Wall Street’s not so scary Halloween stories

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October 23, 2017 – DJIA = 23,328 – S&P 500 = 2,575 – Nasdaq = 6,629
“It was the witching time of night…”[i]

October has a history of being a frightening month. Shorter days means more darkness together with a chill in the air. Of course, Halloween is accompanied by tales of ghosts, goblins, demonic developments and the release of B-rated horror movies. And scariest of all, Congress is in session.

Of course the financial markets also have a history of paranormal Octobers. The 1929 and 1987 crashes occurred in October as well as the Panic of 1907. In addition to these historic events, October has had other seminal market tribulations such as Long Term Capital Management’s implosion (technically this was a September event but had October fallout) and 2008’s drop after Lehman Brothers failed which helped start the financial crisis.

Despite this maniacal reputation, 2017’s October has been a continuation of the pleasant and steady move higher that has dominated the year. In fact, this year might become the “calmest” on record. Ryan Detrick, Senior Market Strategist at LPL Financial Research, suggests one way to determine volatility (or lack of it) is by measuring the absolute value of the average daily change. Mr. Detrick uses the S&P 500 and calculates this daily change at 0.30% so far in 2017. This is the second lowest reading with 1964 coming in at 0.26%.[ii]

The chart above shows this measurement dating back to 1928. It is interesting that there were three consecutive years of this type of low volatility in the mid-1960s. We can’t rule out the possibility that we are beginning another similar stretch. Another common belief is that when volatility returns it will signal the start of a bear market. Please note the low number registered in 1995. This was followed by much higher volatility readings in conjunction with the bull market of the late 1990s.

The serene capital markets in the face of the current headlines is similar to a perplexing mystery penned by Edgar Allan Poe. There is a great deal of irony that the markets are experiencing one of the least volatile years in the face of cultural division, protests, terrorism, political polarity, and widespread social tension.

Not only are the markets curiously calm, they are trading at all-time highs. The S&P 500 closed at a record high every day last week. Thursday was the 30th anniversary of the 1987 stock market crash where the Dow Jones Industrial Average lost over 20% in one day. Stocks marked this by staging a 2017 type crash – plunging a painful one-half of one percent – before rallying back and closing higher on the day.

The S&P 500 has now recorded 61 record highs in 2017 which is the third most behind 1928 and 1964. And there are two months remaining for this year. Below is a chart showing the yearly number of record closes for the S&P 500.[iii]

While the streak of daily records for the S&P 500 is impressive, there is more to this story. Jason Goepfert, the head of Sentiment Trader, points out that the S&P has 6 weekly record closes in a row and 7 consecutive monthly record closes. As Mr. Goepfert points out, this is 18 record closes across daily, weekly and monthly time frames. He goes to say that this is the most in history and that other periods that had a comparable series of records did not mark major stock market tops.[iv]

It is interesting that the S&P 500’s accent has happened despite battling some intimidating zombies. Bellwether stocks such as AT&T, Disney, Exxon-Mobile, General Electric, IBM, Target, and Wells Fargo are not participating and, in fact, are all lower year-to-date. These blue chip, dividend paying stocks were last year’s darlings but have become “the walking dead”. It’s remarkable that the averages have performed so well despite this drag. Here are the major indexes year-to-date numbers at the close of last week.

2017

Dow Jones Industrial Average 18.0%
S&P 500 15.0%
Nasdaq Composite 23.1%
Russell 2000 11.2%

Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.

Inquiring minds want to know why the financial markets are doing so well when the world seems to be crumbling around us. The answer has nothing to with Mr. Market playing a cruel game of Trick or Treat but rather fundamental improvements together with Wall Street’s masterful marketing.

First, corporate earnings have been strong and are projected to keep growing. This has been the trend for 2017 and it has continued in the 3rd quarter. 63% of the companies that have reported so far have beaten consensus earnings estimates. Stocks trade at lofty valuations but investors currently appear to be willing to pay higher multiples as long as the bottom line keeps growing.

The popularity of passive investing and the use of index ETFs and mutual funds also contribute to the tranquil environment. Passive investing involves buying exchange traded funds (ETFs) or mutual funds that track an index. Investors seek to invest in various asset classes via these funds. For example, SPY is the SPDR S&P 500 Trust and it tracks the S&P 500 index. AGG is the iShares Barclays Aggregate Bond Fund that track the Barclays Aggregate Bond Index which is a broad bond market index.

Capital flows into passive investment strategies have been astounding. BlackRock is the sponsor of the iShares family of ETFs. They recently reported inflows of $96 billion in the third quarter. This brought the year’s total to $264 billion which easily exceeds last year’s inflow of $202 billion.[v]

Vanguard Group, the leader in index mutual funds, has seen inflows of $291 billion in the first nine months of 2017. This is below last year’s influx of $323 billion but will likely be surpassed by the end of the year.[vi]

BlackRock and Vanguard are not the only organizations offering these approaches. There are many other significant investment firms with similar options. But just counting these two firms, a remarkable total of over $1 trillion of investment capital has been gathered in the past two years. We would guess that the majority of these dollars were directed to a passive indexed strategy.

This means that as soon as the dollars get in the ETF or mutual fund, they are invested. There is no discussion over timing and no holding for a better price – the money immediately buys more of the holdings of the index it is mirroring. $1 trillion of indiscriminate buying could be a major force behind the stock market’s steady move higher despite an unsettling news flow.

This develops into a self-feeding cyclical phenomenon and Wall Street is very happy to help promote. The more capital that flows into these funds the better the market performs and the better the market performs the more capital it attracts. So if it’s low cost, index strategies that investors want for their IRAs and 401k’s, the financial industry are more than happy to meet the need with all kind overlapping index products. “Low cost investing for the long term” is a pretty easy sell. We’re sure somewhere in the fine print it mentions that stocks can go down.

The scarier part of this situation is that passive investing is so widespread. It seems everyone is doing it which is eerily similar to some other periods of popular investing fads. Portfolio insurance was a popular strategy in 1987. It was supposed control losses by hedging through stock futures contracts. It ended up contributing to the 1987 Crash.

More recently, tech stocks in the late 1990s were can’t miss as the internet was changing the world. The internet did change the world but somewhere along the way the markets realized that not every dot com company was going to be successful. Stocks crashed again. We won’t go into the money lost on condo speculation in the 2000s.

With the current landscape, the real horror story will be when the markets start to weaken and everyone wants out at the same time. It could be a sudden and dramatic trip lower and once again investors will be wondering what went wrong. Of course, the timing of such an event is the difficult question. For now, that’s enough of fearsome tales of investment ghosts and goblins – it’s time for Halloween candy.

[i] “The Legend of Sleepy Hollow”, Washington Irving
[ii] LPL Financial Research, October 22, 2017
[iii] The Bespoke Report, October 20, 2017
[iv] Sentiment Trader, October 21, 2017
[v] Almost Daily Grants, October 16, 2017
[vi] Ibid

Jeffrey J. Kerr, CFA

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

2017 2nd Qtr.Kildare Asset Mgt-Kerr Financial Group client review letter

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Not only did June mark the end of 2017’s second quarter, it was also the eighth anniversary of the end of the Great Recession. This recovery has had plenty of detractors so may it surprise many that this has become the third longest economic expansion since World War II. Only the dot-com boom (10 years – 1991 to 2001) and the 1960’s (9 years – 1961 to 1969) are longer. To put this into further perspective, the average post war expansion is 58.4 months (just shy of 5 years) according to the National Bureau of Economic Research.

When measuring by strength, however, this expansion is not as impressive. Normally an economy that has been expanding for so long would show both above average and accelerating growth. This is not the case for the post-2009 recovery which has a compounded annual growth rate of 2.1%, well below the 3.6% rate of the 1990’s and the 2.8 % of the 2000’s.

Of course, the causes for this below average growth is the subject of intense debate. Much of this deliberation revolves around the impact of the Federal Reserve and monetary policy. Both have played important roles in trying to stimulate the economy as well as stabilize the markets. And both have been controversial in their execution and their effect.

The severity of the financial crisis, according to our central bankers, called for drastic and aggressive measures. The Fed has used “unconventional” to describe their methods which included ‘operation twist’, ‘QE’ (quantitative easing), ‘QE1’, ‘QE2’, and ‘QE infinity’. In contrast to the fancy terminology, the strategy has been simple. It has three basic components – reduce interest rates, print money, and use that newly created money to buy bonds in the open market.

Fed critics believe that these policies and strategies have distorted the markets. Interest rates are unnaturally suppressed which distorts market prices and discounting calculations. Further, some think that the economic recovery would have been much stronger absent central bank meddling.

The magnitude of these programs is illustrated in this chart. The blue line represents the assets owned by the Federal Reserve which consist of securities such as bonds. Prior to the financial crisis, the Fed’s balance sheet normally ranged between $700 million to $900 million.

The blue line spikes at the beginning of the crisis. And after this initial jump, the Fed’s holdings steadily climb until 2014. For the past couple of years, the balance sheet has been steady at approximately $4.5 trillion or more than quadruple the typical balance before the financial crisis.

This shows how dramatic the QE programs were. And while the economic impact of this monetary policy is unclear, the chart shows that the stock market, as measured by the S&P 500 (red line), has benefited. This leads to the question of what happens when the Fed starts to reverse these programs. In June, Janet Yellen and Mario Draghi both introduced the idea that their central banks will start shrinking their balance sheets.

This could increase stock market risk. Alex J. Pollock, senior fellow at the R Street Institute, wrote in June, “The Fed’s problem is now simple and obvious: once you have gotten into positions so big relative to the market and moved the market up, how do you get out without sending the market down? The Fed is expending a lot of rhetorical energy on this problem.”

Of course, the hope is that the economy is strong enough to continue to expand during a gradual reduction of monetary policy help. However, markets have gotten accustomed to central bank involvement and any change could be a headwind. The Fed and ECB’s goal (and challenge) is to gradually remove the elixir without disrupting the markets. The risk is that the addiction is greater than it appears.

Returning to 2017’s second quarter, the stock market advanced further. The gains were less than the first quarter but still respectable. Here is a break down for the major averages for the second quarter and year-to-date.

2nd Qtr 2017

Dow Jones Industrial Average +3.32% +8.03%
S&P 500 +2.56% +8.24%
Nasdaq Composite +3.86% +14.07%
Russell 2000 +2.12% +4.29%

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.

2nd Qtr 2017
+2.72% +5.83%

There were a few notable developments within your portfolio. First, Hurco Companies, Inc. had a good quarter. Its stock rose 10% with the majority of the move happening in June after the company reported earnings. Hurco is a machine tool manufacturer. They produce high end machines with proprietary software and sell them globally with typically over 50% of sales to Europe. The company has a strong balance with no long-term debt.

Hurco has made two acquisitions during the past few years that expands their product offering into other sectors of the market. From the company’s recent results, it looks like they are gaining some acceptance. Annual revenues exceed $200 million and for the past three quarters, for the first time, they have received over $60 million of orders in each quarter.

Hurco is a small company with a limited amount of shares outstanding. Further, they don’t communicate with Wall Street well. Management does not do earnings conference calls nor investment presentations. I speak to Hurco’s chief financial officer (Sonja McClelland) regularly and have encouraged her begin doing earnings conference calls to broaden investor awareness. Whether that happens, if the company continues to grow, Wall Street will find it.

Layne Christensen, which has had some successful recent quarters, and Ares Management, LP (alternative asset manager) were small drags on performance. Both stocks were flat to down slightly. Ares has been especially frustrating as it traded above $22 in the first quarter and closed the second quarter at $18.00. We are still receiving a good yield with a dividend of 6% (assuming a $20 cost basis) and the company has been growing assets and developing new sources for future growth. I think both positions will contribute to performance over time.

On the morning of the last day of the quarter, we received good news that another position was being acquired. Parkway, Inc., a real estate investment trust (REIT) which owns offices in Houston, announced that they were being bought by Canada’s Pension Plan Investment Board. As you may recall, Fortress Investment Group announced in the first quarter that they were being taken over which moved the stock much higher and helped first quarter performance.

Parkway was a late 2016 spin out from Cousins Properties, a much larger nationwide REIT. Cousins’ desire to unload the Houston properties was understandable given the trouble that oil and gas companies have encounter during the past few years.

Despite the challenges, Parkway was attractive because of a cheap valuation which priced in a lot of the negatives. Furthermore, management had a history of re-building real estate companies and there was significant potential over time.

In February, Parkway announced that it sold 49% of one of its properties to a joint venture that included the Canadian Pension Plan Investment Board. They obviously liked the situation and saw value in the whole company. The acquisition is valued at $23.05 per share which is a one-time $4 dividend and $19.05 in cash. The deal is expected to close in the fourth quarter.

Looking to the second half of 2017, the markets will deal with issues such the federal government’s debt ceiling, tax reform, geopolitical tensions, and domestic social acrimony. Add to this the possibility that the Federal Reserve and other global central banks may be cutting back on monetary stimulus.

On the bullish side, corporate earnings are growing and business sentiment is optimistic. And internationally, both developed and emerging markets are expanding. As long as none of the challenges gets out of hand or some other event upsets the global economy, further growth is expected. I will continue to monitor the events looking for opportunities while managing risk.

Thank you for your business and continued confidence. Please contact me with any questions.

Jeffrey J. Kerr, CFA

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

If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience

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October 2, 2017 – DJIA = 22,405 – S&P 500 = 2519 – Nasdaq = 6,495

“If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience.”[i]

Investing is hard. Madison Avenue, however, wants us to believe otherwise as TV ads for brokerage and financial advisory firms make it appear so easy. They portray clients who can only squeeze 15 minutes out of their hectic schedules for their finances yet have everything running smoothly. Or other ads where analysis and winning investment decisions are as simple as hitting a button. Contrary to this fantasy, the real world of money management is much more complicated and challenging.

It is especially difficult when deeply set historical trends inexplicably change. In other words, when the markets don’t do what they are supposed to do. We turn to September as an example of Mr. Market’s confounding ways.

Transporting ourselves back one month to end of August, we find Hurricane Harvey devastating Texas, North Korea firing missiles over Japan, the country trying to understand Charlottesville, the Republicans failing to repeal the ACA, and, of course, Tweets from President Trump. It was an uncertain and worrisome time.

As to the capital markets, caution and risk avoidance would be logical strategies given this landscape. A further nerve-wracking piece of the equation was the fact that were entering a potentially tumultuous time of the year – September and October.

Most are aware of that the two stock market crashes happened in October and the month has witnessed some other nasty air pockets. And as bad as Octobers have been, September is worse. It is the only month that averages a loss for the past 100 years!! The table below breaks down the Dow’s average performance by month for the past 100, 50, and 20 years.[ii] September’s average for the past 100 years is -1.09% – the only month that shows a loss for this time period.

To further illustrate this point, here is a graph that shows the results of $100 invested in the S&P 500 for each of the months going back to 1967 (50 years).[iii] The “Septembers” are the thick red line and are clearly the worst performing month. In fact the $100 invested exclusively in September is only worth $71 in 2017. The next worst month is August which has a value of $98.

So given this history combined with the background of social unrest, geopolitical tensions, and the unknown damage from Hurricane Harvey, who in their right mind would want anything to do with the stock market. Clearly, it would be an easy decision to sell everything and prepare for another sad September.

Instead, the stock market does the unexpected and moves higher. The Dow and S&P 500 increased by over 2% and the small caps (as measured by the Russell 2000) jumped over 6% in September. The Nasdaq Composite, which has been 2017’s leader, paused and was down less than ½%. September’s peculiarity is further proven by the Jets winning 2 games and finishing the month with a 2 – 2 record. Indeed, a curious month. Here are the year-to-date numbers for the major averages.

2017

Dow Jones Industrial Average +13.4%
S&P 500 +12.5%
Nasdaq Composite +20.7%
Russell 2000 +9.9%

Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.

This apparent irrational investor behavior could be explained by optimism concerning the strengthening economy and tax reform. Last week the Commerce Department reported that GDP (gross domestic product) for the 2nd quarter grew at 3.1% which was above forecasts.

Of course, this is backward looking as it is a 2nd quarter number and we just finished the 3rd quarter. However, there are some indications that the growth will continue. The ISM Manufacturing report for September came in at 60.8. This was the first monthly reading at 60 or higher since February 2011 and the highest number since May 2004. The survey dates back to 1948 (formally it was called the Purchasing Managers Index) and only 13.9% of the results have exceeded 60.[iv] September’s number confirms economic optimism.

The Trump Administration released the outline of their tax reform proposal last week. Setting aside its virtues and flaws, reducing corporate taxes is a positive as far as the stock market is concerned. A reduction of corporate taxes obviously translates into larger profits but might result in increased capital investment which will have an exponential economic benefit. That’s what the markets are forecasting.

Returning to our table and chart above, a look forward to 2017’s 4th quarter might add to the bulls’ healthy confidence. October, November, and December all average positive returns for the past 100, 50 and 20 years. Looking at the chart for the past 50 years, November and December are in the top 4 months of performance. Of course, just as September didn’t follow its historical trend, there is no assurance that 2017 doesn’t have a disappointing end of the year.

Considering that the negative news flow can’t stop the stocks market, investors are asking, “Is there anything that can?” That’s actually a $3 trillion question as the Fed announced their intention to start reducing their balance sheet. Recall that as part of their quantitative easing programs, our central bank bought bonds in the market with money they fabricated with the push of a computer key. Their total holdings now exceed $3 trillion dollars (this was around $750 million before the financial crisis).

Fed Chairwoman Janet Yellen announced that the Fed will begin this process in October. To start with, the mechanics of the balance sheet reduction will be that the Fed will stop buying bonds. This will obviously reduce liquidity as dollars stay at the Fed as their portfolio matures. This could result in higher interest rates as bond prices move lower in order to attract buyers. Higher interest rates, if it happens, could be a complication to higher stock prices.

Not only did the equity markets survive scary September, they surprised everyone and moved higher. And getting past September puts us into a historically bullish time of the year. To be sure, there is no guarantee that the markets don’t begin react to North Korea, Russia, the intense social unrest, or some other unforeseen event. However, the markets’ strength in 2017 has been impressive and should be respected until it’s broken. Nevertheless, it’s always wise to keep in mind that Mr. Market can be very, very fickle especially when you least expect it.

[i] George Bernard Shaw, 1902
[ii] The Bespoke Report, September 1, 2017
[iii]Ibid
[iv] Bespoke Investment Group, October 2, 2017

Jeffrey J. Kerr, CFA

Kerr Financial Group
Kildare Asset Management
130 Riverside Drive
Binghamton, NY 13905