Posts Tagged wealth management

2019…And the Plot Thickens

“Get your facts first, then you can distort them as you please.” Mark Twain

“There cannot be a crisis next week, my schedule is already full.” Henry Kissinger

According to the Chinese calendar, 2019 is going to be a Pig year and since it is a water animal, it can be as murky and confusing as a mud pile, or as clear as Lake Tahoe. Today, I will attempt to turn the murkiness of the current market conditions into a clearer picture. My goal is to share relevant facts without distorting them, and make useful and actionable forecasts…so, let’s start.

Quick Wrap Up of 2018

Last year presented a typical case of a late cycle, a nowhere to hide scenario for most investors. Major asset classes, like stocks, bonds, commodities and precious metals, either lost money, or at best stayed even. In hind sight, had you bought a 1-year CD in Jan 2018, you would have beaten most professional money managers.

The usual suspects are trade wars with China, FED tightening, the Brexit mess and fears around a maturing economic and market bull cycle.

While this is true for the US, which seemed to have decoupled from the rest of the world, the global picture is bleaker. Industrial countries like Germany, Austria and Japan have posted negative economic growth numbers towards the year end, Australia’s real estate bubble had burst, emerging market stocks lost over 30% from peak to trough, and political uncertainty had been elevated.

As a result, even though year-end numbers don’t look too dreadful, we saw two waterfall declines during the year, the latter pushing major indexes to a bear territory. This downtrend, as usual, hit the winners of the previous cycle’s big winners the most, and those who argued President Trump was good for stocks, remained quiet for the big part of 2018.

A Roadmap for 2019

For the reasons mentioned above, the risk aversion levels have been elevated, and as a result, yields dropped, helping fixed income valuations recover. A case in point can be the 1-year high valuation of a popular investment grade corporate bond Exchange Traded Fund, symbol LQD.

But if risk aversion levels are elevated, what is the cause of the recent rally in the stock market? Two potential reasons:

1 – Technical: It isn’t unusual for initial panic selling to follow a bounce back, but only to retest the initial lows after.

2 – Fundamental: FED chairman Jerome Powell’s words on a “patient” FED has triggered the oversold rally.

Is it sustainable? Highly unlikely. Why?

Because even with a patient FED, the monetary base is still in Quantitative Tightening mode, not only in the US, but in more than 50% of the central banks across the globe.

From a technical view, in similar cases of 2000 and 2015, a bear market rally followed the initial waterfall decline, then a retest of the initial lows, and the resumption of the next bull cycle after capitulation. If we are experiencing anything like the years mentioned above, it wouldn’t be surprising to see more volatility for the next 6 months, and a recovery to follow after.

The Economy and Market Implications

The most recent Economist issue (Jan 26th-Feb 1st) cover probably says it all: Slowbalisation. Currently, the US economy is doing just fine, but the future is pointing to a slower growth. Here, we need to be clear with our terminology. Slow growth doesn’t mean a recession, recession doesn’t mean a depression, and depression doesn’t mean a crisis (don’t want to upset Henry Kissinger). The US economy seems to be far from a recession, but Leading Economic Indicators (LEI) signal for a slower growth. The US Q4 Gross Domestic Product (GDP) growth rate will likely be announced around 2.7%, much lower than the 3.4% in Q3.

I have looked up past periods of extremely low unemployment, and in all cases (1953, 1957, 1970 and 2000) a recession had followed. When I look at current valuations and sentiment, I liken it to the conditions of 2000, which was followed by a recession in 2001.

According to the IMF and OECD, global economy is expected to grow at a rate of 3.5% in 2019, isn’t that great? Not really. Global economy almost never experiences a recession in its most technical sense, which is negative growth two quarters in a row. The only exception to this since World War II was in 2008. According to OECD definitions, global growth rates below 3% is considered recessionary. The IMF is much stricter and conservative in this matter. But when we include the World Bank estimates as well, we can conclude that a global economic recession is not likely in 2019. According to Ray Dalio, the manager of the largest hedge fund in the world, 2020 will be when the rubber will hit the road, and he may very well be proven right.

So, one might ask, if unemployment, sentiment, valuations and stock market action remind us of past periods which were followed by a recession, why is this time expected to be different? Maybe it won’t be, but one tailwind for the US economy is credit conditions. The US is a debt driven consumer economy and as long as there is room for more borrowing, and the cost of carrying loans hasn’t started hurting new purchases, one lesson I have learned from being a market participant for many years, is to never discount the US consumer’s appetite for consumption. The recent rise in oil prices have improved corporate loan quality (these are highly leveraged businesses and they make a huge impact on the web of corporate financing) and the spillover effect is the improved loan quality.

Due to rising risk aversion, a shift from stocks to bonds, and fears of an economic slow-down, 10 year treasury yield unexpectedly dropped form 3.2% to 2.7%. Lower yields relieve the FED from its highly anticipated rate increases this year, and allow it to be more patient as Jerome Powell puts it. Another data point that makes me question the probability of rate increases, is the low inflation rate of around 2%. After years of quantitative easing, low unemployment, rising wages and economic growth, one would surely expect higher inflation. So, why not this time? Because most likely, the name of this uncharted territory is called the Amazon Effect. Each time the price of a particular good goes up, someone somewhere steps up to the plate and provides it at a cheaper cost online. The jury is still out in this discussion but automation and globalization have been a huge weight on inflation and even after 10 years after the 2008 debacle, deflation is still more of a serious threat to economies than inflation.

It would be a sin to not talk about China when discussing the global economy. I have already mentioned the problems Germany and Japan are in, but the biggest contributor to global economic growth has lately been producing forward looking indicators (PMI) pointing to a contraction in growth as well.

One bright star in this gloomy sky, has surprisingly been the UK, but I believe it is due to production that is pulled forward as a preparation for the Brexit approaching fast (or not…who knows?).

As market volatility rises and global economy starts looking gloomier, safe heavens like gold, Japanese Yen and Swiss Franc may benefit and so by definition, dollar may fall, which also may make non-dollar denominated investments more attractive, i.e. international stocks and bonds.

Summary

If this downside correction will look anything like past similar cases, valuations and investor sentiment need to drop a lot more before setting the conditions for the next bull cycle, and it is fair to expect a retest of the lows within the first half of the year and a recovery in the second. So, it’s probably wise to start the year defensive, and to switch and switch gears in the second half. In US sectors, chose non-cyclical and defensive areas like consumer staples, utilities and health care during the first half and switch to more cyclical sectors like tech, consumer discretionary and financials in the second. All of the information above are educated guesses, and your personal goals and risk profiles have to be added to the mix. So, what ever you do, tread carefully and consult with a professional.

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

It’s Official: Correction is Here

 

 

“Nature abhors a hero. For one thing, he violates the law of conservation of energy. For another, how can it be the survival of the fittest when the fittest keeps putting himself in situations where he is most likely to be creamed?” – Solomon Short (David Gerrold’s alter ego, a Star Trek writer)

 

The late September, early October market highs in stocks, may be this year’s all-time high in stock values. This is not due to the US economy doing poorly, or companies reporting dismal results. The stock market is forward looking, and so with rising input, financing and labor costs, along with a slowing down of global trade, European Union troubled with Brexit and Italy, China still on controlled slow down mode, equity investors are having a hard time finding bright spots. One thing is for sure, that the volatility is back and major indexes have touched the correction territory.

It’s a military tactic to know what not to do before everything else, because most importantly, you have to be alive to win battles and wars, and small mistakes can be deadly. In this market environment: don’t try be a hero. Unless you’re a thrill seeker, do not try to time a bottom and get in a concentrated position, because that low may be proven to be not low enough.

General Outlook

The US economy is currently doing well with a 3.5% GDP growth, but the World economy is pointing to a contraction in a year or two. The latest OECD Euro Area Composite Leading Indicator is at 99.6, and anything below 100 signals future negative growth. The US has been the lonely figure on the dance floor and usually when that happens, either the music stops, or more people join the dance. It seems like the former to play out coming into 2020. Or alternatively, growth may slow down to a 2% rate.

In the developed world, unemployment rates are below what would historically create inflation, and the US inflation rate is at 2.1%. Lower inflation rate is attributed to lower commodity prices, technological advancements and globalization, but the signs of a rising inflation have started to appear. This will be truer in the US, especially if the US dollar has peaked and commodities have bottomed.

The US bond prices are in a bear market with yields at current levels. The FED is no longer deemed accommodating, but rather on a neutral position. Combined, this puts pressure on stock prices as relative valuations become less attractive.

A recession in the next 6-12 months is a low probability, but is this good enough? Stocks tend to lead the economy by 6-12 months, so to say that the economy will survive next year may not be a compelling argument for equity investors.

In short, stock investors are confused about the future of corporate earnings. They haven’t given up on stocks yet, but there are serious questions and this doubt creates a tug of war. President Trump’s unwarranted comments on FED actions, and his tariff wars are only making things worse.

For those looking for a silver lining, here is a decent one: stocks typically climb a wall of worry. A case in point, in 1968, Martin Luther King Jr. and J.F. Kennedy were assassinated, USSR invaded Czechoslovakia, there were riots across the country, and the S&P 500 Index had risen 7%. The absence of worry, overly confident investors and frenzy usually is a better indicator of a waterfall decline. When investor worry about a bear market in stocks, that is usually a cause of volatility, but not a full out bear, especially during a time of strong economic growth. As mentioned before, this doesn’t mean go out and try to catch a falling knife, but rather adjust your portfolios for a volatile environment until the dust settles, which may take a few months.

More Warning Signs

There are other concerns for equity investors. The growth sector leaders have also been the leader of weakness, while defensive sectors have shown stronger resistance. This is a typical risk off move. The question is its sustainability. From here, the market usually either sees opportunities in growth areas and this trend reverses itself, or it turns into a bear market.

Rising bond yields, which since 2008 have been associated with a strengthening economy, started to spook stock investors. Globally yields are still low, there is still plenty of liquidity, so one might be skeptical of this analysis. The point I am trying to make, is that higher yields create a double whammy. Higher financing costs and rising relative valuations may have come to a point of hurting stocks.

Usually in a rising rate environment, bank stocks offer a place to hide, as a steepening yield curve translates into higher bank profits. Unfortunately, not this time, not so far. Global worries have been pressuring the long end of the yield curve while FED rates have been pushing up the short end, creating a flatter yield curve, and as a result hurting bank stocks.

Year End Rally and Elections

One action to look forward to in an annual cycle, is the year-end rally. Especially after the mid-term elections, the expectation of political certainty and a stimulus package push stock prices up. This year, the stimulus package, in the form of tax cuts, have already been priced in. In addition, the chance of political uncertainty with a divided government, is also a probable outcome. So, we may see a rather muted Santa Claus this year, if at all.

Tariffs

This is an easy one: tariffs are bad, period. It raises costs for everyone, and hurts economies. If you don’t believe me, ask the people it was supposed to help, like Ford and Harley Davidson. They are forced to lay off workers or go offshore as a result of higher input prices. This, if insisted, can wipe off all the benefits of tax cuts, and we would be stuck with a historic budget deficit with no upside. China is the second largest economy in the world, and the US exports to China is a little less than exports to Germany, UK and France combined. But more importantly, tariffs hurt business confidence, which may lower future capital expenditures, a key driver of economic activity.

Stock Buybacks and Capital Investments

A big supporter of stock prices has been corporate buy backs. How big you say? $560 billion big in the last 12 months trailing June 2018, an all-time high (Source: S&P Capital IQ). The question is, can or will it continue? For reasons shared above, corporations may put a halt to this, or slow it down. With the uncertainty created by tariffs, lower CEO confidence may elevate risk aversion and cash positions.

On the Plus Side

The good news is, a lot of this is already baked in the cake. The question is, how much more bad news is in the pipeline? Usually bear markets follow extreme optimism. Volatility index at 25, and when Nasdaq records daily 4% losses, that’s a hard one to argue for. The recent price action to the downside may be a process of shaking loose ends, creating better valuations and attracting new buyers. Let’s not forget; the FED may not be accommodating, but it is not restrictive either. Its neutral position is accompanied by still  easy central bank policies in Japan, UK and Europe. In addition, the credit conditions index, which is probably the most important factor in a debt driven economy, is not signaling capitulation to a level of a looming recession.

The US economy may extend its growth past 2019. The notion that this has been the longest expansion, is looking at the wrong side of the equation, as it also has been the slowest. The longest GDP growth period in the US was during 1991-2001, 120 months of straight growth. The current cycle is 113 months old, but much more importantly: the aggregate GDP growth during the longest cycle, was 42.6%. The current cycle GDP growth is 22.3%. So, there is still a lot of room to grow for a tie breaker.

Summary

Recessions start because of over investment and dropping demand as a result. Bear markets in equities lead recessions by a few quarters, and usually start with very few buyers left to invest. Both conditions occur during extreme optimism. Currently, we lack this ingredient to call for a full-on bear around the corner. But even still, for the reasons outlined above, equity prices may need to go through a re-balancing phase and create even more pessimism before igniting the next thrust to new highs. Until then, there is nothing wrong with playing defense.

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

…And Now, The End Is Near?

“The sun is gone, but I have a light.” – Kurt Cobain

 

For years now, market participants have been arguing on whether or not “the” market top has been seen. So far, those who had suggested “a” market top yes, but not “the” market top have won the argument and prevailed. That being said, “this time”, both economically and market wise, it appears likely that we are in the later stages of a growth and bull cycle.

This conclusion may be easier to reach compared to the timing of a correction that could follow it. I am watching multiple “big money” sources, and all I see is a wide spread agreement on a tiring up trend, but hugely different projected time lines of a reversal.

Well then, what do we do now?

The Sun is Gone

Since 2008 global financial crisis, central bank balance sheets have grown from 3-5 trillion dollars to 15-20 trillion, China included. This 12-15 trillion created out of thin air did pull the global economy out of a deep hole and some but, has also created a dependency on easy money.

In short, FED driven expansion days are over. We all need to tattoo this on our chests backwards so we can read it in the mirror as a reminder every morning…and drop our habits developed in the last 9 years relying on it. Party bowl is gone and it’s time to sober up.

The direct effect of easy money policies has been stretched valuations in most asset classes. You can see this in your stock portfolios, real estate and speculative investments.

The good news is, that the global economy is still growing, valuations came down a bit from highs due to the drop in Feb-March of this year and forward earnings are closer to historical averages. Plus, just because the monetary easing has stopped and tightening has been resumed, it doesn’t mean liquidity has dried up. There is still plenty of cash hovering around globally.

You might ask: How much longer can the economies grow, and what if forward earnings disappoint?

The answers are: Probably not for much longer, and a correction would only be natural.

But I Have a Light

Yes, the FED sun is gone, but there is still plenty of light. The global growth is in tact and a recession isn’t an evident threat in the short term. Pro-growth policies are gaining traction, interest rates are still low, consumer and business confidence are high. On the cons side, populist rhetoric and policies, trade wars and anti-immigrant sentiment raise political risks, which can override the positives rapidly.

Just when the volatility has risen, inflation is looming, currency fluctuations are hurting trade, oil price is up and FED is in a tightening mode, the last thing markets need is irresponsible and short sighted political outbursts.

Had I just focused on newspaper headlines, I would say liquidate all your holdings and start planting tomatoes cause a third world war is looming. Luckily, there are plenty of reliable indicators suggesting that things are not that bad.

Here is a critical question in that regard: which single data point has the highest probability of predicting a recession in the US? Like any other question in finance, you’ll get many different answers to this but I agree with Ray Dalio, the manager of the largest hedge fun in the world, Bridgewater. He argues that the debt service ratio is the most important single data point as we live in a debt driven consumer economy. The end of a growth cycle usually comes with a debt service ratio high enough to hurt consumption. In other words, once the interest payment on the loan starts hurting new purchases, that’s when the party ends. Business cycles and equity markets are driven by this phenomenon. Without further ado, let me share with you that current debt service ratio in the US is at all-time lows, consumer balance sheets are healthy and household net-worth is at all-time highs.

What’s the Game Plan?

It’s a military rule, that strategic mistakes can not be remedied by tactical moves. Meaning, if you have your longer-term objectives, plans and action items lined up ineffectively, short term shifts can not bring ultimate success. So, first lesson from this is to make sure that you, or your financial advisor, wealth manager, financial planner etc…understand your long-term goals and your portfolios are adjusted accordingly.

The key thing here is to focus on asset classes more carefully then securities within in it, because 70% of a portfolio’s returns come from asset allocation decisions.

Once your asset allocation (stock, bonds, cash, alternatives) fits your long term strategic goals, then in the next 12-18 months, each time you see a high in the stock market, consider using that as an opportunity to lower your risk exposure from stocks to bonds, from international to domestic equity, from cyclicals to non-cyclicals.

Most likely, before the bear market hits, selling your long-time winners, triggering capital gains taxes and investing in potentially low performing investments won’t “feel right”, but once the bear market losses start creeping in on your statements, that feeling speedily reverses.

As far as the timing goes, it is close to impossible to know when the bear will attack, but it’s probably fair to say that sometime within the next year or 2020. We may see a seasonal summer weakness ahead, higher volatility approaching the mid term elections, and a recovery during the seasonal Santa Claus rally.

But looking at the correction in 2015, let’s remember that the recovery at year end was reversed during the following January in 2016. This time around, that reversal to the downside has the potential to has a longer duration. To be fair though, the worst year in a 4-year presidential cycle is the current second year and the best year is the third, which will be next year in 2019, so there is still some things to be hopeful about.

The Key Factor

I was working at a bank during the Nasdaq bubble and at a money management firm during the Global Financial Crisis in 2008. In both cases what I have observed is, that from trough to peak, a buy and hold equity portfolio recovered its losses 5 and 4 years respectively (based on S&P 500 returns). For a risk adjusted, diversified and rebalanced portfolio, that time span was halved.

More importantly, those who got out at the wrong time, missed the fast run up following the drop. So, in other words, your stocks, bonds, cash and alternatives asset allocation, shouldn’t force you to sell at the worst possible time.

In fact, those are the times, in hindsight, appear to be the best times to start buying. The key is to be able to stay invested for the long term.

 Summary

A peak in the economy and equity markets might be near. Timing the reversal of the uptrend is extremely difficult, if not impossible. So in the next year or so, you might want to consider lowering your risk levels during up swings to a level that will not force you to sell during the correction

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

2018: A Challenging Year Might Be Ahead

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

 

First thing first: I hope you had a wonderful Thanksgiving with your family and loved ones, and wish you a great Holiday Season, Christmas, News Year….under whatever name, shape or form you enjoy celebrating. My usual attitude I have adopted from a longtime friend is: “Is there something to celebrate? What are we waiting for?”

If you have read my previous newsletter, you might recall the above quotation and might be wondering if I have forgotten something. No, I haven’t. When I sat down to produce this quarter’s letter, I realized that I couldn’t have found a better quote, so I kept it.

As we’re approaching a new year, following a period of strong performance, many of you are probably nervous or wondering if a deep correction is due. Common questions are: Is this time to sell? Is there more room for growth? Should I invest now or wait for a downturn?

For those looking for quick answers: not yet; probably yes; and what about dollar cost averaging?

It all depends on your goals, time horizon and risk appetite. To demystify my answer, let’s dive in.

Cry Wolf

The current market regime we are in might be best described as the “most hated bull market in history.” For years, many participants have been calling for a correction and yet here we are, with solid returns.

I can not tell you how many client meetings I have had since 2011, making a bullish case, settling a client’s nerves, who had just read a report suggesting that huge losses were ahead.

There is actual research showing that some republican leaning investors had missed out on the “Obama rally”. It looks like now it is the democratic and liberal leaning investors’ turn to sit on the sidelines and watch the market that they so “hate”, to run up.

Looking at valuations and extreme optimism, is this “the” time to go out and save the shepherd from the wolves? If we do so, will we look like fools, again? There is a third way.

Don’t Throw the Baby Out with the Bathwater

There is plenty of research that shows that the majority of portfolio returns come from asset allocation decisions. In other words, whether or not you will be invested in stocks, bonds, alternatives or stay in cash, is the most important decision. The effect of security selection, is miniscule compared to this very fundamental decision.

That being said, like most things, it is not black and white. You should make buy all, or sell all decisions. Better said, fine tune your asset allocation, to fit the current investment regime.

We are not bound to decide whether to fully get out of the market, or blindly stay in it. Instead, we need to keep our eyes on current market drivers, pay close attention to our time horizon and investment goals, and make adjustments accordingly.

Current Market Drivers

I am fortunate to serve many clients who are smarter and better educated than myself. One of them once told me “I don’t get what you’re doing, it seems so complex.” Coming from a man with a PhD in computer science, I was humbled, but to tell you the truth, it isn’t all that complex, it all boils down to:

  • Markets go up because there are more buyers than sellers.

 

  • Economies grow because more money is spent this year than last.

So, the two most important components are: 1 – How much money is out there? 2 – What is the investor/consumer sentiment? In short, it’s all about the FED and psychology.

How about valuations? Research shows that valuations are better indicators for long term (5-10 year) returns, but have a terrible record for shorter term (1-3 year).

The FED, crowd psychology, the economy and politics are undoubtedly interrelated but the end-result on investments has to be separately and carefully analyzed.

We still have a friendly FED, an overly optimistic crowd, a strengthening economy and a market friendly tax bill on its way.

Not too shabby, however the key word here is “overly”. In spite of Keynes’ famous quote “Markets can stay irrational longer than you can stay solvent.” overly optimistic sentiment usually gets punished shortly after.

So…2018?

If you think I am giving mixed messages, that’s because I am. On one hand, I know that when the FED is friendly, the crowd is optimistic, the economy is strong and politicians are market friendly, fighting against this picture is foolish.

On the other hand, looking at historically high valuations, very little cash sitting on the sidelines, and extreme investor optimism, this might be the time to give the shepherd who cried wolf, the benefit of the doubt.

Action Items

How to reconcile these two sentiments?

  • Clarify the purpose of your investment. If you have a long-term goal, short term fluctuations shouldn’t scare you away from investing, but if you may need these funds within a year, this might not be the best time to get in.

 

  • Brace yourself for volatility. 2018 probably has one or two 5-10% pull back(s) built in to it. So, consider how to lower stock exposure, raise cash, or prepare yourself to ride the roller coaster, and have a 10% drop in US stocks as one of your what if scenarios.

 

  • Make sure you’re diversified. Usually, what went up the most, comes down the fastest. In the current case, it is the tech stocks. Make sure your tech stock exposure is in line with your risk appetite.

 

  • Have some international exposure. While the US FED is raising rates, European and Japanese central banks are still in their easing mode, most likely till the end of 2018. These countries, along with Emerging Markets may offer better value.

 

  • If you’re overly concentrated in any particular security, look for strategies such as put options.

 

  • Don’t be afraid of raising cash.

 

  • Watch for earnings because the market is priced for perfection and a negative surprise could be the black swan in the lake.

In Short

2018 will likely end up being a positive year, but returns may be muted and may come with volatility. So adjust your strategy accordingly.

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

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.

, , , , , , , , , , ,

Leave a comment

What is Wrong with the US Stock Market?

“Life is pleasant. Death is peaceful. It is the transition that is troublesome.” Isaac Asimov

 

A client and friend asked why the current US stock market was having a hard time finding a path and if I saw this lack of a path as a threat to the global financial stability.

I started my reply with “In short…”, only to realize I had promised in my last newsletter, to share reasons to be bearish in my next newsletter and Eureka! Without further adieu: “6 reasons why US stock markets are having difficulty forming an uptrend.”

Reason 1: Transition from the Industrial Revolution to Information Age

We are at a juncture where multiple trends are ending and are in transition to the next. The biggest one of these is the end of the Industrial Revolution, which started in the late 1800s in England and probably lasted until the end of the 20th century. I use caution here as trends and cycles are difficult if not impossible to define while in them. Most of the political and economic concepts we live in or with, were either born or have grown strength as a result of this mega step in human history. The world’s governmental and economic systems are built to support this industrial life style based on production, transportation and consumption of goods, while supported by the banking system whose function is to turn profits into investments for businesses and lending for consumers.

And then, there came the technological revolution and globalization. In this new world, information and ideas may have become more important than having access to capital, as money is easily and readily available to invest in marketable ideas. Labor markets are global and therefore more competitive. National borders are less meaningful, as resources move faster than ever. Education systems, at least here in the US, fail to prepare the youth for the skills needed in this new economy. Automation is taking over human participation in production. Productivity growth no longer equals income growth. Since 1970’s incomes haven’t been able to keep up with productivity growth and the gap has been widening (except in the last few years because of falling productivity). With the use of computerized trading systems and financial engineering, risks and returns have grown exponentially. The level of welfare and the income distribution policies are a discussion for a heated debate, as haves can reach resources globally, while have nots end up competing against poorer parts of the world who are willing to work for much less.

As a result of this mega shift, there are 5.5 million job openings in the U.S. that can’t be filled, which was 3.5 million only two years ago. The capital markets and investors are trying to adapt to this new wave of technologies, business models and get a better sense of the present and projected valuations, while seeking balance in risk/return relationships. This tug of war between the past and the future is forcing the global economic machine and its capital markets to give errors in the forms of global financial crisis, massive computerized trading errors, discrepancies in valuations and increased volatility. Are these new challenges? No. But their magnitude brings us to an uncharted territory and at times, the capital markets act like a deer in the headlights. This long period with a sideway trend we have been in since November, could be one example.

Reason 2: Global Economic Slowdown

Are we in a global economic recession? No. According to the Organization of Economic Co-operation and Development (OECD), there have been 13 global downturns since 1960, last one being in 2011, with average length of 22 months. It looks like every 4-7 years, we go through a global recession and it wouldn’t be outside of historical averages if we experience a slowdown in the next 3 years. According to IMF calculations, global economic growth rate was 3.4% in 2014, estimated to be 3.5% in 2015 and 3.8% in 2016. So there is no global downturn currently or in the projected near future. However, it is not robust growth by any means and so it’s vulnerable to shocks. The strongest headwind for growth is the debt hangover. Governments and consumers are trying to pay down their debt as opposed to investing and spending, a minus effect on growth.

In most cases, when the US joins the international community and contributes to negative growth, markets react with a sharp decline. However, when the US is in growth mode while the rest of the world slows down, US stock markets typically go sideways. Given the problems in the EU zone and Japan, the slowdown in the Emerging Markets and US growth rate at around 2.5%, the sideway trend can at least partially be explained by the state of the global economy as a whole.

Reason 3: The Federal Reserve (FED)

We are in a central bank driven, multiple expansion based bull market. (Multiple expansion is paying a higher price for given earnings). Once the FED starts the tightening phase, we will be in a different zone and the US stock market’s reaction will depend on the speed of the rate increase.

Usually market tightening cycles start during an uptrend. Going back to all tightening cycles since 1946, the S&P continues the uptrend for another 4 months after the tightening begins (average of 5 cases). In the case of a fast tightening cycle though (7 cases) a sharp decline immediately starts with the tightening, lasts for 3 months to fully recover in 6

months (Source: NDR). So the speed of the hike is more relevant than the hike itself. Will the FED push rates up at a fast or slower pace? Most likely at a slower pace because the economy is growing at an annual rate of 2.3%, and the inflation rate that FED considers is at 1.8%. Slow growth, no inflation and lackluster income growth doesn’t give FED enough room to push the paddle to the metal. Even so, the markets are trying to adjust to the fact that probably the tightening cycle is only a few months away and as Isaac Asimov noted: “Transition is troublesome.”

Reason 4: Strong Dollar

It is usually a good sign when a currency strengthens. It shows that a country’s stability, the value given to its promises and its credibility are rising. It is however a headwind in the short term for the exporters as it makes the exported goods more expensive. About half of all revenues generated by the S&P 500 companies come from overseas. A strong dollar shrinks those revenues and makes it harder to increase market share. It is however also making imports cheaper, lowers input prices and so mutes the inflation. Since the US doesn’t have an inflation problem, the dollar strength isn’t helping. In time, a better and more efficient allocation of resources can and will usually fix this problem (which is good to have), but it does hurt growth while adjusting to it.

Reason 5: Low Energy Prices

Similar to a strengthening dollar, lower energy prices can be a good thing only if those savings were allocated efficiently elsewhere. The reason why it is a negative for now is that the energy companies are the largest contributors to capital expenditures (capex). Low oil prices mean low revenues for energy companies and low revenues mean low capex. Since one’s expense is another’s income, lower spending subtracts from growth. Also, their profit decline lowers their stock prices, adding more pressure to the market indexes.

Reason 6: Stretched Valuations

Valuation is how much one pays to a security for expected returns (capital gains and income) at the risk level of that return to materialize.

Currently, the stock valuations are a bit stretched. Not so much that major indexes are in a bubble territory, but they certainly are not fairly or underpriced. One area that is in bubble territory is the dividend paying stocks. Those seeking yield have been discouraged by the bond market and have found refuge in dividend payers, which made that space a bit crowded.

The market is more vulnerable to shocks with stretched valuations. There is still upside potential…but the volatility in prices is harder to handle for many investors.

Summary:

The bottom line is that the bull market doesn’t end because it gets tired or it expires. It usually ends because of a recession, bubble type extreme valuations or extreme investor optimism. Currently, we are experiencing none of the above.

I have shared with you the reasons to be bullish and bearish in two market updates. Hope you have enjoyed – see you next time.

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

An Irrational Stock Market?

“Don’t let your ego get too close to your position, so if your position gets shot down, your ego doesn’t go with it.” – Colin Powell.

There are many reasons why managing your own investments is a daunting task. The biggest challenge isn’t the lack of expertise or time…those can be attained. The ultimate challenge is removing your emotions from your money and investments. If you associate success, self-worth, security and future well-being with the balance in your bank account, then you need to be aware of the emotional roller coaster you are on. That’s not even the worst of it all. If you make decisions influenced by these emotions, that’s when you get hurt. Your ego gets in the way and sometimes, what your ego asks you to do in the short term, isn’t necessarily in your best interest in the long run. Your ego should carefully be excluded from your critical thinking. Makes perfect sense and sounds easy to do, but even step one – identifying your ego – is a long process, let alone excluding it from important decision.

So what can we put our trust in? Objective data. To find the right answers, one has to ask the right questions.

What are the most important and main macro drivers of capital markets?

  • Inflation (or deflation)

  • Economic growth or lack of it

  • Demographics (aging population)

  • Policy (FED – monetary and Congress – fiscal)

  • Trend (momentum) and prices

  • Sentiment (consumer and investor)

  • Debt burden (or lack of it)

  • Credit conditions

  • All of the above factors in international markets and geo-political conditions

Now clearly, getting into the details of all the above would be beyond the scope of this newsletter, but we can at least talk about the crème de la crème factors and decide for ourselves, whether or not there is more room for growth in stock values given we are at all-time highs. Ladies and gents, allow me to introduce: Inflation, the FED, credit conditions and the economy.

Inflation:

Research shows that, there is indeed a sweet spot for a market friendly inflation rate, which is somewhere between 1.5% and 2.5%.

Below 1.5%, the economy shows the signs of weakness and the risk of deflation becomes a reality. Here, probably the supply-demand balance is supply heavy. Above 2.5%, the economy starts heating up, borrowing rates start to climb, as a result the FED is pressured to raise rates to fight inflation and cool off the economy.

So in case of low inflation, excess supply slows down stock price appreciation. With high inflation, rising costs become the nemesis. A growing but not overly heated economy is where you want to be.

Current year over year inflation rate, (Consumer Price Index issued by the Bureaus of Labor Statistics) is 1.6%. Judging by weather related economic slow-down (more on this later) and its effects on inflation, high inflation is a low probability event for 2014, so you can add this as a plus.

Last note on inflation: low inflation also means low interest rates; low interest rates mean cheap money; cheap money means an investor friendly environment and relatively low fixed income (bonds) returns. When savings accounts and fixed income investors feel they are wasting time with low returns, they are forced to allocate a higher percentage to stocks. Even if these investors chose large dividend paying companies, this pushes valuation of these stocks higher, making growth stocks relatively cheaper and a preferable habitat for growth stocks as well.

The FED:

 In a free market capitalist economy, there are two masters pulling the strings at the macro level: central banks (the FED) and law makers (the Congress). The FED controls monetary policies while Congress oversees fiscal policies. Together, they aim to provide just the right amount of incentives and limits to foster a healthy environment for economic growth and prosperity of all citizens.

The FED has more influence over the market in the short term. Easy monetary policies make it cheaper to borrow and invest, start or grow a business, refinance existing loans and stimulate the economy. Tighter monetary policies would reduce liquidity, raise interest rates and aim to cool off the economy.

Current FED policies are market friendly and accommodating (even with tapering = cutting bond purchases). Yes, the FED cut the amount of sugar but the candy jar is still out there kids. Just because it’s not all you can eat, doesn’t mean you are on a no-chocolate diet, so yes, add this on your list of pluses as well.

Credit/Lending Conditions:

Remember, we are going through the crème de la crème factors, so credit conditions are equally important and surprise: inter-related to the inflation rate and FED policies.

Ever since societies evolved from a barter economy to transacting with the means of an exchange that today we call money, along came banks and credit. In a healthy and well-functioning economic system, banks serve as institutions that funnel savings into investments and support economic growth. Almost no business today can operate without the help of credit. How many people do you know who bought a house with no mortgage? This is all good and dandy but like most things, human greed and lack of regulations to control that, brought us to an abused and over used borrowing conditions, which popped in 2008. When the lending bubble burst, it created a below-the-means response, which meant that we went from extremely loose lending conditions, to an extremely tight lending zone.

Tight lending conditions in a debt driven economy brings compressed economic growth. It is like having one foot on the gas pedal, one foot on the break. If I had more space, I would share with you charts showing the direct relation between lending conditions and market performance.

Today, we are back to less restrictive lending. We are nowhere near pre-2008 levels, but we don’t need to be. As I have noted earlier, we are in a low inflation, low interest rate environment and that’s a great place to start.

Businesses are awash with cash, which eventually would translate in to capital spending and hiring. One side note: one of the strong tailwinds of the stock market performance has been stock buybacks and mergers and acquisitions activity. So there isn’t much demand for business loans compared to previous recoveries, thanks to technological improvements and related efficiencies but that will change and when it does, we will find ourselves in an increasing demand for loans and banks eager to answer that call. If you were wondering, where the next waive for higher earnings will come from; this one will be a big help.

The Economy:

And last but not the least; the economy has to be in growth mode for stocks to appreciate. The only exception is when the economy is coming out of a recession as stocks are a discounting mechanism. In fact, this is when you get your best returns. Since we are almost five years past that point, without the economic growth, there is no tunnel or light.

The most recent real economic growth rate is 2.4% during the last quarter of 2013. This is slow compared to 50 year averages of 3.5%. Add the weather related slow down, this quarter result will probably disappoint. Then why do stocks celebrate? The expectation is a strong recovery in the second half of the year. I wouldn’t be surprised with a 4% growth during the second half of the year, since we have started seeing over 4% growth rates, like 4.1% during third quarter 2013.

Now there is a lot that can go wrong. The market at an all-time high is challenging to maneuver as it is hard for investors to find bargains when there are so many eager sellers to cash in their gains. Secondly, geopolitical threats can throw a serious punch. Russia, luckily alone in the Ukraine crisis, is contained for now but there is no limit to what Putin can and will do once he takes his shirt off and gets on his high horse. Iran is on the back burner right now but Syria is still a boiling pot. Thirdly, European economies can surprise us to the downside. Current expectation for previously troubled economies is to start or speed up with their recovery and this expectation is priced in. What if they don’t deliver? Or conversely, what if the EURO over appreciates and creates headwinds?

 IMF recently has issued a warning/recommendation to the European Central Bank President Draghi, to print more money. If they do, that would be a market positive move; if not, hard to tell at this point.

 Coming off of a very strong year, being a second year in presidential cycle, right at all-time highs, corrections can be fast and furious, case in point the 6-8% waterfall decline that started on Jan 21st. The challenge this year and task at hand is to handle these corrections with your risk appetite and investment objectives in mind.

 Summary:

 In a low interest rate, low inflation, easy FED, loose credit and with growing economy, stock values tend to move towards the right top corner of your charts. Risks are plenty and corrections are expected but for the cool and collected longer term investor, this year may bring positive returns. Summary of summary: Markets are driven by fear and greed. Do you see more fear or greed out there? I see greed.

 Hope you have enjoyed reading my market update. Please feel free to forward it to your friends and family and don’t forget to email your questions or comments to: bbakan@shieldwm.com

 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

SKEPTICAL EVIDENCE

Fighting cognitive dissonance and confirmation bias in market analysis.

Pragmatic Capitalism

Just another WordPress.com site

The Reformed Broker

An Irreverent and Insightful Blog about Wall Street

The Big Picture

Fighting cognitive dissonance and confirmation bias in market analysis.