Yep, More of the Same, Which is Terrific

“Whatever has the nature of arising, has the nature of ceasing.” – The Buddha

One key concept of Buddhism is “impermanence.” That which changes cannot be real, and so we shouldn’t concern ourselves with what is not real…right?

Given the stock market’s impermanent nature, which is bound to cease at some point (as resilient as it has been), should we still concern ourselves with its potential next move?

I hope so, because I don’t have much else to offer in this newsletter other than offering a forward-looking analysis to global equity markets. I hope you feel the same, will continue to read, and share with others, because otherwise, this has been a disastrous marketing effort.

Let me start with giving myself a pat on the shoulder, as I wrote this in April and it proved to be correct:

“…I will address these concerns, and conclude that the stock market still has room to grow, pullbacks are likely and they should be used as buying opportunities.”

Repeating one’s self is rarely a value-added proposition, but what’s a man to do when you’re exactly at the same spot: pull backs are likely as we enter the seasonally weak period of September- October, and given that long-term trends are intact, these pull backs should be used as buying opportunities.

Why? (Glad to see you’re still here. Buddha would be proud, if pride was an acceptable trait, that is.)

Following on the theme of gracefully repeating myself, I can’t tell you how many newsletters I have written about the infamous “Wall of Worry”. Everybody is worried about a recession, a market crash, a nuclear war, natural disaster…and more.

A few weeks after the 2016 presidential elections, I joined an investor round table at City National Bank in San Francisco; 7 out of 10 investors were bragging about going to cash with the anticipation of a correction. Since election day Tuesday, November 2016, the S&P 500 index market price went up 13%. (No, I wasn’t a part of that seven, and yes, I am proud, as I’m pretty far from being enlightened.)

The question isn’t, what potential problems are out there, which are almost always plenty. The question is, what current regime’s market drivers are out there and what do they tell us about the foreseeable future?

Current Market Drivers

Different market conditions create different winners and losers. My job as an investment strategist is to identify current drivers, track them closely, put them up against historical precedence and come up with a strategy that has a higher probability of being correct than otherwise.

The US dollar has been getting weaker against major currencies, especially the Euro. This favors large companies as they derive some (or the majority) of their income from exports. A weak dollar makes their products relatively more affordable and attractive to potential buyers.

Conversely, it hurts smaller companies because as input prices go up you get less for your dollar and small companies usually have less export exposure.

So, one would expect to see large companies do better in this environment, and that’s exactly what has been happening.

A dollar that is too strong makes US goods too expensive. This is especially true during a time when the US Fed is raising interest rates, strengthening the dollar. A little bit of weakness is welcome news. Of course, there is a line in the sand not to be crossed when it comes to this downside. Looking at macro indicators, the US dollar will most likely continue to deal with a strengthening problem, as opposed to crossing the line of getting too weak, in the short to midterm.

Rising interest rates hurt stocks, or do they? Like the case of the value of dollar, there are lines not to be crossed and within those lines, we can play happily in the sand box. The current slow pace and level of rate increase is far from damaging to the US equity markets. In fact, the positive correlation of bond yields and stock prices come in to play, and the market sees this as a byproduct of strengthening economic conditions. Until when? We’re probably a year or two away from a red zone.

At 4.3%, the current unemployment rate is probably at, or very close to its trough. Unlike the earlier years of this nine-year-old recovery, wages are improving. This may create inflation, and that’s bad for stocks. (We should all get used to a simple way of conveying our message with words like good, bad, disaster, terrific and fantastic. That’s about it. Five is plenty, plenty good, and very terrific.)

That being said, just as the unemployment trend is at a low point, so is the productivity. This implies, with increasing capital expenditures (Capex), companies can invest in their productivity gains and control their costs. This creates a headwind for the inflation rate, which is good, almost terrific.

Trump’s administration has disappointed markets with its lack of commitment to tax cuts and deregulations. So far, beyond some crazy tweets, a disasterous hair style and not so terrific rhetoric, if judged by actions, the executive branch hasn’t done anything a traditional Republican wouldn’t. Markets expected more than that, hence the surprising (or not) Trump Trade. But this disappointment has been somewhat baked in the cake. The excitement has faded, but albeit late, the possibility of corporate tax cuts and lower regulations, a party punch bowl for the markets, has formed a sidesway trend.

Valuations are stretched. Yes, but when was the last time US equities offered good value? The fact is, valuations don’t have a reliable record when it comes to market timing. Eventually, when the correction does happen, someone will say “I told you so.” This has been said for quite some time. Relative valuations however, especially in relation to bonds, still make a compelling argument in favor of stocks.

Global recovery/growth favorable. Markets that count, Emerging Markets in general, China, the Eurozone and Japan, have all been signaling for a path of growth and/or recovery. Speaking of valuations, on a global scale, equities are not overpriced, especially in the Eurozone, China and Japan. In fact, some good value can be found in those markets. Now of course, there are reasons why investors flock to the US markets, but a Blackrock research of the next 5-year equity returns shows the best results will come from the Emerging Markets and Europe.

US consumer and business confidence is high. In fact, Bloomberg Consumer Confidence Index reached a peak level since 2001. There are good reasons for this; low commodity prices, rising wages, overall stable economic conditions, low rates and improving net worth. Thanks to rising asset prices, the US household net worth has reached an all-time high of almost a whopping $95 trillion. In my career, if there is one lesson I have learned, it is to never discount US consumers’ resilience and their appetite for consumption. Under these conditions, if 70% of the US economy is driven by the consumer, the US economy has plenty of gas to push forward for another year or two.

Saving the best for last; the US and global economy is growing. Rainy days do come and they are needed, both literally and figuratively. But in general, they last a shorter time during summer months, and conversely sunny days are fewer in the winter. Similarly, pull backs and corrections tend to be controlled while the economy is in a growth mode. On August 30th it was announced that the US economy has grown 3% in the second quarter. This was expected, as the first quarter growth rate was a dismal 1.2%. Nevertheless, this is clearly favorable and in conjunction with similar results anticipated from overseas. My cautious, yet, optimistic view on the stock market remains intact. For an investment strategy, until proven otherwise, buy the dips, and start looking at international markets as well (if you haven’t already done so).

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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A Mixed Bag of More of the Same

“Thinking is difficult. That’s why most people judge.” – Carl Jung

Many observers are surprised with the current levels of US Stock Indices. There is so much talk about stretched valuations, Trump Trade being over, the potential damage of rising interest rates, trade/currency wars, political uncertainty, rising inflation and last but not the least, the aging economic growth cycle, that given all this, stock prices seem unjustified.

Looking at this wall of worry, one might conclude that “the winter is coming” and it’s time to run to the hills away from the White Walkers, short sellers and bearish bets.

In the past, I have seen how Republican leaning investors, commentators and strategists have allowed their political views to cloud their judgement, and how this led to misguided conclusions, most of which, have been proven wrong.

Unlike the popular rhetoric, the stock market rallied during Obama years, the dollar got stronger, inflation has been tamed, unemployment dropped like a rock, the economy grew and the US has become the safe house in a shady neighborhood.

The thorns of this rosy picture have been stagnant incomes, and stubbornly elevated public debt.

Learning from this experience, investors need to set aside their political views and think with facts in hand, not allowing their preconceived notions to get in the way.

I will address these concerns, and conclude that the stock market still has room to grow, pullbacks are likely and they should be used as buying opportunities.

Concern 1: Stretched Valuations

No matter how you slice and dice it, stocks are expensive. Questions to follow:

1 – How expensive?

2 – Can they go higher from here?

They are extremely expensive when you just look at absolute, traditional, isolated price to earnings ratios. If this is your only gauge, the answer to the second question is a short “no”, and they can’t get go much higher from here.

But when you look at relative factors, especially when compared to other investment vehicles like bonds, real estate, commodities and currencies, stocks still seem to provide growth potential. Roughly a third of US domestic stocks’ dividend payout rate is higher than the yield on 10 Year US Treasury.

In other words, when compared to especially low bond interest rates, stocks are only moderately expensive and the answer to the second question in hand is a “yes”, they can still go higher.

Also, from a purely investment strategy point of view, all we really care about is the asset price action and when we dive in to it, we get good and bad news.

The bad news is that high valuation is a pretty reliable indicator of investment returns in the following 10 years. The good news is that the same cannot be said about the following 3 years. So, if history is any guide, one can conclude that the investment strategy could be to ride the wave while it lasts, especially in the next 3 years but moot your expectations for the next 10 year returns.

Concern 2: Aging Economic Expansion and Bull Market

We are in the eighth year of a stock bull market and economic growth. On average, economic expansions last about 5-7 years and the longest has been 10 years (1992-2002). The stock market not only hasn’t seen a bear market since 2008, it also hasn’t seen a 10% correction for 287 market days as of 4/1/17. So justifiably, some argue we may be approaching a rest stop with a horrible vista point.

I will counter this argument and hope to offer some consolation with 3 supplemental sets of facts.

1 – First let’s get the 287 market days without a 10% pull back, out of the way. Assuming we are in a long-term bull cycle, this is well within historical averages.

2 – The US stock market hasn’t seen bear claws since 2008, but came pretty close with a 15% correction (Q2 2015 – Q1 2016). During the same period, global stock market did face the bear with many developed economies’ losses of well over 30%.

3 – If we expand the above-mentioned period to Q1 2014 – Q1 2016, we’ll see a stock market that was flat for two years (consolidation). Such periods can and do act like a bear market, especially when they last for two years.

On the topic of economic expansion, the key thing to remember is that in spite of its duration, the growth level is still well below past recoveries, and current indicators do not waive the checkered flag for the stop pit.

Concern 3: Rising Interest Rates

It is true that stocks struggle during rising interest rate environments. The reasons for that are plenty but the usual suspects are: 1 – Increasing cost of money, makes it costlier to do business and invest; 2 – Some fixed income securities’ yields start to look attractive compared to risk adjusted equity returns.

That being said, current levels are low enough to give us some time  before the danger zone. If you’d like me to be more specific, the 10 Year Treasury Yield is at approximately 2.5% and historical tendencies point to a 4% rate as the line in the sand in the tug of war. Based on FED actions, it may take us till the end of 2018 or into 2019 to reach that point. Since I try not to make predictions that far in advance, knowing what I know now is good enough to conclude that the current rising rate environment may not hinder equity returns.

Concern 4: Political Uncertainty

Markets have welcomed Trump’s presidential victory as they saw four arrows in his quiver:

1 – Tax cuts

2 – Lower regulations

3 – Fiscal expansion

4 – Trade wars.

Except for trade wars, the rest are deemed to be business friendly and hence will boost earnings. Well, this is a typical case of confirmation bias at least from the earnings point of view. As of 3/31/17, S&P 500 Operating Earnings Per Share has gone up 22.1% (Source: S&P Dow Jones Indices).

In other words, the earnings environment is the best in years and this is due to the pre-Trump economic environment, finally acknowledged by Republican leaning market participants, who for years have advocated a recession. (Sorry to sound speculative and like a sour cherry here.)

I welcome this development as it not only reflects domestic facts more accurately, but also global positive economic surprises.

For those curious minds, the biggest jump came in materials and technology sectors, 36% and 32% respectively, while the biggest loser was real estate by -32%.

In other words, given that a simpler tax code is better for business and the economy, smart deregulation can translate in to a more robust business environment and fiscal expansion is past due because of the FED’s inability to stimulate, setting politics aside, current stock levels may be justified.

Summary

For those readers who look for the blue or the red pill type of conclusion from all this, here is your takeaway:

  • Yes, the market seems moderately stretched
  • Therefore, a correction may be around the corner
  • “Sell in May, Go Away” strategy may prove prudent this year as we approach seasonally weak summer months
  • That being said, long term economic and market trends are in tact
  • Therefore, dips should be seen as buying opportunities
  • Volatility may increase, so tighten your seatbelts and keep your eyes on your long-term objectives

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

 

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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End of an Era: A Big Change Underway

“I finally know what distinguishes man from the other beasts: financial worries.” – Jules Renard, French Author (1864-1910).

When the stock market goes down, we wonder much how lower it can go.

When it goes up, we wonder if we’ve reached a market top.

Wonder, is the name of our game.

Even if the result of the US presidential election were different, the title of my last newsletter for 2016 would be same.

There are some significant changes in long term trends coming our way. I will discuss what those trend reversals are and what they may mean for your investments.

But first things first: I wish you a pleasant Holiday Season and hope that 2017 brings peace, health and prosperity to us all.

Reversal of Long Term Trends

A picture is worth a thousand words, please see 10 Year US Treasury long term chart going back to 1800s.

00001 Please note that the current rise in interest rates is coming off of a base that was last seen during WWII. Bond yields have been in a steady downtrend since 1982. A 5% bond becomes more attractive when new issues pay 4%, and so it gets a premium. This inverse relationship between bond prices and yields has created a 34-year bond bull market since 1982. It is also important to note that the length of the previous bond bear market was 36 years, so I think this much is fair to say; a long-term trend might be in a reversal mode and when it reverses, it may stay there for a very long time. Just when the FED has completed its monetary easing tactics, and was getting ready to take back the punch bowl, something else also had happened: the US presidential election.

Many experts, including the FED itself, have been underlining the diminishing returns in monetary easing policies. In fact, the FED has been complaining about Congress falling short of doing its part in fiscal expansion to stimulate growth and fight deflation.

The unfortunate reality about US politics, is that it has been very difficult for a Democratic Party president and its administration to borrow and spend in this current environment, for two reasons: 1- It is a shared government with a Republican Congress and these efforts get blocked 2 – They are easily labeled as a road to big government and get a push back.

But with the Republican Party holding executive powers, especially with the tailwind created by the disgruntled masses demanding change, along with a Republican Congress, fiscal expansion is now the writing on the wall.

Add them together, this end of monetary easing and the beginning of fiscal expansion, and you get a rising rate environment. This shift will likely become the catalyst for our third big change: falling bond prices.

Although they are interconnected, these developments create some separately affected winners and losers.

For instance, a rising interest rate environment usually hurts stocks…but probably not this time, for three reasons: 1 – Rates are so low, current increase doesn’t pose a threat, just yet. 2 – It also signals the strength of the underlying economy. 3 – And most importantly, it may kick-start the long awaited “Grand Rotation” from bonds to stocks.

To recap, these four big events, 1 – End of monetary easing 2 – Rising interest rates 3 – Beginning of fiscal expansion and 4 – Great Rotation from bonds to stocks, signify the end of an era.

The side effects of this can be a strong dollar, rising equity prices and valuations, and a drop in residential real estate prices. These side effects, though they make sense, may be limited in size and/or occur at a moderate pace.

Moving on to our next big change item; tax cuts, both at the corporate and personal levels.

Corporate tax rates haven’t moved much, at least in a meaningful way since 2000. To be fair, after the 2008 Global Financial Crisis, the Obama administration allowed corporations to deduct their losses from their current profits with a look back period of 5 years. This essentially created a tax cut for corporations, and contributed to an unprecedented profit growth.

Now, a real and significant tax cut may be under way, and I hate to put it this way but otherwise it could be a tough year for US corporations. A stronger dollar can hurt exporters, which most large US corporations are. Rising interest rates increase the cost of borrowing, and if you’re wondering why the US stocks have been going up since the election, along with the reasons mentioned above, the expectation is that a tax cut would more than compensate for these headwinds.

The same can be said about personal income taxes. The top tax bracket has seen an increase in the last few years but a tiny portion of the US population is subject to it. In fact, 50% of the tax payers don’t pay Federal Income Tax (but they do pay FICA taxes).

So, a tax cut would be a game changer depending on how it’s structured. Not all tax cuts are created equal. Someone making $35,000 a year, will likely spend a majority of the additional (marginal) cash that he/she receives. Conversely, someone making a million dollars year, will save a majority of the additional funds he/she receives. This dichotomy creates vastly different end results with tax policies…hence, the reason for all the heated discussions. Also, let’s not forget, lower tax rates mean a lower federal budget and larger deficits, unless of course, the growth it stimulates makes up for it…which is a whole other discussion.

Last, but not the least big change item worth mentioning, is the inflation rate. I think after years of being fearful of deflation, we might start observing some mild increase in the inflation rate which, at these extremely low levels, is not a red flag by any means but rather a significant change.

Your Investments

If one would take all this into consideration and form an actionable investment strategy, what would surface to the top? In my opinion, these areas may benefit from the above trends:

  • Small and mid-size company stocks with limited export exposure.
  • Large companies with cash stock piles, as the borrowing costs may start going up.
  • Industrial stocks may benefit from the infrastructure spending and capital expenditures, where the bulk of the fiscal spending may end up.
  • Tech sector, especially semi-conductors may benefit, as this sector gets a boost from capital expenditures.
  • Bank stocks, especially local banks may be the prime beneficiaries of a rising rate environment.
  • Energy stocks may get a boost, as they present one of the few areas of value in the market and benefit from a stabilizing oil price.
  • Consumer stocks, as tax cuts may boost consumption.
  • On the flip side of the coin, treasury bonds, especially those with long duration may see their values drop, so look for bonds that would be the least affected by rising rates, such as convertibles or inflation linked.
  • Lastly, be watchful of international investments and when you can, look for dollar hedged choices, as a rising dollar may hinder returns from returns from overseas.
  • Real estate prices may be flat or in a downtrend, as the mortgage rates have already started to go up, unless of course deregulation of this industry attracts newer demand.

It is always a fool’s errand to predict the future, but it is my job to take a shot at it. I hope my calculated guesses have presented an informative and interesting read for you.

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

 

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

 

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Surprise: Long Term Equity Trends Intact

“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.” – William Feather, Author of: Business of Life (1889-1981).

While chatting with a friend, who works at a large wealth management firm in San Francisco, I wanted to hear his take on whether we have seen a market top in stocks. He answered “…how many times have we asked this question in the last five years?”

This truly has been one of the most hated bull runs in history, and a stubborn question has been stuck in investors mind about whether we’ve reached a top. This skepticism coincides with all major US stock indexes being at all-time highs. The last time this condition was seen back in 1999, we all know what followed: the tech bubble crash.

In addition to stocks, real estate and fixed income markets have been in an extended uptrend as well. The only major asset class that hasn’t joined this party has been commodities.

By some valuation factors, stocks, along with real estate and fixed income securities, are too expensive to invest. For some market participants, global economy is losing steam if not approaching a recession. This sentiment is supported by data flowing from countries in Europe like Germany, which is at borderline recession and fighting negative interest rates. A similar situation can be seen in Japan. The situation is even sketchier in the United Kingdom as the Brexit boat is undocking to leave the European Union, and this surely hasn’t helped the economic projections of the island’s economy for the near future.

We have been in a growth cycle since 2009, which makes 2016 the eighth year in the current one. On average every six years a recession knocks on the US economy’s door. To add insult to injury, presidential election is fast approaching and the FED is getting ready for a rate hike. Who in his or her right mind would have a bullish view in the midst of all this?

Well, I guess I will cautiously be one of those crazies arguing for further growth in stocks and the US economy.

By no means do I dare to suggest that a 5- 15% pull back in stocks is inconceivable. On the contrary, now that we are in the last third or the second half section of a secular (long term) stock market up trend cycle, I do believe short and shallow corrections will be more frequent and volatility will rise.

The legendary economist John Maynard Keynes famously said “When information changes, I alter my conclusions. What do you do, sir?”. I try not to fight the FED, the trend, and facts, so I will change my mind when presented by information that suggests otherwise, but currently, I conclude a longer-term equity price appreciation hasn’t reached a capitulation phase – just yet.

Why is this? Please read on.

Accommodative Monetary Policy

In addition to the US Federal Reserve Bank, the European Central Bank, the Bank of Japan, and Central Banks of the UK, Switzerland and Canada, have been implementing their own versions of accommodative monetary policies. Add to this, Chinese interventions to stimulate growth and similar tactics implemented by governments and/or central banks around the world, and it is easy to determine that we are in an era of global accommodative monetary policies.

Even though the effectiveness of these policies has been diminishing, and going forward, fiscal policies will be needed to replace them, a dovish central bank still creates a stock friendly environment.

It would be stating the obvious to say that the US Federal Reserve is getting ready to increase interest rates, which scares many investors as this, in theory, is not only bad for stocks, but also fixed income securities, real estate and business in general. But it is important to note that neither inflation nor the economy is heating up to a level that would back the Fed in to a corner. In fact, the current sluggish growth environment allows for plenty of patience.  There is more than a 50% probability for a December rate hike, but a speedy increase is a low probability event, and this is more important than the timing. Since the current starting point is close to zero, there is some room before new levels start hurting the stock market strongly enough to push it to the next bear cycle, though the reception of information will surely result in volatility.

Another important point is that a rate hike would suggest that the economy is strong enough for such an action on FED’s part, which would justify expectations for further earnings growth and valuation expansion.

The US Economy

Another reason why the existing uptrend may have further legs, is that the economic data currently doesn’t suggest a recession. As long as the leading indicators and coincident economic figures point to a non-recessionary period, the chances of being stuck in a deep bear market is, historically speaking, low. Plus, being a leading indicator, the stock market would see a recession approaching and kick start a correction, well before the recession is officially announced. Once again, based on leading indicators, even though growth may tend to stay below average levels, the probability of a recession seems low, which supports the uptrend.

Length of Previous Cycles

As indicated above, a typical business cycle lasts anywhere between 5 to 7 years. With 2016 being the eighth year in this current business cycle, it raises eyebrows. I, myself, am a believer of studying historical trends (aka technical analysis) but the devil is always in the details. Not only the duration of a cycle, but also the level of growth in the cycle is a factor to consider.

Wages have started going up only recently and we still haven’t recovered in aggregate terms matching past recoveries. My point here: current below average growth creates a potential for an elongated business cycle. To reach historical averages, at current growth rates, the economy needs another three or four years to catch up.

Relative Valuations

Having said this, good reasons to be skeptical of continued growth are high valuations and how expensive investments have become. There is more than one way to look at this, and by some absolute calculations, stocks are in a bubble territory. However, when you look at relative valuation measures (stock returns in relation to returns from other asset classes), one gets a different result. In other words, when investing in Treasuries become cost prohibitive in a rising rate environment, and the sweet deals in real estate are harder to come by, a high dividend paying stock may appear more attractive. To gain some perspective, operating price/earnings ratio of Standard & Poor’s index is now around 20, which was around 50 in 2000, before the tech bubble burst.

Past Market Cycles

Last two long-term (secular) stock market periods were between 1942-1966 (24 years) and 1982-2000 (18 years). Current bull cycle, which started in 2009, is in year eight, and it could very well be in the second half or two thirds of a secular cycle. In other words, based on historical periods, the current cycle might very well have more time to run.

 Emerging Markets

Overseas markets such as China, India, South America and Japan, may start seeing reversal of their past downtrends, which will most likely help US markets. This view has already been supported by recent traction seen in these markets. It may also be important to note that more than 50% of Standard & Poor’s company earnings come from overseas. Recent stabilization of the US dollar has created a tailwind for these markets. This is good news for globally diversified investors.

Consumer

Leaving best for last, full employment, increasing participation rates, wage increases, spillover effects of the price appreciation in stocks and housing, low commodity prices, low inflation, and low interest rates, all contribute to the relatively decent shape the US consumer is in. The US economy is 80% consumer driven. The state of the sentiment in this area is extremely important. The reasons I have listed above may go back and forth in mild rates, but a major change doesn’t appear likely in the near term, which supports the consumer theme being intact, as well as the economy and the stock market.

Summary

In summary, I am still cautiously optimistic about the US economy and its stock market, and I believe that the uptrend is intact. At all-time highs, markets are exposed to shocks and higher volatility. These shocks will probably be shallow and short-term, which should be seen as buying opportunities until proven otherwise and data points to a different direction.

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

 

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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First Half Report, Brexit and More

“Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.” Hyman Minsky

At first glance, the US stock market performance in the first half of 2016 can be summarized as a “all hat no cattle” type of action.

Put in other words, a sideway trend has been the name of the game, with a lot of volatility, only to end back to square one for large US stock indexes such as S&P 500 and Dow Jones.

The S&P 500 is almost flat with a 2.69% gain and an 11% drawdown, while Nasdaq finished down by 3.29% with a 16% draw down during the first half.

The story is quite different in European and Emerging Market stocks, and most importantly, in bonds.

Europe closed the first half (Symbol EZU) down 7.91% and Emerging Markets (Symbol EEM) up 6.74%…meanwhile we saw significant bond returns, a 20 Year Treasury Bond ETF (Symbol TLT) gained 15.19% in market value.

For those who are new to my market letters: bond values are inversely correlated with interest rates. As the interests (yields) drop, outstanding bonds with relatively higher interest payments become more attractive investors, and gain value.

During the first half of 2016, interest rates and bond yields have come down in historic ways with no precedence. First time in its history, 10 year German treasury bonds hit negative interest rate territory. US mortgage rates are at historic lows. All this signal a tremendous amount of worry in the market, waiting for a big drop in stock values, or risky assets in general.

Bill Gross, aka the Bond King, came out in the past few weeks and said (paraphrased) “…and so the returns of the last 40 years, may only be found in Mars in the upcoming 40-year period.”

Why so?

Why is there so much fear in the market?

Why do the investment returns of the past 40 years seem a difficult target to reach?

Stretched Valuations

Well, let’s start with stretched valuations. Albeit in varying degrees and timelines, the FED and all other major central banks around the world have been throwing money at the slow economic growth problem, and help push the global debt of all types to $199 trillion, a $57 trillion increase between 2007 and 2014 (Source:  Mc Kinsey Global Institute Report 2015).

The approximate $60 trillion increase in global debt since 2007 has been translated in to inflated asset prices, hence the reason for stretched valuations, especially in stocks and real estate.

Are stock valuations in bubble territory? Measured by major US indexes’ price to earnings ratios, no but definitely at the upper end of the range, eerily close to the bubble territory. For stock values to go further up, one of two things need to happen: a) valuations to stretch in to bubble territory, or b) corporate earnings to improve.

For earnings to improve, ultimately the economy has to grow, and 2016 estimates have been lowered to around 2% in 2016 US Gross Domestic Product.

So, with high valuations and slow growth, it is hard to be a champion of robust equity returns, at least on a risk adjusted basis.

There is some good news from the rising or stabilizing energy prices, which many investors use as an indicator of growth and bring new funds to investments as a result.

Other Macro Trends

In macro trends, I see mixed messages in almost everywhere I look.

Take dollar for instance. The 2016 Gross Domestic Product estimates are slashed by major institutions such as the IMF, World Bank and large research firms. One culprit is the strong dollar, which hurts exports. Usually strong dollar lowers inflation and is good for the consumer but input prices being under deflationary pressures, a strong dollar’s current negatives outweigh the positives.

FED action is another area of concern and also full of mixed messages. A sluggish economy is bad news, but allows the FED to move slowly towards its higher interest rate policy. The market is confused on how to read this…an accommodative FED is good, but a slow economy is bad…so…what a man to do?

At the end of the day, albeit slowly, the economy is growing and supports the mildly and cautious bullish outlook in stocks for those who can stomach the volatility that comes with it, as 2016 first half performance being a case in point.

This outlook is probably good for another 6 months, and to be revised after election results…(more on the US elections below).

Brexit

During a client portfolio review, I found myself saying “…it is not so much the economic risks that worry me, but the political uncertainties.”

Brexit is a case in point.

British establishment politicians, led by Cameron, challenged the Brexiters by offering a simple “yes” or “no” referendum…most likely with a lot of assurances of a “remain” vote.

I speculate this assurance was so convincing, that even the Brexiters themselves thought a “leave” vote would never happen, at least in the short term.

A referendum would just earn good political credits for Nigel Farage and Boris Johnson.

Now, it feels like, the unpredicted result of a “leave” vote is so shocking, and the price tag of its consequences are so high, that it is followed by PM Cameron’s resignation, and winners’ hesitation from declaring victory. Nigel Farage has stepped down from his party and Boris Johnson announced that he wouldn’t run for the PM position.

Now why on earth would a politician do that?

I speculate because they don’t want to go down in the history books as the people who broke the UK, exited the EU and paved the way to an economic and political crisis in their country.

How does all this news affect us?

Other than the immediate shock, the political uncertainty and economic slowdown it will bring to the UK during the drawn out exit process of 2 may be 3 years…not much.

UK contributes only 3% to global economic growth…so a 2-3% drop in their Gross Domestic Product would make financial news for sure, but wouldn’t trigger a global recession.

Scotland and Ireland may leave the UK as they voted to stay in the EU, and that possibility alone may weigh on economic and market performance. But still, it wouldn’t trigger a domino effect leading to a 2008 type of scenario for the same reasons listed above; too small when put in global scale.

Brexit did one thing that might be contrary to some’s intuition; it brought pessimism and weakness, enough to create value and potentially set the stage for the next bull run.

Bad news, followed by panic selling sometimes create the best opportunities…as long as the news doesn’t linger like a bad tooth ache.

The US Presidential Elections

This year’s big whale in the pool is the US presidential elections. Historically, Dow Industrials do significantly better when the incumbent wins. So far, the market has been pricing a Democratic Party (incumbent) victory. So as we approach the election date, the potential for a Republican Party win may trigger a correction to the downside…something to watch for.

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

 

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

Leave a comment

The Key Question Is…

“If you can’t explain it simply, you don’t understand it well enough.” Albert Einstein

Hello tax season survivors. In this commentary, I will do my best to explain the current state of capital markets as simply as it would please Einstein, and dive deeper as I move along.

To gain a big picture perspective, let’s look at the sentiment towards the end of last year:

  • With their easy money policies, the central banks around the globe, especially the FED, have pushed all asset prices higher, punished savings account owners by turning “cash to trash”, gave investors no option but to take risk…and as a result major stock indexes in the US have seen all-time highs.
  • These high prices resulted with stretched valuations and it had become harder and harder to find good value in stock investing.
  • Earnings growth slowed down, corporate profits started to decline.
  • Driven by Chinese slow down, global demand softened, which pushed energy and commodity prices, along with capital expenditures, down.
  • FED was going to begin the tightening cycle and increase FED funds rate four times in 2016, adding up to a 1-1.5% increase. This was going put a tighter leash on both stock and bond markets.

So in short, along with high prices and weaker demand and earnings, the market was set for a correction…and that’s precisely what had happened.

Between November highs and February lows, the SP 500 index lost over 13%. If you date back to July highs, the loss is more like 15%. Other indexes have been struggling and waiving the red flag since the summer of 2014. For example between the beginning of July 2014 and Feb 11 2016, energy lost -69%, emerging markets -32%, Eurozone -24%, Japan -18%. In other words, a global correction has been under way since the summer of 2014 and the US stock markets had caught up with this trend by late 2015.

Since mid-February though, a rebound has been underway. Oil prices have bounced from 30 to 40 dollars range, major US indexes have recovered almost all of their losses, many US companies have been posting positive earnings surprises, market breadth has improved (the rate of total number of rising stocks to total number of falling stocks) and the fear of a global economic recession has been put to rest, at least for now.

Here comes the key question: is the recent bounce a dead cat bounce, a bull trap, or the beginnings of the next bull cycle?

Depending on one’s answer to this question, he/she should move to cash right now, or increase stock exposure.

Here is one big picture aspect of the markets, which I’ve talked about many times in the past. Markets, whether it’s currency, commodity, stock, bond or real estate market, tend to have a longer term trend, with shorter term counter trends within it. To define long and short term, this view determines roughly 5 to 20 years as long, and 1- 3 years as short.

No long term trend, also known as secular trend, is immune to shorter term, also known as cyclical counter trends. In other words, a 15 year bear market may have cyclical bull periods of a year or two within it. Naturally, these counter trends tend to leave a lesser of a mark than the longer term, or secular trend.

To revise our key question, if one believes that the longer term stock bull market that has started in March of 2009 is intact and the recent drawback is temporary, than the next cyclical bull market within a secular bull market may have started. If conversely, the longer term bull market is broken, and what we have seen since February is a bull trap, than we might be at the earlier stages of the next longer term bear cycle.

Clearly, we can call these dates and trends always after the fact …but managing investments require positioning assets based on probabilities and making changes as needed. Unfortunately we don’t have the luxury to wait until answers to these questions are abundantly clear. In the world of investments, there is no value in information known to all participants, except for their contribution to the historical perspective.

So if you go to cash, you might miss the next bull run. Conversely if you increase stock exposure now, you might lose some or all of your gains since 2009.

I think this much can be said with some confidence: the easy money has been made, and going forward one has to accept volatility as part of being in the game. If that’s not your cup of tea, this might be the time to consider a risk off strategy for your portfolios.

Moments like these remind me the scene from the musical Fiddler on the Roof, in which Tevye, the main character, talking about tradition, says “For instance, we always keep our heads covered  and always wear a little prayer shawl. This shows our constant devotion to God. You may ask, how did this tradition get started? Let me tell you. I don’t know…”.

Well, I am paid to have an opinion and turn those opinions in to action. So unlike Tevye, I don’t have the luxury to say I don’t know…but I do recognize that both sides of the argument have valid reasons to stick to their guns.

I believe we have a few more years in this stock bull market. After that, I have concerns.

The main reason why I believe there is still room for price appreciation is that attractive valuations in different pockets of the market, and willing investors to exploit those opportunities are bountiful.

On the other hand, the reason why I am concerned is the lack of ammunition left in central bankers’ arsenal in case of an economic recession.

Speaking of which, let me share this with you: the longest period in the US economic history with no recession is during the 1991-2001 period. In every other case, on average, the US economy has experienced a recession every 5-7 years. Since we’ve been in an economic growth period for 8 years now, by the end of 2018, anticipating a recession wouldn’t be unreasonable.

In such incidents, governments have two resources available to them: monetary and fiscal policies. Monetary policies are driven by the central banks, mainly by managing the amount of liquidity through interest rates, reserve requirement etc. Fiscal policies are driven by the congress through tax policies, regulations, subsidies etc…

Currently, there is almost nothing left for central bankers to do in case of a recession. Rates are as low as they can get. The speed of a reaction is as important, if not more, as the reaction itself. That’s why the central banks, being able to make decisions faster than the congress, are critical in these circumstances.

Finalizing fiscal policies by congress may take months of negotiations and the damage may be done by then.

That’s why, I want to say that the long term/secular bull market is intact, have more legs in this rally and so one should increase stock exposure.

But I am being cautious because the underlying economic strength isn’t there and even though slow economic growth may be enough for the markets to move higher by further stretching valuations, any headwind could cause a fast reversal.

In terms of where to increase exposure to, look for better valuations in the emerging markets, Europe and recently beaten down sectors in the US. Previous winners may be too late to look for gains in the next 6 months or so.

Also bear in mind that we are in an election year and post elections, uncertainty may subside and leave room for another wave of tailwinds for the risk on trade. It also can rock the boat a bit till November.

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

Leave a comment

Looking Ahead to 2016

 

“Chaos isn’t a pit. Chaos is a ladder. Many who try to climb it fail and never get to try again. The fall breaks them. And some are given a chance to climb, they cling to the realm or the gods or love. Only the ladder is real. The climb is all there is.” – Littlefinger, Game of Thrones

On May 21st, the S&P 500 index hit an all-time high, 3.5% above December 31st close, only to drop 12.35% in the following three months.

A similar and even deeper fall occurred during the summer of 2011, a loss of 17.6% in the same index.

But between these two incidents, 2011 and 2015, there hasn’t been a correction over 10%. This uptrend with no breaks had brought valuations to a stretched territory and susceptible to a correction.

Looking at other major indexes and Exchange Traded Funds, the recent 12.35% drop in the S&P 500, was 14.44% in Dow Jones, 13.65% in Nasdaq, 28.98% in Emerging Markets ETF (EEM), 17% in Gold ETF (GLD), 17.78% International Developed Markets ETF (EFA).

In bonds, the loss was 3.4% in 20 Year Treasury Bonds ETF (TLT) and 3.7% in Aggregate Bond ETF (AGG).

Commodities have been in a straight downtrend since June 2014 and the drop is 53.65% from top to bottom.

It has been a difficult market to find positive returns…as stocks, bonds, precious metals and commodities all have been hit hard lately.

Why?

The main culprits have been widely viewed as: the FED fears, global and more so Chinese economic slowdown, oil glut, stretched valuations and strong US dollar.

So looking ahead globally and in the US, what to expect and what should be one’s investment strategy in 2016?

Valuations

The recent drop in equity prices cooled off valuations a bit. Absolute valuation (stand-alone) matrices have been showing stocks as mostly expensive, relatively (to bond yields) fairly valued and cash adjusted within historical averages.

Cash adjusted valuation adjusts the valuation of your stock investment for the cash the company has at its disposal. US large corporations have piled 2.5 trillion dollars of cash and when you invest in them, you get to own a portion of this asset as a shareholder, hence the reason why cash adjusted valuation makes equity prices seem more reasonable.

Where will this cash be spent in 2016? Most likely the past trend will be repeated and it will be allocated to stock buy backs and dividends.

When a company buys its own stock, it lowers the number of available shares. This improves earnings per share without increasing earnings. So even though company earnings don’t improve, its stock valuation gets a boost.

In aggregate, when these funds aren’t invested in capital expenditures or research and development, the economy doesn’t reap their benefits, but investors are rewarded through dividends and buy backs.

Global Stock Markets

The weakness we’ve been seeing in the US equities is a global phenomenon, in some cases even more seriously. But more recently, breadth (percentage of the world stock indices with rising moving averages) is improving and signs of a recovery may already be here.

Japan and Emerging Markets, specifically India and China has more room to the upside as unlike the US stock market with shallow corrections, they have been hit hard. But again, they also carry higher risk, so think twice before you overweight.

US Dollar

A strong US dollar is one of the reasons for headwinds, as it makes US exports more expensive and puts pressure on foreign earnings. Has dollar reached a peak? I doubt it.

Knowing that we are probably only about a month or two away from the next FED rate hike, historical US dollar movement around past rate hikes can be a guide here. Considering the weakness in the global economy, European and Asian central bankers’ rate hike decision is a low probability event. So relatively, the dollar may seem more attractive and continue its strength. Given that the rate hike pace is expected to be slow; the trend in dollar strength may be sustained.

Commodities

If you’re wondering whether or not the bear market since 2014 has created a buying opportunity in commodities, think again. Technical support levels have been broken and there is no reason to think the reversal is near. This is good news for consumers, but bad news for commodity driven industries.

Bubble Economy?

Are we in a bubble, closer to the end of the growth cycle?

It is understandable to look at historical averages and wonder if a recession is here, knowing that historically about every 5-7 years, the US economy finds itself in one.

According to this approach since the growth cycle started in 2009, next year we should start feeling the heat. According to National Bureau of Economic Research, since the Great Depression in 1929-1933, the longest growth cycle was for 10 years (1991-2001) and the shortest was for 1 year (1980-1981). So it may still take a few more years for the US economy to reach that point.

There is also the camp that argues FED’s next to zero interest rate policy has been artificially boosting asset values and once the tightening cycle starts, the bubble will burst.

Before I get to FED, I will say this: growth cycles don’t die because of old age and bubbles form mainly as a result of excessive debt. We live in a fiat currency and debt driven economy. In a usual business cycle, the borrowing goes to the roof and the debt payments become a burden on spending. As one’s spending is another’s income, falling incomes put pressure on growth and the economy goes in to a recession.

So the better question here is the level of debt, especially consumer debt. The answer is, nowhere near peak, in fact consumer debt to consumer financial assets ratio has been falling since 2009.

Also, other signs of an end of a growth cycle usually include high inflation, high interest rates and extreme optimism, none of which are present at current time. In short, a recession in 2016 is a low probability.

The FED

Leaving the best to last, let’s talk about the FED. The most important player and its actions have been so closely followed; that it is hard to report news here. Most likely in December or January the rate hike will be resumed, and will continue through 2016. How will this affect the markets?

As mentioned previously, it really depends on the pace of the rate hike and most likely a slow pace is in the cards in which case, based on historical records, the market may actually continue the uptrend with some volatility for adjustment.

I hope you find this summary of global capital markets and my projections as helpful. Please feel free to send your questions or comments to bbakan@shieldwm.com.

Also, have a pleasant Thanks Giving!

 

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