Too Much of Everything is Just Enough

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May 30, 2017 – DJIA = 21,080 – S&P 500 = 6,210 – Nasdaq = 5,805
“Too Much of Everything is Just Enough”[i]
From tulips to technology, investors have a long history of becoming fixated on fads.  Sometimes these trends become so popular that they develop into bubbles.  Of course, Wall Street is happy to feed these infatuations by offering products and strategies to meet their clients’ desires.  But don’t misjudge this as enhanced customer service and increased altruism – it generates increased commissions.
Under the heading of there’s nothing new under the sun, in recent years, investors have been flocking to an old approach – indexing or passive investing.  We’re not suggesting that this movement ends the same as past overcrowded manias, but it should have investors’ attention.
Passive investing or indexing is a buy and hold approach where investor’s capital is diversified across asset classes.  Typically, this involves assets invested in large cap, mid cap and small cap equity sectors.  It can be further divided on both value and growth styles.  Also, international and emerging markets can be included.  And most passive strategies include fixed income, real estate, and precious metals.
Some of the advantages are ease and economics.  Instead of conducting the research needed to develop a portfolio, it is much easier to buy the index.  Also, buying the index and holding it for the long term reduces trading expenses.
Although many have recently become more aware of indexing, it is not new.  The mutual fund industry has been offering the strategy for decades and Vanguard built an industry powerhouse based on the indexing philosophy.
Passive investing’s popularity has grown to incredible heights during the past few years.  It is estimated that inflows into U.S. equity ETFs have exceeded $15 billion per month for the past 6 months.  For the twelve months ending February, a record $281 billion was invested in ETFs.  Since March 2009 (the start of the bull market), ETFs have received net flows of $1.67 trillion.  This compares to $179 billion into equity mutual funds during the same time.  The chart below illustrates the growth in the investment capital into ETFs.[ii]
When an index ETF receives inflows, they have to invest these dollars in order to maintain the portfolio’s proportional match to the index.  Holding cash is a no-no even if you think the market is risky.  This results in some interesting market dynamics.
Let’s look at the most popular index, the S&P 500, and some of the ETFs that index to it.  Before getting into the ETFs, it’s important to remember that the S&P 500 is a cap weighted index meaning that the larger the market capitalization, the more influence it has on the index.
iShares and Vanguard are the two ETFs families with the largest year-to-date inflows.  The iShares Core S&P 500 ETF (symbol = IVV) has around $9 billion of assets.  Their top ten holdings have to match the S&P 500’s 10 largest stocks and they do.  They are Apple, Microsoft, Amazon, Facebook, Exxon, Johnson and Johnson, Berkshire Hathaway, JP Morgan, Google, and General Electric.
Sticking within the iShares stable, the iShares Core S&P Total U.S. Stock Market ETF (symbol = ITOT) has $1.653 billion under management.  Its top ten holdings are exactly the same as the IVV.
Turning to Vanguard’s S&P 500 ETFs, the Vanguard S&P 500 ETF (symbol = VOO) has $4.475 billion under management including $310 million of recent inflows.  Its top ten holdings are exactly the same as the iShares IVV and ITOT.  The Vanguard Total Stock Market Index Fund (symbol = VTI) is a $3.148 billion ETF which enjoyed a $550 million addition of investment dollars.  It too owns the exact same top ten holdings.
Of course, there are some adventurous mavericks that still participate in the capital markets.  These guns slingers might be courageous enough to deviate from the stock indexes if only for a small amount to complement their passive assets.  Say our brave investor wished to move part of his or her portfolio into the $25 billion Vanguard High Dividend Yield ETF.  Among the top holdings for this independent thinker’s decision are some familiar names – Microsoft, Exxon, Johnson and Johnson, and JP Morgan.  So much for diversification!
Or maybe someone wants to speculate further and include the Vanguard Mega Cap Growth ETF in their portfolio.  Once again, our decision doesn’t add much to a broadening of the investment reach as this ETF’s top holdings include Apple, Google, Amazon, and Facebook.
Naturally, distortions can happen when there is too much demand for something with a stable supply and the stock market provides another the example.   At the end of last week S&P 500 was up 7.89% year-to-date.  If we remove Apple, Amazon, Facebook, Google, and Microsoft, the S&P 500 is up 42 percent less or 4.6%.  This means that the ‘Fab Five’ in addition to accounting for a little less than half of the year’s gains also represent 14% of the index.
Of course, that these leaders are up so much means that they attract even more interest which bids their prices higher.  Where and when this cycle ends is guesswork.  This touches upon an important point to passive investing – economic fundamentals and stock valuations do not matter.  Index ETFs don’t care about such things as earnings, GDP growth, the Fed’s next meeting, or Brexit.  Index ETF’s buy the components of its index, everything else is noise.
Not only has the number of indexes grown, they have gotten creative.  HACK is the symbol for Purefunds ISE Cyber Security ETF.  The Vaneck Vectors coal ETF’s symbol is KOL while their Agribusiness ETF is MOO.  The SPDR Bloomberg Barclays High Yield Bond ETF is appropriately listed as JNK.  Oh those crazy Wall Streeters.
Here is a graph from the Bloomberg report of the history of the number of stocks as compared to the number of indexes.  The number of publicly traded stocks peaked at 7,487 in 1995.  This downward trend seems to have stabilized during the past few years.  On the other hand, the indexes’ hockey stick shaped growth is remarkable.
The ETF population remains well below the number of mutual funds which have plateaued since around the turn of the century.  Here is a chart which includes the mutual fund industry. [iv]
While the popularity of indexing is not an evil, it has distorted the markets.  The market price-to-earnings ratio is historically high and bond yields are low across all sectors.  Both are influenced by capital inflows into passive investing.  It might be hard to imagine but someday, away in the future, investors may want to reduce market exposure. Perhaps one day the capital markets negatively react to an interest rate increase or a terror attack or some Washington wackiness.  If this happens in a large quantity, ETFs will be selling the same positions at the same time likely causing prices to fall.  This could strain liquidity which would cause the retreat to accelerate.  The melt up we’ve witnessed but in reverse.
Of course, there is the possibility that stock and bond prices have experienced a permanent landscape shift and that valuations and yield spreads are at new and proper levels.  In other words, it is different this time.  Investing history tells us that those words can be a dangerous description.  But for now, investor worries are few.  We just hope that someday we don’t have to sing more lyrics to the song we began this newsletter with – “I Need a Miracle Every Day”.
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
130 Riverside Drive
Binghamton, NY 13905
[i] Barlow, Weir, 1978
[ii] Yadeni Research, April 5, 2017
[iii] Bloomberg View, May 16, 2017
[iv] Ibid

We’re on the Road to Nowhere

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The headlines from a year ago, as usual, covered a wide range of events.  For example, Hillary Clinton announced her candidacy for the 2016 Democratic presidential nomination just before the governor of Maryland declared a state of emergency in Baltimore as riots began over the death of Freddie Gray.
Lighter headlines from a year ago included the birth of the Princess of Cambridge, Charlotte Elizabeth Diana who is 4th in line to succeed Queen Elizabeth II.  Also American Pharoah became the 12th winner of horse racing’s Triple Crown and the first since Jimmy Carter was president (1978).
This time last year in the financial markets, the U.S. stock market reached record levels.  This wasn’t noteworthy as stocks had been steadily moving higher for several years.  The Dow Jones Industrial Average closed at 18,312 on May 12, 2015 which turned out to be the last time the Dow has closed at a record.  This 377 day (as measure by calendar days, trading days plus weekends and holidays) streak without making a new high is the 12th longest stretch in history.
The longest time between record Dow closes was the
period from September 1929 to November 1952 which exceeded 9,200 days.  Certainly this is a unique time in history as it contains both an economic depression and world war.  Looking at what might considered a “normal” number of new highs in a year, there were 10 in 2015, 53 in 2014, and 45 in 2013.  The record is 77 in 1995.[i]
This twelve month Dow drought of record highs is part of a wider and multi-year trading range.  The S&P 500 first exceeded the 2,000 level in August 2014.  Since then and for the past 22 months the index has bounced between 1,850 and 2,130.  This is only the 5th time that the S&P has traded in less than 20% range over a 22-month period.  The last two incidents were in 2005 and 2006 which signaled the end of the bull market.  The other two occurrences were in 1984 and the mid-1990’s.  Both of these examples were resolved with the stock market moving materially higher.[i]
We would offer that many are not aware that the markets have been treading water for the past 2 years.  It’s a function of the narrow stock market leadership in 2015 (see FANG stocks) which gave the illusion of healthy landscape.  These handful of large companies drove the major averages while the rest of the market floundered.  Within the MSCI All-Country World Index (a wide scoping global stock index), 66% of the stocks in the index are lower than they were on May 21 last year.  Removing the emerging market portion (which were challenged in 2015) from this index, we still end up with 40% of the market lower than last May.[ii]  This market churn is clearly evident when we look at the year-to-date numbers for the U.S indexes:
2016YTD
Dow Jones Industrial Average           +2.6%
S&P 500                                             +2.7%
Nasdaq Composite                              -2.7%
Russell 2000                                       +1.3%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
The stock markets’ lateral journey has resulted in some very unique measurements in investor sentiment. As reported by the AAII (American Association of Individual Investors), bullish sentiment fell to its lowest level in over a decade at 17.75%.  One would naturally conclude if the percentage of bullish respondents fell, the number of bears must have increased.  Not to be – the bearish number also decreased from 34.1% to 29.4%!
The largest group in this week’s survey was the “neutral” camp which increased from 46.5% to 52.8%.  This is an astonishing event.  Going back to 1987 (or almost 30 years or over 1,500 weeks), there have been only 30 weeks where the bullish sentiment reading was below 20%.  Furthermore, there 28 weeks registering over 50% neutral.[i]
While this outsized neutral view is understandable given:
  • the U.S. economy is stuck in low gear
  • uncertainty surrounding profit growth
  • negative interest rates
  • the possibility of a rate increase in the U.S. in the next couple of months
  • untested monetary policies
  • terrorism
  • a unique and contentious political landscape in the U.S.
Further, this indecision is a sign of apathy towards the markets.  Again, this is reasonable after 2 years of stocks going nowhere combined with a 10% correction last August and the horrid start to 2016.
The debate among strategists and traders centers on how these worries get resolved.  The glass half full view suggests that these issues are already priced into the markets.  This argument holds that stocks could surprise to the upside even with modest economic progress.  Indeed, from a shorter term view, a couple of weeks ago stocks tested the lower level of the range at S&P 500 2,040 for the third time since March.  Sellers pushed the S&P down to 2,025 intraday on May 19th and it looked like the bears may finally gain control and take stocks lower.  Unexpectedly, the selling pressure dried up and stocks recovered before the close.  Equities rallied during the next few days and the S&P 500 quickly moved back to 2,100.
Perhaps the high number of “neutral” investors played a role in the failure of the bears to get the upper hand.  It’s hard to believe that these worried investors hadn’t already sold positions and raised cash.  Maybe there were no sellers left.
While this reversal was noteworthy as it snatched victory from the jaws of defeat, all we have accomplished is a move back into the upper part of the trading range.  Interestingly, when we look at returns after the previous times where bullish sentiment was below 20% and when neutral exceeded 50%, we see reasons for hope.  The S&P 500 has averaged a 6.81% return 3-months after a sub-20% bullish reading.  This improves to 13.26% 6-months after and 19.97% one year later.  Turning to the 50%+ neutral readings, the S&P averaged an 3.59% increase 3-months after hitting this threshold, a 7.67% gain 6-months later, and 19.94% in one year.
Based on sentiment only, we would look for a trading range breakout to the upside.  However, given the possibility of further gaffs from Donald Trump, an indictment of Hillary Clinton, a Bernie Sanders surge, or any other unexpected development, an upside move is far from certain.  2016 has been full of unexpected twists and turns with several very unique developments.  Maybe that is the new landscape and the markets continue to churn throughout the summer.
[i] The Bespoke Report, May 27, 2016
[i] Ibid, May 23, 2016
[ii] GaveKal Research, May 31, 2016
[i] LPL Research, May 24, 2016
Jeffrey Kerr is a Registered Representative of and securities are offered through LaSalle St. Securities LLC, member FINRA/SIPC. Mr. Kerr is an Investment Advisor Representative of and advisory services are offered through Kildare Asset Management, a Registered Investment Advisor. Kerr Financial Group and Kildare Asset Management are not affiliated with LaSalle St. Securities LLC.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is not indicative of future results. Investing
involves risks, including the risk of principal loss. The strategies discussed do not ensure success or guarantee against loss. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is not possible to invest directly in an index. Trading of derivative products such as options, futures or exchange traded funds involves significant risks and it is important to fully understand the risks and consequences involved before investing in these products. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional

Balancing risk and reward Looking for yield without too much risk

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An important consideration when investing in bonds and fixed income securities is that there are two typical kinds of risk.  Credit risk is the possibility that you won’t get your principle paid back. Interest rate risk is the opportunity cost that interest rates move higher while you are invested in a lower yielding instrument.
When dealing with credit risk, you normally receive a higher interest rate to compensate for the higher probability of not getting your investment back.  Credit risk can be avoided by buying treasury bonds and bills.  Of course the yields of today’s government securities are not very exciting.
Interest rate risk is buying a bond or CD with a set rate and having yields subsequently move higher.  For example, buying a CD paying a 4% interest rate and then having the same maturity move to 4.5% while you are receiving 4%.
Interest rates are expected to move higher over the next several years.  If that happens (its far from certain), investing in safer things like CD’s and bonds will be tricky.  It will re-introduce interest rate risk to the market for the first time in 35 years (Interest rates have been falling since 1982).
As a way to educate investors, we have constructed some options to consider.  Please know that this is not a comprehensive list and there are many more options available.  These are used to illustrate the state of the market.  Further this is not a recommendation as they may or may not be appropriate.
The table includes the yield, the duration, and the 3-year range for the price.  Duration, for those who are not familiar with the term, is the time-weighted average of the security’s cash flows.  The higher the number the greater the sensitivity to changes in interest rates.  In other words, high duration bonds will go down in price more than low duration bonds given the same interest rate move.
The 3-year price range is provided to offer a sense of price volatility.  Bond prices move inversely to the move in interest rates.
This table emphasizes price stability or low interest rate risk.  We try to help readers understand what yields are available for the lowest interest rate risk.  Some of these examples do not have credit risk (CD’s and TIPS) but some others do.
        Yield     Duration     3 year price    Variance from mid-pt.
CD’s                     1%         6 months

Franklin               2.12%    1.4 years    $100.14 –              1.57%

Liberty Short                                        $97.04
Duration US
Govt ETF
Fidelity Adv        1.63%     2.6 years   $11.62 –                 1.18%
Ltd. Term                                             $11.35
Bond Fd
Lord Abbett         2.05%     2 years      $4.56 –                   3.28%
Short Duration                                     $4.27
Income Fund
Putnam                6.03%     1.1 years   $8.05 –                   11.42%
Diversified                                           $6.40
Income Fund
Vangurad Short   -0.25%    2.8 years   $52.12 –                 4.31%
Term TIP ETF                                      $47.81
Nuveen NY        3.89%      7.3 years   $14.89 –                 7.16%
Tax Freed                                             $12.90
DoubleLine        0.62%      0.2 years   $10.02 –                 0.10%
Ultra Short                                           $10.00
Bong Fund
For more information or questions, please contact me.
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
130 Riverside Drive
Binghamton, NY 13905

Balancing risk and reward Looking for yield without too much risk

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An important consideration when investing in bonds and fixed income securities is that there are two typical kinds of risk. Credit risk is the possibility that you won’t get your principle paid back. Interest rate risk is the opportunity cost that interest rates move higher while you are invested in a lower yielding instrument.

When dealing with credit risk, you normally receive a higher interest rate to compensate for the higher probability of not getting your investment back. Credit risk can be avoided by buying treasury bonds and bills. Of course the yields of today’s government securities are not very exciting.

Interest rate risk is buying a bond or CD with a set rate and having yields subsequently move higher. For example, buying a CD paying a 4% interest rate and then having the same maturity move to 4.5% while you are receiving 4%.

Interest rates are expected to move higher over the next several years. If that happens (its far from certain), investing in safer things like CD’s and bonds will be tricky. It will re-introduce interest rate risk to the market for the first time in 35 years (Interest rates have been falling since 1982).

As a way to educate investors, we have constructed some options to consider. Please know that this is not a comprehensive list and there are many more options available. These are used to illustrate the state of the market. Further this is not a recommendation as they may or may not be appropriate.

The table includes the yield, the duration, and the 3-year range for the price. Duration, for those who are not familiar with the term, is the time-weighted average of the security’s cash flows. The higher the number the greater the sensitivity to changes in interest rates. In other words, high duration bonds will go down in price more than low duration bonds given the same interest rate move.

The 3-year price range is provided to offer a sense of price volatility. Bond prices move inversely to the move in interest rates.

This table emphasizes price stability or low interest rate risk. We try to help readers understand what yields are available for the lowest interest rate risk. Some of these examples do not have credit risk (CD’s and TIPS) but some others do.

Yield Duration 3 year price Variance from mid-pt.

CD’s 1% 6 months

Franklin 2.12% 1.4 years $100.14 – 1.57%
Liberty Short $97.04
Duration US
Govt ETF

Fidelity Adv 1.63% 2.6 years $11.62 – 1.18%
Ltd. Term $11.35
Bond Fd

Lord Abbett 2.05% 2 years $4.56 – 3.28%
Short Duration $4.27
Income Fund

Putnam 6.03% 1.1 years $8.05 – 11.42%
Diversified $6.40
Income Fund

Vangurad Short -0.25% 2.8 years $52.12 – 4.31%
Term TIP ETF $47.81

Nuveen NY 3.89% 7.3 years $14.89 – 7.16%
Tax Freed $12.90

DoubleLine 0.62% 0.2 years $10.02 – 0.10%
Ultra Short $10.00
Bong Fund

For more information or questions, please contact me.

Jeffrey J. Kerr, CFA

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

Let Me Hear Your Balalaikas Ringing Out Come and Keep Your Comrade Warm

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April 17, 2017 – DJIA = 20,453 – S&P 500 = 2,328 – Nasdaq = 5,805
 
“Let Me Hear Your Balalaikas Ringing Out Come and Keep Your Comrade Warm”[i]
The history of Russia spans over 1,100 years.  As expected with anything that has this longevity, it’s not been a smooth journey.  They have been responsible for historic cultural advancements in art, literature, architecture, and science.  Unfortunately, the lows include revolution, conquest, corruption, oppression, world wars, and cold wars.
Surrounding the U.S. presidential election, Russia became the target of the Democrats’ disdain as they were blamed for Hillary Clinton’s defeat.  The election was close in many key states so anything that swayed votes influenced the outcome.  However, without giving a pass to Boris and Natasha, there are many other scapegoats with several being internal.
Of course, more recently, the list of Russian detractors includes Team Trump which was originally criticized for allegedly being aligned with Moscow.  After Nikki Haley’s United Nations tongue lashing and President Trump’s decision to bomb Syria, it’s safe to assume there are not any White House dinner invitations addressed to Vladimir Putin.  Or vis-a-versa.
Global tensions have risen which is causing some unexpected coalitions.  President Trump has back-peddled a bit on the campaign rhetoric concerning China.  Given Chinese influence over North Korea, issues such currency manipulation and trade imbalances were not on the agenda when Chinese President Xi recently met with Mr. Trump.
Unexpectedly, headlines about Syria, Russia, North Korea, ISIS, and other geopolitical problems have not derailed the stock market.  Admittedly, the major averages have pulled back from the records reached at the beginning of March.  But most would have anticipated much lower prices after the news of bombs in the Middle East together with the unstable Kim Jong-un testing nuclear missiles.  Instead, the 2017 version of the U.S markets take this news in stride.  Whether this is whistling past the graveyard is unknown.  Here are where the major indexes are year-to-date.
                                                                                  2017 YTD
Dow Jones Industrial Average                                    +3.5%
S&P 500                                                                      +4.0%
Nasdaq Composite                                                      +7.8%
Russell 2000                                                                -0.9%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.
A couple of noteworthy nuggets from the current market landscape.  We draw your attention to the numbers above to highlight that the Russell 2000 finished last week lower for 2017.  As a reminder, the Russell 2000 was the best performing index in 2016 and was especially strong after the election.
On the other hand, the Nasdaq is the strongest of the major indexes through the first 3 ½ months.  Returning to 2016, this was the weakest of the bunch after the election as investors were convinced that Trump’s immigration restrictions would be an obstacle to technology related businesses.
Combining these two reversals, this could represent a rotation from small caps (Russell 2000) to technology (Nasdaq).   It could also be a correction of the solid 2016 gains for the Russell.  Once again, this reminds us that past performance is no assurance of future results.
A common commandment at the start of 2017 was that interest rates would be moving higher.  Indeed, the 10-year Treasury yield, which closed 2016 at 2.43%, rose to 2.61% in March.  Since then, however, bond yields have fallen.  The 10-year finished last week back at 2.23%.
This surprising rally for the bond market (lower yields = higher bond prices) is partially caused by the lowering of 1st quarter GDP estimates, delays in tax reform and regulation cutbacks, and lower inflation. And let’s not forget that the U.S. Treasury market is viewed as a safe haven.  With bombs falling and international tensions high, it makes sense that some global capital flows to U.S. government debt.
Another explanation might be that this move lower in bond yields is a function of how one sided the market had become.  After the election, investors believed that the economic growth would pick-up driven by reduced regulations and increased infrastructure spending.  These additional fiscal programs would be theoretically financed by higher government deficits.  Higher yields would be required to entice buyers of these newly issued bonds.
The result was a crowded investment.  Markets are the summation of investor opinions.  If everyone believes that rates were going higher, prices reflect this. If the market becomes too one-sided, in this case everyone bearish bonds, there are fewer and fewer sellers.  Once the sellers exhaust themselves, the market has to move the other way in order to regain balance.
A final point on the fixed income market.  At the same time that longer term interest rates are falling (10- year and 30-year bonds), the Federal Reserve is raising the short maturity rates (federal funds).  This flattening of the yield curve is often a sign of a sluggish economy.  This is case, however, it might be the necessary rebalancing of the bond market which includes the punishing of the bond bears.
The capital markets have had a lot to digest recently.  And there more on the way – French elections this weekend, British elections in early June, first quarter earnings, and the steady stream of presidential tweets.  Of course, the geopolitical landscape can throw in a knuckleball any time.

It is a bullish sign that the global markets have navigated the recent cross currents without a more prominent pullback.  Nevertheless, this remains a highly-valued market facing a lot of uncertainties.  This skinny margin of safety won’t be problem as long the economy expands, the Fed doesn’t raise interest rates too fast, France stays in the EU, the fleet of U.S. aircraft carriers can cover all international calamities, Congress accomplishes something, Amazon becomes the only retailer left, and the New York Jets don’t do anything too stupid in next week’s NFL draft.  That’s not too much to ask for!

Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
130 Riverside Drive
Binghamton, NY 13905
[i] Lennon-McCartney, 1969

016 4th qtr-year end Kildare Asset Mgt-Kerr Financial Group client review letter

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Vladimir Lenin, founder of the Russian Communist party, said, “There are decades where nothing happens; and there are weeks when decades happen”[i].  There were a lot of weeks in 2016 where decades happened.  The year contained a number of historic events that changed the direction of societies, political systems and economic structures.  While a lot of these events surrounded a rise of populism, their impact flowed to the financial markets.
The year began with the markets in turmoil over worries surrounding China.  The concerns were that a large devaluation of the Chinese currency would lead to a deflationary shock that would cripple the global economy.  This led to the worst start of a year for U.S. stocks.  The major averages lost 10% – 15% in the first six weeks of 2016.
China did not devalue the renminbi and markets stabilized.  Amazingly, U.S. stocks fully recovered their losses and by April they were up for the year.  For the next couple of months, the markets traded in a range as they debated the Federal Reserve’s next interest rate increase and awaited the Brexit vote in June.
As we know, the United Kingdom unexpectedly voted to leave the European Union.  Once again, global markets were chaotic and stocks plunged.  The U.S. stock market dropped over 5% in three trading days.  And once again, prices recovered regaining the losses in the next three days
The exclamation mark for this incredible year was the U.S. presidential election.  Once again there was an astounding change in the markets’ point of view.  In the weeks before the election the U.S. stock market dropped whenever Donald Trump gained in the polls.  And as Hillary Clinton fell behind on election night, U.S. stock futures tumbled with the Dow Jones Industrial Average futures plunging over 800 points.  Then the markets, without obvious reason, reversed course and have not looked back.
Here’s the final tally on the major U.S. stock indexes for 2016.  I’ve also included the returns after the election as they were a significant part of the year’s numbers.
                                                               2016        Election to year end
Dow Jones Industrial Average               +13.4%              +7.8%
S&P 500                                                 +9.5%                +4.6%
Nasdaq Composite                                 +7.5%                +3.6%
Russell 2000                                          +19.5%              +13.5%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.

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

2016            Election to year end

                                                           +16.42%                +4.97%
There were several holdings that contributed to the 2016 performance.  As was covered in the 2nd and 3rd quarter reviews, positions in closed end mutual funds that focused on high yield corporate bonds and corporate loans.  Throughout the year these funds appreciated in price which was a bonus to the real reason for their purchase – 6% to 8% dividend yields.
Layne Christensen (symbol LAYN) has been a long term holding that moved higher in the second half of the year.  The company is a global water management organization that provides solutions for water, mineral, and energy resources.  The company has had problems involving underperforming divisions as well as pressure from the energy sector when commodity prices fell.  Last year they achieved progress in some of the initiatives to improve efficiencies.
Layne’s stock price in late June was less than $7 per share.  It ended the year over $11 or 50% higher than late second quarter.  If management can continue to make improvements, I think the stock price could see further gains in 2017.
Avianca Holdings (AVH) is another position that contributed to 2016’s gains.  AVH is a leading Latin American airline based in Columbia.  It has one the broadest flight coverages throughout Central and South American together with flights to major U.S. cities.
AVH was undervalued by most financial measures.  While airlines typically trade at discounts to market multiples, Avianca seemed to be mispriced.  Part of the problem was that some of their debt was issued in U.S. dollars.  As the dollar rose in 2015 and 2016, AVH had to pay more in interest as measured in Colombian pesos.  While the company was profitable and fuel expense was declining, the market didn’t like its capital structure.
Outside of the financials, Avianca’s route network appeared to be an asset that would be difficult to reconstruct.  To this point, rumors developed during 2016 that the company could be a takeover candidate.  In December, some U.S. airlines starting having discussions with AVH about acquiring the company or forming a partnership.  The stock rose above $10 per share.  It began the year around $4 but had risen into the $6’s by mid-year.  Avianca is currently in talks with United however the structure (partnership vs. acquisition) is unclear.  Depending on the direction of the discussions, we may move out of the position in 2017.
2016 will long be remembered as its many everts were historic.  Further what happened last year will continue to impact future years on many levels – societal, political, economic, and international relations.  As these pertain to the capital markets, I will remain watchful for opportunities while focusing on managing risk.
Jeffrey J. Kerr, CFA

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

March Madness – April Absurdity. “Curiouser and Curiouser”

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April 3, 2017 – DJIA = 20,663 – S&P 500 = 2,362 – Nasdaq = 5,911
 
March Madness – April Absurdity
The term “March Madness” is typically associated with the men’s college basketball tournament that happens this time of the year.  The exciting games and inevitable upsets attract widespread interest and viewership.  Of course, March Madness can be used to describe other events that happened during the month such as the weather, the markets and the search for Tom Brady’s Super Bowl jersey.
Of course, this year the madness of the NCAA basketball tournament cannot come close to the madness in Washington.  President Trump is discovering that the campaign was a walk in the park compared to being President.  He is criticized for Congress’s failure to repeal Obamacare.  He is scrutinized over wiretapping claims and is questioned on his relationship with Vladimir Putin and the Russians.  Of course, his brash unconventional approach invites detractors.
The wackiness of Washington isn’t exclusive to the executive branch.  Congress’s dysfunctional behavior moves within and across party lines.  And we must not forget the fourth branch of government – the press.  Their job of covering our political leaders has not been exactly objective.  Clearly, we will need more synonyms for ‘madness’ to form alliterations for the other months – April Asininity, May Mindlessness, etc.
This lunacy has had surprisingly little negative impact on the stock market.  Normally such acrimony and uncertainty are headwinds for higher stocks prices, but investors seem to be focused on other factors (or ignoring it).  Stocks just finished their 6th consecutive positive quarter.  There were solid gains for all the major averages.
                                                                          2017 YTD
Dow Jones Industrial                                             +4.6%
S&P 500                                                                 +5.5%
Nasdaq Composite                                                 +9.8%
Russell 2000                                                           +2.1%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.
Despite the stocks markets’ recent rally, not all investors are reaping the rewards.  Last week’s American Association of Individual Investors (AAII) survey showed that more respondents were pessimistic than optimistic.  There were 37.4% bears vs. only 30.2% bulls.  This is remarkable on several levels.  First, bulls normally outnumber bears.  Next considering that stocks reached record levels in the beginning of March, we would expect a lot more excitement than the gloominess that those numbers suggest.  Lastly, both figures have deteriorated since the beginning of the year as bullish sentiment stood at 46% in January while the ursine camp was down at 25%.
Away from Wall Street, people are cheerful (this shouldn’t be surprising!).  Last week’s Conference Board’s Consumer Confidence survey jumped to 125.6 from 114.8 in February.  This is the highest reading in 16 years. Naturally, a smiling consumer is good for the economy.
Another part of the survey indicated that consumers have higher expectations for increased income.  Of course, these two are joined.  One of the reasons for a higher confidence level is the belief that you going to see more in your paycheck.
The contrast of a sanguine consumer and gloomy investor is an interesting economic backdrop.  Why the conflict?  Are the consumers’ views a result of being on the frontline of commerce and things are pretty good?  Workers are feeling upbeat about both their current conditions as well as their future and they respond accordingly.
Returning to the grumpy investors.  Are they overly influenced by headlines that are casting the new administration as a modern-day Marx Brothers?  Or does he or she view stocks prices as a little high and getting ahead of the fundamentals?  This latter point does not explain why the pessimism has been increasing while stocks have been rising.  Usually higher prices generate more excitement and enthusiasm rather a river of tears.
The fixed income markets offer another puzzling development.  The Federal Reserve fulfilled their earlier smoke signals by hiking the federal funds rate in March.  And everyone knows that interest rates will be rising.  But for some peculiar reason, interest rates have gone down during the past several weeks.  The 10-year Treasury note’s yield reached 2.6% in mid-March.  This rate closed last week at 2.39%.  The 30-year Treasury bond had a similar drop as it fell from 3.20% to 3.01% at the end of the month.
These moves may seem minor but, for several reasons, they are noteworthy.  First, the bond market is supposed to be less volatile.  Fixed income is regarded as ‘safer’ than equities and is theoretically used to reduce portfolio risk.  We’re not sure a 5% move in two weeks defines stable.  Secondly, interest rates are expected by everyone to be moving up.  That they are doing the opposite calls into question market forecasts and suggests that something else in underfoot.  That there might be unknown market influences logically increases risks.
As we transition from March Madness to April Absurdity, the markets are digesting some large conflicting signals.  While equities have corrected in the last couple of weeks, they remain resilient.  Perhaps this is an example of Wall Street climbing a wall of worry.  The summation of the current market milieu is that it is not an opportune time to increase risk.  Yet, there is no guarantee that the markets provide better entry points for investing capital.   As Alice observed, “Curiouser and curiouser”.
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
130 Riverside Drive
Binghamton, NY 13901

Who’s Afraid of the Big Bad Wolf?

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The stock market has been on a historic run since the election. A steady series of record highs in spite of a landscape of protests, name calling, and divisiveness. Given the elevated level of widespread acrimony, one would logically expect stocks to be broadly lower instead of at all-time highs. Nevertheless, there hasn’t been a meaningful correction since the before the election. Two weeks ago, the major averages had their largest weekly loss of 2017 and it was first time the S&P 500 had a down week in a month and one-half. It also ended a seven-week winning streak for the Nasdaq and four consecutive advancing weeks for the Dow.

The averages got back on the winning side last week thanks to a spike higher on Wednesday afternoon after the Federal Reserve’s increased the federal funds rate 25 basis points. Since a rate hike was widely expected, this decision was discounted. Instead, the rally was driven by dovish comments by Janet Yellen concerning future rate increases. The market had begun to fear four increases in 2017 which could push against economic growth. But, after Wednesday’s press conference, the markets are now expecting only two more in 2017 (three total for the year).

Of course, higher interest rates result in increased borrowing costs and lower profits. Not the typical recipe for a good stock market. Furthermore, higher interest rates result in lower present values of future cash flows i.e. lower asset prices. However, past Fed tightening cycles have not always translated into troubled markets. The table below shows the returns for stocks, bonds, and cash during past periods that the Fed was increasing interest rates.[i] Surprisingly, these asset classes do quite well during rising interest rates. As can be seen, stocks averaged a gain of +21.61% during the 15 cycles since 1958. Even fixed income and cash have historically done well, +5.77% for bonds and +10.26% for cash. Maybe the markets’ current worries are focused on the wrong area – it wouldn’t be the first time.

The danger of rising interest rates might increase after the last rate hike. Below is another table showing the average returns for stocks, bonds, and cash after the last rate increase of a cycle.[i] As can be seen, the average returns one year after the cycle ends are much lower for stocks and cash (+8.79% and +6.71% respectively) but better for bonds (10.08%). The average annual returns for the five years after the end of the cycle is 10.79% for stocks, 9% for bonds and 5.77% for cash.

A couple of notable and worrisome numbers are the returns after the last two tightening cycles. Stocks did poorly after both examples down 14.83% in 2000 and down 13.12% in 2007. Of course, these were the bursting of the tech bubble and the beginning of the financial crisis, but it causes one to wonder if another bout of higher interest rates will lead to another crisis.

We reached another stock market milestone two weeks ago – the 8-year anniversary since stocks bottomed in March 2009. Much has changed in 8 years. First, investor psychology is very different. It hasn’t traveled the typical journey from deep bearishness to widespread optimism. Instead there remains a general mistrust of the capital markets combined with the begrudging acceptance that some level of exposure to the stock market is required.

This mistrust is an extension of a lack of confidence in our financial leaders and regulators. One of the reasons the Federal Reserve was created was to prevent these types of meltdowns. Yet we suffer through a stock market bubble followed by a systemic crisis and the central bank’s response is more of the same approach that led us into these messes. The public recognized that money printing in the form of programs such as TARP and QE together with lowering interest rates was the same old stuff and they didn’t trust it. The markets eventually stabilized but it’s debatable whether the reason was central bank policy or the internal, self-clearing market mechanisms.

Another notable difference between March 2017 and March 2009 is the composition of leaders. There are several currently popular stocks that weren’t around 8 years ago. Facebook came public in May 2012. Tesla’s IPO was June 2010. Other significant IPO’s during this time period were Twitter (November 2013) and Alibaba (September 2014). At a minimum, this shows that the markets continue to evolve and move forward.

Returning to 2017, as mentioned, it has been a good year so far and there are some signs that it will continue. We recently passed the 50th trading day for the year and, at that time, S&P 500 was up 6.03%. Since World War II when the S&P 500 is up at least 5% at the 50th trading day of the year, stocks have a remarkable history of continuing higher. Of the 22 prior occurrences, the S&P 500 added to those gains 21 of those years. The average gain was 12.16% in the remainder of the year. Sticking with this indicator, gains can be stronger in the first year of a presidential cycle with 5 prior examples – 1961 +12.89% the rest of the year, 1985 +18.57%, 1989 +19.74%, 1997 +6.67%, and 2013 +9.61%.[i]

Events over the past year give pause to confident predictions and using history as a guide to the future. Maybe this will be one of those rare years where the first 50-day rally fizzles. Furthermore, the current landscape in Washington looks to be changeable. Given that much of the Trump rally has been driven by anticipated changes in tax code and business regulations, the markets could be susceptible to disappointment if there are delays or cancellations of this agenda.

Add to these crosscurrents and confusion the fact that the Federal Reserve will be raising interest rates again later in the year. Then mix in the valuation backdrop of a pricey stock market at all-time highs and we have markets that could use a correction. In the short term, we have end of the 1st quarter approaching which is normally supportive of equities. Perhaps we get a pullback next month. If that happens it could recharge the bulls for another leg higher. Of course, this assumes the economy strengthens and Washington pushes through the expected changes. This promises to be an interesting year.

Jeffrey J. Kerr, CFA

Kerr Financial Group
Kildare Asset Management
130 Riverside Drive
Binghamton, NY 13901

[i] Bloomberg, March 10, 2017
[ii] ibid
[iii] The Bespoke Report, March 17, 2017

Beware the Ides of March

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The Trump presidency and the stock market are two perplexing affairs. Given their developments during the past few months, they would be fascinating on their own. Stocks reversed direction the day after the election and have rallied strongly as the Dow surpassed 20,000 and then 21,000. On the other side, the new administration has had an equally unique trip. Twitter has become a news outlet, executive orders are implementation devices, and no one knows what news is real or fake.

And while they are separate and independent (kind of), the stock market and the White House have had an undeniable connection since Donald Trump became President-elect. Naturally, the markets are more closely watching the president then the other way around. Investors are scouring the news wires looking for nuggets that will lead to economic growth. The latest example was last week’s Congressional speech which led to an explosive move on Wall Street the next day. All the major averages closed at record highs.

The speech didn’t contain much detail as there weren’t specifics concerning programs or initiatives nor a timeline for enactment. Yet it was enough that the indexes rallied more than 1% which was the first time this happened in the last 55 trading days. Here are the where the major indexes closed the week.

2017 YTD

Dow Jones Industrial Average +6.3%
S&P 500 +6.4%
Nasdaq Composite +9.1%
Russell 2000 +2.7%

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

The Dow has risen through three 1,000 point levels since the election – 19,000, 20,000 and, as of last week, 21,000. And while prices are up, there has not been the commensurate increase in earnings. Below is a graph of the S&P 500’s trailing P/E[i]. As can be seen, history shows other times of higher valuations, however, it will be important to see an acceleration of earnings. It would be much nicer to see this blue line move lower because the “E” is larger rather than the “P” getting smaller.

Turning to the numerator in the P/E equation, 63% of reporting companies “beat” earnings forecasts in the 4th quarter. This was higher than the third quarter number and toward the upper end of the range for the past several years. The “beat” rate on revenues was 57% which was also higher than the previous quarter and the highest in two years. Further progress for sales and earnings would be important support for stocks. Certainly, valuations could move higher, but as the chart shows, valuations don’t stay elevated for long.

Social media has become a central part of our culture. Presidential tweets, Facebook followers, and LinkedIn connections are now part of our routines. Wall Street, always trying to help (and make a buck) brought Snapchat public last week. In addition to fees on the deal, the investment bankers deserve a round of applause for the timing of the deal – the day after the markets close at all-time highs. We’d bet that they’ll be OK with the fees if they don’t hear an ovation.

SNAP IPO’d at $17 per share which was above the expected range of prices. It began trading around $24.50 and moved as high as $26 or 53% above the offering price. At the close of the first day of trading, the company was valued at $28.3 billion. To put this into perspective, Snapchat had a higher valuation than all but 173 companies in the S&P 500. This includes such organizations as Tyson Foods, American Airlines, Hershey, Yum! Brands, Molson Coors, Dollar General, Expedia, T. Rowe Price, Viacom, DR Horton, Chipotle, and Macy’s. Maybe social media companies are more valuable than struggling retailers (Macy’s and Dollar General) and restaurants (Yum! Brands, and Chipotle). Or maybe Snapchat can figure out how to fix their problems[ii].

Moving from stocks to fixed income, bonds got a punch in the nose last week. Multiple Fed heads were on the speaking circuit at the end of last week and they were unanimous in calling for a rate hike. The FOMC meets next week with a decision on Wednesday (the Ides of March).

Prior to these appearances, the market had only assigned a 33% probability for an interest rate increase in March. That moved to 88% by the end of the week. The 10-year Treasury note’s yield closed last week at 2.49% which was a jump from 2.32% the prior week.

It seems that many are worried over the Federal Reserve raising interest rates. The problem with this mindset is that the markets have already moved. Below are yield curves from last month, November and one year ago[iii]. The long end of the curve has clearly moved higher and, as the November and February 2017 yields are so close, this happened well before the much-ballyhooed December increase. The short maturities, the spot that the Fed can control, have not moved as dramatically. Until last week.

The three-month U.S. Treasury bill, which began the week at 50 basis points, spiked to 70 basis points by the end of the week. This is not a normal move for the short-end of the fixed income market. There was no immediate fall out last week, but it could be the start of increased volatility throughout the fixed income markets. This has potential to be an economic headwind as higher interest rates across the curve could increase corporate borrowing costs.

The combination of elevated valuations and rising interest rates aren’t typically part of the equations that lead to higher asset prices. However, the Trump Administration is teaching everyone that the old rules are subject to change. Wall Street, which encompasses plenty of fickle emotions, could change their view of things at any time. If, for whatever reason, support for the Trump Trade decreases, the capital markets could shift to a more volatile backdrop. However, unless signs of a recession start to appear, any pullback in prices should be contained. It could result in a much-needed correction with attractive entry points for investment capital. Or it could result in monthly Congressional addresses by President Trump.

Jeffrey J. Kerr, CFA

Kerr Financial Group
Kildare Asset Management
130 Riverside Drive
Binghamton, NY 13901

[i] The Bespoke Report, March 3, 2017
[ii] ibid
[iii] Grant’s Interest Observer, February 24, 2017

There’s a Lady Who’s Sure All That Glitters is Gold

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At this time last year the stock market had been falling since New Year’s Day.  It was the worst start to any year for stocks.  In the prior months, crude oil had collapsed from $100 per barrel in early 2015 to under $30.  Further there were broad worries that China would devalue their currency which would place additional pressure all developing economies.  Angst and pessimism abound.
The markets stabilized in mid-February and began a stair step journey that has lasted a year.  This pattern of advance, pause, advance, pause, withstood Brexit, the U.S. presidential campaign, elections in France and Italy, and of course, Donald Trump’s victory.
The chart below covers the S&P 500 for the past 12 months.  The red line is the 200-day moving average, the blue line is the 50-day moving average, and the black line is the 10-day moving average.   These lines provide context for viewing the markets for different time periods.  The 10-day line is an indicator commonly used by traders to gauge short-term movements.  The 200-day gives perspective for a longer time frame as it is the average for almost a year’s worth of trading and it considered significant when it is crossed – both advancing above and falling below.
As can be seen, once the 200-day (red line) was reclaimed in March, it was only tested in late June (Brexit) and just before the U.S. election.  Both times the level held and the markets bounced signaling the bulls were in control.  Since the election, the 10-day (black) and 50-day (blue) have acted as support for the rally.

 


The steadiness of the rise since the election is another noteworthy characteristic of the chart.  There has not been a daily drop of 1% or more since October.  This totals 89 trading days which is abnormal.  You would have to go back to before the financial crisis to find a streak this long.
Here are how the major averages have performed from the lows of last February.  Also included are the year-to-date numbers for 2017.
YTD 2017        Since Feb 2016 lows
Dow Jones Industrial Average                   +4.4%                      +31.70%
S&P 500                                                     +5.0%                      +28.54%
Nasdaq Composite                                     +8.5%                      +36.85%
Russell 2000                                              +3.1%                       +46.78%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.
 
The Nasdaq has led the way so far in 2017 and it is part of the 37% advance over the past 12 months.  Below is a chart that calculates the Nasdaq’s rolling 1-year percentage change.  A couple of noteworthy observations.  First, this past year isn’t that significant as there are many years with higher returns.  Secondly, there are many examples of disappointing years following a 30% or better gain.(i)
“‘Cause You Know Sometimes Words Have Two Meanings”
Looking in the rearview mirror, it’s easy to think it was a good time to make money and that everyone had a great year.  That does not appear to be the case.  A lot of money was pulled out of equity mutual funds during the past few years and we have mentioned this in previous newsletters.  Of course, a good portion of that capital stayed invested but used exchange traded funds which can be traded throughout the day and, in many cases, have lower expenses.
The chart below show the weekly equity mutual flows for the past two years.(ii)  Notice the massive and steady outflows especially in the past year as U.S. stocks zig-zagged higher.  There was even a large outflow in December as the Trump rally was well underway.  Also, please note that there was a net inflow in the last report.  On one hand this could be the start to a trend which could help fuel further stock gains.  On the other hand, this could mark a capitulation top as the crowd has a history of poor timing.


There is an old market adage that stocks climb the stairs up but take the elevator down.  In other words, moves lower happen a lot faster than the rallies.  The U.S. stock markets have clearly been taking the stairs for the past year.  Is there an elevator trip in our future?  At some point, probably.  But that can provide an opportunity for investors who are properly positioned to put capital to work.
The markets have been strong so far in 2017.  There have been a series of record highs together with strong breadth.  Looking forward, we anticipate that the markets will be much more challenging than they appear in the hindsight of the past 12 months.  Remember the volatility surrounding Brexit and Donald Trump’s upset win?  It was easy to move to the sidelines and into cash.  There will be those types of trials again.  But opportunities arise out of these types of situations and a new stairway will appear.
 
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
130 Riverside Drive
Binghamton, NY 13901
i.The Bespoke Report, ,February 17, 2017
ii Topdown Charts, February 17, 2017