Yesterday All My Troubles Seemed So Far Away. Now It Looks as They Are Here To Stay. Oh I Believe in Yesterday.

 

 

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

January 22, 2018 – DJIA = 26,071 – S&P 500 = 2,810 – Nasdaq = 7,336

 

Somethings aren’t what they used to be.  This comment isn’t a nostalgic yearn for the ‘good ole days’ but, instead, an observation that virtually nothing is protected from the ever present upheaval impacting our lives.

Take the National Football League for example.  NFL football games used to be around three hours in length.  Now due to a combination of constant reviews of officials’ rulings and endless player celebrations over the most routine play, the games are a tedious bore and have become unwatchable.

Another example of how times have changed involve federal government shutdowns.  They used to have much more meaning.  Previous shutdowns came with intense angst and fear over their unknown length.  Further they used to be accompanied by threats of credit rating downgrades, a falling U.S. dollar, and widespread fallout.  Sadly, government shutdowns have turned into an exercise in name calling and casting of blame with everyone knowing it won’t last long.  They’ve become routine.

And of course, the stock market is not immune to perception change.  For example, bold headlines used to announce when the Dow Jones Industrial Average crossed a 1,000 point threshold.  The business television stations would break out the party hats and it would be the topic of the day.  Last week the Dow crossed 26,000 for the first time and, if you weren’t paying attention, you could have easily missed it.

Perhaps this has become too common.  Last week’s 26,000 mark is the eighth 1,000 point level gained since Election Day in November 2016.  Furthermore, this latest threshold only took 13 calendar days from when the Dow crossed 25,000 – hardly enough time to get the Dow 26,000 hats made.  This is the shortest number of days for the Dow to move from one 1,000 mark to the next.  Obviously, 1,000 is a much smaller percentage and therefore an easier accomplishment at 26,000 than at the lower numbers.  Nevertheless, this has been a historic move for the Dow.

Not only has the stock market been moving up, it has been a remarkably steady, smooth journey.  Last week the S&P 500 set a new record for the longest time without a 5% correction.  At 395 days, this new stretch beat the 394 days in the 1990’s and 386 days in the 1960’s.  To further point out how rare this is, the S&P 500 has averaged four 5% corrections annually dating back to 1927.  In other words, there are normally four 5% corrections every year but we have’t seen anything close to that since the beginning of 2016.  Investors should consider the possibility that we might have some catching up to do.  Below is a graph showing the previous streaks. (Financial Time, January 19, 2018)

 

Looking at this month’s trading, the rally continues.  The S&P 500 started the year with 9 consecutive days of closing higher than it opened.  Further, it closed at a new record high 11 out of the first 14 trading days.  While this does not set a record for the best start to a year, it is among the top.  Here are the gains for the major averages through last Friday.

2018
Dow Jones Industrial Average    +5.5%
S&P 500    +5.1%
Nasdaq Composite    +6.3%
Russell 2000    +4.0% 

 

Another noteworthy financial market development of 2018 involves a spike in interest rates.  We know that the Federal Reserve raised rates in December and that the shorter maturities of the yield curve had been moving higher for several months.  However, the rates on the longer end of the curve (10-year and 30-year bonds) had not moved much.  In 2018, the longer dated rates have moved up.  Last week the 10-year Treasury note closed around 2.66% which is up from 2.41% at the end of 2017.  The 10-year note was last above 2.5% in March 2017.

On the surface, these higher interest rates might seem insignificant.  But in a leveraged financial system and in an economy that has gotten used to low rates with little volatility, this is a change.  Of course, if rates are moving up due to strong loan demand and that capital is being used to fund investments that will result in further economic growth, that is good.  However, if other factors are pushing rates (inflation, deficit concerns, etc), this could lead to wider spread problems.  Higher interest payments will lead to higher interest expenses for the federal, state, and local governments.  This will lead to larger deficits if tax receipts don’t grow.

Another worry involves individual and corporate debt.  For loans with variable or adjustable interest rates, this move will increase the cost of borrowing.  Whether it’s an adjustable rate mortgage or a bank loan tied to LIBOR, these higher yields will change the landscape.

System wide debt levels are high.  According to the Federal Reserve Bank of St. Louis, non-financial corporate business debt exceeded $6 trillion at the end of the 3rd quarter 2017.  This is up from $3 trillion in the mid 2000’s.  On top of this, individual mortgage debt exceeds $1,300 trillion.  And these totals do not include such things as credit card balances, automobile financing, and student loans.  Clearly there is a lot of debt in the system and this leverage could be stressed if interest rates continue to rise.

Foreign exchange is another market with some important developments.  Actually, this story dates back over a year but has been getting more attention in the New Year.  The value of the U.S. dollar has noticeably fallen against other major currencies.  The dollar index is an index that measures the U.S. dollar against a basket of major global currencies (euro, yen, pound, etc.). It has steadily declined since December 2016 and closed last week at the lowest level since late 2014.  This has gone against the widespread belief that a Trump Administration, with the ‘Make America Great Again’ initiative, would result in a strong dollar.  That turned out to be a bad bet.  Below is a chart for the DXY (dollar index) provided by Bespoke Investment Group.

The U.S. dollar is critical to the international financial markets and global trade.  Virtually all international trade, including crude oil, is transacted in the U.S. dollar.  For example, if Japan imports liquefied natural gas from Australia, it is done through the greenback – the yen and Australian dollar are both converted to U.S. dollars to complete the transaction.  The same flow would occur when China imports commodities from Brazil and Sweden exports to Canada.

The value of the dollar also influences the competitiveness of U.S. companies.  With a weak U.S. dollar, the products sold by U.S. based companies are cheaper in terms of other currencies – the euro or yen buy more dollars.  This means that domestic companies with international markets should be more competitive from a price standpoint and those businesses should see increased sales.

While this improved competitive position is obviously good, a weaker currency has its drawbacks.  A falling currency is usually associated with countries experiencing trouble or instability.  Further, a weak currency can be the result of capital outflows which could turn into a strong economic headwind.

So far, there hasn’t been any noticeable deterioration or impact from the U.S. dollar’s retreat.  This can change but the current landscape is unaffected.  Perhaps the main force behind the fall is the relative position of central bank policy.  The Federal Reserve has been raising rates for a couple of years while the European Central Bank has only begun reducing their monetary easing.  It could be that the markets have already discounted the Fed’s anticipated rate increases while recognizing a strong European economy and higher continental interest rates later this year.

It’s been an exciting new year for the capital markets including a strong rally for stocks.  And while a repeat of 2017 would be welcome for equities, a pick up in volatility is expected.  Given that we typically get four 5% corrections in a year and we haven’t had one in two years, it shouldn’t be a surprise for the markets to be a little choppy in 2018.  Of course, maybe like the NFL and all of the other things in our lives that are going through subtle change, perhaps the markets have transformed into a smooth path of always going up.  That presumes the four most dangerous words in investing – “It’s different this time”!  Yes, somethings in our lives aren’t what they used to be but risk isn’t one of them.

Jeffrey J. Kerr, CFA

Kerr Financial Group

Kildare Asset Mgt.

45 Lewis Street – Lackawanna RR Station

Binghamton, NY 13901

 

 

 

 

I Just Want to Celebrate Another Day of Livin’

 

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

January 8, 2018 – DJIA = 25,295 – S&P 500 = 2,743 – Nasdaq = 7,136

As we look back at the holiday season, there was some joyful reflection and celebration including relaxing time spent with family and friends.   Unfortunately, for some, the holidays are a time of overwhelming stress and frustration.  Sadly, there appears to be a thin line between these two emotional states and, hopefully, more people enjoyed much of the former and little of the latter.

This range of holiday emotions is comparable, on a certain level, to those that result from dealing with the financial markets. Sometimes there’s a great deal of cheer and jubilation and while other times are filled with lament and despair.  Looking back at 2017, joy and celebration dominated the capital markets.

In most years there are sectors of the capital markets that don’t perform well and even decline.  For example, sometimes an asset class such as commodities, real estate, or fixed income fall due to currency and interest rate movements or economic developments.  It is the natural ebb and flow of the markets.  In 2017, however, all asset classes advanced during the year.

Below is a chart reviewing various asset class returns for 2017.  It shows the steady move from lower left to upper right for stocks (both U.S. and international).  Equities were followed by U.S. real estate and bonds.  Commodities and managed futures (likely related to commodities) both recovered losses in the first half of the year and posted gains.  Hedge funds, as a group, provided mid single digit returns and continued to under perform stocks which provides more ammunition to the passive investing supporters.

The table below shows annual returns of various asset classes dating back to 1998.  The sectors are ranked each year from best (on top) to worst.  The asset classes are basically stock and bond indexes.  It has two major U.S. stock indexes with the S&P 500 (dark green) and Russell 2000 (dark brown) .  International stocks are tracked via the MSCI World ex U.S. (gray), and MSCI Emerging Markets (orange).  Two fixed income indexes are included – the Bloomberg Barclays U.S, Aggregate Bond index (light green) and the Bloomberg Barclays U.S. Aggregate High Yield index (teal).  For more detail, the S&P 500 and Russell 2000 are broken down into growth and value – S&P 500 growth is light brown, S&P 500 value is dark blue, Russell 2000 growth is yellow, and the Russell 2000 value is light blue. (Apologies that size constraints make the text difficult to read).

Some noteworthy nuggets include the fact that for the past two years every sector has show positive returns.  While there are examples of this happening, three year streaks are not common.  This would suggest heightened risks for 2018.

Another important point is the rotation of the leading and trailing sectors.  In other words, last year’s winners could become this year’s laggards.  This rotation gives the table a quilt type appearance as leading sectors change and the colors move around (The exception to this is that emerging markets were the best performing sector 5 consecutive years – 2003 through 2007.  The move was very impressive with yearly gains of 55%, 25%, 34%, 32%, and 39%.  However, the emerging markets plunged 53% in 2008.)

More recently there has been the classic rotation.  In 2016, the Russell 2000 Value provided the best returns with an almost 32% increase.  2017 was a much different story as it was third to last and only up 8% (S&P 500 was up 22%).  It was the worst of the stock indexes and only beat the two bond indexes.  Another example involves the emerging markets index again.  For the 5 year stretch from 2011 to 2015, the emerging markets were the worst performer 3 years and the second to worst performer for 1 year.  They showed losses in each of those 4 years.  But from these depths it returned to be the top dog in 2017 (up 37%).

The table highlights the folly of blindly chasing yesterday’s winners while overlooking opportunities that have fallen from grace.  To be sure, sectors of the market can remain leaders for extended periods of time, but following an  investment strategy that is equal to a popularity contest will likely result in disappointment.

 

In hindsight, it’s easy to see that 2017 was a good year for the markets.  The Dow Jones Industrial Average closed at a record 71 times during the year.  This is the most in history exceeding 69 in 1995, 62 in 1962, and 52 in 2013.  Moreover, it was a steady and smooth trip.  In 95% of the trading days, the Dow traded in less than a 1% range as measured by the day’s high and low.  This bring up the questions – Why can’t they all be this easy?

It’s not hard to forget that the tranquil markets were in sharp contrast to news flow.  There was plenty of news that could have potentially derailed the markets.  The antagonistic political setting including open talk of impeachment of President Trump.  Terrorist attacks in New York, London and Spain.  High levels of social division leading widespread protests (Charlottesville) and massacres (Los Vegas, California, Texas).  High geopolitical tensions including North Korea’s effort toward a nuclear weapon.  Natural disasters with hurricanes hitting Houston, Florida, and Puerto Rico.  With this kind of backdrop, it is remarkable the market were not lower and a lot more volatile.  Here are the final 2017 numbers for the major averages.

2017

DOW JONES INDUSTRIAL AVERAGE                                                                              +25.1%

S&P 500                                                                                                                                      +19.4%

NASDAQ COMPOSTIE                                                                                                            +28.2%

RUSSELL 2000                                                                                                                         +13.1%

Enough of the rear view mirror – inquiring minds want to know what’s going to happen in 2018?  It’s easy to think that the market is poised to pull back given the strength of 2017.  After all it’s second longest stretch in history for the S&P 500 trading above its 200-day moving average and markets don’t normally act this way.  On the other hand, if the capital markets have not only survived but prospered given the events of 2017, it might be another strong year ahead.

Looking at history, Bespoke Investment Group provides some data.  The table below gives the annual performance for the S&P 500 in years following a year with a 20% or greater gain.  As shown, the year after a 20%+ move is positive 68% of the time with an average gain of 10.46%.  Further, there are several examples of back-to-back years of 20% or greater returns.

While the markets absorbed 2017’s body blows, the bears are not extinct (yet).  Some of the remaining ammunition is in the form of potentially higher interest rates and high valuations.  The Fed has been raising the fed funds rate and is projecting further interest rate hikes in 2018.  Rate increases during the past couple of years have been absorbed  by the economy.  But the impact of future raises could be more disruptive.

Corporate earnings growth accelerated in 2017.  However, stock prices climbed faster leaving valuations elevated.  Some of the stock market jump was in anticipation of tax reform and the lowering of corporate tax rates.  How much of this bottom line benefit has been priced in is a critical question facing stocks in 2018.  Another important question is beyond the bump from lowered rates, how much more will earnings grow on a comparative basis.

As hard as it was to predict a smooth and historic year for the financial markets back in January 2017, it is equally difficult to forecast 2018.  There are some expected developments (interest rate hikes) in 2018.  However, it’s the unexpected stuff that could move markets.  Investors should remain flexible and, as much as possible, on top of things.  But before we get too far into the year, there are some New Years resolutions to break.

Jeffrey J. Kerr, CFA

Kerr Financial Group

Kildare Asset Mgt.

45 Lewis Street – Lackawanna RR Station

Binghamton, NY 13901