And I could tell the wise men from the fools

June 26, 2017 – DJIA = 21,394 – S&P 500 = 2,428 – Nasdaq = 6,265
“And I could tell the wise men from the fools”[i]
Going into the Memorial Day weekend, the S&P 500 was up 7.89% YTD.  A nice 5-month stretch.  But for those keeping score at home, there’s more to this story as not all stocks deserved a long weekend.
The 5 largest stocks in the index (Apple, Facebook, Amazon, Microsoft, and Google/Alphabet) were responsible for about 40% of this number.  In other words, without these “Fab Five”, the S&P 500 would have advanced a more modest 4.6%.  As a result of their stock prices’ success, our five horsemen have grown to become 14% of the index’s value which exceeds $20 trillion.
That these are premier companies is indisputable.  That their collective financial results should drive such a disproportionate stock market gain is a bull market.  Regardless of the level of logic involved, the fact is that the FAAMG stocks are leading this bull run.  And we must remember that perception is reality in the stock market – it may not make sense but market’s price is the market’s price.  (As a point of clarification, the more commonly used stock market acronym is FANG which includes Netflix at Microsoft’s expense and the “A” accounting for both Apple and Amazon).
Stock market trends eventually end and it may be happening to this one.  On June 9th, a day like most, these investor favorites were leading the indexes to new record levels.  Then suddenly, out of nowhere, the favorites fell.  Apple, Amazon, Facebook, and Google all fell over 3% that day.  Netflix dropped 4.7% and Nvidia dove 6.5%.
The Nasdaq Composite retreated 1.8% from the previous close and 2.1% from the morning highs.  The Nasdaq 100 (the 100 largest of the Composite) fell 2.44%.  The weakness was primarily in technology as the Russell and Dow Jones Industrial Average (both less technology weighted) advanced that day while the S&P 500 was flat.
Interestingly, there was no definable event or cause for this tech wreck.  Some attributed the reason to a Goldman Sachs report that was released that morning which suggested these stocks had increased “mean-reversion risk”[ii]  In other words, these stocks had gotten extended from the rest of the markets in both performance and valuation.  In addition to this Goldman Sachs news, there were rumors that short sellers were targeting some of the names.
Despite this sell off, technology remains the best performing sector for 2017 by a wide margin.  One of the main reasons is that these companies are showing the most growth in an economy struggling to find a higher gear.  Here are the year-to-date returns for the major averages through last Friday.
                                                                                     2017 YTD
Dow Jones Industrial Average                                       +8.3%
S&P 500                                                                         +8.9%
Nasdaq Composite                                                         +16.4%
Russell 2000                                                                  +4.2%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.
It is noteworthy that many of the targets of the June 9th carnage remain below the levels from that day.  For some of these stocks it may have been an “emperor’s new clothes” moment and marked a longer-term inflection point.
Companies like Apple, Amazon and Google are transformative.  They have developed products that changed consumers lives, and as a result, have a high level of customer loyal.  However, all tech stocks are not equal especially when it comes to valuation.
For example, Apple trades at a price-to-earnings ratio of 16.8 and 11.4 times its enterprise value-to-EBITDA.  (The enterprise value to EBITDA ratio compares the value of the company’s stock and net debt to cash flows from operations).  Both numbers are reasonable for a premier organization like Apple.
Google and Microsoft trade at slightly higher valuations.  Google’s P/E is 31 and its EV-EBITDA is 18.  Mr. Softy’s P/E is 22 while its EV-EBITDA is 14.
Turning to the other high-profile market leaders, Amazon’s valuation is rich.  It trades 183 times trailing twelve months earnings and 36 times EV-EBITDA.  In addition to this nosebleed price, the retailing powerhouse is getting into the grocery business by buying Whole Foods.  While grocery industry has a notorious reputation as being a miserable business, Jeff Bezos has proved many doubters wrong as he changed the retail industry.  Maybe he can do it again in this low-margin, cut throat business.  It will be interesting to see what happens.
Netflix’s credit rating is junk (single B) and its stock carries a 197 P/E and a EV-EBITDA multiple of 12.  Apparently, Mr. Market is willing to overlook such details as long as they keep growing revenues at 30% per year and the stock price keeps moving up.
The June 9th reversal in the stock market’s technology leaders should be noted.  It might be nothing more than another dip that gets bought with no lasting impact.  Or it could be an important declaration that these stocks are overpriced and a correction is needed.  Just as it took a child to pronounce the obvious in “The Emperor’s New Clothes”, the Goldman Sachs observation might embolden the bears – what few that are left.
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
130 Riverside Drive
Binghamton, NY 13905
[i] The Emperor’s New Clothes, Hans Christian Andersen, 1837
[ii] Barron’s, June 10, 2017

“How Do You Measure Yourself with Other Golfers? By Height.[ii]

June 16, 2017 – DJIA = 21,080 – S&P 500 = 6,210 – Nasdaq = 5,805
“How Do You Measure Yourself with Other Golfers?     By Height.[ii]
The Federal Reserve raised interest rates on Wednesday for the third time since December.  It was widely expected as the market had placed a nearly 100% probability on the event.  However, hours before the announcement, the economy, trying to fit into the populist movement, coughed up a couple of hairballs at the feet of our bureaucratic bankers.
Specifically, the Labor Department reported that seasonally adjusted consumer prices fell a 0.1% in May.  Also, the Commerce Department reported that retail sales dropped 0.3% in May.  To be sure, these are just two data points but they are suggesting slow growth.   A softer economy, if this becomes a trend, is not what the Fed is expecting and will not mix well with rising interest rates.
In another display of irony, long-term interest rates have been declining as short-term rates have been climbing.  This has resulted in a flattening yield curve.  In fact, the spread between the yields on the 2 year and 10 year Treasury note (a commonly watched indicator) closed yesterday at 81.5 basis points. The spread between the 5 year note and 30 year bond reached 102 basis points or 1.02%.[iii]  In other words, investors are rewarded 1% for buying a bond with a 25 year longer maturity.  Ummm…. we’ll pass.
Inquiring minds want to know – what’s causing this?  Is the economy slowing and with it loan demand?  Or is this a temporary situation and a good time to sell long maturity bonds before interest rates move higher?

Some interesting data related to this debate is that the St. Louis Federal Reserve released business loan numbers recently.  Commercial and industrial loan (C&I) growth has been stagnate over the past 7 months at just under $2.1 trillion.  As a point of reference, C&I loans grew 49% from 2012 to 2016.[iv]  A strong, expanding economy should be generating increasing loan demand.  

That it isn’t happening is something to be noted.
This, of course, places increased importance on upcoming reports such as June’s employment figures, ISM surveys, and orders for durable goods.  It promises to be a busy summer.  Wall Street didn’t need a vacation.
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
130 Riverside Drive
Binghamton, NY 13905

[i], June 14, 2017

[ii] “Caddyshack”, 1980
[iii], Grants Almost Daily, June 15, 2017
[iv] Ibid, June 12, 2017

“I Think I Can, I Think I Can…”

Stocks reached a new 2016 high in the first half of last week at 2,120 for the S&P 500.  Traders and strategists agreed the next stop would be a short trip to 2,130 and a new record high.  This would break a 13-month drought without a fresh record close.  However, by week’s end the S&P was back below 2,100 and the optimism shifted to gloom as worries grew over U.S. interest rate increases, slowing global economic growth, and BREXIT.
The 2,100 level on the S&P 500 has been a difficult level to overcome.  This was where the markets began the year and before the nasty selloff that marked January and February.  After equities stabilized, the rally brought the S&P back to 2,100 in April from where it fell back again.  This latest assault appeared to be a ‘third time is a charm’ event as we traded 7 consecutive days above 2,100 before retreating.
Eventually the S&P as well as the Dow Jones Industrial Average will rally to make a new high.  But last week’s selloff raises the risk that we test materially lower before celebrating new all-time highs.  Market breadth deteriorated as stocks fell with Friday being especially weak.  This could be a sign of increased selling pressure before finding a bottom.
The worries mentioned above go beyond stock market turmoil.  Bond yields are the lowest in history.  Over $10 trillion of global government debt trades at a negative yield with Germany’s 10-year Bund trading just above 0% (at 0.02%).  The Swiss 10-year bond changes hands with a negative 0.5% yield and the Japanese 10-year bond is negative 0.17%.  Obviously, this would not be the case in a normally functioning economy or even the prospect of one.  The fact that more debt has recently slid into negative yield territory could also be a result of a declining confidence in policy makers and their various forms of quantitative easing.
While negative yields are a head scratcher, there are some bond market sectors that are performing well.   High yield bonds are those with credit rating of BB and lower (BBB and above are considered investment grade).  They normally are issued by medium and smaller companies and usually offer a higher interest rate to compensate for the higher risk of repayment.
High yield bonds, after being hit hard in 2015, have rebounded in 2016.  The declining price of crude oil and natural gas was a big component in last year’s selling.  Many energy producers used bonds to finance operations and investors sold that debt as commodity prices plunged.  Indeed, some in the energy area have filed bankruptcy in 2016.  However, there are many non-energy issues that got thrown out with the bath water and presented a good opportunity.
The high yield market bottomed in December.  Clearly, this area has been helped by crude oil’s rebound as $50 per barrel gives the producer more bottom line than a $30 price.  But, also sentiment got too pessimistic as there were predictions of widespread financial calamity in energy.
Looking at the two high yield bond ETF’s, HYG and JNK, they have performed well during 2016 and especially strong since the February market lows.  HYG is up 3.4% year-to-date and 8.8% since bottoming in February.  These returns are competitive with the stock market but exceed equities when the almost 6% dividend is included.  The JNK has similar YTD returns – 4% YTD and 12% since February.  JNK trades with a dividend of 6.3%.
As a comparison, here are the major averages for 2016.
2016 YTD                            
Dow Jones Industrial Average   +2.5%
S&P 500                                   +2.6%
Nasdaq Composite                    -2.3%
Russell 2000                             +2.5%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
The stock market often rallies when the headlines are bleak – climbing a wall of worry.  And while it can always get worse, it is hard to imagine anything exceeding the current news flow.  We have slowing economic growth combined with many levels of global uncertainty on top of ongoing terrorist attacks wrapped in a presidential campaign with two polarizing candidates.  That’s a pretty steep wall of worry.  Perhaps this is why some high profile investors (Stanley Druckenmiller, Carl Icahn, George Soros) are recommending getting out or shorting the stock market.
Nevertheless, we’ve been dealing with these obstacles for a while and it could be argued that they are priced in.  As mentioned in the last newsletter, investor sentiment has been pretty negative for some time.  In the short term, it would be constructive for the U.S. markets to hold their 50-day moving averages and the May lows.  That could recharge the stock market for yet another run at the record levels.  If that fails to happen, it might be a tough summer.
Jeffrey Kerr is a Registered Representative of and securities are offered through LaSalle St. Securities LLC, member FINRA/SIPC. Mr. Kerr is an Investment Advisor Representative of and advisory services are offered through Kildare Asset Management, a Registered Investment Advisor. Kerr Financial Group and Kildare Asset Management are not affiliated with LaSalle St. Securities LLC.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is not indicative of future results. Investing involves risks, including the risk of principal loss. The strategies discussed do not ensure success or guarantee against loss. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is not possible to invest directly in an index. Trading of derivative products such as options, futures or exchange traded funds involves significant risks and it is important to fully understand the risks and consequences involved before investing in these products. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional

Too Much of Everything is Just Enough

May 30, 2017 – DJIA = 21,080 – S&P 500 = 6,210 – Nasdaq = 5,805
“Too Much of Everything is Just Enough”[i]
From tulips to technology, investors have a long history of becoming fixated on fads.  Sometimes these trends become so popular that they develop into bubbles.  Of course, Wall Street is happy to feed these infatuations by offering products and strategies to meet their clients’ desires.  But don’t misjudge this as enhanced customer service and increased altruism – it generates increased commissions.
Under the heading of there’s nothing new under the sun, in recent years, investors have been flocking to an old approach – indexing or passive investing.  We’re not suggesting that this movement ends the same as past overcrowded manias, but it should have investors’ attention.
Passive investing or indexing is a buy and hold approach where investor’s capital is diversified across asset classes.  Typically, this involves assets invested in large cap, mid cap and small cap equity sectors.  It can be further divided on both value and growth styles.  Also, international and emerging markets can be included.  And most passive strategies include fixed income, real estate, and precious metals.
Some of the advantages are ease and economics.  Instead of conducting the research needed to develop a portfolio, it is much easier to buy the index.  Also, buying the index and holding it for the long term reduces trading expenses.
Although many have recently become more aware of indexing, it is not new.  The mutual fund industry has been offering the strategy for decades and Vanguard built an industry powerhouse based on the indexing philosophy.
Passive investing’s popularity has grown to incredible heights during the past few years.  It is estimated that inflows into U.S. equity ETFs have exceeded $15 billion per month for the past 6 months.  For the twelve months ending February, a record $281 billion was invested in ETFs.  Since March 2009 (the start of the bull market), ETFs have received net flows of $1.67 trillion.  This compares to $179 billion into equity mutual funds during the same time.  The chart below illustrates the growth in the investment capital into ETFs.[ii]
When an index ETF receives inflows, they have to invest these dollars in order to maintain the portfolio’s proportional match to the index.  Holding cash is a no-no even if you think the market is risky.  This results in some interesting market dynamics.
Let’s look at the most popular index, the S&P 500, and some of the ETFs that index to it.  Before getting into the ETFs, it’s important to remember that the S&P 500 is a cap weighted index meaning that the larger the market capitalization, the more influence it has on the index.
iShares and Vanguard are the two ETFs families with the largest year-to-date inflows.  The iShares Core S&P 500 ETF (symbol = IVV) has around $9 billion of assets.  Their top ten holdings have to match the S&P 500’s 10 largest stocks and they do.  They are Apple, Microsoft, Amazon, Facebook, Exxon, Johnson and Johnson, Berkshire Hathaway, JP Morgan, Google, and General Electric.
Sticking within the iShares stable, the iShares Core S&P Total U.S. Stock Market ETF (symbol = ITOT) has $1.653 billion under management.  Its top ten holdings are exactly the same as the IVV.
Turning to Vanguard’s S&P 500 ETFs, the Vanguard S&P 500 ETF (symbol = VOO) has $4.475 billion under management including $310 million of recent inflows.  Its top ten holdings are exactly the same as the iShares IVV and ITOT.  The Vanguard Total Stock Market Index Fund (symbol = VTI) is a $3.148 billion ETF which enjoyed a $550 million addition of investment dollars.  It too owns the exact same top ten holdings.
Of course, there are some adventurous mavericks that still participate in the capital markets.  These guns slingers might be courageous enough to deviate from the stock indexes if only for a small amount to complement their passive assets.  Say our brave investor wished to move part of his or her portfolio into the $25 billion Vanguard High Dividend Yield ETF.  Among the top holdings for this independent thinker’s decision are some familiar names – Microsoft, Exxon, Johnson and Johnson, and JP Morgan.  So much for diversification!
Or maybe someone wants to speculate further and include the Vanguard Mega Cap Growth ETF in their portfolio.  Once again, our decision doesn’t add much to a broadening of the investment reach as this ETF’s top holdings include Apple, Google, Amazon, and Facebook.
Naturally, distortions can happen when there is too much demand for something with a stable supply and the stock market provides another the example.   At the end of last week S&P 500 was up 7.89% year-to-date.  If we remove Apple, Amazon, Facebook, Google, and Microsoft, the S&P 500 is up 42 percent less or 4.6%.  This means that the ‘Fab Five’ in addition to accounting for a little less than half of the year’s gains also represent 14% of the index.
Of course, that these leaders are up so much means that they attract even more interest which bids their prices higher.  Where and when this cycle ends is guesswork.  This touches upon an important point to passive investing – economic fundamentals and stock valuations do not matter.  Index ETFs don’t care about such things as earnings, GDP growth, the Fed’s next meeting, or Brexit.  Index ETF’s buy the components of its index, everything else is noise.
Not only has the number of indexes grown, they have gotten creative.  HACK is the symbol for Purefunds ISE Cyber Security ETF.  The Vaneck Vectors coal ETF’s symbol is KOL while their Agribusiness ETF is MOO.  The SPDR Bloomberg Barclays High Yield Bond ETF is appropriately listed as JNK.  Oh those crazy Wall Streeters.
Here is a graph from the Bloomberg report of the history of the number of stocks as compared to the number of indexes.  The number of publicly traded stocks peaked at 7,487 in 1995.  This downward trend seems to have stabilized during the past few years.  On the other hand, the indexes’ hockey stick shaped growth is remarkable.
The ETF population remains well below the number of mutual funds which have plateaued since around the turn of the century.  Here is a chart which includes the mutual fund industry. [iv]
While the popularity of indexing is not an evil, it has distorted the markets.  The market price-to-earnings ratio is historically high and bond yields are low across all sectors.  Both are influenced by capital inflows into passive investing.  It might be hard to imagine but someday, away in the future, investors may want to reduce market exposure. Perhaps one day the capital markets negatively react to an interest rate increase or a terror attack or some Washington wackiness.  If this happens in a large quantity, ETFs will be selling the same positions at the same time likely causing prices to fall.  This could strain liquidity which would cause the retreat to accelerate.  The melt up we’ve witnessed but in reverse.
Of course, there is the possibility that stock and bond prices have experienced a permanent landscape shift and that valuations and yield spreads are at new and proper levels.  In other words, it is different this time.  Investing history tells us that those words can be a dangerous description.  But for now, investor worries are few.  We just hope that someday we don’t have to sing more lyrics to the song we began this newsletter with – “I Need a Miracle Every Day”.
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
130 Riverside Drive
Binghamton, NY 13905
[i] Barlow, Weir, 1978
[ii] Yadeni Research, April 5, 2017
[iii] Bloomberg View, May 16, 2017
[iv] Ibid