“I’m Caught in a Crossfire That I Don’t Understand”

September 18, 2017-DJIA = 22,268-S&P 500 = 2,500 – Nasdaq = 6,448

“I’m Caught in a Crossfire That I Don’t Understand”[ii]

Headlines deteriorate, capital markets appreciate. It is a perplexing mystery that has many confused and incredulous. Issues such as North Korea, Charlottesville, social protests, political discord, terrorism, and natural disasters dominate the headlines. Everyone is aware of them and naturally assume the financial markets should be a tumultuous mess. Yet, markets maintain a calm levitation.

Last week the Dow Jones Industrial Average closed at all-time highs for 4 consecutive days including Friday. The S&P 500 also closed the week at a record high while the Nasdaq reached a record earlier in the week and closed slightly below that level. Even more remarkable is the fact that this is happening in September which is one of the historically weakest months.

Here are the major averages’ performance at the close of last week.

2017

Dow Jones Industrial Average +12.7%
S&P 500 +11.7%
Nasdaq Composite +19.8%
Russell 2000 +5.5%

A partial explanation for the markets’ strength is that numerous negatives provide a wall of worry for prices to advance. In other words, there is so much bad news and it is so widely known that a lot of that risk is priced into current levels. As mentioned, a logical investor, given this news landscape, has probably already distanced him or herself from risk assets.
Another important support for record stock prices is corporate earnings growth. S&P 500 earnings have been quietly and materially expanding. For 2017’s 2nd quarter, profits grew at a double digit rate with the year-over year growth over 12%. Additionally, S&P 500 revenues have grown more than 5%. We’re not sure investors who are focused on the myriad of negative headlines appreciate this development.

Part of the story of earnings growth is foreign exchange related. The U.S. dollar has fallen in comparison to other currencies and is having one of its worst years ever. The chart below shows the value of the dollar in 2017 compared to every year going back to 1995.[iii] It is kind of a messy chart but the red line clearly shows this year’s performance. The irony of the beaten up greenback is that a Trump Presidency was supposed to be accompanied by a stronger U.S. dollar.

The weaker dollar has boosted earnings of large, international companies. The value of foreign sales in euros or yen, for example, translate into higher numbers in U.S. dollars because the euros and yen ‘purchase’ more dollars as they are ‘converted’ for accounting purposes.

Given this financial tailwind, as expected, stocks with significant international sales have greatly outperformed those that have largely domestic customers. Borrowing another chart from Bespoke, this illustrates the difference in the stocks’ gains.[iv] The blue line is S&P 500 companies with greater than 50% of their revenues from international markets and the red line are stocks that have 90% or more of their revenues from the U.S. As you can see, the “domestic’ stocks are up a little more than one-third the gain of their “international” siblings.

This also partially explains the underperformance by the Russell 2000. This index is primarily smaller businesses with domestic customers. On the other hand, larger companies that have global markets, including technology, are included in the S&P 500 and Nasdaq.

Another ‘under the headlines’ reason for the stock market’s record level is the prospect of tax reform. President Trump committed to revamping and reducing the corporate tax burden as part of his campaign. Within dysfunctional Washington, this issue has moved higher on the to-do list and is gaining some momentum.
It is unlikely that anything gets completed in 2017, however, there is a growing chance that something is done in 2018. A new tax law reducing corporate rates will have a major benefit to company bottom lines. The likelihood of something happening on this front is moving stocks higher now.
In addition to growing profits, reducing taxes could easily increase investment back into the business in the form of capital expenditures. This could have an exponential benefit as investing in their company will have a far reaching economic impact. The stock market is discounting this as well.
While the financial markets seem to be oblivious to the bombardment of negative news, it might the case of investors focused in the wrong area. It seems that we are overlooking some important economic positives. Specifically, corporate earnings are healthy and could become a lot stronger if tax reform becomes a reality. Of course, relying on Washington is a risky proposition. However, all parties realize the importance of these market expectations and will ultimately work with the opposition to accomplish something meaningful. And as we wait, we hope that the news flow improves because it’s pretty discouraging right now.

[i] Grant’s Interest Rate Observer, September, 2017
[ii] Bruce Springsteen, 1978
[iii] Bespoke Investment Group, September 8, 2017
[iv] Ibid

Jeffrey J. Kerr, CFA

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

“The Smiles Are Returning To the Faces”[i]

The level at which any security trades is part fundamental valuation, part supply/demand, and part assumption regarding future events.  These conjectures concerning upcoming developments can be fickle especially as headlines impact investors’ attitude.  In fact, Wall Street’s reaction to the news is often more telling than the news itself.  In other words, when traders are bullish, good news is good and bad news is good.  Of course, in a bearish backdrop, all news is lousy.

 

The current mentality is that all news is good.  And to be sure, there have been some rays of sunshine that optimists can point to.  Housing has improved, there are no U.S. troops in Syria (yet), and Congress took August off.  The bad news, however, has been visible.  Whether Mr. Market is viewing all bad reports as good because it leads to more quantitative easing or is just overlooking anything negative, we think it is dangerous to believe that all problems can easily be solved by loose monetary policy.


[i]George Harrison


A recent example of Wall Street’s rose colored glasses was the markets’ reaction to the August employment data.  The report’s headline numbers were pretty good with the unemployment rate falling to 7.3% (the lowest in 5 years) and an estimated 169,000 jobs created in the month.  That brought the six month average job growth to 180,330.  Unfortunately, this is below the 200,000 target that some policy makers have set.[i]

 

Disconcertingly, adjustments to July and June’s data showed softer employment growth.  The estimated number of jobs added in July was reduced from 164,000 to 104,000 while June’s payroll gain was lowered by 16,000.[ii]  Some strategists emphasize the size and direction of the revisions as a sign of the job market’s, and the economy’s, health.  They are dismayed by these adjustments.

 

Further the decline in the unemployment rate was caused by a bigger drop in the overall labor force rather than job growth.  The number of workers employed fell by 115,000 while the overall labor force declined by 312,000.  This caused the labor participation rate (the number of people either working or looking for work as a share of the working-age population) to drop to 63.2%.  This is the lowest level of participation since 1978 or 35 years ago.[iii]

 

This soggy job market is clearly a drag on the economy.  Not only do consumers have less income, there are fewer and fewer workers supporting an increasing number receiving government benefits.  Perhaps QE is not all that it’s supposed to be.

 

Stocks immediately fell after the report but steadily clawed their way back throughout the day and finished little changed.  In the glass is half full view, the bad jobs data supported the Wall Street belief that that the Fed will not “taper” their $85 billion monthly bond purchases which have supported risk assets such as stocks.

 

After a monthly fall in August, equities have rebounded in September and, at the end of last week, have climbed back to approach 2013’s highs.  Here are the year-to-date performances for the major indexes.

 

                                                  2013[iv]

Dow Jones Industrial Average  +17.3%
S&P 500                                    +15.2%         
Nasdaq Composite                    +23.3%

Russell 2000                              +24.1%

 

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

 

While there are some other noticeable blemishes (last week we had lower than expected consumer sentiment and retail sales reports), it is not affecting investor cheerfulness.  45% of the respondents to the AAII survey were bullish (the long term average is below 40%).[v]  This type of reading is often viewed as a contrary indicator (high bullish readings are bearish).

 

“It Seems Like Years Since it’s Been Here”[vi]

 

Another concern is the current high level of margin debt.  Margin is debt that is financed with investment securities used as collateral.  The amount of borrowings being financed has returned to levels that coincided with some not so pleasant times for the capital markets.  As shown in the nearby chart, the previous times that margin debt was at the current levels were March, 2000 and July 2007.[vii]  In case readers need a reminder, both dates were followed by material drops in the stock market.

 

Another troublesome observation is the return of market leadership by exciting, revolutionary companies.  Upstart organizations that change the playing field are a constant part of a dynamic economy.  The United States has experienced this creative destruction regularly.  The automobile industry in the early part of the 20th century was followed by radio and then TV.  More recent, of course, are computers, internet, and cell phones in the information technology area.  In addition, medicine has experienced incredible bio-tech advancements, robots are becoming more prevalent, and energy sources are being discovered and recovered from heretofore unheard of areas.

 

As stated above, current investment prices discount future revenues and profits.  And some of the companies offering new products and services seem to have unlimited potential.  The debate over what to pay for this prospective success is being fought in the current stock prices.

 

We offer some examples.  Tesla Motors, the manufacturer of electric cars, carries a $22 billion valuation in the stock market while their trailing 12 month (TTM) sales barely exceed $400 million.  To be sure, $3.50 per gallon of unleaded allows for alternatively powered vehicles.  However, in our opinion, a price-to-sales multiple of 55 times discounts some significant growth.

 

Yelp describes their business as “an online urban city guide that helps people find places to eat, shop, drink, relax, and play based on the informed opinions of a community of locals in the know”.[viii]  Investors must have a pretty high outlook for this business because the stock’s worth in the markets exceeds $2.5 billion.  We are not sure exactly how Yelp generates revenues but they are less than $150 million.  Another bothersome detail for Tesla and Yelp is that they are both losing money.

 

Even the most primitive Luddite knows what Facebook is.  While many will assign “failed IPO” to this social media leader, it has undoubtedly changed the way we communicate.  The stock has returned to favored status recently.  Mark Zuckerberg’s venture carries an $84 billion market capitalization as it generates $5 billion in sales.  One distinction from Tesla and Yelp, is that Facebook has a bottom line.  At a price in the mid-$40’s, the price-to-earnings is 190.

 

Energy exploration in shale formations is dramatically changing our economy.  Cheaper energy is driving a manufacturing renaissance in the U.S.  New plants are being built throughout the mid-west and south.  Furthermore, the abundant natural gas is being targeted as an eventual American export.  Many areas of the world are currently importing liquefied natural gas as an important energy source (Japan and Europe are two large importers).

 

Cheniere Energy is in the process of building one of the first exporting facility in the U.S.  If all goes as planned, it will be operational sometime in 2015.  Wall Street can not contain their excitement.  The stock trades at a market capitalization over $7.5 billion despite only $260 million in sales and substantial red ink on the bottom line.

 

Returning to the overall landscape, the stock market has had many reasons which could spark a decline.  While August was lower, it was shallow in comparison to 2013’s move.  Investors returned from the Labor Day weekend and bid prices higher.  There appears to be little to worry about.  Of course this is much different from autumn 2012 when worries over the election, Europe, and the fiscal cliff caused investor angst and pessimism.

 

A year ago we advised clients that a lot of bad news was priced into the markets.  It turned out to be somewhat correct despite a nasty selloff after the election.  With the current environment so cheerful, we fear there is little risk associated with the future outlook for the economy.  We hope for continued expansion but fear the markets’ expectations.

 

 

[i] Wsj.com, September 6, 2013

[ii] ibid.

[iii] Bloomberg Business Week, September 6, 2013

[iv] The Wall Street Journal, September 14, 2013

[v] aaii.com

[vi] George Harrison

[vii] BOA/Merrill Lynch Global research.

[viii] Yahoo.com

 

 

 

 

 


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 NASDAQ Composite Index is an unmanaged, market-weighted index of all over-the-counter common stocks traded on the National Association of Securities Dealers Automated Quotation System. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. The Russell 2000 Index is an unmanaged market-capitalization weighted index measuring the performance of the 2,000 smallest U.S. companies, on a market capitalization basis, in the Russell 3000 index. It is not possible to invest directly in an index. Investing involves risks, including the risk of principal loss. Additional risks are associated with international investing, such as currency fluctuations, political and economic instability and differences in accounting standards. 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.

Past performance does not guarantee future results

“There Shall be Disaster After Disaster, Rumor After Rumor”

September 5, 2017 – DJIA = 21,987- S&P 500 = 2,476 – Nasdaq = 6,435

“There Shall be Disaster After Disaster, Rumor After Rumor”[i]

Contrary to what you might expect, the above is not a recent CNN headline describing the Trump administration. Rather it was written around 600 B.C. by the profit Ezekiel, who was exiled to Babylon. He was describing his vision of the unthinkable decline and ruin of Jerusalem which ultimately took place. It was an accurate description of what took place 2,000 years ago and, remarkably, today’s current events.

While it seems that we are undergoing a modern fulfillment of Ezekiel’s prophecy, it is amazing that this has had no impact on the capital markets. The stock market is within a few percentage points of all-time highs, bond yields have fallen, and the dollar has been drifting lower.

The stock markets below the surface view, however, is less tranquil. The Dow Jones Transportation Average peaked out in July and as of August 24th had given up all of 2017’s gains (it bounced higher last week).

Smaller cap stocks have also been moving lower. The Russell 2000, S&P Smallcap 600 and S&P Midcap 400 declined in August and all three indexes are lower for the 3rd quarter. The Russell, as measured from the July high to the August low, fell 6.4% in 4 weeks.

Even within the S&P 500 (large cap index), there’s some blemishes as the smallest of these large companies are lagging. When the index is broken into deciles by market cap size, incredibly the 10th decile (the smallest market cap of the 500 stocks) is down 2.11% year-to-date. Contrasting this with the entire S&P 500’s 10% year-to-date gain, the under-performance is shocking.

Of course, the S&P 500 has FANG which has pushed the index. FANG is the anacronym for current stock market darlings Facebook, Apple and Amazon, Netflix, and Google. And as the index is weighted by market cap, the larger companies have a bigger influence. With Facebook, Apple, Amazon, and Google (Alphabet) all in the top 10 market values, they have been especially influential as these stocks are materially higher for the year.

Also, the trend toward passive investing has a self-fulfilling aspect as the S&P 500 is a popular way to gain equity exposure in this approach. And when money goes into the index it buys more Apple, Amazon, Google, etc.

Here are the year-to-date numbers for the major indexes. Note the disparity between the Russell and the Nasdaq. Is this a sign that the broader market is weakening and the bigger stocks will follow? Or is this an opportunity for contrarian investors to enter the small cap market?

2017

Dow Jones Industrial Average +11.3%
S&P 500 +10.6%
Nasdaq Composite +19.5%
Russell 2000 +4.2%

The Nasdaq’s 2017 gains are noteworthy and, as expected, this has pushed the size of the technology sector to 23.5% of the S&P 500. It would be even greater if Amazon was considered a tech stock. It might be natural to assume that technology’s popularity has pushed the sector’s valuation to unreasonable levels. Surprisingly, this is not the case. The current P/E based on trailing earnings is around 23. As the chart below shows, this is slightly above the average of the past 20 years.[ii]

Another important stock market trend for 2017 is the significant lagging of value stocks as compared to growth stocks. Below is another Bespoke chart illustrating this difference.[iii] While this only accounts for stocks within the S&P 500, the spread is not typically this wide. As mentioned with the disparity of large cap vs. small cap, there will be a time when value investing outperforms growth.

The capital markets are facing many economic, political, and societal crosscurrents. And they are doing it at a historically troubling time of the year as September and October can be volatile months for the markets. That the markets have not suffered any significant setbacks given developments such as Charlottesville, North Korea, a possible U.S. federal government shutdown, and Hurricane Harvey is confounding. Maybe it’s a sign of underlying strength or it could be a delayed reaction with forthcoming pain.

Regardless of what the financial markets do, our thoughts and prayers are with those impacted by Harvey and those who will be hurt by Irma.

[i] Ezekiel, chapter 7, verse 26
[ii] The Bespoke Report, September 1, 2017
[iii] Ibid

Jeffrey J. Kerr, CFA

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

“Yes It’s Been Quite a Summer, Rent-a-cars and West Bound Trains”[i]

Ideally summertime offers chances for getting away to relax.  This typically involves leaving the day-to-day stresses behind and enjoying some nice weather perhaps in the mountains or at the beach.  2015’s summer, however, hasn’t allowed much downtime as the headlines have been both significant and active.
This shouldn’t be a surprise as any year that includes Hillary Clinton and Donald Trump in a presidential campaign will be memorable.  The developments and sound bites from Camp Clinton and Trump should make the next few months interesting.  But there are some other astonishing events playing out – the ongoing saga over whether Greece remains in the European Union or finally departs.  And then what it means to the European financial system.
Additionally, there is the battle over the Iranian Nuclear Deal, Puerto Rico telling creditors it may or may not pay them mañana, and the Fed both deciding when to raise interest rates and then deciding how to let the markets know.  And finally, China choosing to devaluate their currency, the renminbi, against the U.S. dollar, relations with Cuba and, of course, Bruce Jenner.
Certainly there are many other important developments and ranking the list in order of importance is a challenge. We think that near the top of everyone’s lists should be monetary policy and the Federal Reserve.  Specifically, when the Fed will raise interest rates and what it means for the economy and capital markets.
[i] Jimmy Buffett, 1974
“I’m Tore Down, I’m Almost Level With the Ground”[i]
As we know, interest rates are low.  But, within a historical context, it is astonishing how low they are.  In many cases, they have NEVER been at these levels – and “NEVER” involves 500 years in some instances!!  The Dutch government bond markets dates back to 1517.  The lowest yield levels were hit earlier this year when the yield on their 10-year bond touched 0.45%.  The Bank of England was formed in 1694 and the “base lending rate” was established in 1705.  The current rate of 0.5% is the lowest ever.  Landmark lows in other sovereign markets include France (dating back 1746), Italy (1807), Germany (1807), Spain (1821) and Japan (1870).  As Michael Hartnett, chief investment strategist at Bank of America/Merrill Lynch, points out “There have been depressions, wars, earthquakes, famines, all sorts of stuff, yet interest rates have never been lower”[ii]
Shifting from history to looking forward, it seems that the only thing the financial media talking heads are concerned with is when the Federal Reserve will increase interest rates.  The hyperbole surrounding this decision would make reasonable men and women conclude that the future of the human race depends on what the Fed does.  Sadly, perhaps this is not hysteria but reality.
To be sure, our monetary policymakers have followed their current strategy with the well intentioned goals of preventing another crisis as well as restore the economy to growth.  However, their strategies of zero interest rates, asset purchases, and other stimulative efforts aren’t guaranteed to accomplish their objectives.  In fact repressing interest rates distorts the value of any financial asset because of the artificial interest rate used to discount future cash flows.  As Jim Grant describes it, “With one hand, the Fed is manipulating interest rates, therefore the value of myriad financial claims tied to interest rates.  With the other hand, it’s trying to impose safety and soundness from on high.  Left hand and right hand are working at cross-purposes”.[iii]
Beyond the capital markets, record low interest rates are an economic obstacle rather than the intended contributor.  Charles Gave from GaveKal Research describes the issues, “As a rule, entrepreneurs have zero confidence in prices fixed by the authorities, which can change overnight on a politician’s whim (as anyone who invested in Spanish solar power learned to their cost). They also know that very low interest rates bring forward future demand, and they worry what will happen when there is no longer any future demand to bring forward. In response, they stop investing in order to maximize the cash on their books or to buy back their own shares. Meanwhile consumers, knowing that businesses want to reduce their wage bills and afraid they will lose their jobs, begin to save as much as they can. The result is a collapse in the velocity of money, and declines both in economic activity and in prices.”[iv]
Despite good intentions, perhaps manipulating interest rates and capital flows is not providing the desired outcome.  Growth has been much lower than previous economic recoveries and wage growth has been elusive.  This deviation from the planned outcome risks a reduced confidence in central banks which could cause further market volatility.
Last week the Dow Jones Industrial Average fell 1,000 (5.82%) including a 500 point plunge on Friday.  It was the largest weekly point drop for the Dow since 2008 and Friday’s loss was the worst in four years.  The Dow is now down 10.3% from its record high set on May 19th and this is the first time the index has experienced a 10% correction since 2011.  There is nothing significant about the 10% threshold (other than it’s a round number) but it does show that stocks have steadily climbed in recent years.
Here are the year-to-date numbers for the major averages.                              2015YTD[v]                                     Dow Jones Industrial Average  -7.7% 
S&P 500                                   -4.3%
Nasdaq Composite                   -0.6%
Russell 2000                            -4.6%                           
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
Some other notable market developments include crude oil declining to $40.00 per barrel (down 33.7% YTD) and the yield on the 10-year Treasury note falling to 2.05%.  Gold rose 4% last week closing the week at $1,160 per ounce.
Emerging markets experienced much of last week’s pain as China reported some soggy economic data increasing worries of slowing growth.  The purchasing managers’ indexes fell to a 6 ½ year low and imports fell 8% in July.  This pressured all emerging markets.
While the slumping stock market grabbed everyone’s attention, real news was happening in the foreign exchange markets.  China, Vietnam, and Kazakhstan devalued their currencies against the dollar.  It would be easy to shrug the shoulders and mutter ‘Vietnam and Kazakhstan don’t matter’.  This was probably a common reaction to Thailand’s baht devaluation which started the 1997-1998 Asian Crisis.
“I’d Like to Get You on a Slow Boat to China”[vi]
Regarding China’s devaluation, there are several theories behind this decision.  China had pegged the value of the renminbi to the U.S. dollar so as the greenback strengthened vs. other currencies over the past year, so did the renminbi.  This placed China at a slight disadvantage from a global competitive perspective.
Many believe the move was an effort to increase the chances of being included in the IMF’s Special Drawing Right.  This SDR is a basket of global currencies but is not used for foreign exchange or trade.  It is largely a symbolic IMF gadget.  However, inclusion, which will be decided in a November decision, is important to the Chinese government.  A pegged renminbi would be harder to get IMF approval as it would be viewed as the same as the U.S. dollar.  So China views breaking this tie to the dollar as a necessary step in the renminbi’s evolution.
Another factor influencing this move is the fact that China wants to expand their capital markets to have a bigger global presence.  Free trading markets are an important component of that equation.  Unhinging this peg to the dollar sends a message to the international community that China is serious about moving to a market based system (at least in some areas).
After last week, the financial markets will struggle with whether these devaluations and slowing emerging market economies will result in recessions in the developed countries.  Or the cheaper energy costs will continue to lower cost structures and drive further global growth.
Some are proclaiming that last week will be like October 2014 when U.S. stocks fell 7% in the first half of the month only to fully recover in the second half of the month.  After that, they resumed the pattern from the past couple of years namely a gradual and steady advance.
The ursine side of the debate points to the damage to the global economies and stock markets.  While last October turned out to be a “V” bottom, there are many other dynamics in 2015 that make a repeat unlikely.  The U.S. will be raising interest rates, many economies have too little growth and too much debt, and the stronger dollar hurts major U.S. companies.
As summer winds down, we realize that it has been an eventful year.  And it has not all been bad – we have a triple crown winner in horse racing (first in 37 years), the U.S. women’s world cup team won the gold medal, Serena Williams winning 2015’s first 3 major tournaments in tennis (the U.S open forthcoming), and the New York Mets are in first place.  We hope that some of this good news flows into the capital markets and calms things down.  A little chance to catch our breath would be helpful.  The remaining four months of 2015 should be very interesting.

[i] Carbert Music, Inc. 1961
[ii] Bank of America/Merrill Lynch, “The Longest Picture”, February 22, 2015
[iii] Grant’s Interest Rate Observer, March 20, 2015
[iv] GaveKal Research “Five Corners”, July 15, 2015
[v] The Wall Street Journal, August 22-23, 2015
[vi] Frank Loesser, 1948

SERENITY NOW!! (Insanity later)[i]

July 24, 2017 – DJIA = 21,580 – S&P 500 = 2,472 – Nasdaq = 6,387
 
SERENITY NOW!! (Insanity later)[i]
For something that comprises so much emotion, the stock market has amazingly ignored the passionate yet venomous division in the United States.  In the midst of name calling, violence, protests, and a prevailing sense of hatred of those with opposing views, the stock market climbs higher.  With the acrimony and polarity so elevated, why hasn’t this impacted the markets?
And not only have stock prices risen in the face of societal deterioration, they have done it in a remarkably smooth and steady manner.  The S&P 500’s largest pullback this year is a hardly noticeable 2.8%.  We all know that there have been times where the markets approach that level within a day! And not only is this incredible given the current landscape, it is historic.  This is the smallest intra-year correction since 1995 and the second smallest dating back to the Great Depression.[ii]
This stock market serenity has gotten so widespread the U.S. seems to be exporting it as international stock markets are experiencing a similar tranquility.  As measured by the MSCI EAFE (Europe/Asia/Far East), the MSCI EM (emerging markets), and the Nikkei 225 (Japan), global bourses are near record low levels of volatility.  Traditionally, emerging markets are one of the riskiest assets classes with high levels of uncertainty.  Yet so far in 2017, the MSCI EM has only undergone a mere 3% pullback.  Contrast this to 1995’s 13% correction which was one of the least volatile years in history for emerging markets.[iii]
In 1995 the Nikkei 225 fell 26.4% from peak to trough.  While this is not the lowest annual pull back for this index, it is among the smallest.  Yet so far in 2017 the spread is a miniscule 6.5%.
Below is a graph showing variance for the S&P 500, the MSCI EAFE, the MSCI EM, and the Nikkei 225 since 1990.  The red circle on the right is 2017.  As measured by these four indexes, this is an astonishingly calm year within the backdrop of chaos.[iv]
There is no definitive reason for this quiet price action.  Until recently, central banks were keeping short term rates low and this has likely contributed.  Also, it is helpful that economies have been growing at a slow but steady pace. Indexing and passive investing has played a role as investors have been buying ETFs which index the market and its various sectors.  These funds buy their underlying components as they receive inflows without concern for valuation or timing.
Whatever the cause, the stock market’s peaceful price action will end and volatility will return – someday.  As shown in the graph, there is a cyclical component to this and there’s no reason to think things have been permanently altered.  Whenever market volatility returns there will be much wailing and gnashing of teeth as investors will not be expecting it.  In the meantime, the steady move higher continues and, as mentioned, the major indexes reached records last week.  Here are the year-to-date returns as of the end of last week.
                                                                                       2017 YTD
Dow Jones Industrial Average                                          +9.2%
S&P 500                                                                            +10.4%
Nasdaq Composite                                                            +18.7%
Russell 2000                                                                     +5.8%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend. 

Looking at the fixed income market, short term rates have move noticeably higher.  First the 3-month Treasury bill’s yield closed 1.17% last week and this was actually higher than the longer dated 6-month T-bill which closed at 1.10%.  Moving further out, the yield curve returns to its normal upward sloping direction with the 2-year Treasury note at 1.36%, the 10-year Treasury note at 2.24% and the 30-year Treasury bond at 2.81%.  An interesting (and easy) place to park some short-term liquidity might be 6-month CD’s which were yielding 1.35% – 1.40% last week.
Foreign exchange is another market that is offering some unexpected developments.  At the beginning of 2017, the common forecasts were for a stronger U.S. dollar based on the “Make America Great Again” theme.  Increased domestic manufacturing, increased exports, and restrictions on imports were part of the landscape that would drive the dollar higher.  Instead, as measured by the Wall Street Journal Dollar Index, the greenback has fallen 7.25% against a basket of currencies in 2017.
This translates into unexpected stock market leadership.  Companies with high domestic revenues, which would typically benefit from a stronger U.S. dollar, were supposed to lead the markets.  And companies with a more international customer base were supposed to be hurt.  However, with the weaker dollar, technology (with big international sales) has benefited.  Apple, for example, has approximately 60% of their revenues from foreign markets.  Dow Chemical also has over 60% international revenues and the stock has done well.
Once again, this points out how the markets move against conventional wisdom.  In the fixed income market, the yield curve has flattened rather than the predicted steepening.  And again, the U.S. dollar has weakened instead of rallying which switched the stock market leaders.
Where can we currently look for similar predictions to be wrong?  There appears to be two industries that are widely expected to have problems.  One is retail.  Everyone (including Amazon) expects Amazon to ultimately supply all of our purchases and that there won’t be a need for anyone else.  To be sure, some retailers will continue to be challenged and some will fail.  On the other hand, many will survive and trade at very cheap valuations.
Energy is another washed out sector.  As the oil and natural gas markets seem to be well supplied, energy stocks have been laggards. The obvious problem is that the success of these businesses is largely a function of the commodity price.  However, despite the growing popularity of electric cars and more renewable supplies, global hydrocarbons demand is predicted to grow.  As with the retailing sector, there are some investment bargains in the energy stocks.
One of the biggest investment mysteries of 2017 is the markets’ disregard of the widespread social acrimony.  Typically, such chaos and strife would be reason for at least caution, if not widespread selling.  So far it has not happened.  We don’t expect the division and polarity to subside anytime soon.  This means that investors should keep watching how the markets react to new developments. If the indexes begin to lose momentum, it could be a sign that the serenity is switching to the insanity.  In the meantime, deep breaths everyone.

[i] Seinfeld, October 9, 1997
[ii] LPLresearch.com, July 25, 2017
[iii] Ibid
[iv] Ibid
Jeffrey J. Kerr, CFA

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

2017 1st qtr Kildare Asset Mgt-Kerr Financial Group client review letter

 

As I have mentioned in previous letters, prices in the capital markets are highly correlated with corporate earnings which are a function of economic strength.  And while this didn’t change in the first quarter of 2017, there was another dominating influence – politics.
We know that investors began discounting the prospects for business friendlier policies and stimulus programs the day after the election.    Naturally, this continued into and after the inauguration as excitement and optimism climbed higher.  The expectations of reduced regulations, tax reform, and infrastructure spending powered stock prices and interest rates higher.
The stock market edged higher at the beginning of January and churned sideways until the inauguration.  After the ceremony, the rally resumed and there was a steady climb throughout February.  There was another surge higher to new record levels after President Trump’s State of the Union speech at the beginning March.  In the final month of the quarter, stocks encountered a little turbulence after the failed attempt to repeal and replace the Affordable Care Act.  However, stocks rallied into the end of
the month but remained below the records reached in early March.
Here are the returns for the major averages for 2017’s first quarter.
                                                                                         2017 Q1
Dow Jones Industrial Average                                        +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.

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  Q1                                                                                                          +3.03%

Similar to markets having an oversized impact from politics, your account was influenced by one position – Fortress Investment Group.  Fortress (symbol = FIG) is an investment management company that operate hedge funds, private equity funds, and credit funds.  They manage over $70 billion of assets which makes them one of the largest publicly traded companies in this sector.
Fortress charges a fee for managing investments for their clients.  In addition, they can earn incentives and bonuses if performance reaches certain thresholds.  Their clients include institutions such as pension funds, endowments, and foundations, as well as high net worth individuals.  FIG’s largest expense is compensation and benefits for their staff which includes executives, portfolio managers, analysts and traders.
I was first attracted to Fortress Investment Group because I believed it was an undervalued security that offered an attractive yield.  The company has a very strong balance sheet as well as a history of consistent profitability.  It has underappreciated assets and I thought that there was a
good chance that the business would continue to grow.
Concerning the dividend, the amount the company has paid varies based on its net income.  Fortress often set a stable dividend payment for the year based on its projections and then paid a special dividend after they determined their actual results.  The ‘normalized’ yield was approximately 6% with the ‘special’ dividend usually adding another 5% – 9%.
While this sounds like it was an easy and straightforward investment idea, there many legitimate reasons that Fortress was priced so cheaply.  First, FIG is a limited partnership.  Financial reporting for partnerships is different and, as a consequence, the analysis has some added steps as compared to the analysis of corporations.  For example, in addition to net income, investors should consider such calculations as distributable earnings and net economic income.  These metrics can be different from net earnings and may present a much different picture than typical analysis.  These analytical complications can dampen investor interest.
Secondly, the alternative asset management industry (hedge fund, private equity, etc.) has been under intense pressure from clients.  The appeal of these investment managers is the potential to outperform the benchmark averages while controlling risk.  However, during the past several years, most hedge funds have underperformed the stock market averages and clients have become frustrated.  Many have asked for their capital back including the high profiled decision by the California Public Employees Retirement System (CalPERS) to withdraw all money from hedge funds.  As a result of this and similar institutional decisions, many hedge funds have closed.
Lastly, hedge funds and private equity funds are facing a potentially massive shift in the form of tax reform.  As a limited partnership structure, these organizations enjoy some tax advantages.  Specifically, some of the income from incentives and bonuses, which can be very material, are not taxable or, at worst, tax deferred.  There have been efforts during the past several years to change the tax code and eliminate this benefit.  So far, it remains in place.  Eliminating this provision would significantly change the industry’s profitability and make these businesses less attractive.  And with tax reform again in the news, the prospect of future scrutiny is a heavy weight on publicly traded investment partnerships.
Coming into 2017, Fortress had been in a narrow trading range for an extended period.  It finally broke above the $5.50 level on high volume at the end of January.  This price action was a strongly positive sign and, as a result, I added to the position.  In the middle of February, Softbank Group offered to buy Fortress for $8.08 per share.
While there has been some minor debate whether this was the proper valuation (some have suggested that FIG is worth more than $8), the deal should close in the third quarter.  While I think Fortress’s share price would have moved higher over time, this gives us the opportunity to stay in the same church but move to a different pew.
Blackstone Group and Ares Management are two investment management companies similar to Fortress and are being added to your account.  Blackstone (symbol = BX) was a recent featured recommendation in Barron’s.  Further this has been a position in long time clients’ account since the end of the financial crisis.  BX’s dividend strategy is similar to Fortress’s as they pay a variable amount based on the quarterly bottom line.  Blackstone’s current yield is 6.6% (based trailing twelve months).  While they face the same challenges listed above, they are positioned to capitalize on opportunities throughout the financial markets.
Ares (symbol = ARES) is another investment management company that has good long term potential despite the industry challenges.  They have numerous fee generating funds (a new one was added in the first quarter) as well as a pipeline of additional opportunities.  The current dividend yield is 4.75%.  I think the dividend payments have a good chance to grow over the next few years.
The capital markets had a busy first quarter.  Things such as a Federal Reserve interest rate increase and the European political campaigns were overshadowed by a new administration in Washington.  This brought both excitement and anxiety.  Some were optimistic about the change of direction while others were despondent by the disrupted status quo.
While this divide could easily grow as the year continues, the markets have digested it so far.  Of course, past reactions are not guaranteed to remain the same and the markets could change its sentiment if the craziness increases.  It promises to be an interesting year.
Regardless how events development, I will continue to look for opportunities as well as monitor current positions.  With the markets digesting the anticipated crosscurrents of 2017, there will surely be some favorable circumstances to take advantage of.  Thank you for your continued support and please call with any questions.

Jeffrey J. Kerr, CFA

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

And I could tell the wise men from the fools

June 26, 2017 – DJIA = 21,394 – S&P 500 = 2,428 – Nasdaq = 6,265
“And I could tell the wise men from the fools”[i]
Going into the Memorial Day weekend, the S&P 500 was up 7.89% YTD.  A nice 5-month stretch.  But for those keeping score at home, there’s more to this story as not all stocks deserved a long weekend.
The 5 largest stocks in the index (Apple, Facebook, Amazon, Microsoft, and Google/Alphabet) were responsible for about 40% of this number.  In other words, without these “Fab Five”, the S&P 500 would have advanced a more modest 4.6%.  As a result of their stock prices’ success, our five horsemen have grown to become 14% of the index’s value which exceeds $20 trillion.
That these are premier companies is indisputable.  That their collective financial results should drive such a disproportionate stock market gain is a bull market.  Regardless of the level of logic involved, the fact is that the FAAMG stocks are leading this bull run.  And we must remember that perception is reality in the stock market – it may not make sense but market’s price is the market’s price.  (As a point of clarification, the more commonly used stock market acronym is FANG which includes Netflix at Microsoft’s expense and the “A” accounting for both Apple and Amazon).
Stock market trends eventually end and it may be happening to this one.  On June 9th, a day like most, these investor favorites were leading the indexes to new record levels.  Then suddenly, out of nowhere, the favorites fell.  Apple, Amazon, Facebook, and Google all fell over 3% that day.  Netflix dropped 4.7% and Nvidia dove 6.5%.
The Nasdaq Composite retreated 1.8% from the previous close and 2.1% from the morning highs.  The Nasdaq 100 (the 100 largest of the Composite) fell 2.44%.  The weakness was primarily in technology as the Russell and Dow Jones Industrial Average (both less technology weighted) advanced that day while the S&P 500 was flat.
Interestingly, there was no definable event or cause for this tech wreck.  Some attributed the reason to a Goldman Sachs report that was released that morning which suggested these stocks had increased “mean-reversion risk”[ii]  In other words, these stocks had gotten extended from the rest of the markets in both performance and valuation.  In addition to this Goldman Sachs news, there were rumors that short sellers were targeting some of the names.
Despite this sell off, technology remains the best performing sector for 2017 by a wide margin.  One of the main reasons is that these companies are showing the most growth in an economy struggling to find a higher gear.  Here are the year-to-date returns for the major averages through last Friday.
                                                                                     2017 YTD
Dow Jones Industrial Average                                       +8.3%
S&P 500                                                                         +8.9%
Nasdaq Composite                                                         +16.4%
Russell 2000                                                                  +4.2%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.
It is noteworthy that many of the targets of the June 9th carnage remain below the levels from that day.  For some of these stocks it may have been an “emperor’s new clothes” moment and marked a longer-term inflection point.
Companies like Apple, Amazon and Google are transformative.  They have developed products that changed consumers lives, and as a result, have a high level of customer loyal.  However, all tech stocks are not equal especially when it comes to valuation.
For example, Apple trades at a price-to-earnings ratio of 16.8 and 11.4 times its enterprise value-to-EBITDA.  (The enterprise value to EBITDA ratio compares the value of the company’s stock and net debt to cash flows from operations).  Both numbers are reasonable for a premier organization like Apple.
Google and Microsoft trade at slightly higher valuations.  Google’s P/E is 31 and its EV-EBITDA is 18.  Mr. Softy’s P/E is 22 while its EV-EBITDA is 14.
Turning to the other high-profile market leaders, Amazon’s valuation is rich.  It trades 183 times trailing twelve months earnings and 36 times EV-EBITDA.  In addition to this nosebleed price, the retailing powerhouse is getting into the grocery business by buying Whole Foods.  While grocery industry has a notorious reputation as being a miserable business, Jeff Bezos has proved many doubters wrong as he changed the retail industry.  Maybe he can do it again in this low-margin, cut throat business.  It will be interesting to see what happens.
Netflix’s credit rating is junk (single B) and its stock carries a 197 P/E and a EV-EBITDA multiple of 12.  Apparently, Mr. Market is willing to overlook such details as long as they keep growing revenues at 30% per year and the stock price keeps moving up.
The June 9th reversal in the stock market’s technology leaders should be noted.  It might be nothing more than another dip that gets bought with no lasting impact.  Or it could be an important declaration that these stocks are overpriced and a correction is needed.  Just as it took a child to pronounce the obvious in “The Emperor’s New Clothes”, the Goldman Sachs observation might embolden the bears – what few that are left.
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
130 Riverside Drive
Binghamton, NY 13905
[i] The Emperor’s New Clothes, Hans Christian Andersen, 1837
[ii] Barron’s, June 10, 2017

“How Do You Measure Yourself with Other Golfers? By Height.[ii]

June 16, 2017 – DJIA = 21,080 – S&P 500 = 6,210 – Nasdaq = 5,805
“How Do You Measure Yourself with Other Golfers?     By Height.[ii]
The Federal Reserve raised interest rates on Wednesday for the third time since December.  It was widely expected as the market had placed a nearly 100% probability on the event.  However, hours before the announcement, the economy, trying to fit into the populist movement, coughed up a couple of hairballs at the feet of our bureaucratic bankers.
Specifically, the Labor Department reported that seasonally adjusted consumer prices fell a 0.1% in May.  Also, the Commerce Department reported that retail sales dropped 0.3% in May.  To be sure, these are just two data points but they are suggesting slow growth.   A softer economy, if this becomes a trend, is not what the Fed is expecting and will not mix well with rising interest rates.
In another display of irony, long-term interest rates have been declining as short-term rates have been climbing.  This has resulted in a flattening yield curve.  In fact, the spread between the yields on the 2 year and 10 year Treasury note (a commonly watched indicator) closed yesterday at 81.5 basis points. The spread between the 5 year note and 30 year bond reached 102 basis points or 1.02%.[iii]  In other words, investors are rewarded 1% for buying a bond with a 25 year longer maturity.  Ummm…. we’ll pass.
Inquiring minds want to know – what’s causing this?  Is the economy slowing and with it loan demand?  Or is this a temporary situation and a good time to sell long maturity bonds before interest rates move higher?

Some interesting data related to this debate is that the St. Louis Federal Reserve released business loan numbers recently.  Commercial and industrial loan (C&I) growth has been stagnate over the past 7 months at just under $2.1 trillion.  As a point of reference, C&I loans grew 49% from 2012 to 2016.[iv]  A strong, expanding economy should be generating increasing loan demand.  

That it isn’t happening is something to be noted.
This, of course, places increased importance on upcoming reports such as June’s employment figures, ISM surveys, and orders for durable goods.  It promises to be a busy summer.  Wall Street didn’t need a vacation.
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
130 Riverside Drive
Binghamton, NY 13905

[i] Hedgeye.com, June 14, 2017

[ii] “Caddyshack”, 1980
[iii] Grantspub.com, Grants Almost Daily, June 15, 2017
[iv] Ibid, June 12, 2017

“I Think I Can, I Think I Can…”

Stocks reached a new 2016 high in the first half of last week at 2,120 for the S&P 500.  Traders and strategists agreed the next stop would be a short trip to 2,130 and a new record high.  This would break a 13-month drought without a fresh record close.  However, by week’s end the S&P was back below 2,100 and the optimism shifted to gloom as worries grew over U.S. interest rate increases, slowing global economic growth, and BREXIT.
The 2,100 level on the S&P 500 has been a difficult level to overcome.  This was where the markets began the year and before the nasty selloff that marked January and February.  After equities stabilized, the rally brought the S&P back to 2,100 in April from where it fell back again.  This latest assault appeared to be a ‘third time is a charm’ event as we traded 7 consecutive days above 2,100 before retreating.
Eventually the S&P as well as the Dow Jones Industrial Average will rally to make a new high.  But last week’s selloff raises the risk that we test materially lower before celebrating new all-time highs.  Market breadth deteriorated as stocks fell with Friday being especially weak.  This could be a sign of increased selling pressure before finding a bottom.
The worries mentioned above go beyond stock market turmoil.  Bond yields are the lowest in history.  Over $10 trillion of global government debt trades at a negative yield with Germany’s 10-year Bund trading just above 0% (at 0.02%).  The Swiss 10-year bond changes hands with a negative 0.5% yield and the Japanese 10-year bond is negative 0.17%.  Obviously, this would not be the case in a normally functioning economy or even the prospect of one.  The fact that more debt has recently slid into negative yield territory could also be a result of a declining confidence in policy makers and their various forms of quantitative easing.
While negative yields are a head scratcher, there are some bond market sectors that are performing well.   High yield bonds are those with credit rating of BB and lower (BBB and above are considered investment grade).  They normally are issued by medium and smaller companies and usually offer a higher interest rate to compensate for the higher risk of repayment.
High yield bonds, after being hit hard in 2015, have rebounded in 2016.  The declining price of crude oil and natural gas was a big component in last year’s selling.  Many energy producers used bonds to finance operations and investors sold that debt as commodity prices plunged.  Indeed, some in the energy area have filed bankruptcy in 2016.  However, there are many non-energy issues that got thrown out with the bath water and presented a good opportunity.
The high yield market bottomed in December.  Clearly, this area has been helped by crude oil’s rebound as $50 per barrel gives the producer more bottom line than a $30 price.  But, also sentiment got too pessimistic as there were predictions of widespread financial calamity in energy.
Looking at the two high yield bond ETF’s, HYG and JNK, they have performed well during 2016 and especially strong since the February market lows.  HYG is up 3.4% year-to-date and 8.8% since bottoming in February.  These returns are competitive with the stock market but exceed equities when the almost 6% dividend is included.  The JNK has similar YTD returns – 4% YTD and 12% since February.  JNK trades with a dividend of 6.3%.
As a comparison, here are the major averages for 2016.
2016 YTD                            
Dow Jones Industrial Average   +2.5%
S&P 500                                   +2.6%
Nasdaq Composite                    -2.3%
Russell 2000                             +2.5%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
The stock market often rallies when the headlines are bleak – climbing a wall of worry.  And while it can always get worse, it is hard to imagine anything exceeding the current news flow.  We have slowing economic growth combined with many levels of global uncertainty on top of ongoing terrorist attacks wrapped in a presidential campaign with two polarizing candidates.  That’s a pretty steep wall of worry.  Perhaps this is why some high profile investors (Stanley Druckenmiller, Carl Icahn, George Soros) are recommending getting out or shorting the stock market.
Nevertheless, we’ve been dealing with these obstacles for a while and it could be argued that they are priced in.  As mentioned in the last newsletter, investor sentiment has been pretty negative for some time.  In the short term, it would be constructive for the U.S. markets to hold their 50-day moving averages and the May lows.  That could recharge the stock market for yet another run at the record levels.  If that fails to happen, it might be a tough summer.
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

Too Much of Everything is Just Enough

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