Balancing risk and reward Looking for yield without too much risk

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

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

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”

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?

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

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

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

“The First Thing we do, Let’s Kill All the Stockbrokers”[i]

January’s employment report estimated that 227,000 new jobs were added to the economy during the month.  This was the largest monthly gain since September.  Despite this good news, however, the unemployment rate ticked up to 4.8% from 4.7%.  This was the result of more Americans, who previously were not looking for work, joining the workforce.  The labor force participation rate moved up to 62.9% which was an improvement from recent readings but remains well below the mid-to-upper 60% readings from before the financial crisis.
Of course, some jobs are more desirable than others.  Likewise, some jobs are more respected than others.  As evidenced by the fact that every politician (on both sides) campaigned strongly against it, Wall Street, for many, is near the bottom of the respect scale.  Not that politicians are widely adored, but for now they have someone other than lawyers below them.
Despite its lowly status, Wall Street rescued the stock market last week.  Specifically, it was the stocks of Wall Street that saved the Dow 20,000 level. Returning to the beginning of last week, stocks opened broadly lower and the Dow dropped below 20,000.  This was the first trading day after the White House announced the immigration restrictions and there was angst over its fallout.  As the markets fell, the buzz was the this marked the end of the Trump rally.
After this selloff, the Dow and the rest of the stock market slinked sideways until Friday.  With the strong January jobs report, stocks jumped and the Dow reclaimed the 20,000 level.  The Dow was up 186 points on Friday which was the biggest one-day gain in almost two months.
Looking closer at this, four stocks accounted for 66% of the move.  American Express, Goldman Sachs, JP Morgan, and Visa were alone responsible for 124 of Friday’s spike.  Goldman alone accounted for 72 points of the move.  Thank you, Wall Street!
Here is a chart of two banking indexes since the election.  The blue line is the S&P bank ETF while the green line is the regional bank ETF.  The purple line is the S&P 500.  The banking stocks have clearly led U.S. equities since November 8th.[ii]  The ETF represented by the blue line includes the major Wall Street banks.  If this continues, investment bankers, stock brokers and hedge funds might claw their way above lawyers and politicians.
Friday’s rally helped push the major averages’ YTD performance.  The Dow and Russell had some trouble keeping positive during January.  After the push higher to start the year, prices drifted lower in the last half of the month.  The Dow, S&P 500 and Russell had a three-day losing streak going into Friday’s move.  Here are the year-to-date number for the major averages.
                                                                                              2017 YTD
Dow Jones Industrial Average                                                 +1.6%
S&P 500                                                                                   +2.6%
Nasdaq Composite                                                                   +5.3%
Russell 2000                                                                             +1.5%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.
The fixed income market was much less volatile than the equity market.  Treasury yields were a little higher week over week.  The 10-year Treasury note closed Friday at 2.496% up from 2.48% the prior week.  This yield peaked out in mid-December above 2.6% and since then it has traded in between 2.3% and 2.5%. There appears to be some sellers around the 2.3% level which pushes yields back up once it is reached.
Other fixed income chatter involved future Federal Reserve interest rates increases.  The March FOMC meeting now has a greater chance of another fed funds rate increase given January’s employment report.
Besides the jobs data, the news flow been hectic.  In addition to the fast-moving developments in Washington and President Trump’s Twitter account, year-end earnings reports were in full swing.  There have been around 1,000 companies that have released year-end and quarterly results.  65% of the reporting companies have exceeded consensus earnings estimates and 56% have beaten revenue estimates.[iii]
While analyst estimates still involve a management wink and nod, the 65% beat rate, if it finishes there, would be the highest quarterly result in many years.  The 56% revenue beat is better than recent quarters but below levels of many prior quarters.[iv]
Another important earnings season metric is management guidance for future financial performance.  There is a negative spread between companies raising guidance to those lowering expectations (more companies lowering numbers).  This is typical in recent years.[v]
Part of the reason for this is that analysts begin with optimistic annual predictions which then gets ratcheted lowered over time.  An example is the forecast for the S&P 500 annual earnings number – it starts at a high number showing strong year-over-year growth but gets lowered throughout the year ending up with a much more subdued final number.  Again, this has been a pattern for many years.  Several market skeptics have been critical of this ‘game’ but the markets have chosen to play along (so far).
U.S. stocks have traded sideways for the last few weeks.  Given the rally from election day into mid-December, this is a healthy price action.  Further, we have seen a rotation of market leadership.  Technology, which lagged in the weeks after the election, is the leader in 2017.  Also, it’s especially noteworthy that stocks have had plenty of opportunity to correct or selloff but haven’t.  With all the acrimony, protests, and general mudslinging since the inauguration, we have had plenty of reasons for investors to reduce risk.  Yet stocks remain at record levels and that is encouraging.
The economic fundamentals (strong jobs report, corporate earnings, low inflation, etc.) point to growth.  This could help support stocks and even push prices higher.  There is a lot of uncertainty and stocks valuations are not cheap.  But market tops are rarely caused solely by stock valuations.  More importantly, if the markets keep climbing, Wall Street may ascend the reputational ladder and we may stop worrying that Henry VI’s line will be changed.


Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
10 Riverside Drive
Binghamton, NY 13901

[ii] CNBC.com, February 3, 2017, Factset
[iii] The Bespoke Report, February 3, 2017
[iv] ibid
[v] ibid

“Alex, I’ll Take ‘Stock Market Trivia’ for $20,000.”

The Dow Jones Industrial Average, after many failed attempts, finally rallied above the 20,000 mark.  While it seemed like a lengthy, arduous battle, the reality is that it only took 64 days from the time that the Dow first crossed 19,000 to the time it got to 20,000.  In fact, this is the second shortest time between 1,000 point thresholds with the move from 10,000 to 11,000 taking only 35 days.
To be sure, it is easier to accomplish this with larger numbers as a 1,000 point move from 19,000 is 5.2% vs. 10% from 10,000.  This makes the move from 10,000 to 11,000, a 10% jump in 35 days, that much more impressive.  The real journey was that from 10,000 to 20,000 – it took almost 17 years as 10,000 was first hit in March 1999.
As some may recall, as the Dow got to 10,000 in 1999, the 20,000 mark was just around the corner on a trip to 36,000.  At least that’s what some popular pundits were confidently predicting.  Unfortunately, some stuff got in the way – the tech bubble, housing bubble, sub-prime crisis, great recession, etc.  It’s a reminder that some roads can unexpectedly get rough.  Before moving on, a trivia question on the Dow – prior to 20,000, what are the two 1,000 point thresholds that were only crossed once (obviously on the way up)?  The answer later.
Dow 20,000 is an exciting milestone but when do we get to 21,000.  From a momentum standpoint, stock prices have been moving from lower left to upper right since the election.  Also, the breadth of advancing issues vs. declining issues has been good which points to a broad participation.  Moreover, 67% of the S&P 500 are trading above their 50-day moving average which is a good sign.  Finally, the number of new 52-week highs vs. the number of new 52-week lows has been a support for equities.  This ratio expanded further last week as the Dow exceeded 20,000.
Valuation is another important metric.  On this front, U.S. stocks are not cheap.  The price-to-earnings ratios for the major averages are below.  The earnings component is based on as reported earnings for the trailing twelve months.[i]  The estimate is based on forecasted earnings for 2017.
                                                           Trailing                   Estimate
Dow Jones Industrial Average            21.11                       17.50
S&P 500                                              24.74                       17.52
Nasdaq Composite                              20.10                       19.15
While the numbers are not obscene, they are well above what is considered fair value which are levels in the mid-teens.  The forward-looking P/E’s are reasonable but, of course, assume a larger denominator in the form of higher earnings.    Part of that should be the result of a lower corporate tax rate and a stronger economy but neither is assured.
The P/E of the index provides an overall market valuation but breaking them down by sector gives a sense of where the opportunities and risks are.

Consumer Discretion      20.51          Consumer Staples      21.42

Energy                             139.17        Financials                  16.09
Healthcare                        19.21         Industrials                  19.48
Materials                          20.03         Technology                 22.92
Telecom                           16.13          Utilities                      17.15
These calculations are done by Bespoke Investment Group and are based on trailing twelve month earnings numbers.[i]  On their face value, energy looks extremely overpriced but we would assume that the earnings number was dramatically reduced by write offs forced by the collapse in commodity prices.  This P/E should come down in 2017 as oil prices have stabilized and the industry has cut expenses.
On the other hand, telecom and financials look undervalued.  However, telecom might be facing growth obstacles while financials are dealing with heavy regulations.  Both industry landscapes might improve under the Trump administration but the market appears to be waiting for the policy details.
Last week we got a first look at economic growth for 2016’s 4th quarter.  GDP was reported as growing at 1.9% which was below the expected 2.2%.  GDP is calculated by adding consumption, government spending, investments, and exports and then subtracting imports.  Investment was much stronger in Q4 vs. Q3 and a big component of this was in mining, shafts, and oil and gas infrastructure.
This is a little misleading as there wasn’t a lot of investment in this area as it was only slightly positive.  But this was the first quarter since Q4 of 2014 that this calculation was positive.  As the energy industry adjusted to the fall in oil and gas prices, wells were shut down and capital investments were written off.  The result was a negative number in the GDP formula from the energy industry throughout 2015 and the first 3 quarters of 2016.
Another noteworthy number from this report is that investment in industrial equipment is at an all-time high.  Businesses are investing in equipment as this amount has exceeded the level reached before the financial crisis.
Inventories grew in the 4th quarter which reverses a trend of falling inventories levels for 6 straight quarters.  Importantly there was no large drop in demand during this period of declining inventories.  In other words, companies cut back on inventories as they anticipated slowing demand that never happened.  Historically, this leads to a sharp recovery of inventories as businesses re-stock which is helpful to economic growth.
Another positive report from last week was the University of Michigan Consumer Sentiment report.  This is a monthly release and its latest reading was 98.5 which is a multi-year high.  Consumers are feeling upbeat about their situation and this should be supportive of stronger economic growth.
One conclusion in summarizing the above is that the economy is doing well but it has already been discounted in the capital markets.  This data along with such things as the job market, productivity, and the housing market suggest a pretty good economy.  Market valuations and dividend yields further suggest that stocks have already priced this in and are looking for a continuation of this growth.
Turning our focus from backward to forward, we are facing uncertainties.  The Federal Reserve will be raising interest rates in 2017 which could be a headwind.  Also, it could lead to a stronger dollar which slows exports and pressures the emerging markets.  The global financial system is very much linked together so disruptions in other markets could make their way to our shores.  This would be an unexpected problem.
As we know, there’s a new sheriff in town.  This was clearly demonstrated in President Trump’s first week in office.  One thing we can assume is that there will be some gigantic shifts that take place.  They will impact the economy and there are going to be winners and losers.
Concerning the new president, the chart below is something to keep in mind.[ii]  It shows the performance of the S&P 500 for the 60 days prior to a Republican inauguration day and the 60 days subsequent.  As you can see, stocks after President Trump’s victory have outperformed prior GOP presidents.  However, there is a clear decline in past examples and it begins around inauguration day.  2016 was a year to expect the unexpected so maybe this trend is broken with this Republican president.
Returning to the beginning of this newsletter, the answer to the question of the two Dow 1,000 point thresholds that were only crossed once are 19,000 and 5,000.  The 19,000 level could be easily crossed again as it’s only 5% away.  Obviously, a normal 10% correction puts that level in play.  Let’s hope that the 5,000 number is never in doubt.
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
168 Water Street
Binghamton, NY 13901

[i] The Wall Street Journal, January 28-29, 2017
[ii] The Bespoke Report, January 27, 2017
[iii] Topdown Charts, January 2017

Republicans and Russians and Bulls…. Oh My

Donald Trump was sworn in as the 45th President of the United States on Friday.  The inauguration was as anticipated including all of the tradition and pomp.  The oath of office, the speeches, parades, balls and celebration, all were done as expected.  Looking forward, it may be a while before we get this degree of predictability out of the Trump administration again.
Everyone knows the general direction the Trump administration wants to move.  There is risk that the implementation of this direction gets complicated.  Issues such as tax policy, cabinet appointees, trade policy, fiscal budgets, foreign relations, and regulations are things that need to be worked out and wrinkles could easily arise.
On election day, the stock market had a sudden change of heart regarding Donald Trump and has signaled its approval ever since.  There is little debate that Washington’s economic influence will shift from hindrance to supportive.  Lower corporate tax rates, reductions in business regulations, and fiscal programs and incentives will boost economic growth.
An important question centers on how much of these positives have already been discounted.  In anticipation of these tailwinds, the Trump rally has carried stocks to record highs.  As U.S. equity valuations are above the historically normal levels, this then leads to another question – are we getting a little ahead of ourselves?
If the new administration’s transition goes smoothly and its policies and programs get implemented without problems or delays, the economic impact could arrive quickly.  This would be stock market friendly for both the current levels as well as higher prices later in the year.  However, if President Trump and his team encounter problems with execution of the plans and programs, the stock market could correct.
History shows that a president’s first year in office can be tough.  Below is a graph showing the presidents that had a recession in his first year.[ii]  This might be caused by uncertainty surrounding a change of direction or battles with Congress or decision making errors. At this point, President Trump might be an exception as there no signs of a recession.  Still there are many variables that still could cause problems such as trade wars or a spike in inflation.
If the January stock market is any indication on the economy or new president, the short-term message is unclear.  After moving higher in the first week, U.S. stocks have traded sideways.  Last week the major averages closed marginally lower.  The Nasdaq, which underperformed after the election, has been the leader in 2017.
2017 YTD
Dow Jones Industrial Average                                              +0.3%
S&P 500                                                                                +1.5%
Nasdaq Composite                                                                +3.2%
Russell 2000                                                                          -0.4%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.
In fixed income, bond yields rose last week but are around the same level as they started the year.  The 10-year Treasury note closed the week at 2.466% up from 2.38% the prior week.
One of the most popular predictions for 2017 is that the U.S. dollar will rise against other currencies.  Expectations for higher interest rates together with stronger economic growth make the greenback more desirable.  Last week, however, the dollar index fell and it is down 1.47% in January.  Maybe dollar bulls have gotten tired.
Commodities are higher in 2017 as the CRB commodity index is up 0.78% for 2017.  Crude oil and natural gas are lower but precious and base metals are higher.
Although it is very early in the earnings reporting cycle, the results have not disappointed.  63% of reporting companies have exceeded EPS forecasts which is about average. The story on the revenue part of the income statement is different.  More than half of the reporting companies have missed analysts’ revenue estimates.[iii]  The amount of companies reporting will be much higher in the next few weeks and we’ll keep readers informed how the results are.
Putting everything together, we think there are a few consensus views for 2017’s capital markets.  Many strategists and managers are calling for U.S stocks to be moderately higher for the year.  It seems that the expectations are for high single digit gains for equities.  As mentioned above, conventional wisdom also looks for a rising dollar and higher interest rates.  These experts appear to not overly concerned with potential obstacles and potholes as they believe all of them are manageable.
We would like to share in this optimism but have some concerns.  First, current events rarely play out as smoothly as everyone expects.  Given the proposed and expected changes in Washington, there is a lot that could go awry.  With stocks at record levels and elevated valuations, any deviation from a smooth Trump transition that results in stronger economic growth might cause stocks to dip.  If the stock market develops some doubts over President Trump or the economy, we would expect prices to correct.  We wouldn’t expect a nasty bear market, but a correction that adjusts valuations to more normal levels.  It promises to be an interesting year and we look forward to the opportunities in front of us.
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
168 Water Street
Binghamton, NY 13901

[i]  The New Yorker, January 2017
[ii] DoubleLine Funds, January 2017
[iii] The Bespoke Report, January 20, 2017