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What, Me Worry?

Summary

Trade war is a threat, as is rising interest rates.

Conditions for a major stock market sell off do no appear to be a worry.yet.

Another leg up for US stocks is more likely than the start of a bear market.

What Me Worry?

Quarter end and Half year report June 30 2018

Year to Date Statistics (through June 30, 2018)

Morningstar U.S. Equity index + 3.08%

MSCI International Index -2.75%

Long term bonds - 4.25%

Intermediate Term bonds - 1.19%

Preferred Stock index down -1.19%

The Virtue of Worry

I try to remind myself that worry is suffering felt for an injury that has not happened. But I worry anyway. In finance, worry is a useful tool. A worry wart is well suited for the financial world-he/she is unlikely to plunge or become over confident. Planning involves worrying about what could go wrong. I think of how many lives were lost in Europe near the end of World War II because once on land, Allied forces were unable to fully exploit their momentum due to logistical problems. Many factors can cripple the forward march of an army: dwindling supplies of fuel, inability to find food, second rate technology in weaponry. During World War II, Patton’s lightening progress through Europe and toward a reeling German military late in World War II was halted largely due to supply shortages. On August 28, 1944 Patton summed it up this way: “At the present time our chief difficulty is not the Germans, but gasoline. If they would give me enough gas, I could go all the way to Berlin!”. In a similar vein, financial expansion draws its ability to move forward from multiple sources. Right now, the expansion is being fueled by a surplus of available investment cash, corporate buybacks, and consumer optimism fueled largely by the highest employment rate since the year 2000. The last time unemployment was lower was 1969!

Source: U.S. Dept Labor Statistic

Consumer optimism, and by extension investor optimism is currently strong:

Source University of Michigan

However a large contingent of business people do not like the implications of a tariff war, and this has stopped portions of the equity market in its tracks. History has shown protective tariffs lead to tit- for- tat behavior between trading partners. Even if the current administration is successful in pressuring certain countries, notably China to lower barriers to U.S. products, a sense of uncertainty may well be delaying capital expansion projects that would otherwise keep the current economic growth cycle going. How worried should investors be?

So far, the market is taking potentially disastrous news in stride. Sure, volatility is up from recent years, but really, it has only returned to “normal” levels:

Source: Federal Reserve Board of St. Louis

Year- to- date, returns for stocks are pretty much in line with long term trends, although NASDAQ index, heavy with technology companies has significantly out performed the broad averages. There are no overt signs of an impending collapse for equity or bond values, only a long list of worries…and what year has lacked worry? We get paid to worry for you, so, anticipating a normal summer swoon have shifted to the largest allocation to short term fixed income assets in ten year. But, I suspect we will be proven too cautious by year end.

Here are the the positive economic developments that have, so far overcome fear and uncertainty in the minds of investors:

The Dollar rose some 5% in the past quarter, a stunning performance. This appears to be the result of a combination of factors. First, the USA is the only major financial zone with attractive short term interest rates on liquid fixed income investments, making it a good currency in which to park cash[1]. Then there is the probable effect of repatriation. With corporate income tax rates slashed to their lowest level in modern history, companies with well-known stashes of un taxed profits held abroad are now bringing home the bacon - the Wall Street Journal estimates this at about $175BB in the first half of 2018. There is plenty more where that came from, and estimates I’ve seen are that another $200BB or so may find its way back to the US this year, which helps strengthen the dollar. A rising dollar can create a virtuous cycle where foreign investment funds favor U.S. equities because the strengthening dollar offers some cushion even if the U.S. stock market is not roaring upward.

Stock buybacks With operating profits strong and funds returning to our shores from repatriation, stock buybacks were happening at a record pace last quarter, and are expected to repeat or exceed the performance when statistics for this quarter are published. Buy backs tend to create capital gains for shareholders by reducing a company’s float of common stock. Buy back activity appears to have supported the technology sector more than old line firms, because tech firms, notably Microsoft and Apple were diverting profits to overseas subsidiaries for years. A significant amount of that money is flowing home and into share repurchases.

Four years ago, we recommended Apple as a buy. Our reasoning was that a)this “maturing” company’s sales would slow yet b)It would succumb to investor pressure to raise its dividend. In fact, Apple has raised its dividend, up 55% in the past four years. Apple reported at its May quarterly analyst conference call that it will be spending an additional $100BB buying back its stock, which is supportive of not only the share price of AAPL but of the market in general. We continue to own the stock for many clients.

U.S. Manufacturing sector is strong. The Wall Street Journal reported on July 3 that manufacturing was accelerating in the last two months of the quarter, and although this is a coincident indicator, the acceleration trend appears predictive of expanding economic activity, certainly not a slow down. It is anticipated that June Employment will increase by 175,000 jobs, a strong figure.

When will the party end? Perpetual bears have been trying to talk the market down for nearly a decade. The amount of money left on the table by people who believed their tale of woe is criminal. The aftermath of the Great Recession was an opportunity to go “all in” with stocks, but being rational and careful, we found quality corporate and municipal bonds that were being avoided by many who remained paranoid about falling back into recession. Many clients still hold issues purchased in that period, with nominal yields that exceed anything available from more recent issues[2]. Sure, I was nervous too, but a value investing approach suggested that besides bonds, nibbling on some tasty stock opportunities were a worthwhile risk. We’ve booked profits on many of these holdings in the past decade. Some, like Enterprise Product Partners (NYSE:EPD) we continue to hold collecting an outsized quarterly cash flow along the way. Still, the forces that will likely slow the party are already in place: rising short term interest rates, labor shortages, rising volumes of risky debt and trade spats. An imbalance in supply vs demand is pushing up home prices in some of the same markets that collapsed ten years ago: Miami, Phoenix, Las Vegas. But I believe that before the next recession, the odds are we will have another leg up for stocks, especially if the current trade disputes are resolved (and they may well be resolved, despite current posturing by the parties). Why? The financial sector is poised to a run. Banks are being given freer rein to make loans, pay higher dividends and buy back stock. The financial sector is a major portion of stock indexes, about 15% or nearly $8 TT (source: www.thebalance.com). Technology, now representing 25% of the broader index, does not appear to be endangered. Although tech is not cheap, it is no where as over valued as in the lead up to the Tech Wreck, and as mentioned earlier, this sector is still being helped by share buybacks. Between them, these two promising sectors represent 40% of the capitalization of the Standard & Poor’s 500. Importantly, investors are not yet over- confident nor are they ebullient. Note that investor sentiment lies about in the middle of the range of bullishness of the past five years:

Source: Y Charts

My anecdotal conversations suggest that the pain of the past recession remains pretty fresh in the memory of investors, especially the powerful Baby Boom generation. Demographics are important. Boomers control most of the wealth in this country, they are retiring at the rate of 10,000 a day….and they do not want to risk much of their retirement savings. It will be for the next generation to make the big investing mistakes. They are not yet wealthy enough , in my opinion to ignite a “melt up” for stocks. Perhaps in five more years, but not just yet.

Three sectors did not do well in the second quarter: banking, healthcare and utilities. The utility and banking weakness is likely tied to rising interest rates. With short term rates at the highest level in nearly a decade, long term interest rates rose above 3.00% and appeared likely to stay there. This worried the utilities sector as utilitiy stock ownership tends to be concentrated among income investors. They are prone to bolt when bond yields begin competing. How much worse will it get for utilities? The worst may be over, for a while. Because of investor worries and a flow of foreign money into the strengthenind dollar, demand for safer assests like treasury bonds, has, at least for a while stopped the rise of longer term interest rates. As the quarter ended utilities appeared to be rebounding.

http://www.stockcharts.com/c-sc/sc?s=%24UTIL&p=D&yr=1&mn=0&dy=0&i=t25539131425&r=1530668906670

Source: Stockcharts.com

Although banks and other financials underperformed in the past quarter, because their net interest margins are threatened by rising short term interest rates and competition from non-bank lenders,loan demand appears strong, and a considerably friendlier set of regulatory decisions, allowing smaller banks to escape stress tests for example, holds the promise of improved profit reporting ahead.[3]

Healthcare investors are holding their breath to see what if anything the Trump administration will do to control the soaring price of prescription pharmaceuticals. The president has rattled his sword and with elections coming in five months, some sort of gesture may be forthcoming, but most Americans understand that big drug companies own Congress and pay the bills for TV stations through their extensive advertising, thereby reducing criticism in the media. My guess is healthcare stocks will return to a bull trend before year end, further supporting the general market.[4]

Looking Ahead

The S&P 500 has closed at its calendar year high in the second half of the year (i.e., during the 6 months of July-December) 74% of the time since 1950. In 15 of the last 25 years, the index’s calendar year high has occurred during the month of December. The S&P 500 is up +4.0% YTD (total return) through Friday 6/22/18. Over the last 25 years (i.e., 1993- 2017), the S&P 500 has produced an average gain of +9.7% per year. The first 6 months of the year (i.e., January-June) have gained an average of +4.5% over the last 25 years, so despite the broad index underperforming year to date, this appears to be a normal year in terms of equity index performance. (Source: BTN Research, a service of MFS funds group).

Rising Interest Rates- the Death Knell for a Bull Market?

It’s pretty well established that valuation of equities is, in part a function of the cost of money. When competing instruments, primarily bonds are offering attractive yields as compared to stock, money tends to get squirreled away in fixed income instruments, sapping fuel from the stock market. Perhaps it is surprising, therefore that despite a significant rising in the yield for ten year Treasury bonds, the market has been generally strong since late 2016 (in the graph below, T-Bonds are the black line while stocks, as represented by the S&P 500 index are represented as the red- and- black weekly range.) Until stock market yields are swamped by T-bond yields perhaps when the rise toward 4%, interest rates are unlikely to be a threat.

http://www.stockcharts.com/c-sc/sc?s=%24TNX&p=D&yr=2&mn=0&dy=0&i=t54060778298&a=481853100&r=1530548147402

Source: Stockcharts.com

So in a quarter that has seen the eruption of a Trump induced trade war and rising interest rates, a market that faces the uncertainties of an election later this year, the fact that markets have corrected little seems to me to be evidence of an underlying strength the bodes well for longer term thinking investors. Recall a chart I’ve shared many times before, the “real” value of a broad index of common stocks. Below is the S&P 500 adjusted for the distortions of inflation. When it rose to a historic high near the end of 2014, I became more convinced that we are in the throes of a “secular” period of rising equity values. Subsequent market behavior appears to confirm that the new high reached in 2014, after a 16 year period of price consolidation and, of course, the worst correction in two generations, is a sustainable trend.

http://www.stockcharts.com/c-sc/sc?s=%24INDU%3A%24%24CPI&p=M&st=12/31/1975&en=(today)&i=p97763662486&a=382999977&r=1530495570141

Source: Stockcharts.com

While the foundation stones of the next recession, likely to be preceded by a bear stock market, are being laid, I believe we have another two years before a leveling of US economic growth and fears of a new, less business friendly Congress begin to drag the stock indices lower. There appears to be more upside to come, but plenty of worries along the way.

Gary E Miller, CFP®


[1] We have recommended moving a significant portion of client cash into over night traded short term money funds whose yield is now above 1.7%

[2] Some of these holdings, as they near maturity are candidates for sale, as “yield to maturity” may no longer be attractive

[3] The Wall Street Journal reported on July 3, 2018 that two prominent money center banks received special treatment in the latest round of stress tests: Morgan Stanley, Goldman Got Help From Fed on Stress Tests

[4] The Wall Street Journal reported on July 2 the giant Pfizer is raising prices on its most successful drugs, including Viagra, for the second time in 2018: Pfizer hikes prices on dozens of drugs for second time this year

Disclosure: I am/we are long aapl.