June 2018 – Monthly Commentary

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June 2018

In the days and weeks leading up to the recent imposition of tariffs on China, nervous investors sold stocks and pushed bond yields lower.  However since the tariffs went into place stock prices have risen, with the S&P 500 just ticks away from its recent high and less than 3% away from an all-time high.  Apparently, investors have chosen to look past the immediate trade rhetoric and are focusing on the coming earning season, expecting it to be another terrific one.  In addition to the initial $50 billion in tariffs, President Trump is threatening to impose sanctions on another $200 Billion of Chinese goods later this summer.  In considering how to best position our client portfolio’s for the fallout from a potential trade battle, we consider the best and worst case scenarios as detailed below.

Obviously, the worst case is that the tariffs turn into a long-term trade war between the U.S. and China, resulting in a pronounced uptick in the price of goods sold in the United States.  Pushing inflation higher has been the mandate of the Federal Reserve since the financial crisis ten years ago.  However, with inflation now above their targeted 2%, a rise meaningfully above that level is unlikely to be a welcome outcome.  Arguably, the Fed has enjoyed engineering inflation higher, but it is unlikely they would equally enjoy the uncontrollable effects of tariff-inflated prices.  Some estimate that the uptick in inflation would amount to no more than one or two percent.  It is nearly impossible to offer a definitive estimate but what is certain is that a rise of that magnitude would not be welcome by equity investors.  In that instance, we expect there would be a meaningful pullback in stock prices.  However, we also view the possibility of a meaningful drop in bonds yields as somewhat limited because the inflationary uptick would not likely influence the Fed predisposition to raise interest rates.  In fact, it could have the opposite effect and embolden them to raise their target neutral rate.

At the other end of the spectrum, the possibility exists that the trade gambit is actually a net positive for the U.S.  We can envision a possibility in which the trade battle is short lived and China opens up their markets to greater competition and improved intellectual property rights.  Under this scenario, American corporations would have the opportunity to participate in the rapid growth China has experienced and is likely to continue to experience as it moves from an emerging market into a developed one.  In this instance, the Federal Reserve would likely continue with their plan for measured rate hikes and ongoing monitoring of the domestic economy.

What is certain, the U.S. economy continues to grow at a rapid pace as witnessed by the June employment report.  For the month, the economy added 202,000 new jobs.  That puts the average monthly gain over the last year at just a shade under 200,000.  That’s remarkable for this stage of the economic cycle.  Even more encouraging, 499,000 people reentered the workforce.  Because of those additional workers, the unemployment rate actually ticked back above 4.0% from the prior months 3.8%.  While we prefer to see unemployment tick lower, in this instance, we interpret the move as unambiguously positive.  This late in the economic cycle the unemployment rate typical ticks up because people are losing their jobs, not because they are being hired.

May 2018 – Monthly Commentary

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May 2018

The bastion of calm that swept over capital markets evaporated in May, as a number of emerging market economies and their markets suffered under the strain of bad policy.  After years in financial purgatory following their 2001 default, Argentina is again facing financial strain.  The serial defaulter returned to the global bond market two years ago with a $16 billion multi-tranche deal that received $70 billion in orders.  Investor demand had grown so strong that last year the Republic issued $2.75 billion 100-year bonds in another wildly oversubscribed new issue.  With interest rates at artificially low rates in the United States and a voracious appetite for risk, investors ignored the history of the borrower.  The euphoria wasn’t limited to the bond market.  The Argentine stock market has been on an upward trajectory similar to that of developed market stocks.  Foreign money flooded into the country in anticipation that the party would continue indefinitely.  Of course, it rarely does when imprudent policy rules the day, as has been the case in Argentina.  The Republic has followed a policy of borrow and spend (not dramatically different from the U.S. policy) for years and with their reentry into the capital markets, the profligacy has accelerated.  That was until it dawned on investors that Argentina is again over her skis.  With inflation solidly in double digits and the debt piling up, investors are on the verge of panic and have begun to sell equities, the Peso, as well as local and dollar-denominated bonds.  The repatriation of assets has caused a rout in the peso.  As the value of the peso falls, the servicing cost of the debt rises, which effectively increases their dollar denominated debt exposure.  In an effort to combat the currency weakness the government raised overnight interest rates to 40% and bought Pesos in the open market.  The action seems to be stabilizing the situation for the time being, with each greenback fetching 25 pesos, a 20% plunge in the last month.

Turkey and Brazil are facing similar situations as deficit spending, rising debt and double digit inflation panicked investors and, similar to Argentina, the value of those currencies have fallen by more than 20% versus the U.S. dollars.  The irony is that the panic in emerging markets can be directly tied back to the ultra-loose monetary policy of the U.S., European and Japanese Central Banks.  In their thirst for yield, investors in the developed markets were willing to invest in risky emerging markets to capture a higher return.  When they realized they weren’t being compensated for that risk, they sold and threw the EM economies into disarray.  The problem the emerging markets face is that in order to keep their currencies from plunging, they need to intervene and buy their currency and hope that their buying is enough to push the value of it back up.  So far, intervention alone has not been enough and all three have been forced to raise short term interest rates in an effort to squeeze short sellers.  The problem with implementing an onerous interest rate is that it risks running the local economy into a recession.

At the time of this writing, the International Monetary Fund has announced an agreement to lend Argentina $50 Billion in an effort to stabile their currency.  The reaction by the market was to send the Peso to a new low.  Despite the emerging market woes, contagion to the developed market seems unlikely, given the momentum of the domestic economies.

April 2018 – Monthly Commentary

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April 2018

Now that we’re well into the new year and the first quarter earnings season is almost fully behind us, it makes sense to pause and try to understand where we are in the economic cycle and what we should expect in the near term future.

The most notable recent change is the stock market.  Compared to February, volatility has diminished markedly.  However, the “buy the dip” mentality that drove stock indices to ever higher levels since 2009 seems to have vanished.  Indeed, since reaching an all-time high in January, the S&P has basically moved sideways, with a few scary price drops followed by “melt up” rallies.  Going into earnings season, we had expected that stock prices would be at or above the previous high by now if earnings came in anywhere near our expectations.  In fact, earnings came in much better.  Through May 5, year-over-year sales are up 9.5% and of those that have reported, 77% have beaten expectations while only 17% have disappointed.  Operating margin during the quarter expanded to 11.56% from 9.84% prompting Standard and Poor’s to boost their 2018 earnings forecast to $157.65, a 26% rise over the $124 earned last year.  S&P forecasts that earnings will rise another 10% to $173 in 2019.  By all measures, this earnings season has been stellar.  What’s perplexing though is that a number of analyst’s have discussed the concept of peak earnings; the idea that this is as good as it gets.  The concept came about on the Caterpillar Corporation’s quarterly conference call.  Several days after the call the CEO clarified the comment to imply that he meant the company had a stellar quarter not that it is likely to be the best quarter of this year or this cycle.  Nonetheless, the media focused on the concept for the better part of a week.

At the other end of the spectrum is the bond market.  The Federal Reserve has raised the Fed Fund interest rate 5 times and has indicated that they’ll probably hike three more times this year.  What’s not received much focus is that the bond market is starting to feel like it’s entering a bear market.  The Barclays Aggregate index has been down 6 of the last 11 months and year-to-date is down -2.19%, while the 10-year Treasury Note briefly traded above 3% recently.  Making the case for higher interest rates, headline inflation registered 2.5% year-over-year in April.  With inflation now trading above the Fed’s stated target, the FOMC has changed the tone of it language, indicating that they’ll tolerate inflation that runs at 2% plus or minus some unspecified amount.  That should be an unmitigated bearish signal to the bond market that inflation is at risk of moving materially higher.  Despite the rising specter of inflation, the interest rate differential between the 2-year notes and the 30-year bond, known as the yield curve, has fallen below 0.60% for the first time since the financial crisis.  As discussed in previous updates we don’t consider the flattening of the yield curve as a leading indicator of a recession.  Instead, we believe it’s just another side effect of the flawed monetary policy.

With regard to employment, the jobs market simply could not be better.  The number of unfilled jobs has risen to an all-time high of 6.5 million positions while the unemployment rate stands at 3.9%, just 0.1% above the all-time low.  Goldman Sachs has forecast that they expect that given current dynamics in the economy, the unemployment rate will fall to 3.25% by the end of 2019.  To put that into perspective, unemployment reached a low of 4.4% during the pre-crisis housing boom.  If Goldman’s forecast comes to pass average hourly earnings and inflation are likely to continue to climb.  With that, we expect inflation will continue to climb, providing a tailwind for the Fed’s interest rate normalization.

March 2018 – Monthly Commentary

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March 2018

March has followed the pattern of the previous two months, with heightened equity market volatility creating worry for anxious investors. Despite that worry, the bond market has been a bastion of calmness with the 30-year bond trading in a relatively benign range of 3.22% to 3.00%. Given the continued strength of the U.S. economy, we had expected the bond to come under price pressure pushing the yield closer to 3.5%. That price action has been befuddling, especially given the steadily deteriorating budget deficit. On April ninth, the Congressional Budget Office announced that the deficit would likely hit $1 trillion dollars in 2020, two years sooner than earlier forecast. Investors didn’t blink an eye, which really is no surprise given the complacency that has swept over the public with regard to the U.S.’s profligate spending. The reaction was much the same last month when Republicans pushed through the $1.3 trillion spending bill.

American’s seem to have come to the conclusion that the Fed has and will continue to ensure prosperity for all and the idea of fiscal responsibility has become nothing more than an old fashioned notion. However, we got a glimpse of the future last month when the Treasury Department flooded the market with Treasury Bills. With the risk of a government shutdown earlier this year, Treasury reduced bill issuance in an attempt to stay under the borrowing cap. Because of the prospect of a shortage of T-bills, the yield to maturity in the secondary market plunged below the low end of the Fed Funds range. As a result, the Federal Reserve’s reverse repo program, which is available to select institutional clients and a de facto loan to the U.S. Government, skyrocketed to nearly $500 billion dollars. When a shutdown was averted and the debt cap lifted, Treasury issued nearly $300 billion in additional T-Bills, a 38% increase over the amount issued in February. As a result, T-Bill yields rose sharply and traded above the upper bonds of the Fed Fund range as investors sought to digest the additional supply.

With the increase behind us, T-Bills maturing in early June have fallen in yield by 15 basis points despite the rate hike in March and the expectation of another rate hike in June. The open interest in the reverse repo program also plunged from $500 billion at the peak to $4 Billion at the time of this writing, a nearly 100% plunge in open interest! The message here is that large moves in supply and demand will move the market, despite the Fed’s manipulation. It just so happened that with the freeze in the Bill market there was an alternative investment. We wonder who’s going to be the alternative source of buying when the Treasury is issuing a trillion dollars of additional debt year after year.

There are those who believe that should interest rates rise meaningfully in the face of supply, the Federal Reserve would restart their bond buying program to absorb the additional supply. While that may be sustainable in the near term, it’s a deeply flawed solution longer term for a number of reasons. First one trillion dollars is approximately 5% of GDP and as interest rates rise the compounding effect is going to cause the debt load to rise at an unsustainable pace. Secondly, as rates rise, the value of their existing portfolio is going to fall in value and that is likely to come under congressional scrutiny. Under the current spending regime both of those outcomes have a material probability of coming to pass. The fiscal irresponsibility of the U.S. Government resembles an individual getting caught up in the vicious circle of credit card debt. The debt is sustainable in the beginning but as spending exceeds income, it ultimately overwhelms the borrower.

In the history of money there have been numerous instances of countries pursing such a policy and in the vast majority of cases, the country was forced to either default on their debt, devalue their currency, or both. One has to wonder what will be the outcome for the U.S. dollar. It currently enjoys the status of being the world’s reserve currency and it’s bonds the store of wealth for many nations. That is unlikely to change overnight, but there’s a very good chance that it will erode. The big question is to what extent?

February 2018 – Monthly Commentary

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February 2018

Six weeks ago, as we closed out January, the S&P 500 Index settled just below its all time high. Financial pundits
at the time were saying that a healthy correction would be good for the market. The term healthy correction
has always seemed an oxymoron. How can a decrease in the value of one’s investment portfolio be
described as healthy? Yet, the term has been in the lexicon of Wall Street for as long as traders have been
able to short stocks. The state of the market since the first of February is a telling example of the lunacy of a
healthy pullback. Stocks plunged more than 10% in the first two weeks of February and despite having
bounced off of the low, nervousness still abounds as witnessed by the sharp intraday spikes higher and lower.
Anecdotal evidence suggests that ETF’s were at least partly to blame for the panic. We’ve written on
numerous occasions of retail investors bemoaning that stock valuations were too high and rather than buying
expensive stocks, have invested in an ETF instead. To be clear, the SPDR S&P 500 ETF invests in every stock in the
S&P 500, even the overvalued ones. To maintain the correct proportions, the ETF manager must buy in the
open market. When demand rises for an ETF, the buying pressure lifts the entire market. Conversely, when
investors dump the ETF, the manager must dump all of the stocks and in the instances we saw in February, the
result is a precipitous drop in the overall market value. Compounding the selloff was an excessively large short
position in stock index volatility (VIX and VIX-like) products. These products have become a fad with active
traders and we believe that many of those trading them did not fully understand the ramification of the risk.
The VIX is a proxy for the expected annualized volatility of the S&P 500 and has traded mostly below 10% since
last summer. Investors had been collecting income by buying an inverse structured note that went higher in
price as implied volatility fell. Viewed as a “no brainer” money maker, retail investors piled in. The problem was
that when stock prices fell, implied volatility rose, inflicting losses on the VIX sellers. The market makers of the
products were forced to buy offsetting positions in the open market which pushed the value of implied volatility
higher and had the collateral effect of further spooking ETF holders. In short order a vicious circle developed
which drove the price of the broad market 10% lower in the course of a week. Happily, corporations stepped
in to buy back stock at a ravenous rate, staunching the selling and emboldening investors with the confidence
to do what they’ve been conditioned to do since 2009. Namely, buy the dip!

While not directly responsible for equity weakness, newly sworn-in Fed Chairman Powell made his first public
comments in testimony before Congress and his remarks were interpreted as being decidedly hawkish. Before
the testimony, consensus opinion was for three rate hikes this year, with some members of the FOMC arguing
that even that was too hawkish. Since the testimony, the market now reflects 100 basis points of tightening this
year including one later this month at the March 21st meeting. That has translated directly into higher interest
rates, with 3-month LIBOR crossing the magical two percent level. Also adding upward pressure to short
maturity interest rates is the sharply higher amount of new T-bill issuance coming to the market. As we’ve
discussed last month, the U.S. government is going to need to finance their continued excessive deficit
spending and that means more debt issuance.

Also catching the eye of investors was the rise in the yield of the 10-year note as it approaches 3%. This is the
third time since 2012 that the yield has approached 3% only to reverse direction. We’ll be watching that level
closely. Quite often in markets when a price, or in this case yield, breaks through a resistance level on its third
attempt, it usually follows through in meaningful way. If we get through 3%, we could very well see 3.5% before
too long.

January 2018 – Monthly Commentary

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January 2018

The Federal Reserve, in managing the U.S. economy, is tasked with the dual mandate of ensuring full employment and stable inflation. The mandate is somewhat contradictory in that at full employment the tight labor force is likely to force wages higher which, in turn, risks pushing the overall level of inflation higher. That is, of course, if the numbers accurately reflect the actual rate of inflation, which we regularly argue is not the case. By focusing on an underreported rate of inflation the Fed has fallen dramatically behind in adjusting interest rates and now finds itself facing an overheating economy. Evidence is abundant in fourth quarter earnings reports, with strong revenue growth, rising cost of goods sold, and rising labor costs. In short, business is good but the cost of doing business is rising and output is at risk of being constrained by a shortage of goods and labor.

Prior to the most recent expansion, conventional wisdom held that the economy was operating at full capacity when the unemployment rate reached the theoretical level at which a further decline would cause a rise in inflation. The measure known as the Non-Accelerating Rate of Unemployment or NAIRU, was a completely subjective measure, but was considered to exist at approximately 5.2%. Economists would debate the precise level of NAIRU while bond traders sold bonds when unemployment approached the feared 5.2%. It was understood that the Federal Reserve would raise rates in advance of achieving full employment, so as to not let the inflation “genie” out of the bottle. Of course, that was thirty years ago and the inflation nightmare of the 1970’s was still fresh in the minds of most Americans. Fast forward to the current situation and the concept of NAIRU has all but disappeared. So much so that as we start the New Year and financial firms put forth their 2018 economic forecasts, some have called for the unemployment rate to fall below 3%. Applying the logic of NAIRU, if 5.2% unemployment is a sign of a strong economy, isn’t 3% a sign of an overheating economy? Despite that, the Fed continues to keep interest rates low, and notwithstanding the recent market volatility, the appetite for stocks remains strong. Indeed, the S&P 500 generated a positive return in every month last year; the first time that’s ever happened. Moreover, with the recently passed tax reform, corporations are likely to repatriate the vast sums of cash that they hold overseas. The hope of the President is that they’ll use those sums to fund research, development and expansion. The worry, instead, is that they will use the repatriated cash to buy back shares of their stock. We suspect that corporations will do a little bit of both. With every sector of the economy running at peak performance and the tax cuts putting more money in the pockets of consumers and corporations, and the stock buyback machine continuing to operate at full speed ahead, what could go wrong?

Investors have contemplated that question in the last several trading sessions and the answer seems to be concern that the Fed will finally begin to move more aggressively in raising rates. To be sure, the risk always exists that a mild selloff could develop into something more significant creating a material pull back in stock prices, greater than the 9% drawdown we’ve seen this month. But that’s seems unlikely to happen for two reasons. First, the Fed is not going to suddenly become hawkish. Despite the economy running at full capacity, there are some members of the FOMC that are still arguing against normalizing interest rates. Secondly, since 2009 the Pavlovian response to any market weakness has been to “buy the dip.” That goes for individual investors and corporate buybacks. But that’s not to say that stocks are cheap. We’d argue otherwise and that the selling is justified by the valuation. But anecdotally, the first quarter has started on a healthy note and there’s a very strong likelihood that first quarter earnings will surprise to the upside which is likely to embolden the bulls.

Then where is the risk? If the Fed is supportive of stock prices and there is a seemingly insatiable demand from investors, what could hurt the market? The answer is the hidden in plain sight, and it’s the climbing debt load. Every year during his eight years in office President Obama ran an enormous budget deficit. It became an issue for about a political “minute” when the now-defunct “Tea Party” Congressmen tried to fight it, but it’s since decidedly become a non-issue. So much so that the $1.5 trillion price tag for the Trump tax cut was merely a minor issue in negotiations. Currently the value of outstanding U.S. government debt stands at $20 trillion, that’s more than double the size of the debt when Obama took office. And with some forecasting $1 trillion annual deficits in the coming years, the bond market could be headed toward a point of saturation. The biggest question of all will be how the Fed will respond if the saturation point comes at the same time that inflation becomes a problem. The bigger question is how close are we to that point?

December 2017 – Monthly Commentary

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December 2017

While the team at Halyard evaluates the economic and market backdrop on a daily basis, we like to commit those thoughts to paper periodically, and especially so as we kick off the new year. Our starting premise this year is that the United States economy closed out 2017 with unmitigated strength. From a sector by sector perspective, we’re delighted to find the strength was broad based and not concentrated in any one sector or industry.

While too early to tally the result of the just ended holiday selling season, it’s seems likely that retail sales set a record with internet sales clogging the delivery channels late in December. Holiday shopping seems to have been forever changed, as the madness of black Friday has decidedly been replaced by cyber Monday which really was more like cyber December. Many of the individuals with whom we spoke said they happily avoided visiting the mall altogether this year. Nonetheless, sales were strong and UPS, FedEx, Amazon, and Walmart took an outsized share of the spoils. The very high level of consumer confidence and the robust jobs market were directly responsible for the success of the season as consumers felt confident about their prospects for job retention and wage growth.

Consumer confidence also benefited the housing market as new home sales sold at a pace not seen since pre-crisis. Despite the uptick in sales, new home construction is still well below the peak rate registered in 2005, which should be supportive of further industry gains. Moreover, the builders have carefully managed inventory to avoid a repeat of the oversupply witnessed during the peak. Similarly, the inventory of existing home sales continues to dwindle as sales outpace offerings. With the relative tightness of inventory, home prices, as measured by the Case Shiller index, closed the year with a 6.3% annual rise in price. The phantom wealth gain of rising home prices is contributing to a virtuous circle of ebullient consumer confidence and their propensity to spend.

Manufacturing continued its renaissance as the sector continued to grow, adding 79,000 new employees in the fourth quarter and registered employment gains in every month of 2017 save one. That’s a pleasant change from the month after month job cuts witnessed in the 2000’s.

With the backdrop of full employment and strong consumer confidence we believe the economy will continue to expand at least at a moderate pace. Moreover, as the Trump tax cuts work their way through the economy, the potential exists that the moderate growth could expand into a consistently greater than 3% annualized GDP growth. That’s a scenario that we believe would alarm the Federal Open Market Committee and perhaps cause them to consider more aggressive tightening. For the foreseeable future, however, we expect they will continue on the path of slow and steady rate hikes with three or four hikes in the coming year. Similarly, we expect that their bond purchase tapering will continue at the stated pace. One nuance that could be changed is the mix of asset purchases related to the recent flattening of the yield curve. Much talk has focused on the yield curve flattening as portending a recession or at best resulting in a drag on the financial sector. In thinking about the flattening, it’s important to keep in mind that it’s a direct result of the Fed’s manipulation of interest rates in the open market. It’s also important to remember that the Fed has an open dialogue with the money center bankers and considers their concerns when developing monetary policy. Given those considerations, we would not be shocked if the Fed decided to buy less of the longer maturities and allow that rate to drift higher, thereby steepening the yield curve. The challenge they face, should they decide to follow that course of action would be the size of the reduction and to what level they would like to see the yield curve move.

As for our portfolio construction, we continue to be of the mind that interest rates are too low and long duration exposure should be avoided. Currently we’re keeping maturities under three years and focusing heavily on floating rate notes. With the expectation that the Fed will continue to tighten, floaters will perform well as their coupon adjusts higher with each rate hike, thereby anchoring their price at close to par. Finally, given the relative expensiveness of riskier assets, we are limiting our exposure to investment grade corporate and municipal issuers while avoiding European banks, emerging market debt, and high yield issuers.

November 2017 – Monthly Commentary

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November 2017

In 2004, an acquaintance left his job as a banking clerk to become a real estate sales agent. Almost overnight his income doubled as the homes he represented sold briskly. The market was so hot that he was working seven days a week and his income soared well over $200,000. However, in 2006 sales began to slow and buyers were grumbling that home prices had grown out of reach. Builders continued to build new homes, albeit at a diminished pace, and realtors aggressively argued that all was well in the market. The neophyte real estate broker, in an effort to sustain his business added a “click-through” to his website entitled the “anti-bubble argument.” When clicked, a series of charts popped up comparing home prices to a number of measures, concluding that not only was real estate not in a bubble, but the opposite was true. To not buy would be to miss out on the next leg of another profitable run in home prices. His logic was that if he could convince his clients that U.S. home prices were going higher, he’d be able to ensure that his recent uptick in income would continue. Of course, that wasn’t to be and he is now blissfully, though less profitably, operating a boutique organic vegetable farm. I was reminded of his anti-bubble argument as I listened to the parade of investors and traders on the financial news program one recent morning. One after another, the experts agreed that stock prices are expensive and the risk level elevated, but each suggested looking past valuation so as to not miss the next leg up in prices. They are engaging in the same attempt at deception as the real estate agent. The profitability of their employers depends on investors remaining invested in their funds. When pressed on the matter of valuation, the usual retort is to say that they mitigate the downside by focusing on high growth stocks or defensive stocks, or some combination of both. We see many similarities between the current stock market and the 2006 Real Estate market. It impossible to know for how much longer the stock rally will last, but by nearly every measure, stock prices are expensive.

We’ve written on several occasions about our frustration with government reported data and the release of the October consumer price index (CPI) is another stark reminder of why. The Bureau of Labor Statistics reported that headline CPI rose 2.0% year-over-year, decelerating from the 2.2% pace recorded the previous month. Often we’ve said that the muted CPI seems directly at odds with the rising cost of living of the average American. Digging into the details of the report offers a glance as to why and we reference several components to illustrate the point. The first is shelter, which constitutes 33% of the index. The economic profession looks to the Case Shiller national index as the definitive measure of home price inflation and the last reading was a 6.07% rise in home prices year-over-year. That’s far higher than the 3.2% change measured in CPI. Adjusting for the actual change in home prices would add approximately 0.71% to the top line inflation measure. The next items we question are medical care and health insurance, rising 1.9 and 0.2%, respectively. Unlike home prices, there is no definitive data to substitute for these items, but one can attest that when co-pay and co-insurance are factored in the cost of a visit to the doctor, and the staggering annual increase in insurance premiums, health insurance costs are rising far faster than the ridiculous rates suggested by the BLS. Finally, according to the BLS the cost of telephone and internet services fell -7.1% and -1.0% year-over-year, respectively. Regarding those two items, the BLS has said the move to unlimited data earlier this year would result in a falling adjusted price when the additional service is considered. In essence, they’re saying that you’re getting more for your money so that’s deflationary. I can tell you that neither the cost of our phone nor the cost our internet access has fallen. Ever! To solve for the inaccuracies presented by the BLS, we made a number of subjective statistical adjustments that are in no way definitive, but nevertheless, we believe are more reflective of price changes. Based on those adjustments we believe the year over year change in the cost of living is closer to 3.25% rather than the 2.0% report by the BLS. By that measure, the real return on the 10-year Treasury note would be -0.85%.

October 2017 – Monthly Commentary

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October 2017

Last month marked the 30th anniversary of Black Monday, October 19, 1987, prompting us to take a look back at how the Dow Jones Industrial Average has evolved since that infamous day. Of the 30 stocks in the index at the time, Bethlehem Steel, Eastman Kodak, GM, Union Carbide, U.S. Steel, and Woolworths have all gone through bankruptcy. Some reorganized and reemerged, but most didn’t. Sears, which also was part of the index in 1987 is quite likely to be gone in the next six months. Digital Equipment Corporation (DEC) was not in the index, but as the leader in mainframe computer production, it was the premier technological company at the time. Unfortunately for DEC investors, the utilization of mainframes dwindled as minicomputers sales soared, and a significantly diminished DEC was bought by Compaq computer in 1998. At the time of the time of the DEC purchase, Compaq was a pillar of the tech industry, and together with Dell, Microsoft, Intel and a host of other tech companies were represented in virtually every growth portfolio. Four years later, Carly Fiorina, the one-time Presidential hopeful and then Chairwoman of Hewlett Packard engineered an $87 Billion “friendly” merger between HP and Compaq. The integration of the two companies did not go well and it wasn’t long before investors were punishing the stock which, in turn, led to the ousting of Ms. Fiorina.

One would think that such woeful performance would weigh heavily on investors as they evaluate the riskiness of the current stock market as it rallies to new highs on a nearly daily basis. Last month we wrote about Warren Buffet’s proclamation that the Dow index would probably hit 1,000,000 in the next 100 years. The “Oracle of Omaha” in his promotion of buy and hold investing, didn’t mentioned that the Dow Jones Index is not a buy and hold index and regularly drops underperforming companies. The theory of a buy and hold portfolio completely ignores what to do when a company starts to show financial strain or loss of competitive advantage. To hear Buffet tell it, investors would be best served by buying and never selling. However using the 1987 Dow Jones index as a proxy for a buy and hold portfolio, an investor in that index would have had 20% of their 1987 portfolio fall to zero. Of course that’s taking portfolio construction to an extreme and the investor would have been well served by simply rebalancing their portfolio to mirror the new index components. The point is, setting it and forgetting it, as Mr. Buffet suggested, is a perilous plan; and that goes for the bond market as well. With interest rates pegged at artificially low rates and credit spreads at the low end of their long term range, it’s easy to be lulled into a false sense of security. We see it in abundance across the various sectors, both domestically and internationally, high yield and investment grade, emerging market and sovereign debt. Driven by the incessant search for yield, appetite for return is forcing investors to take risks that aren’t commensurate with the measly returns offered. While it’s plausible that the low rate environment could last for the foreseeable future, we believe that investors will ultimately be punished for imprudent investing.

Turning to the economy, data reported during October painted a picture of unmitigated strength. The litmus test for economic health is the labor market and despite hurricanes Irma and Harvey-related hiccoughs, the economy continues to create jobs at a rapid pace. The unemployment rate fell to 4.1% as 261,000 new jobs were gained in October, and the prior month’s job figure was revised higher by 51,000. Equally encouraging was the 3.0% GDP growth rate registered in the third quarter. Economists had warned that the aforementioned hurricanes were likely to trim as much as one percent from that growth rate and were shocked to see the three “handle”. To summarize the state of the U. S. economy, the labor market is at full employment, manufacturing is booming as is the tech sector, inventories are lean, and home builders can’t build houses as fast as they’d like because of a shortage of workers. Historically, at this stage of the economic cycle, the Fed would have overnight interest rates at a level 75 to 125 basis points above inflation. That would translate to a short term rate somewhere between 3.00% to 3.50%, instead of the 1.25% level at which it currently stands. Our concern is that the economy is at risk of a spike in wage growth that spooks the Fed and it’s bevy of new governors and they respond by speeding up the pace of rate hikes or more sharply curtailing the quantitative easing still in place. That would undoubtedly destabilize stock and bond prices. As we said earlier, investors will ultimately be punished for imprudent investing.

September 2017 – Monthly Commentary

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September 2017

Signs of excess abound in the capital markets as the ongoing emergency monetary policy supports frothiness and exuberance at every turn.  Last month, billionaire Warren Buffett commented that he wouldn’t be surprised if the Dow Jones Industrial Index, currently valued at 22,600, climbed to 1,000,000 in the next one hundred years.  In making that audacious prediction, Mr. Buffett seemed to be showing unbridled confidence in the stock market.  However, solving for the average return, a mere 4% compounded annually would take the index to 1,000,000 in 2117.  Since 1928, the average annual return for the index was has been approximately 11.4%, or nearly three times that expected by Buffet.  To measure the variation around that average return, statisticians look to the standard deviation, which for the same period was approximately 19.7%.  Sparing the reader the calculations and explanations, that standard deviation implies that an investor can expect, with near certainty, that the return of the Dow Jones average will be between and -47% and 70%.  That’s an enormous range, but reflective of what has been witnessed since 1928.  The worst year was -43% in 1931 and the best year was 52% in 1954.

At this point the reader may be wondering why an investment firm specializing in fixed income cares about the risk/return profile of stocks.  The short answer is that stock prices are one of the macro factors that impact interest rates.  What prompted our thinking was the collapse of implied volatility imbedded in S&P500 option prices, often referred to as the VIX, or as the media likes to call it, the fear index.  On September 21st, the day after the FOMC meeting, the implied volatility on S&P 500 options touched 6%, one of the lowest levels ever witnessed.  To put that into context, let’s assumes that for the next for the next 100 years the average expected return of the S&P 500 will be 11.4% as it was for the last 100.  If so, that 6% implied volatility is indirectly saying that you can expect the stock market to generate between -7% and 29% with near certainty.  Of course, the options we’re talking about expire in two weeks, not 100 years.  But the concept is the same and illustrates the ridiculous degree of complacency that’s crept into the capital markets.

The irony is that the media had been abuzz in September with continued nuclear saber-rattling out of North Korea, the catastrophic results of two category 5 hurricanes, the worst earthquake in Mexico in over 30 years, and hawkish language from the Federal Reserve.  To further drive home the irrationality of the capital markets on that same September day that implied volatility bottomed, pundits were pointing to the yield differential between the 5-year and 30-year Treasury notes as indicating that a recession is looming.  If a recession is looming, stock prices should be a whole lot lower, and implied option volatility a whole lot higher.  Recall that in a recession profits recede from their previous high and the price/earnings ratio of those earnings contracts, taking stock prices lower.

We do not share the view that the U.S. is at risk of recession, but we are of the opinion that stock prices are overvalued, especially if interest rates rise, which seems likely, albeit at a very slow pace.  With that opinion and the exceptionally low cost of option protection, now may be a good time to hedge one’s equity portfolio.