SERENITY NOW!! (Insanity later)[i]

July 24, 2017 – DJIA = 21,580 – S&P 500 = 2,472 – Nasdaq = 6,387
SERENITY NOW!! (Insanity later)[i]
For something that comprises so much emotion, the stock market has amazingly ignored the passionate yet venomous division in the United States.  In the midst of name calling, violence, protests, and a prevailing sense of hatred of those with opposing views, the stock market climbs higher.  With the acrimony and polarity so elevated, why hasn’t this impacted the markets?
And not only have stock prices risen in the face of societal deterioration, they have done it in a remarkably smooth and steady manner.  The S&P 500’s largest pullback this year is a hardly noticeable 2.8%.  We all know that there have been times where the markets approach that level within a day! And not only is this incredible given the current landscape, it is historic.  This is the smallest intra-year correction since 1995 and the second smallest dating back to the Great Depression.[ii]
This stock market serenity has gotten so widespread the U.S. seems to be exporting it as international stock markets are experiencing a similar tranquility.  As measured by the MSCI EAFE (Europe/Asia/Far East), the MSCI EM (emerging markets), and the Nikkei 225 (Japan), global bourses are near record low levels of volatility.  Traditionally, emerging markets are one of the riskiest assets classes with high levels of uncertainty.  Yet so far in 2017, the MSCI EM has only undergone a mere 3% pullback.  Contrast this to 1995’s 13% correction which was one of the least volatile years in history for emerging markets.[iii]
In 1995 the Nikkei 225 fell 26.4% from peak to trough.  While this is not the lowest annual pull back for this index, it is among the smallest.  Yet so far in 2017 the spread is a miniscule 6.5%.
Below is a graph showing variance for the S&P 500, the MSCI EAFE, the MSCI EM, and the Nikkei 225 since 1990.  The red circle on the right is 2017.  As measured by these four indexes, this is an astonishingly calm year within the backdrop of chaos.[iv]
There is no definitive reason for this quiet price action.  Until recently, central banks were keeping short term rates low and this has likely contributed.  Also, it is helpful that economies have been growing at a slow but steady pace. Indexing and passive investing has played a role as investors have been buying ETFs which index the market and its various sectors.  These funds buy their underlying components as they receive inflows without concern for valuation or timing.
Whatever the cause, the stock market’s peaceful price action will end and volatility will return – someday.  As shown in the graph, there is a cyclical component to this and there’s no reason to think things have been permanently altered.  Whenever market volatility returns there will be much wailing and gnashing of teeth as investors will not be expecting it.  In the meantime, the steady move higher continues and, as mentioned, the major indexes reached records last week.  Here are the year-to-date returns as of the end of last week.
                                                                                       2017 YTD
Dow Jones Industrial Average                                          +9.2%
S&P 500                                                                            +10.4%
Nasdaq Composite                                                            +18.7%
Russell 2000                                                                     +5.8%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend. 

Looking at the fixed income market, short term rates have move noticeably higher.  First the 3-month Treasury bill’s yield closed 1.17% last week and this was actually higher than the longer dated 6-month T-bill which closed at 1.10%.  Moving further out, the yield curve returns to its normal upward sloping direction with the 2-year Treasury note at 1.36%, the 10-year Treasury note at 2.24% and the 30-year Treasury bond at 2.81%.  An interesting (and easy) place to park some short-term liquidity might be 6-month CD’s which were yielding 1.35% – 1.40% last week.
Foreign exchange is another market that is offering some unexpected developments.  At the beginning of 2017, the common forecasts were for a stronger U.S. dollar based on the “Make America Great Again” theme.  Increased domestic manufacturing, increased exports, and restrictions on imports were part of the landscape that would drive the dollar higher.  Instead, as measured by the Wall Street Journal Dollar Index, the greenback has fallen 7.25% against a basket of currencies in 2017.
This translates into unexpected stock market leadership.  Companies with high domestic revenues, which would typically benefit from a stronger U.S. dollar, were supposed to lead the markets.  And companies with a more international customer base were supposed to be hurt.  However, with the weaker dollar, technology (with big international sales) has benefited.  Apple, for example, has approximately 60% of their revenues from foreign markets.  Dow Chemical also has over 60% international revenues and the stock has done well.
Once again, this points out how the markets move against conventional wisdom.  In the fixed income market, the yield curve has flattened rather than the predicted steepening.  And again, the U.S. dollar has weakened instead of rallying which switched the stock market leaders.
Where can we currently look for similar predictions to be wrong?  There appears to be two industries that are widely expected to have problems.  One is retail.  Everyone (including Amazon) expects Amazon to ultimately supply all of our purchases and that there won’t be a need for anyone else.  To be sure, some retailers will continue to be challenged and some will fail.  On the other hand, many will survive and trade at very cheap valuations.
Energy is another washed out sector.  As the oil and natural gas markets seem to be well supplied, energy stocks have been laggards. The obvious problem is that the success of these businesses is largely a function of the commodity price.  However, despite the growing popularity of electric cars and more renewable supplies, global hydrocarbons demand is predicted to grow.  As with the retailing sector, there are some investment bargains in the energy stocks.
One of the biggest investment mysteries of 2017 is the markets’ disregard of the widespread social acrimony.  Typically, such chaos and strife would be reason for at least caution, if not widespread selling.  So far it has not happened.  We don’t expect the division and polarity to subside anytime soon.  This means that investors should keep watching how the markets react to new developments. If the indexes begin to lose momentum, it could be a sign that the serenity is switching to the insanity.  In the meantime, deep breaths everyone.

[i] Seinfeld, October 9, 1997
[ii], July 25, 2017
[iii] Ibid
[iv] Ibid
Jeffrey J. Kerr, CFA

Kerr Financial Group
Kildare Asset Management
168 Water Street
Binghamton, NY 13905

2017 1st qtr Kildare Asset Mgt-Kerr Financial Group client review letter


As I have mentioned in previous letters, prices in the capital markets are highly correlated with corporate earnings which are a function of economic strength.  And while this didn’t change in the first quarter of 2017, there was another dominating influence – politics.
We know that investors began discounting the prospects for business friendlier policies and stimulus programs the day after the election.    Naturally, this continued into and after the inauguration as excitement and optimism climbed higher.  The expectations of reduced regulations, tax reform, and infrastructure spending powered stock prices and interest rates higher.
The stock market edged higher at the beginning of January and churned sideways until the inauguration.  After the ceremony, the rally resumed and there was a steady climb throughout February.  There was another surge higher to new record levels after President Trump’s State of the Union speech at the beginning March.  In the final month of the quarter, stocks encountered a little turbulence after the failed attempt to repeal and replace the Affordable Care Act.  However, stocks rallied into the end of
the month but remained below the records reached in early March.
Here are the returns for the major averages for 2017’s first quarter.
                                                                                         2017 Q1
Dow Jones Industrial Average                                        +4.6%
S&P 500                                                                          +5.5%
Nasdaq Composite                                                          +9.8%
Russell 2000                                                                   +2.1%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.

Using a size weighted average, here is how the average Kildare Asset Management-Kerr Financial Group client’s account performed. This is calculated after all fees and expenses.

2016  Q1                                                                                                          +3.03%

Similar to markets having an oversized impact from politics, your account was influenced by one position – Fortress Investment Group.  Fortress (symbol = FIG) is an investment management company that operate hedge funds, private equity funds, and credit funds.  They manage over $70 billion of assets which makes them one of the largest publicly traded companies in this sector.
Fortress charges a fee for managing investments for their clients.  In addition, they can earn incentives and bonuses if performance reaches certain thresholds.  Their clients include institutions such as pension funds, endowments, and foundations, as well as high net worth individuals.  FIG’s largest expense is compensation and benefits for their staff which includes executives, portfolio managers, analysts and traders.
I was first attracted to Fortress Investment Group because I believed it was an undervalued security that offered an attractive yield.  The company has a very strong balance sheet as well as a history of consistent profitability.  It has underappreciated assets and I thought that there was a
good chance that the business would continue to grow.
Concerning the dividend, the amount the company has paid varies based on its net income.  Fortress often set a stable dividend payment for the year based on its projections and then paid a special dividend after they determined their actual results.  The ‘normalized’ yield was approximately 6% with the ‘special’ dividend usually adding another 5% – 9%.
While this sounds like it was an easy and straightforward investment idea, there many legitimate reasons that Fortress was priced so cheaply.  First, FIG is a limited partnership.  Financial reporting for partnerships is different and, as a consequence, the analysis has some added steps as compared to the analysis of corporations.  For example, in addition to net income, investors should consider such calculations as distributable earnings and net economic income.  These metrics can be different from net earnings and may present a much different picture than typical analysis.  These analytical complications can dampen investor interest.
Secondly, the alternative asset management industry (hedge fund, private equity, etc.) has been under intense pressure from clients.  The appeal of these investment managers is the potential to outperform the benchmark averages while controlling risk.  However, during the past several years, most hedge funds have underperformed the stock market averages and clients have become frustrated.  Many have asked for their capital back including the high profiled decision by the California Public Employees Retirement System (CalPERS) to withdraw all money from hedge funds.  As a result of this and similar institutional decisions, many hedge funds have closed.
Lastly, hedge funds and private equity funds are facing a potentially massive shift in the form of tax reform.  As a limited partnership structure, these organizations enjoy some tax advantages.  Specifically, some of the income from incentives and bonuses, which can be very material, are not taxable or, at worst, tax deferred.  There have been efforts during the past several years to change the tax code and eliminate this benefit.  So far, it remains in place.  Eliminating this provision would significantly change the industry’s profitability and make these businesses less attractive.  And with tax reform again in the news, the prospect of future scrutiny is a heavy weight on publicly traded investment partnerships.
Coming into 2017, Fortress had been in a narrow trading range for an extended period.  It finally broke above the $5.50 level on high volume at the end of January.  This price action was a strongly positive sign and, as a result, I added to the position.  In the middle of February, Softbank Group offered to buy Fortress for $8.08 per share.
While there has been some minor debate whether this was the proper valuation (some have suggested that FIG is worth more than $8), the deal should close in the third quarter.  While I think Fortress’s share price would have moved higher over time, this gives us the opportunity to stay in the same church but move to a different pew.
Blackstone Group and Ares Management are two investment management companies similar to Fortress and are being added to your account.  Blackstone (symbol = BX) was a recent featured recommendation in Barron’s.  Further this has been a position in long time clients’ account since the end of the financial crisis.  BX’s dividend strategy is similar to Fortress’s as they pay a variable amount based on the quarterly bottom line.  Blackstone’s current yield is 6.6% (based trailing twelve months).  While they face the same challenges listed above, they are positioned to capitalize on opportunities throughout the financial markets.
Ares (symbol = ARES) is another investment management company that has good long term potential despite the industry challenges.  They have numerous fee generating funds (a new one was added in the first quarter) as well as a pipeline of additional opportunities.  The current dividend yield is 4.75%.  I think the dividend payments have a good chance to grow over the next few years.
The capital markets had a busy first quarter.  Things such as a Federal Reserve interest rate increase and the European political campaigns were overshadowed by a new administration in Washington.  This brought both excitement and anxiety.  Some were optimistic about the change of direction while others were despondent by the disrupted status quo.
While this divide could easily grow as the year continues, the markets have digested it so far.  Of course, past reactions are not guaranteed to remain the same and the markets could change its sentiment if the craziness increases.  It promises to be an interesting year.
Regardless how events development, I will continue to look for opportunities as well as monitor current positions.  With the markets digesting the anticipated crosscurrents of 2017, there will surely be some favorable circumstances to take advantage of.  Thank you for your continued support and please call with any questions.

Jeffrey J. Kerr, CFA

Kerr Financial Group
Kildare Asset Management
168 Water Street
Binghamton, NY 13905