Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

 

 

 

 

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

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

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

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

 

 

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

 

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

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

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

 

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

[i] Doubleline Funds, December 11, 2018

[ii] Ibid

[iii] The Financial Times, December 16, 2018

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

 

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

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

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

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

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

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

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

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

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

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

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

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

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

2nd Qtr               2018

Kerr Financial Group – Kildare Asset Management

+2.38%

+6.28

 

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Jeffrey J. Kerr, CFA

Kerr Financial Group

Kildare Asset Mgt.

45 Lewis Street – Lackawanna RR Station

Binghamton, NY 13901

[i] www.tpwim.com, June 27, 2018

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

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

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

 

“Life is a clue in a crossword”[i]

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

2018

Dow Jones Industrial Average                                                                           +2.4%

S&P 500                                                                                                                 +6.0%

Nasdaq Composite                                                                                               +13.6%

Russell 2000                                                                                                         +9.9%

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

 

[i] Ian Anderson, 1979

[ii] The Bespoke Report, August 3, 2018

[iii] www.theice.com