“Art for Art’s Sake” – April Newsletter

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

April 19, 2021 – DJIA = 34,200 – S&P 500 = 4,185– Nasdaq = 14,052

“Art for Art’s Sake”

 

With all of the ways that we communicate combined with the speed that it is delivered, it should be easy to keep up with everything.  We have cell phones, email, text messages, social media, phone apps, and hundreds of radio and cable channels.  Unfortunately, having countless ways to stay connected doesn’t equate with being informed.  It often feels like we are using smoke signals while the rest of the world is telepathically in sync.

This brain bruising overload happens in all parts of our lives – news, fashion, music, sports, and, of course, the financial markets.  Within recent years investors have had to deal with a flood of new things like SPACs, crypto currencies, blockchain, and NFTs.  These are new and complex products and it makes some traders yearn for the simpler days that included such things as physical trading floors and handwritten orders.

For those who might be off the grid, SPACs are Special Purpose Acquisition Companies.  They raise money to buy another company which is typically private which becomes an alternative method for an IPO (initial public offering).  SPACs have grown in popularity and have raised a lot of money.  With all this money comes risk as there is a finite number of strong buy out candidates waiting to run into the arms of a SPAC.  This means that there are plenty of bad deals are being done.

Crypto currencies are digital currencies that are not controlled by any central authority.  There are many versions of cryptos but Bitcoin and Ethereum are the most popular and have generated the most excitement.  Blockchain is part of the crypto currency universe.  It is an open ledger which is monitored and reviewed by a network of computers.  Wall Street is developing strategies involving crypto currencies and related assets.

NFTs are non-fungible tokens which are a unit of data stored on a digital ledger (blockchain).  NFTs are growing in the digital collectable markets and they offer a level of authenticity.  NFTs do not include the copyright so duplicates can be available to anyone.  NFTs can be bought and sold with all transactions being recorded on the blockchain.

NFTs have gained notoriety when Christie’s auction house recently sold a digital collage of 5,000 images for $69.3 million dollars.  The image is at the top of this newsletter and the piece is entitled “Everydays: The First 5000 Days”.

These controversial financial products are difficult to understand and, perhaps, harder to analyze.  SPACs indirectly fit into conventional analysis.  They have a cash value prior to acquiring a company and, after the ‘de-spac’, shareholders have ownership of a company.  At this point, the security is a claim on the assets, revenues, earnings, and cash flows which can be valued.

There are deep debates about how to view and evaluate cryptos and NFTs.  Believers argue these are alternatives to the U.S. dollar and will ultimately become the economy’s currency.  Digital bulls point out that the dollar has been under attack from the Federal Reserve and the Federal Government and has lost over 90% of its value in the last 100 years.  They say the time has come for a replacement.

Crypto skeptics contend that Bitcoin, Ethereum, et. Al. will not be able to gather enough confidence to become a method of exchange.  Without acceptance, it is difficult to become a store of value which is a characteristic of currencies.  Many detractors believe cryptos will turn into a commodity.

Blockchain has potential to transform our lives.  It has the capability to offer lower cost, transparent, and accurate record keeping.  This digital data base could change the way we perform financial and legal transactions in the future.  As crypto currencies are linked with blockchains, they are expected to have a role in the financial landscape.

With these possibilities in mind, bystanders could be bewildered by the price of Bitcoin and the rest of the crypto currencies.  For those not following, Bitcoin’s price has moved from $10,000 last summer to over $60,000 last week.  Ethereum has climbed from below $200 to over $2,500 during the same period.

In addition to all the fundamental twists and turns during the past 10 months, a fair amount of emotion has helped drive crypto prices.  Crypto believers have deep faith in the future applicability and value of Bitcoin.  It seems like the only thing that will dent their enthusiasm is a drop in prices.  Perception and feelings have always been a part of the capital markets so this wouldn’t be the first time that human emotion overtook a market sector.

The Dutch Tulip Mania in late 1636 and early 1637 saw a spike in the price of tulip bulbs which was followed by a sharp plunge.  The chart below reflects the price action.[i]  Tulips had no economic value beyond the aesthetic qualities and the prices were set by what the buyers and sellers agreed upon.  It’s a classic example of an emotional financial bubble.

This is not a prediction that the prices of crypto currencies mimic tulips bulbs in the 17th century.  Bitcoin and the others probably have legitimate roles but there are many unanswered questions about their valuation.  The volatility of the crypto prices indicates a lot of emotional buyers and sellers which may continue until their economic use and value become better defined.

While Bitcoin and Ethereum are current examples of sentiment driven markets, a case can be made that the entire financial system is one big pretense.    The U.S. stock market is at all-time high levels and the S&P 500 has made 8 new record closes in April.  At the same time, the U.S. has over $27 trillion of debt and over $120 trillion of debt and unfunded budget liabilities.  And there is no plan to address this.  Any credit analyst or auditor who looked at the U.S. financial statement would easily conclude we are bankrupt.

Below is a chart of the amount of U.S. Federal debt as a percentage of GDP.[ii]  It shows that we are approaching the record levels from the end of World War II and the forecast is not good.  Over the next 30 years, the CBO expects our level of debt as a percentage of GDP to double.  This is a sad gift we are leaving to our children and grandchildren.  Perhaps this is contributing to the rush to crypto currencies and other financial alternatives.

 

 

Despite the U.S. fiscal condition being an embarrassing disaster, the capital markets continue to function.  Explaining this is on the same level as understanding the fundamentals of the Bitcoin.  Perhaps there is a link between the two.  Traders have a large amount of emotion in the form of confidence that the Federal Reserve keeps the liquidity at a level that keeps the system operating.

This charade can keep going indefinitely.  Afterall, this financial insolvency didn’t happen overnight, and stocks and bonds have overlooked this situation for years.  One of the chief reasons is that the U.S. dollar is the world’s reserve currency.  This means that everyone needs dollars to execute international transactions.  This further means that dollars held by international organizations and governments often get recycled back to the U.S. in the form of U.S. Treasury securities purchases.  This helps the entire U.S. fixed income market which helps other asset classes including stocks.  As long as the U.S. dollar is used for international trade, it helps boost confidence which allows the financial theater to persist.

Of course, there are countless catalysts that could upset this complacent landscape.  If a highly leveraged hedge fund or financial institution becomes impaired, it could be disruptive.  If foreigners’ reliance on the dollar declines, it will have a negative ripple effect.  If the markets and foreign investors stop buying the debt that federal government is relying on to fund the deficits, it would be a tumultuous twist.  This would likely cause a sizable increase in interest rates which would be a problem to an overleveraged system.   Finally, other troubles could be a sustainable rise in inflation or if geo-political issues erupt.

While these matters remain part of the financial equation, Mr. Market continues to view the glass as half full.  The start of 1st quarter earnings reports has been encouraging.  Also, the economic data is expected to further strengthen as more areas reopen.  This has the potential to be a huge systemic tailwind.  In anticipation, the Dow Jones Industrial Average and S&P 500 closed last week at record levels.  Here is the year-to-date performance for the major averages as of April 16.

Stocks have had a good year which is historically a positive.  In years when the 1st quarter is up, the remainder of the year typically builds on those gains.  Of course, one can make the argument that this is anything but normal and the markets are facing a different set of risks.  It would be irresponsible to blindly rely on historic trends in 2021.  If the recent past has taught us anything, there is no such thing as normal.

However, there are a few things that we can be assured of as the year continues.  We will continue to be pounded by the information tidal wave.  The bombardment of news and data is something we will have to learn to manage.  Otherwise, you might miss out on a critical, market moving statement by Fed Chairman Powell on interest rates.  Or more importantly, you wouldn’t risk overlooking the latest Bitcoin prediction from Kim Kardashian or a NFT by Meghan Markle.

[i] https://www.history.com/news/tulip-mania-financial-crash-holland

[ii] CBO and Hedgeye Risk Management

Copy of the 4th Quarter Review Letter

KERR FINANCIAL GROUP

KILDARE ASSET MANAGEMENT

45 Lewis Street, Lackawanna RR Station

 Binghamton, NY 13901

Phone: 607-231-6330                                                     email: jkerr@kerrfinancial.com

The following is a copy of the 2020 4th quarter letter sent to clients. It reviews the markets and the client account’s activity and performance for the 4th quarter of 2020.

The volume of books and articles that will be written about 2020 will reach to the boundaries of our universe.  Any time span that includes a presidential impeachment, a global pandemic, an economic shutdown, a disputed presidential election, and vast social divide is a good candidate for a defining and historic year. 

 

Of course, given these events, the economy and capital markets also experienced a historic year.  We had record high unemployment, a record contraction in economic activity, record low interest rates, and, after a broad painful stock market selloff, a recovery to record levels. 

 

Looking at some of these financial market details, the U.S. unemployment rate reached 14.8% in April and remained above 10% until September.  Government bond yields plunged to incomprehensible levels as the 10-year note fell below 40 basis points (0.40%) and the 30-year bond sank to 83 basis points (0.83%). 

 

Think about that – bond buyers were lending money to the U.S. government at less than 1/2% for 10 years and less than 1% for 30 years!  For those who have bond mutual funds in a retirement account or a target date mutual fund, you were part of the lending posse lining up to buy these bonds at ridiculous prices.  

 

The major stock market indexes fell over 30% from February’s peak to March’s trough.  The Russell 2000 was down over 40% in the same period.  The Russell is a broader reaching benchmark that is made up of small cap stocks and, in many cases, is more representative of the average stock. 

 

It was unclear, at the time, what was going to happen.  The economy was being closed and no one knew for how long and to what extent.  Further, there were estimates that the virus would claim millions of lives.  Uncertainty ruled the day. 

 

The equity market’s rebound began as a function of government programs to stabilize the economy.  The Federal Reserve announced astounding sized bond buying programs to inject liquidity into the financial system.  Our central bank’s balance sheet spiked from $4.1 trillion to $7.4 trillion or an 80% increase during the year.  This means that within a few months our Treasury Department printed a mindboggling $3 trillion and then turned it over to the Fed.  The Fed went into the markets and bought all kinds of bonds.  

 

The financial markets quickly regained confidence as they understood that the government was going to use all possible options and use them in an enormous scale.  The result was that the Nasdaq Composite recaptured its losses by June.  It took until August for the S&P 500 to recover and November for the Dow Jones Industrial Average and the Russell 2000. 

 

From the view point that Washington was back stopping everything, the stock market’s steady climb made sense.  However, looking through the lens that showed burning cities, an economy that was shut down, and an upcoming election, it was inexplicable.  Viewing this conundrum without seeking a logical narrative provides a possible answer.

 

Quantitative analysis and trading are playing a big role across the financial markets.  This approach is driven by hundreds of computer algorithms and programs.  The software scans the markets looking to capitalize on patterns or outlier events.  Although some do include headline keywords and other news influences, the variables usually look at things such price action, volume, volatility, and standard deviations.  They watch how differing asset classes trade relative to each other.  For example, the U.S dollar in the foreign exchange market vs. the S&P 500 or the 10-year Treasury note vs the price of crude oil. These seemingly unrelated markets can influence each other, and the quantitative models attempt to discover trends.  

 

Importantly, these relationships and their derivatives normally have nothing to do with fundamental and real-world developments.  Computer algorithms typically don’t care who won an election or about a switch in monetary policy.  These types of events will likely work their way into factors of price or the standard deviation of a security, but it may take some time.  In the meantime, the trend that the quants are following remains intact and that is what determines the trading. 

 

The use of quantitative trading has grown, and I think it is a big reason that the Dow can trade above 30,000 while the economy and small businesses are being crushed.  Of course, the reverse can be true as markets can be tumultuous despite rosy headlines.  

 

The stock market closed 2020 at record levels which contrasted with the year’s challenges.  The Nasdaq lead the way and the indexes had very good years. Here are the 4th quarter and full year performance numbers.

 

 

In addition to stocks, bonds performed well as the Barclay’s Aggregate Index (a composite of many sectors of the fixed income market) had a 7.5% total return.  Gold climbed 24.6% in 2020.  In general, commodities were higher during the year except for oil.  Crude oil fell to the single digits during the initial shutdown and recovered later in 2020 but was down around 20% for the twelve months.  The U.S. dollar fell against the other major currencies and the dollar index declined 6.7% in 2020.

 

I spent time throughout 2020 learning and trying to better understand the quantitative approach.  This included reading several books on the topic as well as adding a subscription to a math-based investment approach.  The combined influences helped your performance. 

 

One example of a quantitative assisted decision relates to Cerence, Inc. (symbol = CRNC).  The company develops voice recognition software for the automobile industry. The 3rd quarter review letter contains more details on the company.  CRNC was a strong performer in 2020 and it doubled in the 4th quarter jumping from $50 to $100 per share. 

 

On a purely fundamental basis the stock was overpriced in the $50’s but from a quantitative view, the trend was up, and the company is growing quickly.  In many cases, algorithms focus on relative performance (are things improving or deteriorating) more than absolute performance (traditional fundamental valuation).  From this perspective, we held the stock and were rewarded. 

 

Another holding that was included from a computer algorithmic basis was MP Materials (MP). This was purchased in November in the low teens and it closed the year in the $30’s.  MP is a rare earth mining company that came public via a SPAC (special purpose acquisition company).  SPAC’s are organizations that raise money with the goal of buying an operating business.  They are a growing part of the stock market and MP is one example. 

 

Returning to the old fashion fundamental research approach, Popular, Inc. (BPOP) also drove 4th quarter performance.   Popular is the largest bank in Puerto Rico.  There is limited competition as many of the U.S. banks have left the island.  This is understandable given the challenges to the Puerto Rican economy.  Natural disasters, a population exodus, and slowing business activity have hurt. 

 

As mentioned, Popular has a dominate position on the island.  When it was purchased for your account, the company was solidly profitable, and the stock was trading at half of its book value.  Our entry price offered a 4% dividend yield.  BPOP’s stock price moved from the mid-$30’s to the mid $50’s during the 4th quarter.  Despite this move, the stock remains cheaply valued. 

 

The capital markets overcame the country’s and the world’s struggles.  While they recovered and performed well, many of the issues are unresolved.  The events from last year will impact our world for many years and they will produce opportunities as well as new risks. I will look to balance these conflicting forces to help you grow your assets.     

                                                                              

Sincerely,

 

Jeffrey J. Kerr, CFA

“And I Feel Like I’ve Been Here Before” – March Newsletter

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

March 1, 2021 – DJIA = 30,932 – S&P 500 = 3,811– Nasdaq = 13,192

“And I Feel Like I’ve Been Here Before”

 

As much as everyone looked forward to hitting the delete button on last year, the extensive optimism over the new year might be in for a test. Sadly, the first two months of 2021 look like they belong to 2020. To be sure, there is plenty of time left in the year to overcome our country’s challenges and return to some version a normal society. But the direction of current events is deteriorating rather than improving.

In addition to the news not improving, it looks like it’s been recycled from 2020. As you recall, last year began with a presidential impeachment. 2021 also began with a presidential impeachment. In late January 2020, President Trump was acquitted. He was acquitted this January as well.

The virus hit the U.S. in the first quarter of 2020. The country was shut down and the focus for the remainder of the year was battling the pandemic. This introduced the concepts of ‘Social distancing’, wearing masks, and working from home. In 2021, there are concerns over variants of the virus which could delay re-opening the economy as well as bring new challenges.

In February 2020, the stock market moved to record highs. Similarly, stocks traded to all-time high levels in February 2021. Of course, last year the capital markets panicked as the economy shutdown. Stocks plunged and the bond market froze on the unknowns over the severity of the virus’s impact on the population and the length of time that the economy would be shutdown.

The U.S. dollar rose against other currencies as it was viewed as a safe haven. The commodity markets plunged because closed economies have very little industrial demand. Crude oil futures traded at negative prices. This meant that the buyer of the futures contract got the oil and got paid to take it. In 2021, let’s hope this is a case of déjà vu instead of an actual repeat of last year’s disruptive events.

The first two months of this year have had some events that smelled like 2020 but were very unique to 2021. The Reddit/Robinhood/GameStop saga is something not seen before. A few weeks ago, this was the lead story on every news outlet including the non-business/financial channels. Strangely it has gotten very coverage after the “meme stocks” settled down.

The fact that journalists have moved on from the Redditt rebels does not mean that the risks have receded. This episode exposed some structural issues that have developed within the markets’ plumbing.

One of the strategies of the Robinhoodies was buying heavily shorted stocks. Hedge fund, institutions, and large investors had made massive bets against certain companies. When the Robinhoodies started buying these stocks their prices spiked higher. This resulted in big losses for the hedge fund crowd. As the losses escalated, the negative bets were forced to be unwound which meant more buying and even higher prices and larger losses. It became a violent cycle causing widespread pain.

During these events, many market blemishes were uncovered. It was known that many traders and hedge funds were using leverage to boost returns and measurements of systemwide borrowings have been near record levels. What was not as understood was that the leverage was on top of very concentrated portfolios with limited diversification.

Leverage wasn’t the only Reddit revelation. We learned that these market players were buying the same stocks. This institutional overlap and concentration isn’t a problem until the positions start losing money and the markets turn into a huge game of musical chairs.

These risks could ultimately become systemic. If an overleveraged player becomes impaired and are forced to raise cash, they will likely have to sell the positions that are heavily owned by others. This could cause other firms to suffer losses and make them sell which then forces the pain to ripple throughout the markets.

It is possible that these risks might be contained through hedging strategies. It is difficult to determine the systemwide summation of risk reducing hedging, but it is possible that it could be an answer. Another solution is that hedge funds and investment firms reduce leverage and concentration over time. Given the history of hedge fund trading, that is not an expected development.

While systemic risks exist, the markets continue to trade as if the party is nowhere near an end. The stock market indexes are up in 2021 but the leadership has shifted from large cap tech to energy and small cap stocks. Here is the performance of the major indexes for the first two months of the year.

 

The stock market rally could continue as the economy reopens and unemployment declines. The year-over-year comparisons will be

financial market supportive as 2020’s 2nd quarter numbers were among the worst in history. Also, judging pent up consumer demand for travel and entertainment is tricky but this could support even stronger GDP growth later in 2021.

The déjà vu from other parts of the markets did not spread to the fixed income market. In 2020 bond yields declined. First, yields fell as the collapse in economic activity crushed any demand for loans. Secondly, the Federal Reserve bought billions of dollars of bonds as a way of supporting the markets and the economy. This forced interest rates lower. The 10-year Treasury bond’s yield traded below 40 basis points (0.40%) last year.

It’s been a different story in 2021. The 10-year Treasury bond began the year around 90 basis points (0.90%) but closed last week at 1.46%. This may not seem like a significant move but on a relative basis it is an over 50% move in 2 months. Also, the 10-year bond is a critical, far reaching security in the fixed income market as many other products (mortgages, corporate bonds, etc.) get priced off the Treasury market. The 10-year’s higher yield will cause higher interest rates throughout the markets.

This rise in longer term interest rates is typically a result of economic growth or inflation expectations. The bad news for 2021 is that inflation worries are behind this increase in interest rates. Crude oil and commodities prices have climbed in recent months as suppliers and miners have kept operations at reduced levels. If inflation is the reason for this development, it becomes another risk to the stock market and is likely the reason for the tech stocks’ recent weakness.

The end of 2020 brought anticipation of a new and more pleasant time. Unfortunately, that hasn’t been the case. Some of the disappointment is an extension of last year’s developments. New issues have popped up in 2021 which have helped spread the cultural angst. Instead of suffering further déjà vu of 2020, hopefully we will be experiencing new and enjoyable events.

 

 

[i] David Crosby, 1970

 

Copy of the 3rd Quarter Review Letter

 

KERR FINANCIAL GROUP

KILDARE ASSET MANAGEMENT

45 Lewis Street, Lackawanna RR Station

 Binghamton, NY 13901

Phone: 607-231-6330                                                     email: jkerr@kerrfinancial.com

 

The following is a copy of the 2020 3rd quarter letter sent to clients. It reviews the markets and the client account’s activity and performance for the 3rd quarter of 2020.

 

There was a time when all stock trades were done on a floor of an exchange that had a physical location.  The New York Stock Exchange was the most famous but there were additional regional exchanges that included the American Exchange (also in New York), the Boston Exchange, and the Philadelphia Exchange.  Specialists and floor brokers were the men and women at these locations who handled the trades.

The world has changed so naturally the mechanics of trading stocks have also changed.  Computers handle most of the today’s transactions as floor brokers are as relevant as a phone book.  As progress has accelerated, computers have taken a larger role in finance.  Now, in addition to handling transactions, computers are widely used in research and investment decisions.

Financial markets used to seek out and reward successful companies that had growing sales and profits.  Things have changed and the correlation between strong financials and a rising stock price has decreased.  Math based algorithms look at a much different set of factors to make decisions which reward not so successful companies (as measured by traditional methods).

Computer programs and algorithms scan oceans of data within seconds looking for price patterns or anomalies that offer trade setups.  These algos are driven by sophisticated mathematical formulas.  Unlike traditional investment research which focuses on financial statements and economic conditions, computers utilize calculus and statistics as they concentrate on such things as price action, volatility, and correlations between asset classes.

This high-tech approach has changed the investment decision making process.  Algorithmic trading tends to be more frequent and have short holding periods.  It doesn’t rely on price-earning (P/E) ratios, book values, or dividend yields.  Instead, sales growth rates and relative movements (are things getting better or worse) are the focus.  Further, the rates of change of the indicators such as revenues and EBITDA is an important driver of the computer programs.  This can lead to stocks with upward price momentum becoming be a market leader even if its financial condition is weak.

This new landscape can be maddening as stocks that appear to have challenges and outsized risks surprisingly become market leaders.  As an example of this new landscape, “If you bought every company that lost money in 2019 that had a market cap of over $1 billion (of which there were about 261)…you’d be up 65% for far this year”.  (This quote is from Grant’s Interest Rate Observer, October 30, 2020.)

Institutions, trading firms, and hedge funds devote big resources to algorithmic trading and it is responsible for a significant amount of daily trading activity.  There is fierce competition to find the newest and most accurate program that provides an edge over others.  Algorithms are important part of the capital market environment and will continue to play an important role.

Given the importance of computer programs, I have tried to implement some of these approaches into my decision making process.  Many data providers now include a computerized ranking systems or similar type service offering recommendations.  On their own, none of these are the Holy Grail.  But, they become part of the equation and are helpful in determining such things as entry points and slowing price momentum.

As reported by The Wall Street Journal, more stocks have risen 400% or greater than any year since 2000.  Given that stocks plunged at the end of the 1st quarter, these moves largely took place in the 2nd and 3rd quarters.  The list of this year’s highfliers has many technology and biotech stocks.  Many of these names are losing money or are marginally profitable but the rates of change for their sales and EBITDA are improving.

Beyond these shooting stars, the broader stock market had a good quarter.  The indexes steadily rose during July and August but was down in September.  Despite the upcoming election, the capital markets’ chief focus was on stimulus programs and the possibility of another economic shutdown.  Here are the major averages’ performances for the 3rd quarter and year-to-date.

 

We had some positions that were helped by the algorithmic trading.  Cerence Inc. (symbol – CRNC) is a developer of software and artificial intelligence products that does voice recognition for automobiles.  They have relationships with every car maker throughout the world.  Until 2019, they were a division of another voice recognition software developer (Nuance) but were spun out in the 3rd quarter of 2019.

Cerence generates over $300 million of annual revenues and is forecasting growth.  The company has a history of working with auto manufacturers and is continuing to add features for new voice commands for the next generation of cars.  Importantly, they are involved in the autonomous navigation developments.

CRNC’s stock began the year in the mid-teen’s.  Since the markets’ lows in March, the stock has dramatically climbed.  It recently has traded in the mid $60’s.  At current levels, the stock is overvalued and could see a pullback if the market suffers a correction.  However, Cerence is experiencing positive rates of change across many indicators and that might be enough to keep the algorithms happy.

New Fortress Energy is another example of a fast growing company with a surging stock price.  NFE builds and operates LNG (liquefied natural gas) import terminals and facilities in smaller markets who need cheaper energy.  Current operations are in Jamaica, Puerto Rico, Mexico, Nicaragua, Pennsylvania, and South Florida.  New Fortress delivers LNG to these areas and converts it back to natural gas which is a lower cost energy source for the local economy.

NFE’s stock was in the low and mid teen’s as recently as June.  It recently reached $52.  While the company is young, New Fortress has been adding new operations and signing agreements for future projects.  The current growth rate is high and the potential for further expansion looks bright.

Once again, NFE is an overpriced stock and it took a large dip at the end of October on their quarterly report.  However, if business conditions are favorable and the company can execute on its growth plans, the stock price will recover and move to new highs.

There are many approaches to investing.  Computerized trading and algorithms have become a large part of the landscape.  This is a much different approach from the traditional research and portfolio construction methods.  While there have been much development and success using these new techniques, they have not eliminated risks.  Nevertheless, they offer additional pieces into the decision making process which will help spot future opportunities.

“There’s Battle Lines Being Drawn, And Nobody is Right if Everybody is Wrong”

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

February 1, 2021 – DJIA = 29,982 – S&P 500 = 3,714– Nasdaq = 13,070

“There’s Battle Lines Being Drawn, And Nobody is Right if Everybody is Wrong”[i]

 

There was a common and popular plea throughout 2020 and it was for the year to end as quickly as possible.  This widespread wish was based on the belief that 2021 could not come close to matching 2020’s troubles and, by default, would have to be better.  Further, there was hope that life would return to normal as defined by pre-pandemic conditions.  While the New Year is only a few weeks old and optimism reins, signals suggest that 2021 could match or exceed last year’s misery.

Last year we suffered through a pandemic, economic shutdowns, stay at home shut-ins, widespread business failures, and historic unemployment.  As a result, we learned about Zoom meetings, masks, hand sanitizer, social distancing, and Netflix binging.  The situation was intended to be temporary until the case numbers decreased or a vaccine was available.

Another notable characteristic of 2020 was cultural differences and division. Unfortunately, no medical solution will heal this, and, despite calls for unity, the situation is worsening.  The opposing sides appear to be moving farther apart as well as expanding the number of issues of disagreement.  Before you know it, we’ll be yearning for the good old days of 2020.

Our cultural split began years ago and was generally defined along political parties.  This has morphed into the current battle map with squiggly lines that have many angles to define allies and the enemies.  The landscape has turned into a “Uni-Party” of the ruling class and their financial supporters against anyone outside the aristocrat category.  This is no better illustrated than by the walls that were put up to ‘protect’ our elected officials and staffs while the wall on our southern border protecting the rest of us is judged unnecessary.

A new front in this war began last week in lower Manhattan.  A large army of individual investors did battle against hedge funds and traditional Wall Street enterprises.  These firms and banks had made massive bets against some struggling companies via short sales.  This is when someone borrows the shares from a brokerage firm with the intent of returning the shares later.

The hedge funds and traders that are borrowing these shares are betting that the price of the security declines.  Once the price of the stock falls, they then buy the shares that they borrowed at the lowered amount and make a profit. The goal is to make money on a falling stock price.

The short seller’s risk is that the stock price increases after they sell the borrowed shares. The borrowing firm must return the shares so any increase in price will result in a losing trade.

The hedge fund and large traders had targeted some businesses with significant challenges.  One of the lead companies in this confrontation is GameStop, the world’s largest video game retailer.  They are facing a network of stores which increases fixed costs, declining sales, shrinking margins and increased competition.  This appeared to be the flawless short sale situation.

Hedge funds and their colleagues took dead aim and sold the stock with both fists.  The strategy got so popular that over 100% of the float (the number of shares outstanding less shares held by insiders and other restricted shares) was shorted.

This extreme positioning got the attention of a group of individual investors who used a Reddit.com chat room to exchange ideas.  They bought GameStop which dramatically drove the price higher.  Then others saw what was going and bought the stock.  The shares jumped from under $20 to almost $480 in two weeks.  Other heavily shorted stocks also were bid up in similar fashion.  AMC Entertainment, Nokia, and Blackberry.  They had one thing in common – they were heavily shorted.

The higher price caused indigestion among the players that were short, and many were forced to cover (buy the shares to repay the shares on loan).  Some hedge funds lost billions of dollars and one of the hedge funds, Melvin Capital, had to get bailed out due to large losses.

This saga is a classic David vs. Goliath.  The Reddit Rebels, a diverse group of individuals, combating the sophisticated and shrewd Wall Street.  This band of individual investors initially got the upper hand as they drove their targeted stocks higher and forcing losses and pain on the hedge funds.

Then the plot took an unexpected twist as Wall Street unilaterally changed the rules.  Without notice Robinhood, a popular trading app, restricted “buy” orders in the names that the hedge funds were short.  Without the Robinhoodies’ buying support, GameStop fell from over $450 to under $200 in one day.

The developments behind the restriction are unclear.  Some claim that Robinhood had too little capital but that doesn’t explain why only a few stocks were banned.  Others claim that large hedge funds pressured Robinhood so that they could recover some of their losses.

The battle eventually turned into a public relations dispute as media outlets and regulators defended the established Wall Street crew.  Some claimed these were necessary measures to maintain Wall Street’s integrity.  Others declared these small traders were an attack on the free market system.  Finally, one compared the Redditors to insurrectionists like those who invaded the Capital offices and labeled them as a national security threat.

These allegations were hyperbolic media manure.  “Free markets” is an anachronistic term.  If global central banks manipulate interest rates and the capital markets (as they do now), we are not in a free markets system.  Further, “integrity” and “Wall Street” is a laughable and blatant oxymoron.

Reddit defenders accused the hedge funds of collusion as they suppressed trading access and manipulated the stock market for their gain.  Besides Robinhood, other brokerages firms like TD Ameritrade and Charles Schwab abruptly restricted trading in GameStop and other popular Reddit stocks.  There was no mention of capital calls for these firms.

As retail investors took on the establishment, they got support from a wide and surprising diverse group.  Donald Trump, Jr. complained, “This is what a rigged system looks like, folks!”[ii].  New York Congresswoman Alexandria Ocasio-Cortez was equally critical of the brokerage industry pointing out that the people who have treating the economy as a casino are angry at a group of individuals doing the same thing.

While the outcome is uncertain, GameStop may be a one hit wonder for the Redditors.  To be sure, there will be other stocks to trade, but one obvious conclusion is that some of the participants need more financial education and trading experience.  Nevertheless, there should not be some nobility restricting their freedom to execute their decisions with their own money in the capital markets.

This conflict has multiple parallels to the censorship and suppression that is spreading across our culture.  Those who question the aristocracy or refuse to mouth the party line are being a targeted as threats and must be punished.  Political leaders, bureaucrats, and big tech have combined to police our society.  Similarly, those who challenge corrupt insiders in the financial industry are being besieged as evil radicals that must be destroyed.  The view from the Wall Street and Washington insiders is that this uprising and challenge to their position must be squashed at all costs.

While this war raged, there was worry that it would become systemic and deeply impair the capital markets.  Hedge funds use massive leverage in their trades.  Also, there is a great amount of duplication within hedge fund positions.  That is one of the reasons behind the astounding amount of shorts on things like GameStop.  As many firms were losing billions due to the Reddit Rebels, there were concerns over critical failures within the hedge fund community that could pull the system down.  It hasn’t happened – so far.

It is encouraging that the capital markets have withstood this dramatic tale.  However, stocks did selloff in the last 4 trading days of January and the Dow Jones Industrial Average and S&P 500 closed lower for the month.  The small cap stocks (represented by the Russell 2000) were the weakest sector in 2020.  With a new year, we have new leadership as the small caps were the strongest in January.  Here is the performance of the main indexes for January.

 

There is an old Wall Street adage that January gives the direction for the full year.  If January is positive, there was a high probability that the year would be up.  This was historically measured by the Dow’s and S&P 500’s performance and is called the January Barometer.

Data in recent years is questioning the strength of this relationship.  According to LPL Financial (February 1, 2021), 8 out of the last 9 times that the S&P 500 was lower in January, the index was higher over the 11 remaining months.  However, there might be a different result from a red January.  Volatility spiked in recent years that had a down January which is an obvious and expected outcome for 2021 given the country’s divide.

The economic and social landscape is at an unstable point.  The established elites will fight to maintain their position and power.  Given the progress of the Redditors, the individual investor doesn’t seem likely to backdown.  This situation as well as the issues facing our country will likely intensify rather than go away.  Perhaps this can be summarized as the banks and their colleagues are too big and important to fail and the individual is too small and insignificant to succeed.

 

 

[i] Stephen Still, 1966
[ii] The Washington Examiner, January 28, 2021

 

“Those who vote decide nothing. Those who count the vote decide everything.”

 

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

 

January 4, 2021 – DJIA =30,606 – S&P 500 =3,756 – Nasdaq = 12,888

“Those who vote decide nothing. Those who count the vote decide everything.”

 

Although the above quote is associated with Joseph Stalin, there is debate whether he is the actual source.  Regardless, it appropriately describes the 2020 U. S. Presidential election and is emblematic of our divided country.

The right to choose our government representatives fairly and freely is a core component of the United States.  From local office to federal positions, the right to vote gives the individual an equal say in our country’s direction and leadership.   And despite some nasty and messy examples, our elections have been the envy of the world

This latest election was different.  Unconventional campaigns, censorship and biased news reporting, and newly instituted tabulation methods intersected during 2020.  These developments clearly damaged the election’s transparency which resulted in voter doubt.  This loss of confidence further widened the country’s divide.

Throughout the year there was hope that after the presidential election, the social ill will would recede.  This kumbaya moment would be a period of healing and then a return to our pre-2020 existence. Unfortunately, the election has inflicted more and deeper wounds which will not easily heal.

The soldiers and battle lines of this civil war are different from the conventional conservative Republicans vs. the liberal Democrats.  The new battleground cuts across different sectors of our culture which brings together diverse elements into the opposing groups.  Populists squaring off against globalists, the middle class opposing the elites, and the Davos crowd vs. the deplorables.  And as the war matures, there will likely be other curious alliances and divisions.

While the election has inflamed the emotions of the fight, the core of the conflict centers on the balance between individual freedoms and providing for the common good.  This struggle is as old as mankind.  This war has countless fronts and battles, and both sides have dug in.  It is difficult to see a path to unifying the United States citizens in 2021.

This social division will ultimately alter our economic wellbeing.  To many, it is one of the great mysteries of 2020 that the financial markets performed as they did.  Not only did they recover from March’s air pocket, but they functioned well in a year with a pandemic, economic shutdowns, riots and protests, and the turmoil surrounding the election.

The stock market had amazing returns given this backdrop.  Here are the 2020 performance numbers for the major averages.

 

 

An interesting 2020 stock market development was the influence of the individual investor.  As a result of working from home (or just at home and not working), stock trading became a favorite pastime.  In addition to online trading, a stock trading mobile app called Robinhood became the preferred platform.

Robinhood offered $0 commissions, the ability to purchase partial shares, and option trading.  It became so popular that websites began tracking and reporting on the most widely held positions.  Unfortunately, education and experience weren’t required.  One young investor mistakenly thought he lost $700,000 in his trading account and, sadly, took his life.

Looking at the other markets, the bond market provided good returns.  The Barclay’s Aggregate Index (a composite that tries to capture the treasury, mortgage, and corporate bond markets) had a total return (price and income) of 7.51%.

The yield on the 10-year Treasury bond began the year around 1.9% and ended at 0.91%.  This yield traded below 40 basis points (0.40%) during the March turmoil which an all-time low for this security.  Of course, global central bank intervention played a huge role in holding interest rates low to help the economy.  This could be a place to watch in 2021 as interest rates have been moving higher.  The 10-year yield traded around 0.50% in August but has been steadily rising since then.

The U.S. dollar declined from its March peak and lost 7.14% in 2020.  As measured by the U.S. Dollar Index (symbol = DXY), it reached 103 as stocks plunged in March. It gradually declined the rest of the year and closed 2020 at 89.68.  A falling dollar can coincide with rising inflation as the cost of imports go up.  Again, this is a trend that could become a problem in 2021 especially if it signals that the international community is losing trust in the U.S.

Commodities often trade opposite the dollar and it happened in 2020.  The Dow Jones Commodity index rose 13.9%.  Gold sold off in the 4th quarter but was up almost 25% for the year.  Crude oil did not trade with other commodities and declined 20.5%.  Oil plunged during the start of the shutdown and traded at a negative price in the futures market in April (Yes – the sellers paid the buyers to take the contract for oil).  Since then, prices have been rising and the price approached $50 per barrel at the end of the year.

Bitcoin and crypto currencies returned the spotlight in the second half of the year.  Bitcoin fell to $5,000 in March but finished the year over $29,000.  The trade, like other currencies, has a weak dollar element so the falling DXY has been a tailwind.  However, there is a perception that it could become a stronger store of value against inflation.  If that proofs to be true, Bitcoin and the crypto currencies will be a big story in 2021.

2020 will be remembered as a year full of calamities.  It will be a defining point in history like the Great Depression or World War II.  While many expect a much different and brighter 2021, regrettably, many of the same challenges continue to confront us.  There is no guarantee that 2020 was an inflection point and 2021 could turn out to be worse.  Nevertheless, our country is resilient and, somehow, we will eventually regain some sort of cultural reconciliation and move forward.  That will be good for everyone including Mr. Market.

“O Little Town of Bethlehem, How Still We See Thee Lie.”

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

December 21, 2020 – DJIA = 30,179 – S&P 500 = 3,709– Nasdaq = 12,755

“O Little Town of Bethlehem, How Still We See Thee Lie.”

 

This year has been one of intersections.  Tectonic and life altering collisions of dire events have changed the world.  The challenges that we are facing will impact our lives for many years.  While there is widespread hope and belief that we return to the lifestyle of pre-pandemic society, this is becoming less likely as time passes.  The unexpected outcome might be that 2021 is worse than 2020

Our turbulent year is ending with another historic intersection and, fortunately, this one doesn’t appear to be a disastrous pit.  The “conjunction” of Jupiter and Saturn in the Earth’s December sky is a different type of intersection and, who knows, it might signal an inflection point for the better.

A planetary conjunction is when two heavenly bodies seemingly meet as seen from Earth.   While the conjunction of our solar system’s two largest planets happens around every 20 years, they rarely pass as close to each other as they will this year.  Also, this year’s occurrence is notable as it is easily seen without a telescope.

This year’s astronomical intersection is being referred to as a “great conjunction” because the planets seldom appear this close to each other.  The orbits of Jupiter and Saturn do regularly intersect as viewed from our planet, but it is not as close or as bright as what is happening now.  The last time Jupiter and Saturn appeared so close and was so visible was March 1226.

Because of their infrequence, some scientists look for historic events surrounding “great conjunctions”.  Johannes Kepler was a 17th century astronomer and mathematician who was a big influence on others such as Isaac Newton.  Kepler researched the possibility of a “great conjunction” being the Star of Bethlehem that guided the Three Wise Men as described in St. Matthew’s Gospel.  He concluded that there was a “great conjunction” around 7 B.C.

In addition to our cosmological excitement, the stock market has also acted celestial.  Stocks had one of their best months ever in November. The Dow Jones Industrial Average recently traded over 30,000 and the Nasdaq Composite has been on a moon ride and is up over 40% in 2020.  All the major averages are in record territory.

These gains contrast with the earthly background of the U.S. economy.  It is a huge contradiction that we have stock market records along with shutdowns and restrictions, high unemployment, and the destruction of small businesses.  However, perception is reality in the financial markets and computer algorithms do not typically look at the fundamental data.  They are more concerned with things like price action which can be a self-fulfilling circle.

Here are the major averages year-to-date performance as of December 18th.

 

The declining value of the U.S. dollar has been a boost to the stock market.  The dollar index (symbol = DXY) is down 7.9% year-to-date.  More importantly, it is down 12.6% since the peak in March.  While a low double digit drop doesn’t seem like a lot, the dollar has a wide-ranging global impact.  It has a much greater force on other economic factors and markets than its absolute movement against other currencies.

The 120-day correlation between the DXY and the S&P 500 has decreased to a negative 88%.  Statistical correlations range between 1 and -1.  A correlation of 1 means that the two factors move together relatively and directionally.  The negative 1 would mean that the factors move in opposite directions.  At -.88, the DXY has clearly helped the stock market.

The factors weighing on the U.S. dollar are many.  The United States is over $27 trillion in debt. Further, there is well over $100 trillion of debt and unfunded liabilities.  While there are other countries in similar or worse fiscal conditions, the global capital markets may be losing confidence in the American situation.  This devaluation of the U.S. dollar is helping financial assets – for the time being.

Another shining star in the financial markets is Bitcoin.  The crypto currency is up 121% in the 4th quarter and 228% year-to-date.  Again, this trade has an anti-dollar component, so the dollar’s slide has supported Bitcoin.  Here is a chart Bitcoin’s price for 2020’s 4th quarter.

 

 

Confidence in the crypto currencies is increasing for some of the same reasons that the dollar is falling.  Out of control government spending, record deficits, and no plan to address these issues.  Nothing travels in a straight line, but if the dollar falls further, stocks and Bitcoin could keep rising even as the societal shutdown continues.

In a year full of historic developments, our solar system reminds us there is consistency of heavenly cycles.  This is in sharp contrast to the chaos that has overcome our lives.  If this “great conjunction” marks a change in our world, hopefully it brings a shift to healing, peace and an honest, truthful effort of moving humanity closer to a heavenly nature.

Merry Christmas, Happy Holidays, and Best Wishes in the New Year.

“We Are All Pilgrims in Search of The Unknown”

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

November 30, 2020 – DJIA = 29,910 – S&P 500 = 3,638– Nasdaq = 12,205

“We Are All Pilgrims in Search of The Unknown”

 

In the early 1600s the Pilgrims moved from England to Holland seeking separation from the Church of England.  While the Netherlands provided religious tolerance, the Pilgrims didn’t completely fit into the culture and in 1620 they left Europe looking to start a community in the New World.

One wonders what was stronger – desperation or determination.  It’s hard to understand what would cause a group to give up an established but perhaps unpleasant existence to risk their lives to travel to an unknown and uninhabited part of the world and completely start over.  It gives a hint to the cultural and religious persecution of the 17th century.

The difficult trip took over 60 days and Mayflower landed in what would become Massachusetts in November.  The ship was blown off course and landed north of the intended destination which was near the Hudson River and within the jurisdiction of the Virginia Company.  Only about half of those who set foot on Plymouth survived the winter.

Since they were outside of the Virginia territory, they felt they should establish their own rules of governance.  An agreement was written which became to be known as the Mayflower Compact and everyone signed it including many non-Pilgrims.  It setup a representative government with elected leaders and played a key role as the area flourished and, 150 years later, it influenced the United States Constitution.

Progress has improved many parts of our lives in the last 400 years.  Unfortunately, human nature doesn’t change which means we are constantly at risk of repeating past mistakes.  This might explain what looks to be a return of religious intolerance.

As part of the pandemic shutdown, churches, synagogues, and other places of worship were closed.  Upon re-opening, occupancy restrictions were implemented which were similar to what were imposed to other organizations.  However, as time passed it seemed that churches and synagogues were scrutinized for violations.

In early October, synagogues in Brooklyn were ordered to be limited to 10 people.  The order was handed down just before two holidays that are traditionally involve large gatherings.  Elsewhere in the state, churches were ordered to limit attendance while looser restrictions were imposed on other parts of our lives.

Last week the United States Supreme Court ruled against New York State and Governor Andrew Cuomo’s restrictions on places of worship.  The Court determined that the regulations on religious facilities were more restrictive than secular ones.  The ruling opinion cited the First Amendment and included “But even in a pandemic, the Constitution cannot be put away and forgotten” as reasons for the ruling.

The divide and acrimony taking place throughout the United States will likely result in a revisiting of this issue.  The recent Supreme Court ruling will initiate other efforts against churches and religious groups.  The intolerance that the Pilgrims sought to escape is becoming a larger part of today’s culture.

Religious oppression reaches beyond limiting the size of worship services.  Being a person of faith is culturally unacceptable and results in being stereotyped as a Bible hugging, smallminded, luddite.  And religion is only one sector of the multi-faceted on-going civil war.

Despite the historic upheaval and discord, the financial markets function as if we have arrived in heaven.  U.S. stocks are having one of their best months in history.  The Russell 2000 has jumped 20% in November and the Dow Jones Industrial Average, the S&P 500, and the Nasdaq have all rallied over 10% in the month.  What a remarkable move.

The Russell is the largest of these four indexes and is comprised of smaller companies.  Its outperformance is a sign of broadening within the U.S. equities market.  Historically, this can be a sign of further gains.

Here are the major averages year-to-date performance as of November 27th.

 

 

The mystery behind the market’s climb in face of widespread turmoil has several explanations.  First, there appeared to be a lot of nervousness going into the election.  The wide differing implications of the outcome forced many to get defensive.  It’s not clear which candidate caused more market fear, but when everyone realized that life would go on, investors stopped selling and returned to buying.

Along with getting past the election, the markets are anticipating an effective COVID vaccine and a complete economic re-opening.  This would include re-hiring of the idled workers, increased consumer spending, and capital investments. The expectation of starting on the path of economic growth helped drive the recent rally.

From a corporate earnings perspective, 2021 will look a lot better than 2020.  Markets discount future events and Wall Street believes that the U.S. will get through the pandemic.  This will help company bottom lines and the capital markets love to see an improving trend more than the absolute level of the numbers.  So, if the data is moving from lower left to upper right, the markets will be happy.

Another development that has helped the stock market has been a declining U.S. dollar.  The dollar index (symbol = DXY) began November at 94.12 and ended last week at 91.79.  This is normally a low volatility index, so this is a material move.  The 30-day correlation between the S&P 500 and the U.S. dollar is -.87.  The negative number indicates the two factors move in opposite directions and it strengthen as it approaches 1 or -1.  This recent weakening of the dollar has undoubtedly helped push the stock market higher.

This landscape could remain supportive for a while longer.  Our fiscal deficits and the prospect of increased borrowings are a significant drag on the greenback.  If the correlation remains deeply negative, stocks could keep rising.

The United States is facing several historic crises.  The pandemic, the election, the possibility of adding new states, and social division can strongly impact the direction of the country which will influence the economy and the markets.    As the Pilgrims’ bold actions changed history, we could be at a similar point.  The resolution of the issues we are facing will have a long-lasting effect.

“You can look around and there’s not a sign of hypocrisy. Nothing but sincerity as far as the eye can see.”

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

October 26, 2020 – DJIA = 28,335 – S&P 500 = 3,465 – Nasdaq = 11,548

“You can look around and there’s not a sign of hypocrisy. Nothing but sincerity as far as the eye can see.”

One of the highlights of October is Halloween.  A time of the year when deception and trickery is encouraged.  Of course, if you are in politics, trickery is not just limited to the end of the October – it’s an everyday event.  And with this being an election year (what else would you expect from 2020!), the shenanigans have increased exponentially.

Naturally, the financial markets also have their level of chicanery.  Stock prices are near record highs while Main Street struggles, small businesses try to stay afloat, and the unemployment numbers remain stuck at uncomfortable levels.   Many are counting on a “V” shaped economic recovery and anything different could be a material disappointment.

In addition to the economic troubles, another mystery involves the market’s rally given the massive cultural division, civil unrest, and the uncertainty over the election.  Turmoil and doubt about the county’s future path would often result in volatile markets and a move to safety.  Currently, however, that doesn’t appear to be the case.  Rather, the capital markets are driven by optimism that the stimulus packages and economic bailouts will save the day.

Stocks are not the only asset class that is masquerading.  There was a time when bonds were considered a boring but safe investment.  But thanks to central banks’ intervention, they no longer fit that description. Interest rates across the markets are down to inconceivable levels.  The 10-year Treasury note closed last week (October 23rd) with a yield of 0.84% which is up from a recent yield of 0.71%.  The 30-year bond closed at 1.64%   This means that to receive an interest rate of 3 or 4%, investors must get creative or assume a lot more risk.

Instead of offering investors interest payments, many of today’s fixed income securities exchange hands with negative yields.  In other words, the price of the bond (the price that it is traded at after it has been issued) is so high that the interest payments don’t offset the premium paid.  The total return is negative.

The European Central Bank, the Bank of Japan, and other central banks buy bonds in the secondary market as a stimulus tool  This massive demand forces prices higher and the result is that the higher price outweighs the interest rate received – a negative yield.  With central banks cornering the fixed income markets, those who are forced to buy bond (fixed income mutual funds, insurance companies, etc.) must overpay for the securities they need.

The graph below shows the total amount of bonds (as measured in U.S. dollars) that have negative yields. After a drop in the amount of negative yielding bonds in the spring, we are again approaching record levels.  Massive stimulus, which includes central banks (the Federal Reserve) buying bonds to save the economy, is the chief reason behind this.

 

With so much of the world’s bonds trading at prices that result in negative interest rates, fixed income securities are massively mispriced.  This impacts many other sectors of the financial markets as fixed income securities can no longer offer lower risk.  This forces conservative capital to move somewhere else.  Which then causes imbalances in other markets.

An example of this rippled distortion is the high number of zombie companies.  A zombie company is a highly leveraged, unprofitable organization that uses the bond market as a source of cash and capital.  Unfortunately, these zombies, if they can get funding, survive past Halloween.

Under normal conditions, these companies would go out of business because a lack of profits and additional funding.  Central bank manipulation and bond buying injects money into the markets which eventually reaches the riskiest sectors including the zombies.  Without this liquidity, they would fail.  That wouldn’t be all bad as their demise would reward the zombies’ profitable competitors which would strengthen the economy with higher growth rates.

 

 

Along with Halloween, it is also earnings season.  This raises the question of which one will be scarier.  The quarterly results, in general, have been good but the stock market’s reaction has not reflected these earnings reports.  The major stock averages declined last week as spooked investors were more concerned the possibility of an increase in Covid-19 and delays in the getting another round of stimulus approved.  Given that a lot of the economy remained constricted or shutdown, the better than expected corporate earnings could be an encouraging sign for a continued recovery.

Here is where the major averages closed on October 23rd.

 

Everyone is aware of the Great Pumpkin’s reputation of only visiting sincere places so clearly, the corner of Wall and Broad Streets and Washington D.C. won’t be on the itinerary.  However, like the Great Pumpkin’s mystical power, there might be a larger force behind the stock and bond markets peculiar ability to remain higher as the world is crumbling.

Modern Monetary Theory (MMT) is a controversial approach that might be the driving force behind the capital markets.  First, MMT uses fiscal policy to impact the economy.  It calls for printing unlimited amounts of money and giving to the federal government to spend.  Budget deficits, according to this, are not a concern.  The only risk is inflation.  But if that happens, taxes are raised, and this is supposed to slow demand and eventually calm inflation.

One of the first to embrace MMT was Bernie Sanders as he included it as his economic policy for his latest presidential campaign.  It was the cornerstone as the method of financing the expansive social programs that he was to implement.  Outside of Sanders’ supporters, MMT has been widely criticized and disparaged by traditional economists.

Difficult times call for desperate decisions and it sure looks like the Federal Reserve and the Federal Government borrowed Bernie’s playbook in battling the economic shutdown.  During 2020 we have printed a lot of money and expanded the Federal Governments deficit to unimaginable levels.

A measurement of the money that is in circulation is the Federal Reserve’s balance sheet.  The Treasury Department may print the currency, but the Fed puts the money into the banking system.  This distribution process puts the dollar bills on the Fed books.

Below is a graph of assets held by the Fed.  To be clear, these ‘assets’ were bought by the dollars the Fed put into the banking system so money supply is the other side of the ledger.  Before the financial crisis on 2008-09, these assets totaled less than $1 trillion.  This quickly quadrupled to over $4 trillion by 2014 through the countless QE programs.

The Fed attempted to normalize monetary policy and return their balance sheet to more traditional levels in 2018 and 2019.  However, the bailouts, PPP, and various stimulus programs have pushed the total of assets held at the Fed to the current heights.  Of course, the Federal Government’s budget deficit will be equally astounding which gives the current situation all the markings of Modern Monetary Theory.

 

 

As measured solely by the rebound of the financial markets and the economy, so far so good.  This incredible amount of liquidity injected into the economy has certainly helped in pushing up the financial markets.  And until there some signs of inflation, central bankers have little appetite to turn off the printing presses.

However, there is typically some unintended consequences when untested theories are put into place.  It’s not being discussed but there is risk that inflation isn’t brought under control as easily as predicted.  Further, history has shown that high growth in the money supply causes bubbles to arise.  The downside to MMT aren’t limited to these goblins as there are many other dangers that could develop.  We must remember, there’s no free lunch.

In the meantime, whether Bernie Sanders gets credit or not, further increases in stock prices and financial assets could be in the future.  This economic trick or treat could keep going until everyone fills their bags with candy.  But like believing in the Great Pumpkin, as long as there is confidence in the Fed’s ability to deliver, the system carries on with only Charlie Brown getting the rocks.

“Now I Know My ABC’s, Next Time Won’t You Sing With Me”

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

September 28, 2020 – DJIA = 27,173 – S&P 500 = 3,298 – Nasdaq = 10,913

 

“Now I Know My ABC’s, Next Time Won’t You Sing With Me”

 

Meteorology has run out of letters.  The process of naming tropical storms and hurricanes has reached the end of the alphabetical runway and this has forced weather people to move to Greek letters.  To be sure, range of storms that are named is wider and the threshold is lower than in the past.  Nevertheless, it becomes another amazing event of 2020.

It’s unclear if this will have any impact the current ongoing civil war, but things are so acrimonious even an insignificant blip like this can push people over the edge.  The New York Times will report that it’s all President Trump’s fault for not instituting more letters to our alphabet.  FOX News will proclaim that the Democrats wouldn’t allow an expanded alphabet without additional funding for Central Park’s barley farmers.

Ruth Bader Ginsburg’s death will also sharpen the differences between the country’s polarized groups.  Controversy on confirming her replacement will add to the extraordinary and lengthy list of events making 2020 an astonishing year.

Impeachment, COVID, economic shutdown, protests, riots, job losses, and all the stressful issues have impacted everyone.  Fatigue is commonplace.  The graph below is from the Pew Research Center and shows America’s anger, frustration, and dissatisfaction.  With so much disagreement within our society, it is easy to understand that 87% of respondents were dissatisfied “with the way things are going in this country today”.  As shown, this is up from the 68% area where it has been for the past 3 years.

Further, when having to choose between “Angry”, “Fearful”, “Hopeful”, and “Proud” as the answer to “in thinking about the state of the country these days”, a wide majority say they feel “Angry” and “Fearful”.  It’s not a surprise to see that the answer “Proud” was a distant last.  It will be a societal marathon to return to anything resembling togetherness, but the United States has faced enormous challenges and will survive.

 

Another disconcerting divide is the one between Main Street and Wall Street.  Job losses continue grow, people battle to pay their bills, and businesses struggle to re-open.  At the same time, the stock market reached all-time highs in early September.

The capital markets are obviously expecting a quick and far reaching economic rebound.  The popular cliché is a “V” shaped recovery with the letter “V” representing the direction of the economy (sudden and sharp drop followed by a quick recovery to its previous levels).  It’s what the stock market is counting on.

Naturally, there are some less optimistic forecasts.  Staying with the alphabet, some are predicting a “W” recovery.  In other words, a sharp decline followed by a recovery that peaks at a much lower level.  This is followed by a return to the depths of the recession which is then followed by a complete recovery of the previous high level of economic activity.  The “W” recovery normally has a much longer timeline as compared to a “V” shaped bounce with more pain in finding a base where the system can bounce from.

Another letter that is used for economic predictions is “U”.  This is an unpopular character as it suggests that, after the initial drop in the economy, activity stays weak and bounces around the lower level for an extended period.  When the recovery finally arrives, it takes the economy back to previous strong levels.  Again, this is not an enjoyable process.

Some are pointing to a fourth alternative that is represented by the letter “K”.  This is a complicated scenario and is illustrated below.  As shown, economic activity bounces as the shutdown is lifted.  However, after the initial push, the system fragments into two paths with diverse outcomes for various sectors of our society.

According to JP Morgan, demographic groups like the wealthy and white-collar workers will do well.  On the other hand, the middle class, blue collar, and small businesses suffer as these groups encounter further headwinds and don’t benefit from the Fed’s programs and Washington’s bailout of large companies.  Under this development, there would likely be more social division rather than healing.  The paths of economic convergence after the separation have many and unpredictable possibilities.

 

The “W”, “U” and “K” scenarios are the least desirable and maybe the stock market is realizing that the “V” is far from certain.  After peaking in early September, the Dow Jones Industrial Average and S&P 500 have declined 4 weeks in a row.  The Nasdaq had a small gain last week after falling for 3 consecutive weeks.  The major indexes fell below their 50-day moving averages for the first time since April.

Despite the recent dip, the stock market benchmarks remain near record highs.  Here are the year-to-date returns for the major averages as of September 25th.

 

 

After a bounce in economic data during the summer, there are signs of slowing.  Initial jobless claims last week were 870,000.  Although this was higher than forecast, the number has been declining in recent weeks and the 4-week moving average is at 878,250.  Nevertheless, this number means that almost 1 million people are filing for unemployment benefits for the first time each week.  This needs to be a lot lower in order for the economy to return to normal conditions.

August’s reported unemployment rate was 8.4%.  This was a significant decline from 10.2% in July and was below the forecasted 9.8% level.  As the economy reopens, the number of people returning to work naturally increases and the unemployment rate decreases.  The headwind to future progress in this area is the prospect of small businesses not reopening.  This number will have a material multiplier effect on the economy.

The Conference Board’s Leading Economic Index reading rose 1.2 percent in August to 106.5.  That is good but is lower that July’s 2 percent gain and June’s 3.1 percent increase.  The press release included the following, ““While the US LEI increased again in August, the slowing pace of improvement suggests that this summer’s economic rebound may be losing steam heading into the final stretch of 2020”.

As troublesome as the current state of society is, there is a good chance it worsens.  The replacement for Justice Ruth Bader Ginsburg, the presidential campaign, the ongoing protests and riots, and a contested election are events that we must work through in the next couple of months.  It’s easy to think that these developments will contribute to our country’s angst.

How this impacts the economy and the markets is a difficult forecast.  Stocks have set records in the face of cities being burned and a modern civil war.  Perhaps the capital markets can continue to move higher despite our discord.  However, some worry that like running out of letters in the alphabet, the financial markets will run out of optimism over the arrival of cultural healing and a rebounding economy.