“We Can Evade Reality but We Cannot Evade the Consequences of Evading Reality”


Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

 

April 29, 2019 – DJIA = 26,543 – S&P 500 = 2,939 – Nasdaq = 8,146

“We Can Evade Reality but We Cannot Evade the Consequences of Evading Reality”[i]

With the Mueller Report released, we’ve learned that there was no Trump – Russian collusion.  Of course, this did little to reduce the controversy surrounding the Trump administration and both sides claimed the report defended their view.  The investigators, now that they are done with the President, should turn their focus to the stock market because it sure looks like some collusion is going on.

The mystery in U.S. equities is the incredible and historic start to 2019 despite a backdrop of weaker fundamentals.  As stocks have recovered from the last year’s 4th quarter selloff, many are wondering what is driving the buying.  The global economy is slowing, the U.S. Treasury bond yield curve is flat and flirting with inversion, and corporate earnings estimates are declining.  Yet stocks keep climbing.

Of course the bulls have justifiable reasons for this rally.  But before covering them, let’s look at some of the glass half empty views.  Two are centered on interest rates.  One is the message being sent by the fixed income market that dramatically differs from the stock market strength.  The other looks at the structure of the yield curve that is also in conflict the equity rally.

Normally, higher stock prices are a function of growing earnings which is associated with a strong economy. A growing economy is usually accompanied with higher interest rates as there is a greater demand for capital.  Below is a graph of a world stock index vs. the shape of the U.S. Treasury bond yield curve.

Usually the yield curve is shaped from lower left to upper right as lenders require a higher interest for the uncertainty that comes with longer time periods.  The graph’s blue line captures this as it is the yield on the U.S. Treasury’s 10-year minus the yield on the 3-month bill.  As this blue line travels lower, it means the spread shrinks.  When the difference between the short term rate and the long term rate is small, the yield curve is flat and this is associated with slow growth or recession.

The orange line on the graph shows 2019’s strong rebound in global stocks.  This points to expectations of economic growth.  However, at the same time, the flattening yield curve is showing that the bond market is calling for a slowing economy.  Looking back, there was a similar, albeit smaller, divergence last summer.  It was initially resolved in the middle (stocks came down some and the yield curve steepened a little).  But ultimately, stocks fell to the December lows.  Maybe the Fed’s recent policy pivot is enough to keep the shark from biting anything.

 

The chart below is the yield curve.  It is the yields of the U.S. Treasury market at various maturities.  It differs from the previous chart in that the “shark chart” shows the numerical difference between the 10-year and 3 month bonds at various points in time.  The yield curve below shows the yields at all maturities for a point in time.

In the yield curve chart, the blue line is the current status (April 2019) while the black line represents April 2018.  Last year’s yield curve was steeper as the 10-year note’s yield was around 3% while the short maturities were close to 1.5%.  Currently, both are around 2.5% and there is inversion from the short end to the 3 – 5 year maturities.  While inversion to the 3 to 5 year time frame doesn’t fit the classic recession red flag, it is disconcerting.

 

Obviously, corporate earnings are another indication of economic activity and, in this area, there are clouds forming.  Below is chart that shows the S&P 500 vs. the 2018, 2019, and 2020 consensus earnings estimates for the index.  Note how all three lines moved higher throughout last year.  But, as you can see, profit estimates plunged in January 2019 as shown by the light blue line (2019) and the red line (2020).  Yet in the face of these falling forecasts, stocks prices moved higher.

A silver lining could the separation of prices and estimates in 2017.  As shown, the S&P 500 steadily moved higher during 2017 while S&P 500 earnings expectations lagged.  Forecasts rebounded at the end of the year helped by the passage of the Tax Cuts and Jobs Act of December 2017.

 

Given these blemishes, some may call it whistling past the graveyard.  But there is no question that the stock market has had a historic rally since the beginning of the year.   The S&P 500 and the Nasdaq have only had 2 weekly declines in 2019.  In addition to its size, the rally has been steady with only a handful of 1% daily moves (up or down).  This is where the major indexes stand at the end of last week.

2019
Dow Jones Industrial Average 13.8%
S&P 500 17.3%
Nasdaq Composite 22.8%
Russell 2000 18.0%

 

As covered above, there are some reasons to question 2019’s stock market rally.  However, there are two sides to every trade and the bulls are not completely delusional.  The job market is at the strongest level in history.  Last week 1st quarter GDP was estimated to be growing at 3%.

But there are three additional themes that the bulls are relying on to keep the markets moving.  1). The Fed won’t be raising interest rates.  2). China trade deal gets done. 3). Second half of the year earnings growth.

The Fed’s sudden reversal regarding monetary policy is the biggest reason for December’s bottom and 2019’s surge.  Prior to the flip in early January, investors were debating over the number 2019 interest rate increases of between 2 and 4.  Now the expectations are for no increases with the talk of a possible cut.  It seems strange to be cutting interest rates with stocks at record highs but there are a lot of peculiar things going on.

A China trade deal is a highly anticipated development for the financial markets.  The belief is that once a deal is done it will release some delayed activity and set the path for further growth.  A deal likely gets done however, given all of the hype, the markets could easily be disappointed.

The second half earnings recovery is contingent on the other two.  Any profit expansion would require a friendly Fed.  And with the world so intertwined, a trade deal between the two largest economies would help the global system.

The U.S. financial markets have rebounded from last year’s 4th quarter turmoil.  The return to all-time high levels has not been accompanied by strong economic data and there are some significant soft patches in the global landscape.  This has led to some conspiratorial questions concerning the stock market’s move.

Everything may work out as the year unfolds but there are risks that might derail the current optimism.  And if things start to unravel, the economic support is not at the same level as last year.  This would cause the rosy expectations to quickly sour.   The result would be a situation that requires another Mueller investigation.

[i] Ayn Rand

“Some Are Born Mad, Some Achieve Madness, and Some Have Madness Thrust Upon ’em.”

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

April 1, 2019 – DJIA = 25,928 – S&P 500 = 2,834 – Nasdaq = 7,729

“Some Are Born Mad, Some Achieve Madness, and Some Have Madness Thrust Upon ’em.”[i] 

Each of the over 60 college basketball games in this year’s NCAA tournament has to be a triple overtime, buzzer beating last second shot in order to compete with the other madnesses of March.  In fact the basketball tournament, with all of its excitement and suspense, could not crack the first 10 spots of the 2019 Billboard Top 40 of insanity.

Some of the madness is not new.  Such things as the BREXIT negotiations and negative interest rates have been with us for some time.  But the new lunacy is breathtaking.  The college admissions bribery scandal, the Green New Deal, the Jussie Smollett case, Modern Monetary Theory, the Robert Kraft scandal, the Mueller report, Jerome Powell’s pivot and an inverted yield curve.  The list is historic.

And as tempting as it is to comment on the non-financial, the focus will be on the issues demonstrating financial madness.  To start, as we know, the capital markets are influenced by many emotions including euphoria, despair, and, of course, madness.  As emotions become stronger, they can outweigh logic and lead to insane decisions.

Some recent head scratching developments could have a long lasting impact.  For example Fed Chairman Powell quickly changed his stance on interest rates and monetary policy in late December and early January.   In what is being called the “Powell Pivot”, he switched from a path of steady interest rate hikes and tighter monetary policy to an accommodative stance.  This curious flip has many wondering what is going on.

Usually the journey from tight monetary conditions to an accommodating landscape are because of soft economic data.  While there were signs of economic weakness this time, they were mainly outside the U.S.  Domestically, the economy had a very strong 2018 but growth appeared to slow some late in the year.

In addition to being driven by economics, normally Fed changes are both gradual and widely telegraphed.  The markets generally know what the Fed is thinking and are rarely caught off guard.  The “Powell Pivot” was neither gradual nor telegraphed.

Without the typical conditions and mechanics for a switch in Fed policy, markets were a little hesitant.  But once traders concluded that the Fed was on hold for future interest rate increases, it was buy first and ask questions later.  It resulted in a strong rally and one of the best quarters in years for the stock market (more on this later).

Nevertheless, Federal Reserve critics questioned the motives behind Powell’s decision.  Many in the markets conjectured that it had nothing to do with the central bank’s two stated objectives (price stability/inflation and employment).  Instead it was widely thought that it was entirely in response to a declining stock market as prices tumbled 20% in the 4th quarter.

Of course in today’s fluid moral system, the ends (a higher stock market) justify any means.  This also helps to explain the support for Modern Monetary Theory (borrow and print as much money as needed for federal spending because the consequences are limited and controllable) which has become popular with the socialists in the Democratic Party.   Skeptics (of the Federal Reserve and Modern Monetary Theory) believe these approaches are reckless and that there is a price to pay for such decisions.

Another risk in basing monetary policy decisions on the stock market is that the economy might not respond and corporate earnings might lag.  In other words, if the economy and earning don’t continue to grow later this year, the 1st quarter rally could abruptly reverse course.

Another example of financial market madness involves the U.S. Treasury yield curve.  The yield curve is a graph that plots the bonds yields compared to their maturity.  The normal shape is from lower left to upper right because longer maturities usually command a higher interest rate to compensate for greater uncertainty associated with longer time periods.

By historical standards, the spread between the shorter maturities vs. the longer maturities has been very narrow over the past year.  Two weeks ago the curve inverted causing much wailing and gnashing of teeth as inversion often precedes a recession.  The bulls pointed out that this indicator is not 100% accurate and that the average lead time from an inversion to a recession is around 9 months.

Nevertheless, this yield curve indicates economic abnormalities.  Two obvious conclusions are that the Fed is too tight and short term yields are too high.  Or the economy is weak and there is limited demand for long term capital.  If either or both are the cause, the financial markets could be in line for a correction.

And despite the short term stock market gains, there is the possibility that the chairman of the Federal Reserve panicked.  This could lead to loss of confidence the next time something really bad happens or when we fall into the next recession.

An inverted yield curve is not the only madness in the fixed income markets.  Bonds trading at negative yields is another aspect of this market’s mental illness.  As shown in the graph below, $10 trillion of global debt have negative yields.  Another remarkable point is that only once in the past few years has the total of negative yielding securities been below $6 trillion.  This is zanier than Robert Kraft and Jussie Smollett added together!

 

 

 

 

 

 

The stock market, often at the center of financial lunacy, seemed unfazed by the madness in the markets, culture, and government.  Maybe all of the craziness helped make equities look like an appealing island of tranquility.  The S&P 500 had its best 1st quarter since 1998 while it’s the best start for the Dow Jones Industrial Average since 2013.  Here is how the major averages performed in the 1st quarter.

2019
Dow Jones Industrial Average 11.2%
S&P 500 13.1%
Nasdaq Composite 16.5%
Russell 2000 14.2%

The stock markets have rebounded from December’s lows and finished the quarter just below record levels.  Under normal conditions, a strong start to the year leads to further gains.  But 2019 has not been normal.  Given the sudden policy flip by the Federal Reserve and an inverted Treasury bond yield curve, financial history may not repeat itself.

Nevertheless, stocks are trading well.  The optimism over equities is based on a trade deal with China, a second half of the year economic pick-up, and continued Federal Reserve support.  If anything derails these expectations, more madness may develop in the financial markets and it could painful.   As for lunacy outside the financial markets, that looks like a strong bull market and it might be just starting.

 

 

[i]Emilie Autumn, The Asylum for Wayward Victorian Girls   2009

 

“Good Times, Bad Times, You Know I’ve Had My Share”

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

 

February 25, 2019 – DJIA = 26,031 – S&P 500 = 2,792 – Nasdaq = 7,527

“Good Times, Bad Times, You Know I’ve Had My Share”[i]

Reviewing the past 3 months in the U.S. financial markets, we had the worst “December” since 1931, which was within the worst quarter since 2011.  Then we had the best January since 1987 that has extended to a 9 week winning streak for the Dow Jones Industrial Average, the Nasdaq Composite, and the Russell 2000 (the S&P 500 rose for the 4th consecutive week last week).  This sets up the best yearly start in over 25 years for the stock market.

The Dow and S&P 500 are approaching their September all-time high levels which few would have predicted at the end of December.  Certainly, the 20% selloff and subsequent rebound provide ammunition for the passive/buy and hold investors.  Why try to time the market if you are confident that selloffs will always be temporary?

Undoubtedly, Wall Street’s bears have been caught off guard with the stock market recovery.  There were many calls that December’s selloff was the start of a long and painful bear market.  Their crystal balls didn’t predict a broad two month rally.  The only people having a worse 2019 are the main stream media with their premature conclusions covering the Covington Catholic and Jussie Smollett stories.

It is said that Wall Street climbs a wall of worry.  This refers to the logic defying situation where markets are strong in the face of bad news. When this happens, it is a confounding backdrop and many are left scratching their heads.  This takes place regularly and could be a function of oversold conditions where all the negative news flow has already been discounted.

The great start to 2019 might be another example of “climbing a wall of worry”.  Certainly, the headlines are providing enough bricks, stones, and concrete to build a tall and sturdy wall.  First, December’s retail sales report was horrific.  It was the weakest monthly report since September 2009 or in the midst of the financial crisis.

Some other problematic data include a large drop in small business optimism, signs of weakness in the housing market, and notable softening in purchasing manager data.  Obviously, this has not discouraged investors.  And while it might be a classic “wall of worry”, the bears would suggest it’s “whistling past the graveyard”.

While the market skeptics have valid concerns, the bulls have an overpowering force on their side – the Federal Reserve.  Fed chairman Jerome Powell began to change his message from monetary hawk to dove in late December.  It continued in early January when he stressed words “patient” and “flexibility” when speaking about future interest rate increases and reduction of the central bank’s balance sheet.

Since then the accommodative rhetoric has increased.  The Fed sent out a slew of speakers last Friday featuring New York Fed President John Williams and Fed Vice Chairman Neil Clarida.  Mr. Williams addressed inflation targeting and the Fed’s inability to reach its goal.  Vice Chairman Clarida offered that the Fed will consider new monetary tools, if needed, including radical policies such as capping Treasury bond yields.

The bears are quick to point out that, despite recent bad news, the economy is expanding.  It’s puzzling that this dialogue is taking place within growth conditions.  There are many that think the Fed’s fickleness is all in response to the falling stock market.  Further Fed critics propose that the central bank panicked over the market turmoil during the 4th quarter and is sending the wrong message to the global capital markets

This has reinforced the belief that the Fed adjusts monetary policy not on economic developments but to protect the stock market.  This is known as the “Fed put” meaning that traders and investors don’t need downside protection because the Fed will take care it.  Anytime the market goes down, the Fed will step in to increase liquidity and reduce interest rates.  The criticism is that this distorts the markets role of price discovery and actually increases systemic risk.

It’s been 10 years since the financial crisis and these extreme policies are considered the solution.  Over 22% of the world’s debt trades at a negative interest rate.  The European Central Bank controls the continent’s bond market.  China has flooded its economy with over $1 trillion of liquidity in past two months as it tries to patch its financial potholes.    All this intervention (manipulation) is supposed to help the markets trade normally yet these are far from ordinary markets.  Maybe central banks are the problem.

If the stock market is the measuring stick, things are fine.  As mentioned, prices have stabilized and bounced from the Christmas Eve lows.  They have recovered back to levels in early December but remain below the all-time highs reached in early October.  Here are the major averages’ 2019 returns.

2019
Dow Jones Industrial Average 11.6%
S&P 500 11.4%
Nasdaq Composite 13.4%
Russell 2000 17.9%

The Dow and the S&P 500’s strong yearly start could be a sign of more good things to come.  According to Dow Jones Market Data, when these two indexes rise 10% or more in the first two months, it often leads to further gains.  The graph below shows previous years when this happened.

As shown, it breaks out January and February versus the remainder of the year.[ii]  The two exceptions of when the rest of the year diverts from the direction of the first months are notable.  After a strong a start in 1987, stocks crashed in October.  In 1931 stocks began the year higher and then fell as the Great Depression was started to set in.

Analyzing the financial markets in 2019 has an added factor of bad news is good news and good news is bad.  This is because if there is enough bad news, the Fed won’t raise interest rates.  And if the Fed doesn’t raise interest rates that’s good news and stocks will go up.  And then this becomes bad news because the Fed will look to raise interest rates like in 2018.   And then this will cause the stock market to go down and the Fed will hold off which is good news.  It’s like Bud Abbott and Lou Costello are running monetary policy.

Although its’s never easy, the wild crosscurrents ripping through the world’s capital markets makes investing decisions more difficult than usual.  And within this backdrop, relying on the ability of global central bankers is not a safe strategy.  Let’s enjoy the good times while keeping an eye for the bad times.

 

 

 

 

[i] Page, Jones, Bonham, Plant, October 1968

[ii] The Wall Street Journal, February 22, 2019

“You’ll Like This Guy. He’s All Right. He’s a Goodfella, One of Us.”

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

February 4, 2019 – DJIA = 25,063 – S&P 500 = 2,706 – Nasdaq = 7,263

“You’ll Like This Guy. He’s All Right. He’s a Goodfella, One of Us.”

Two weeks ago President Trump and the Democratic leadership agreed to end the federal government shutdown.  The continuing resolution calls for three weeks of funding while negotiations for a long term answer will take place. The status of Speaker Pelosi’s European/middle east trip was not mentioned.

This shutdown set longevity records as the opposing sides dug in.  And while some economic reports were delayed which could be a problem in gauging economic progress, Wall Street seemed unconcerned about the government employees who were out of work.    On the other hand, it was very concerned with some Washington workers who remained at their desk.

To the dismay of some, Federal Reserve chairman Jerome Powell (technically not a government employee) punched the time clock each day. And while he had no direct involvement in the government’s closure, Mr. Powell has recently received investors’ wrath.

Stock market bulls are blaming the Fed’s less accommodating posture for the financial markets’ 4th quarter mayhem.  To be sure, monetary policy changed in 2018 – interest rates were going up, not down, and the Fed was no longer buying bonds (monetizing debt).  This certainly left its mark and played a role.  But there are more issues beyond Fed policy that have contributed to the financial markets’ chaos.

Before discussing the why, let’s review the what.  As measured from the highs in September to the lows in late December, the major indexes tumbled approximately 20%.  December was worst ‘December’ for the Dow Jones Industrial Average and S&P 500 since 1931 and it was the worst monthly drop since February 2009.  For the Dow and S&P 500 it was the worst quarter since 2011 and for the Nasdaq it was the worst since 2009.

With the New Year came a new direction.  The S&P 500 rebounded 7.9% last month which made it the best ‘January’ since 1987 and the best of any month in over 3 years.  Given the severity of the selloff, a bounce was not a surprise.  The bears view it as a “dead-cat” variety while the bulls think the lows are in and this is the start of a longer lasting move.

Returning to the Federal Reserve, they raised the short term interest rate in December which was the 9th time since December 2015.  It’s easy to forget that when this string of increases began the overnight interest rate was at 0%.  Further, it is also easy to forget that the rate had been at 0% for 7 years!

This series of rate increases is the Fed’s attempt to normalize monetary policy 10 years after the financial crisis.  The debate concerning the overnight lending rate’s appropriate level has been a hot topic within the financial markets for the past several years.  However, this discussion intensified in the second half of 2018 especially as forecasts for 2019 added 2 to 4 more increases combined with signs of global economic weakness.  Investors feared that the Fed was determined to raise interest rates and reduce their balance sheet which could accelerate any economic slowdown.

Certainly this could have contributed to the markets’ 4th quarter upheaval.  But there are some other problems.  China has been coughing some hairballs in form of some very soft data.  Also, two large peer to peer leading organizations failed.  These are companies that gather investor capital and then lend and invest it – similar to a bank but without branches.  There are estimates that this Chinese lending sector has over $200 trillion of loans.  It’s hard to know the fallout of these failures but it could be material.

No man is an island.  Likewise, no country is isolated in today’s international financial system.  So naturally, China’s slowdown has an influence beyond its borders and perhaps the biggest impact is felt in Germany. China is one of Germany’s largest export markets and has contributed to declining activity in Europe.  Germany is the largest economy in the EU and the 4th largest in the world.

Closer to home, there are other market worries besides the Federal Reserve.  The federal government shutdown obviously causes uncertainty and disruptions.  It also made an already chilly political environment colder which doesn’t help consumer and business confidence.

This all may turn out to be much ado about nothing as the Fed has quickly had a change of heart on playing the villain.  Fed Chairman Jerome Powell has retreated on future interest rate cuts and balance sheet reductions.  He recently used word like “patient” and “flexibility” referring to future policy decisions.  This is a change from the projected interest rates hikes for 2019.  The news has greatly emboldened the bulls as they believe that the Fed has their back once again and won’t let the stock market get too sloppy.

The Fed has long been “data dependent”.  This is kind of a sophisticated way of saying “we are not sure what to do so we’ll wait for the economic reports and then react” (As a side issue, the Fed has a payroll of over $5 billion per year. One might ask, “If you relying the data to formulate their decisions, why are you paying all those PhD’s?”)

Importantly, this latest flip from tightening to neutral (and possible loosening) contradicts the economic data.  We have record low unemployment, corporate profits are very strong, and the highest GDP growth in many years.  This illogical shift of position is both significant and puzzling.  The answer is related to the unstable stock market.

The Fed will not admit that they are using the stock market as an indicator for policy.  This is despite claims by skeptics that the central bank intensely watches (and supports through strategic intervention) the stock market.  A quick look at a collection of statements from Jerome Powell provide some insight.

On October 3rd, Chairman Powell referred to the Fed’s stance as “a long way from neutral”.  In others words, expect more interest rate increases as the economy was strong.  In November he said the rate, which was around the same level at the time of his October statement, was “just below” the appropriate level.  How did we go from “a long way” to “just below” neutral?  The stock market fell 10% in between those comments.

In December the Mr. Powell offered some more stern comments about the reducing the Fed’s balance sheet (tightening) only to reverse course on January 4th.  It was at the January presentation that he used more conciliatory words.  Since then stocks have spiked higher giving us the best January in over 30 years.

Tying monetary policy to stock prices sounds innocent.  However, if investors are confident that the Fed will prevent any serious decline, prices can easily climb to extreme levels and risk becoming a bubble.  Further if interest rates are too low relative to economic strength, there will be misallocations of capital.  This is what helped inflate the housing bubble last decade as the Fed kept interest rates too low for too long.  As you may remember, this was the solution used to fix for the Dot Com stock market bubble.

The Federal Reserve is trying calm the financial markets after the recent turmoil.  It’s soothing language and signals worked in January.   However, the unintended consequence could turn out to be enhanced systemic risk as assets are mispriced.  And overvalued financial markets in an overleveraged global systems with slowing international economies could get much worse than 2018’s 4th quarter.

 

2018 3rd. Qtr. Kildare Asset Mgt.-Kerr Financial Group client review letter

The following is a copy of the 3rd quarter letter sent to clients. It reviews the markets and the client account’s activity and performance for the 3rd quarter and year to date 2018.

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

 

Economic statistics tell a story that the financial markets interpret and, ultimately, convert into prices at which trades occur.  Of course, understanding the data is only one part of the process.  Another critical step is the interrelationships between the various statistics as well as the magnitude of their importance.  In other words, some data influences other economic reports and some statistics have greater importance than others.

For example, the monthly employment report is given much more attention than a release on business inventories.  This is natural as jobs growth has a widespread economic influence as it directly impacts things such as consumer spending and inflation (through wage growth).

As sign of its importance, the financial world seems to stop on the first Friday of the month at 8:30 AM eastern time when the U.S. employment report is released.  It is amazing that this news release attracts so much attention with countless beforehand forecasts and then subsequent dissection of the details.  All this hype for a report that is revised numerous times in the months following its original release.

Accurately analyzing the various economic numbers is a significant step in making good investment decisions.  However, an additional part of navigating the markets goes beyond the economy.  Politics, fiscal policy, and international relations impact stocks, bonds, currencies and commodities.  Reviewing 2018’s 3rd quarter, investors had to deal with a lot of this news.

The domestic economic news was strong.  During the quarter, we learned that the estimated growth rate for the U.S. economy was 4.2% and it was the best back to back quarters since 2011.  The unemployment rate fell to 3.7% in September which was the lowest rate since 1969.  These broad numbers translated into surging corporate earnings.

It was a much more challenging quarter for the international economies.  Headwinds such as rising crude oil prices and a stronger U.S. dollar resulted in painful obstacles for some countries.  Nations that have to import oil (India and Japan for example) encountered higher commodity costs.

Within emerging markets, Turkey and Argentina were pressured by the stronger U.S. dollar that ended up stressing their financial systems. The Italian budget dispute added uncertainty to the international financial system.  And, of course, talks over tariffs generally hurt global trade.

The result was a disturbing divergence between the rest of the world and the U.S. stock markets.  At the end of September, the Dow Jones Global index (excluding the U.S.) showed a year-to-date decline of 5.2% while the U.S. indexes traded near all-time records.  Here is a list of 2018 year-to-date returns through September for some noteworthy international indexes:

2018
Shanghai Composite (China) -14.70%
Hang Seng (Hong Kong) -7.10%
Nikkei 300 (Japan) 1.30%
DAX (Germany) -5.20%
FTSE (London) -2.30%

To compare, here are the U.S. major indexes.

3rd. Qtr 2018
Dow Jones Industrial Average 9.0% 7.0%
S&P 500 7.2% 9.0%
Nasdaq Composite 7.1% 16.6%
Russell 2000 3.2% 10.5%

Today’s global economic system is interwoven through trade and the financial system.   The separation in direction between the foreign stock markets and the U.S. averages is noteworthy.  Obviously, there are times when one country or area outperforms the rest of the world, but for the U.S. stocks to be moving in a dramatically different direction from other major indexes is worrisome.

I included the chart below in a September newsletter.  The two lines are the S&P 500 (blue line) and the Vanguard All-World Index that doesn’t include the U.S. markets (red line). It clearly shows the two indexes trading closely together before diverging in May.  Since then, the gap has widened.

Focusing on the U.S. stock markets the 3rd quarter saw a continuation of the recovery from the painful drop in February.  As a reminder, the Dow was down year-to-date at the end of June while the S&P 500 showed very modest gains.  In the 3rd quarter, the Dow and S&P recaptured the losses from earlier in the year and traded to new record highs in September.  As mentioned in the September newsletter, the markets’ leadership was narrow with the four largest U.S. stocks accounting for 50% of the S&P 500’s gain in 2018.  This was disconcerting as advances with more participation are normally more sustainable.

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

 

3rd Qtr 2018
Kerr Financial Group – Kildare -0.46% 6.19%
Asset Management

 

Normally I review some of the details of your account during the quarter, but, given recent market developments, it’s important to review October and November. October was the worst ‘October’ since 2008.  Also, it was the worst of any month since 2011.  Recently there have been rough months such as August 2015, January 2016 and February 2018.  While these suffered monthly losses, October 2018 exceeded them

Some important changes in the market backdrop have taken place.  The U.S. dollar has risen in value as compared to other currencies.  This has strained some foreign financial systems and, with today’s global system so connected, any small problem can have far reaching impacts.

Interest rates have moved higher in the U.S. throughout 2018.  This has been partially driven by the Federal Reserve on the short end of the yield curve but also driven by the markets.  There is a lot of debt in our economic system and higher interest costs will be a problem.

Lastly, 3rd quarter earnings reports were released in October and the numbers were good.  However, guidance and forecasts for future profits were lowered which surprised the Wall Street.  The markets are continually discounting future events and if profits are expected to be flat or lower, market prices will decline.

I have tried to use various hedges in client accounts together with cash balances as an attempt to avoid the declines.  October’s action was so widespread that this wasn’t as effective as anticipated.  As a result, I have raised more cash and will likely continue to do so if markets don’t begin to stabilize.  Ultimately, this will provide ammunition when prices reverse this decline.

Please feel free to call with any questions.  Thank you for your business and continued confidence placed in me.

Jeffrey J. Kerr, CFA

Kerr Financial Group

Kildare Asset Mgt.

45 Lewis Street – Lackawanna RR Station

Binghamton, NY 13901

“Professor Plum, With the Candlestick, in the Conservatory”

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

December 17, 2018 – DJIA = 24,100 – S&P 500 = 2,599 – Nasdaq = 6,910

“Professor Plum, With the Candlestick, in the Conservatory”

 

Before cable TV offered hundreds of stations, board games were a big part of family entertainment.  While classic board games are still around and are occasionally played, they have become a nostalgic memory.  And as our lives have changed, family time spent with a board game has turned into checking our social media accounts while watching reality TV.

One of the most popular board games is “Clue”.  It is a murder mystery game that requires players to determine who committed the crime, in which room, and with which weapon.  Those familiar with the game will remember colorful character names including Miss Scarlett, Mrs. Peacock, Colonel Mustard, and Professor Plum.  The rooms included the conservatory, lounge, billiard room, study, and library.  The candlestick, lead pipe, revolver and rope were some of the weapons used.

For those sentimental souls who have a yearning to play but don’t have a worn box of “Clue” in the storage closet, the financial markets might be an alternative.  Instead of the game’s characters, we have President Trump, Jerome Powell, Theresa May, and President Xi.  The weapons are interest rates, the U.S dollar, and tariffs.  The locations are the New York Stock Exchange, the bond market and Washington DC.  Let’s start the game.

There is plenty of mystery behind the recent economic and financial developments.  The major stock market averages reached record levels in September but have fallen since.   After an attempted bounce in early November the weakness returned later in the month and into December.  Stocks are on pace for one of the worst 4th quarters in history.

The weakness in stocks can be shown by a couple of examples.  The week of Thanksgiving is historically a strong period for the stock market but for just the second time since 1964 the Dow Jones Industrial Average fell all four trading days of that week.  This out of character decline could be sending a message.

The week after Thanksgiving gave investor relief as stocks rallied.  It was the best week in 7 years for the S&P 500 and Nasdaq Composite.  Unfortunately, equities gave back all of these gains the following week (two weeks ago) as the Dow, S&P 500, and Nasdaq Composite all fell over 4% while the Russell 2000 dropped over 5%.

Last week a mid-week rally attempt failed miserably and the major averages closed at the lowest levels since February.  There was real carnage in some other areas.  The Dow Jones Transportation Average and Russell 2000 made new 52-week lows on Friday.  The Transportation Average is down 18.1% from its record high in September while the Russell has fallen 19% from its record.  On the bullish side, the Dow Jones Utility Average made a 52-week high this.  Unfortunately, utility stocks are not considered a good leading sector.

Equities have endured a lot of selling during the past couple of months and some sort of bounce would be expected.  But it is not good when we get it (last week of November – again best week in 7 years as well as the middle of last week) and then immediately give it back.  Here is where the major averages are year-to-date as of last Friday’s close.

2018
Dow Jones Industrial Average -2.5%
S&P 500 -2.8%
Nasdaq Composite 0.1%
Russell 2000 -8.1%

Another puzzling piece of the market puzzle is the bond market.  Two aspects need discussion – the yield curve and the level of yields.  The yield curve has recently been a major Wall Street topic.  The yield curve is a graph which shows the yield or interest rate on a type of bond for various lengths of time (normally a few months out to 30 years).  It shows the relationship between interest rates and time.  Below is a recent yield curve for the U.S. Treasury debt market.

 

The orange colored yield curve (from one year ago) is a typical structure.  The slope of the line moves from lower right to upper left which means the longer the bond’s length of the time until maturity the higher the interest rate.  Lenders demand this higher rate as longer time periods have more uncertainty and unknowns.

As the above chart also shows, the shape of yield curve has changed and the slope of the treasury yield curve has declined (flattened).  This means that short term rates have increased while the long end has declined.  The rise in short term interest rates is easy to explain – the Federal Reserve has increased the federal funds rate for the last couple of years and this part of the treasury yield curve is highly responsive to the Fed.

The long end of the curve has been a different story.  Within the last month, the 10 and 30-year maturities have declined.   This is illustrated by the change of the green line (November) with the red and blue lines (both December).

The decline in the long end on the yield curve is a mystery.  With a strong economy, such as now, the longer maturing rates should be moving up.  There is normally more demand for capital as the economy expands and this usually results in higher interest rates especially in long maturities as this finances capital investment.

The drop in the long end of the Treasury curve have traders looking for more clues.  Some worry that it could be signaling an upcoming slow down.  And certainly the global economies have slowed as both Germany and China reported disappointing data last week.

Another development causing some confusion is recent statements from Fed Chairman Jerome Powell.  On October 3rd, the Fed Chairman spoke about interest rates and future increases, “We may go past neutral.  But we’re a long way from neutral at this point, probably”[i].  Neutral refers to the Fed target level.  The Fed Funds rate was 2.18% on that day.

A little over a month later in late November, Mr. Powell said, “Funds rate is just below the broad range of estimates of the level that would be neutral for the economy.”[ii] The Fed Funds rate was at 2.2%.

Some investors called for a timeout to review the video tape.  What just happened?  What caused Powell to go from “long way from” where we need to be to “just below” the target rate while the interest rate didn’t move?  And to do it within two months.

There was no noticeable change or deterioration the economic data.  There was no international flare up beyond the ongoing dialogue and digs that have taken place throughout 2018.  The only obvious reason for the change was the stock market which had a terrible October and November.

As a reminder, the Federal Reserve’s assigned tasks are maximum employment and stable prices.  It’s not clear when the level of the Dow became their concern but Wall Street has had the view that the Fed would pull out all stops to save the financial markets since the time of Alan Greenspan.  Powell seems to following in the footsteps of Greenspan, Bernanke, and Yellen.

The decline in yields in the treasury market could also be a flight to quality.  It’s not much of a strain on the imagination to think of possible landmines that would cause a shift toward safety.  Deutsch Bank has been struggling for years and its failure would cause ripples throughout the global financial system.  There are bloody riots in Paris with calls for President Macron’s resignation.  Then throw in Brexit, Italy, Turkey, Argentina, China and Russia.

The U.S. Treasury market is considered to have very little credit risk so it is a “go to” security when global institutions are looking to reduce risk.  If traders are fearing a systemic credit issue, buying U.S Treasury bonds would be a natural decision.  This could be a part of the lower yields reflected in the above graph.

Liquidity is a crucial part to the markets and the institutions that operate within them.  The availability of money and credit might be shrinking.  Certainly the Fed has been shrinking its balance sheet at the same time that they’ve been raising interest rates.  The European Central Bank hasn’t raised interest rates but they have cut back on amount of bond buying which injects funds into the system.

There are other signs of contracting liquidity.  According to The Financial Times, there has not been a bond offering in the high-yield corporate bond market in December.  The last time this happened was November 2008 or just as the financial crisis was taking hold.[iii]

While this may seem like an unimportant development, the high yield corporate bond market exceeds $1.2 trillion so this is not an obscure fixed income market.  And while December is not a hot month for offerings, deals obviously got done in previous Decembers.  This could be another sign that there is a liquidity or credit problem lurking.

The overall capital market picture is has changed.  Stocks have fallen, the bond market is acting strangely, the dollar is strengthening, and oil has dropped 40% in two months.  The mystery behind these various gyrations is not easy to solve.  And while there are many suspects with plenty of motives, maybe the answer is that the markets are calling the bluff of an over indebted system with no plan to fix its problems.  If this is the case it means that we’ve only begun the game of solving financial system mysteries.  And they will probably get a lot harder.

 

[i] Doubleline Funds, December 11, 2018

[ii] Ibid

[iii] The Financial Times, December 16, 2018

“October. This is one of the peculiarly dangerous months to speculate in stocks.”

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

October 22, 2018 – DJIA = 25,444 – S&P 500 = 2,767 – Nasdaq = 7,449

 

“October.  This is one of the peculiarly dangerous months to speculate in stocks.”

This was written by Mark Twain in his novel “Pudd’nhead Wilson”.  Twain underlines how dangerous the financial markets can be in October. As a reminder, the month has witnessed two stock market crashes with the anniversary of the 1987 version being last Friday (October 19th).  In addition to stocks, there have been debt crises, foreign currency melt downs, and general capital market turmoil in past Octobers.

Mark Twain’s recommended restraint regarding speculation in October extends to some other months.  Within the novel, the above quote continues “The others are July, January, September, April, November, May, March, June, December, August, and February”.

Concerning the markets, the wisdom of Samuel Clemens (Mark Twain’s real name) is extraordinarily underestimated and goes beyond the general admonishment of speculation.  His warnings about October have proved to be incredibly accurate, but the most amazing thing about this was that Twain penned this in 1894!!  Obviously this is well before the Panic of 1907 and the Stock Market Crash of 1929 both of which took place in October.  Thankfully, Samuel Clemens lived in the 19th century and was allowed to focus on writing.  Otherwise, someone with this level of insight in the 21st century would have a hedge fund in Greenwich, Connecticut, robbing us of his real talents.

Returning to October 2018, it is attempting to make its own historical mark.  It’s on pace to be the worst October since 2008.  The S&P 500 and Nasdaq are enduring their worst start to any month since 2011.  This is an important statement as there have been several nasty months in that time such as August 2015, January 2016 and February 2018.

Stocks have widely retreated this month.  Below are the major averages’ returns for October and year to date at last Friday’s close.  As you can see, much of 2018’s gains have been given up in the first few weeks of October.

October 2018
Dow Jones Industrial Average -3.83% 2.93%
S&P 500 -5.02% 3.52%
Nasdaq Composite -7.42% 7.90%
Russell 2000 -9.11% 0.43%

So what is haunting the markets?  There is a long and wide ranging list of possibilities.  Issues such as the Italian fiscal debacle and its battle with the European Union.  Tariffs and trade wars is another worry.  Widespread social division does not help matters.  The markets could be concerned that the U.S.’s mid-term elections could thwart Trump’s economic initiatives.  And, of course, add in hot spots like Russia, Saudi Arabia, and Turkey.

While these factors are most likely contributing to investors’ anxiety, there are other important developments that are changing the financial background.  To borrow from The Food Network’s “Diners, Drive-Ins, and Dives”, let’s call these the ‘Triple D’s’ – the dollar has strengthened, the debt markets are facing higher interest rates, and there appears to be a decline in corporate earnings.

First, the U.S. dollar has risen since the spring as compared to other currencies.  The dollar is an important component of global trade as most transactions are done in U.S. dollars.  When the greenback appreciates, it takes more of the local currency to do a transaction.  This results in higher costs.

Another headwind caused by stronger dollar is higher interest costs for foreign borrowers.  Non-U.S. corporations and governments have sold debt in the U.S. during the past several years.  As the local currency loses ground to the U.S. dollar, it costs more money to make the interest payments.

A strong dollar also hurts U.S. companies that sell in foreign markets.  In dollar terms, the price of the product or service provided by a U.S. company increased in terms of the local currency.  In other words, if the dollar rises against the euro, the price of Microsoft’s software is higher for a European customer.

As a further illustration of this, PPG issued a warning of their quarterly results in early October – their third quarter financial results will be lower than forecast.  One of the reasons given was that foreign sales were less than expected due to the stronger dollar.  PPG is a typical industrial company which means that many other international organizations may share this challenge.  The damage from a strong dollar could become a repeated theme throughout this earnings season.

The debt markets are another complication facing investors. Interest rates have been churning higher all year as a function of the Federal Reserve, a stronger economy, fiscal deficits, and inflation.  Higher interest rates increase borrowing costs and pressure corporate bottom lines which might be what the markets are focused on.

Another important part of this development is that it denotes a change in the landscape.  Interest rates have been declining since the early 1980’s.  A shift in this trend could have far reaching impacts.  On top of tighter money and higher interest expenses, the cost of capital will be greater which bring enlarged scrutiny on business decisions.   Perhaps the biggest adjustment will be that many investors and corporate CFO’s have never experienced this type of market environment.  This could become a very big part of the capital markets over the next several years.

The final “D” in our Triple D analogy is declining earnings.  To be sure, corporate earnings have been very strong and that should not change with 3rd quarter reports.  However, future guidance may not be able to sustain the growth of recent quarters.  Returning to the PPG warning, the company also blamed higher logistic and raw material costs.  Again, these are not unique to PPG and are likely widespread across corporate income statements.

Another example of pressure on corporate earnings is in computer chips and semi-conductors.  During the past two months, Morgan Stanley, Raymond James, and Goldman Sachs lowered their forecasts for the chip industry and their suppliers.  The Wall Street firms each referred to higher inventories and lower demand.  As a reminder, chips have become an essential part of our everyday lives.  They are in everything from automobiles to washers and dryers.  If there is a slowdown in chip sales, it could signal a peak in the economy which is not what stocks are expecting.

The remarkable effect of October on the financial markets returns in 2018 as the first three weeks have been among the worst in memory.  It seems that this is part of a changing financial landscape.  While the headlines have focused on trade wars, politics, and international problems, the real issues might be interest rates and foreign exchange.    Past Octobers have offered opportunities despite this painful process.  It’s like a giant financial game of trick or treat.

2018 2nd. Qtr. Kildare Asset Mgt.-Kerr Financial Group client review letter

The following is a copy of the 2nd quarter letter sent to clients. It reviews the markets and the client account’s activity and performance for the 2nd quarter and year to date 2018.

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

 

The capital markets rarely travel in a straight line.  While bull markets can last for years, they normally have multiple pullbacks within them.  And these corrections can be material with magnitudes of more than 10% and can last several months.  Determining changes in direction of these various time frames is critical for managing risk.

2018 provides clear examples of significant short term moves not disrupting the longer trend. The stock market started the year by continuing 2017’s rally which was an abnormally smooth steady climb that set records for its lack of volatility.  The major indexes climbed into late January setting daily record highs along the way. Then stocks reversed direction and quickly lost 10% in two weeks.

The stock market stabilized in late February and recovered during the second quarter.  However the quarter included a couple of quick drops – one in April and another in June.  Yet, despite this volatility, the multi-year bull market marches on.

The advance that ended in late January was accompanied by extreme bullishness.  As a reminder, sentiment indicators are normally viewed as contrarian or suggestive of a move in the opposite direction of the signal.  In this case, a high level of optimism could be a sign of a top and then a decline.  This is because investors who are bullish have already done their buying and may not have much dry powder left.  This is especially so at extreme levels and it worked in January

Given the rebound from February’s lows, investors are scouring through the countless statistics for a clue on the strength and potential longevity of the second quarter’s rebound.  While such things as GDP and employment data point to a strong economy and higher corporate earnings, there is a couple of breadth indicators that might cause some worry.

Stock market leadership by the FANG stocks (Facebook, Amazon, Apple, Netflix, and Google) has been one constant throughout 2018.  These stocks have driven the Nasdaq Composite and Nasdaq 100 indexes which have outperformed.  In the first six months, Netflix has more than doubled and Amazon is up around 50%.  The 5 largest components of the Nasdaq 100 accounted for over 60% of the first 6 months gains.

This is very narrow leadership which could be troublesome.  The higher number of stocks participating in an advance usually translates into stronger and more sustainable rallies.  There is nothing preventing a broadening to take place but it typically happens after a bottom such as the one in February.

TPW Investment Management conduct concentration studies and they posted some findings in late June.  Since 2000, when the top 5 stocks’ performance represent less than 25% of the yearly attribution (widespread participation), the S&P 500 average annual return was 19.6%.  When the top 5 represent over 25% (more narrow leadership), the average annual return for the S&P 500 was only 1.96%.  In late June, the attribution of the top 5 S&P 500 names accounted for 52% of the year-to-date returns.[i]

Obviously this indicator suggests challenges ahead.  On the other hand, data from 2000 may not be a large enough sample to be useful especially given that in contained an outlier (the housing meltdown and the financial crisis).

Nevertheless, it does highlight a concern that needs to be watched.  As The Wall Street Journal included in its review of the 2nd quarter, “The one-directional nature of the stock rally has left investors increasingly worried that a market whose gains have been heavily dependent on technology stocks could reverse sharply in the second half of the year.”[ii]

The FANG’s out performance in the second quarter is clearly shown by the Nasdaq Composite’s doubling of the S&P 500’s return – 6.33% vs. 2.93%.  The Dow Jones Industrial Average was up less than 1% and showed a year-to-date loss on June 30th.  Here are the details of the major averages for the 2nd quarter and the first 6 months of 2018.

2nd Qtr. 2018
Dow Jones Industrial Average +0.69% -1.81%
S&P 500 +2.93% +1.67%
Nasdaq Composite +6.33% +8.79%
Russell 2000 +7.43% +7.0%

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

2nd Qtr               2018

Kerr Financial Group – Kildare Asset Management

+2.38%

+6.28

 

It was a jittery three months for the capital markets.  Tariff threats and potential trade wars that would pressure global growth were a constant investor fear.  The Federal Reserve raised interest rates in June and forecast more hikes. International turmoil continued with concerns over Turkey, Italy, and Russia.  The dollar strengthened in foreign exchange trading which resulted in intense stress in the emerging markets.  To be sure, all markets have things to worry about but these represent an imposing collection.

As a result of these economic and international obstacles, I focused attention to managing risk in your accounts.  Primarily, this was done through mutual funds that move in the opposite direction of the S&P 500.  While this position helps reduce overall market risks to your account, it does not eliminate them.

This mutual fund was a slight drag on account performance in 2nd quarter and this has continued in the 3rd quarter as the stocks moved higher.  However, I believe including this in the strategy is an important piece of controlling risk during this chaotic timeframe.

There are other positions that underperformed in the quarter.  Athene Holding Ltd and FGL Holdings are similar companies as their main business is annuity underwriting.  Athene declined 8.3% and FGL declined 9.3% in the 2nd quarter.  Both stocks were pressured by a flattening yield curve.

One key to successful underwriting is the spread between the yield offered in the annuity and the yield earned by investing the premiums.  During the second quarter the 10-year Treasury yield (a benchmark used to estimate insurance investment earnings) declined from a May peak over 3.1% to under 2.9% at the end of June.  Investors chose to sell first without waiting to see if the declining yields actually hurt earnings.

Athene had two other strikes against it.  One part of the business didn’t produce as much growth as expected.  Secondly, company management told analysts on the first quarter earnings conference call that they were not planning to use cash to buy back stock. Instead they see the better use of capital in growing the business and see many opportunities to do this.  Disappointing growth and not buying back undervalued stock are two things that puts you in the Wall Street dog house.  So entered Athene Holdings.

FGL Holdings has different blemishes.  FGL did an IPO to raise capital to buy the FGL business.  It was an underperforming annuity business.  The two main parties behind the takeover (William Foley – CEO of Fidelity National Financial which has been a long time successful client holding and owner of the Las Vegas Golden Knights hockey team that made the Stanley Cup finals combined with The Blackstone Group to turnaround FGL) have proven track record in developing these kinds of operations.

This new management team is focused on getting an A.M Best rating upgrade to “A” (the highest rating).  This is the result of a strengthening of the balance sheet through more capital and better investment positioning.  This decision is expected later this year.  Brokers and insurance agents are reluctant to sell less than “A” rated products so this could greatly expand their sales channel.

Both companies are trading at low price-to-earnings multiples and have strong balance sheets. Both have unique initiatives that could transform them into bigger and more profitable organizations.  I think patience will be rewarded.

SMHI, which was performed well in the 1st quarter, helped in the 2nd quarter as well. They provide global marine and support transportation services to offshore oil and gas exploration and production wells.  The stock was up over 21% from April through June.

Graham Corporation is a position that was added at the beginning of the 2ndquarter. The company engineers and builds the interworking chemical plants and refineries.  This is a small company at about $275 million of market capitalization and $100 million of revenues.  Graham has a very strong balance sheet with over $7.50 per share in cash and no long term debt.  This is a cyclical business that is tied to industrial capital expenditures.  The company suffered with the collapse of crude oil prices but are rebuilding sales and its backlog.  In addition to rebounding sales, Graham wants to grow through acquisitions.  The stock was up 20% during the quarter.

Understanding and recognizing risk is important to successful investing.  2018’s second quarter provided a good example as the capital markets had to sift through many complex developments that could turn into significant headwinds.  While large cap technology stocks outperformed, the rest of the stock market traded more defensively.  This could remain the theme of the second half of the year.  It will be important to balance risk management while spotting the opportunities as they arise.

Once again, thank you for your continued trust.  Please contact me with any questions.

 

Jeffrey J. Kerr, CFA

Kerr Financial Group

Kildare Asset Mgt.

45 Lewis Street – Lackawanna RR Station

Binghamton, NY 13901

[i] www.tpwim.com, June 27, 2018

[ii] The Wall Street Journal, June 30, 2018

What a Long Strange Trip It’s Been

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

September 24, 2018 – DJIA = 26,743 – S&P 500 = 2,929 – Nasdaq = 7,986

What a Long Strange Trip It’s Been[i]

 

As summer faded to autumn last week, the Dow Jones Industrial Average set a new record for the first time since late January.  In the current world of sensational headlines, this could’ve been easily overlooked.  Another development that might have gone unnoticed is that the Cleveland Browns won their first regular season NFL game (another embarrassing moment that Jet’s fan will have to endure) since December 2016 or before Donald Trump’s inauguration. And, Tiger Woods won a golf tournament for the first time since the markets were in a tantrum over Ben Bernanke’s “tapering” comments in 2013.

Of course, these developments can’t compete with tweets and headlines covering political bickering, Chinese tariffs, and marijuana stocks.  Nevertheless, the Dow’s recovery is noteworthy despite not qualifying as front page, above the fold material.

As a reminder, stocks moved from lower left to upper right throughout January but then quickly dropped over 10% in the next two weeks.  The following recovery was a narrow move led by the Nasdaq.  The rest of the stock market experienced an irregular, back and forth journey for most of the second quarter. At the end of June the Dow was still lower year-to-date.  In third quarter, the S&P 500 and Dow broke out and traded above some resistance levels and eventually reached record levels.

This recent return to all-time highs for the Dow and S&P 500 occurred during the months of August and September.  These have not been kind stock market months in recent years so making a strong move during this time frame offers more creditability.  Here are the year-to-date performance for the major averages.

2018 YTD

Dow Jones Industrial Average                                                                                       +8.19%

S&P 500                                                                                                                               +9.58%

Nasdaq Composite                                                                                                             +15.70%

Russell 2000                                                                                                                       +11.51%

Across the capital markets it has indeed been a long strange trip.  Events that would be viewed as damaging the economy (such as tariffs) cause temporary dips that quickly turn into rallies.  At the same time, imploding economies from outwardly insignificant developing markets (Turkey, Argentina, et.al.), cause turmoil in the global markets.

The debate between bulls and bears likely ranks below the current societal hostility.  However reviewing both sides could be helpful to predict if the markets’ future path remains strange.

Market optimists have plenty of economic ammunition.  The job market has seen historic strength.  Jobless claims are well below 1% of the work force and less than 1.7 million people are receiving unemployment benefits.

Of course this helps drive consumer confidence.  Also, small business optimism is at the highest level in history (the survey began in 1975).  Corporate earnings are strong with forecasts for almost 20% growth for the remainder of 2018.  Guidance for 2019 is for further growth of high single digits from 2018’s base.  And there are other signs that the economy is strong and expanding.

There are always two sides to every trade and the current landscape is no exception.  The skeptical view can point to the pockets of extreme overvaluation.  Some of the mega-cap stocks trade at historically elevated valuations.  In addition to extreme multiples, these stocks contribute to the narrow leadership.  The four largest U.S. stocks are responsible for approximately 50% of the S&P 500’s gains in 2018.  Rallies with wider participation are usually more sustaining.  So with the gains being driven by only a few stocks, there is risk that the leaders stop leading.

Another potential problem is that international stock markets are diverging from the U.S.  Many international stock indexes are underperforming the American indexes.  At the close of last week, the German DAX was down 3.77%, the Chinese Hang Seng declined 6.5% for 2018 and London’s FTSE 100 was 2.57% lower.  Below is a chart comparing the S&P 500 (blue line) to the Vanguard All-World Index that doesn’t include the U.S. markets (red line).

As can be seen, the S&P 500 and rest of the world traded similarly for the first 4 ½ months of 2018.  In May these two diverged and the gap has been growing.  If there is a history of high correlation, this suggests that the international markets will catch up to the U.S. or the U.S. will fall.  Of course the former will be more pleasant but there is risk of the latter.

The stock market’s 2018 journey has been a challenging if not a strange trip.  Looking forward, both the bulls and the bears have the ammunition that could influence the direction for the rest of the year.  Further, investors will need to consider the important mid-term elections, additional Fed interest rate hikes, more tariffs, and international economic problems.  It will be a lot to work through.  But, “together more or less in line’, we’ll “keep truckin, like the do-dah man”.

 

 

[i] Jerome J. Garcia / Philip Lesh / Robert C. Hunter / Robert Hall Weir 1970

 

Life is a clue in a crossword

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

August 13, 2018 – DJIA = 25,313 – S&P 500 = 2,833 – Nasdaq = 7,839

 

“Life is a clue in a crossword”[i]

Current economic and capital market analysis is like doing a crossword puzzle.  Some developments have multiple intersections with other events and are intensely linked.  At the same time, some news, while important, is a little economically distanced with only peripheral connections.

For example, a six letter word for a tax or duty to be paid on a particular class of imports or exports is “tariff”.  The “r” could intersect with either “r” in “trade war”.  And the other ‘r’ in “trade war” could intersect with the “r” in “dollar”.

Or a 14 letters (2 words) for the calculation of dividing the number of unemployed individuals by all individuals in the work force.  This is obviously the “unemployment rate” and it is connected to “interest rates”.  Bonus points would be awarded for getting the clues for BREXIT, cultural division, inverted yield curve, and $1 trillion market cap.

The obvious point is that the capital markets are at a high degree of interlinkage and it’s hard to stay on top of all of the relationships.  The not so obvious point is that these relationships are dynamic with wide reaching influences.

For example the stock market doesn’t like lower profits – that’s easy.  And tariffs can cause higher expenses and potentially shrinking net income.  But what if the exporting country’s currency drops in value relative to the U.S. dollar.  Does this foreign exchange development reduce the price for the foreign seller to a point where they maintain their sales in the U.S.?  This appears to be the case with the Chinese yuan as recent the fall in its value is offsetting the impact of higher tariffs.

Another important piece of our financial crossword puzzle is “earnings season”.  With the reporting of second quarter results coming to an end, earnings have been good.  Of all of the companies releasing 2nd quarter numbers, 65.6% of these reports have beaten consensus earnings expectations.  Further, 67.5% of companies exceeded the consensus revenue forecasts.  While both of these are good, they are below the previous two earning seasons.

The stock price’s reaction to these reports can be just as important as the numbers themselves.  As expected, good news was rewarded and bad news was punished.  For the second quarter numbers, the average 1-day % change for the stock price of a company after their earnings release was +0.45%.  Dividing this into the number of companies that beat earnings estimates and those that missed earnings estimates, stocks of companies that exceeded earnings estimates averaged a 1-day 1.8% increase in their stock price.  On the other hand, stocks averaged a 3.6% one-day drop for those that missed earnings estimates.[ii]

Within this group of misbehaving companies who experienced a stock market ‘time out’, there are some unexpected name.  This year’s biggest winners ran into some speed bumps in the second quarter.  Not that their earnings and sales numbers weren’t exceptional – they were.  But apparently they weren’t good enough as the market gave them a clear thumbs down.

For example, Netflix (symbol = NFLX) which describes itself as “the world’s leading internet entertainment service with over 130 million memberships” reported a 40% surge in year over year revenues  together with an amazing 482% jump in net income.  Total subscribers grew almost 30% from 2017’s second quarter.  Hard to criticize these numbers and a natural assumption would be for a higher stock price.  Surprisingly it fell over 10% or $50 per share.  Management lowered the forecast of future subscriber growth and current subscribers viewing hours and that’s not something the market was looking for.

Some other FANG (Facebook, Amazon, Apple, Netflix, and Google) stocks suffered similar unexpected reactions to their second quarter earnings.  Facebook tumbled on its release as users spent less time on the website.  Also management reported that expenses would increase as the company enhanced infrastructure and security to deal with their issues concerning privacy.

Amazon’s 2nd quarter revenues increased 39% year-over-year yet its stock price declined.  Apple saved the day with an earnings estimate beat.  Its stock price rose and Apple became the first company to exceed $1 trillion market capitalization (total value in the stock market).

Despite Apple’s accomplishment, it hasn’t been a good stretch for these stock market leaders.  Prior to this earnings season, the FANG stocks have been responsible for a large portion of the stock markets’ year-to-date returns.  Naturally, Wall Street, never missing an opportunity to sell a new product, developed a FANG index.

The FANG + index is “an index that provides exposure to a select group of highly-traded growth stocks of next generation technology and tech-enabled companies”.[iii]   The FANG + index’s components are Facebook, Apple, Amazon, Netflix, Google, Alibaba, Baidu, NVIDIA, Tesla, and Twitter.  These have been investors’ favorites in 2018 and seemingly could do nothing wrong.

However, the weakness in these stocks after their earnings reports could be a sign that too much good news had been priced in.  At the end of last week the index has declined 6.78% since making a 52-week high in late June.  And much of this drop has occurred since Facebook’s earnings release.  With these market darlings selling off, it’s kind of like the popular kids got sent to detention.

Here are the year-to-date performance numbers as of last Friday for the more conventional indexes.

2018

Dow Jones Industrial Average                                                                           +2.4%

S&P 500                                                                                                                 +6.0%

Nasdaq Composite                                                                                               +13.6%

Russell 2000                                                                                                         +9.9%

Another part of the FANG + index, Tesla (symbol = TSLA), is a crossword puzzle on its own.  Or, better yet, a reality show.  The electric car maker has a controversial history with many critics believing that the company has over promised and vastly under delivered.  Tesla has never been profitable and has an annual cash burn rate measured in the billions.

The company’s C.E.O., Elon Musk, has been at the center of the storm that has surrounded this company. Supporters view him as a visionary genius while his detractors claim he is a fraud.  He has fueled the fire with an ongoing soap opera on Twitter. To be sure, there a lot of Twitter soap operas, but the Tesla dialogue has to be near the top.

For example, on April 1, he posted a picture on Twitter of himself passed out against a Tesla car with the post “Tesla goes bankrupt”.  As a reminder, this year’s April Fool’s Day fell on a Sunday which happened to be Easter Sunday.  The peculiar timing increased questions of Mr. Musk’s stability and focus.

Another controversial moment occurred during the company’s first quarter conference call when Mr. Musk rudely dismissed an analyst’s question.  Again this unprofessional conduct brought criticism and questions regarding the conduct of a C.E.O of a $50 billion company.  Mr. Musk apologized during the recent second quarter (three months later).

In July, Mr. Musk referred to one of the British drivers rescuing the trapped soccer team in Thailand as a “pedo” – a shortened term for pedophile.  Vern Unsworth, the driver, had previously described Elon Musk’s offer of a mini submarine as a “PR stunt”.  Mr. Musk deleted the tweet a short time after posting but, by that time, there were many re-tweets and word quickly and widely spread.  Mr. Musk apologized a few days later in an indirect manner as he responded to another post on Twitter.

Last week, in what might be the pinnacle (or nadir depending on your view), Elon Musk posted the “Tweet of the Year” (so far).  Last Tuesday, Musk tweeted “Am considering taking Tesla private at $420.  Funding secured.”  No further details, no press release, no 8-K filing (an S.E.C. filing of material events and news releases), nothing but a tweet.  At $420 per share the deal would exceed $80 billion.

Trading in Tesla’s stock was halted after the tweet.  When trading resumed a couple hours later, the stock jumped to $380 per share.  Then the fireworks really started. Given Elon Musk’s unusual behavior, was this another prank?  Or was this his way of making a factual announcement?  Did the $420 price have drug significance (the number 420 being associated with marijuana)?

As soon as the tweet was posted there was widespread doubt on the claim that financing was secured.  Yes, the bond market has been a 35 year bull market (despite several predictions of its end) and money has been plentiful in the corporate debt markets.  But given Tesla’s challenged operating performance, this was far from a slam dunk.  Secondly, a deal of this size and complexity was not getting thrown together over a weekend.  The required due diligence would take considerable time.  Lastly, a deal of this magnitude, potentially the largest corporate takeover in history, would have generated a constant stream of rumors and leaks.

In addition to these issues, there was outrage over Musk’s tweet given that he is the largest shareholder of Tesla.  Wall Street has a history of stock promotion and things like the internet and financial news networks can be a means to that end.  Many questioned if this was Musk’s way of attacking the large short interest in the stock at same time enriching his net worth.  It is hard to believe that someone would so blatantly and obviously manipulate the stock price.  But given Mr. Musk’s history, nothing is out of the question.  While law suits began over the past weekend, there’s been no enforcement by the S.E.C. (so far).

If listening to earnings conference calls while scanning Twitter wasn’t enough, Wall Street had another meltdown to cope with last week.  The Turkish lira plunged to its lowest level ever over worries about the country’s economic stability.  While no one confuses Turkey with an economic powerhouse, in a financially intertwined global system, everyone matters.

The lira’s decline seriously weaken international confidence and will make it harder for the country to refinance debt.  Also, Turkey’s issues cast a shadow across all emerging markets as well as fragile developed countries such as Italy and Spain.  Also, European banks have exposure to the Turkish economy.

Uncertainty over international stability caused the U.S. stock markets to fall on Friday.  It snapped a string of 5 consecutive weeks of gains for the Dow Jones Industrial Average and the S&P 500.  The S&P 500 had recently broken out of a trading range and had been trending toward a new all-time record level.  It got to within 1% of a new high before Friday’s retreat.

A backdrop of an expanding economy and growing earnings is supportive of higher stock prices.  The employment picture is the strongest since disco was popular and business confidence is at record levels.  Corporate balance sheets are generally strong and business investment is slowly moving forward.

The bearish side of the trade has many intersecting clues.  First global central banks led by the Federal Reserve are talking about or are in a tightening cycle.  This means higher interest rates and less systemic liquidity.  These could turn into significant economic headwinds.

Also, the narrow market leadership is a concern.  As mentioned the FANG + have accounted for such a large portion of the 2018’s stock market gains.  Sustainable market trends typically have a broader participation.

Next sentiment might be overly optimistic.  Some investor surveys are indicating excessive bullishness including an above average level of hedge fund longs in the e-mini S&P 500 futures.  Remember that these indicators are normally viewed as contrarian because investors who are bullish have already done their buying and may not have much dry powder left.

Other risks, of course, include trade wars, geopolitical tensions, and, as mentioned above, emerging market turmoil.  To be sure, these have been potential market obstacles throughout the year but have not had any lasting impact.

Navigating the markets is tricky.  The news flow can have wide reaching effects with unclear connections to other developments.  Something that appears to be pretty straightforward can turn into a tangled mess.  On balance the markets are absorbing the bad news and trading well.  And in an attempt to fill in the blanks and complete the puzzle, perhaps the best mindset for investors is a 19 letter 3 word answer – “optimistic but cautious”.

 

 

 

[i] Ian Anderson, 1979

[ii] The Bespoke Report, August 3, 2018

[iii] www.theice.com