment. There is nothing particularly wrong with the U.S. economy. All this would hardly deserve the market pessimism we’re seeing. But if we add the trade and China tensions, then market nerves make more sense.

We'd go further. If we see a trade deal with China, which is almost certainly likely even if the details won't be as impressive as the headlines, and some wage growth, we’ll see a snap back in the market and the economy.

1.     Crikey, what did the Fed say to move the markets? Pretty much what everyone thought a month ago.

Look, the Fed was always going to raise Fed Funds in December. They had four planned for the year and it was going to take serious deflation or deterioration in financial conditions to stop them. A 10% correction in stocks simply did not count. And a good thing too. It’s time the Fed stopped underwriting stocks every time they have a perfectly normal correction. The President’s advice merely hardened their resolve. What Fed Chair want’s to go down doing the bidding of a mercurial economist-in-chief?

The Fed changed two items in the announcement.

First, that the Committee “judges that some” further increases will happen. Last time it was that the Committee “expects further” increases.

Second, they added that they would monitor economic developments…which means nothing more than “look, we know markets have sucked and we’ll keep an eye on it, but we don't need to do anything yet”. 

All fine and pretty innocuous. But then came their economic projections in the famous dot plots. Here they are in December and three months ago:

I know it’s tough to read but the bottom line is that 1) they lowered growth and inflation expectations and 2) they expect two increases in 2018, not three. The Fed said what everyone knew but didn’t want confirmed: the economy is slowing. The bond market’s reaction was entirely logical. Short term rates up, long term rates down. The 10-Year Treasury is now at 2.78%, up 3% over the last month and the yield curve is at its lowest for the cycle.

Stocks wanted a bail out and didn't get one so promptly sold off 2%. It didn't stop there. By week’s end, the S&P 500 was down 7%. But there was a lot of other bad vibes in the air of which we would list as:

  1. Turmoil in the White House

  2. No end to trade tension

  3. Prospect of a government shutdown and

  4. Some stock specific hits at Johnson and Johnson, Xerox and FedEx, the biggest stock in the Dow Jones Transportation index.

All the Fed did was provide the timing.

2.     FedEx on trade: For those interested, here’s the full quote from Fred Smith CEO and founder of FedEx. He should know a thing about trade, politics and its effect on business.

“And I'll just conclude by saying most of the issues that we're dealing with today are induced by bad political choices, making a bad decision about a new tax, creating tremendously difficult situation with Brexit, the immigration crisis in Germany, the mercantilism and state-owned enterprise initiatives in China, the tariffs at the United States put in unilaterally. So you just go down the list and they are all things that have created macroeconomic slowdowns.”

3.     It feels like a bear market. Is it? No. But it sure feels like it.  We asked this question last week but we’re down again. Not to pile it on, but the S&P 500 is down 8.5% this year. That's a weighted average, of course. The average share was down 9% and the median share was down 10%. But this was a year of the market coming in strong, a fall, a slow recovery to peak and two legs down, one in October and one in December. So the drop in the S&P 500 from the all-time high is -15% but the average stock (i.e. not cap weighted) is down 26% from it’s 52-week high. There are only four companies within 3% of their all time high and 65% of the stocks in the S&P 500 are in their own bear market i.e. down more than 20%. No stock is at it’s all time high.

This is not quite a capitulation. We'd need a wider, deeper and longer fall for that to happen. But it does mean some bargains are beginning to appear.  As we've mentioned before, there is no single way to gauge the over or under valuation of the market. If there were, we'd all be following it. But one we like is the earnings yield. This flips the traditional PE (price earnings) measure and tells you how much a company earns, expressed as a yield. It’s not the same as a dividend because a company does not pay out 100% of their earnings. Then you take that number and compare it in real terms. Here’s the chart:

It’s the yellow and black lines we’re interested in. Both have moved sharply upwards, showing the market is around 30% cheaper than a year ago in nominal terms and 40% cheaper in real terms. More, the earnings yield is at its cheapest in nearly 6 years and in real terms in two years.

This doesn't mean jump in with both feet. But there is no way companies will report 30% lower earnings in 2019. In fact it's more like a growth of 8%. For now the market is living on fear and stocks are getting cheaper. That feels uncomfortable but may be a very good set up for 2019.

4.     Is Brexit any better? No.

Bottom Line. Stocks will finish the year at about the 25th percentile of historical performance. That means a 2018 happens 25% of the time. For volatility it's at a 66th percentile, meaning it’s above median but not alarmingly so. As we've said before, 2018 feels bad because 2017 was so good. We had a year of low volatility and high returns followed by somewhat higher volatility and flat returns (source AQR) . Our guess is that in a few years, we’ll barely remember this year. Treasuries did fine. Here’s to a better 2019.

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A drone shuts down a very large airport

Movie remakes

 --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.

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