Stocks Turn Bearish

The investment environment continues to deteriorate despite the pickup in economic activity in the U.S. the last couple of years.  As the Big Four Indicators I highlighted recently show, the U.S. economy continues to move in the right direction.

Despite the U.S. economy doing well, international economies are performing poorly with few catalysts outside of fiscal or monetary policy to drive them higher.    Europe is in disarray and in a speech yesterday, China’s Premier Xi, signaled little trade flexibility.

In terms of Monetary Policy (central banks), we are in uncharted territory.  On the one hand, market intervention potentially provides a mechanism to avoid financial contagion.  On the other hand, it has added a lot of debt to the global economy and relies on globalization to keep the party going.  The US and Europe are looking to reduce their exposure to globalization trends.

In terms of Fiscal Policy (government revenue/spending), deficit spending is projected for many years which is a concern after a 9-year economic recovery.

Constant increases in government debt, whether through monetary or fiscal policy, are likely to be a fixture of the 21st century economy.  Investors should expect more market intervention going forward.  My job is to manage the effects it has on investments and purchasing power.  Right now, it is looking like global markets are bracing for another round of asset deflation.

The biggest telltale sign of concern about the potential for further asset deflation is not coming from stocks, it is coming from bonds.  With the Fed now selling $50 billion dollars’ worth of bonds every month through Quantitative Tightening (the opposite of QE), analysts expected yields to go up and bond prices to fall.  That is not happening.  Money is moving to the safety of the 10-year Treasury bond.  Money flows to 10-year Treasuries when it is concerned about asset deflation.  10-year Treasury bonds are again yielding less than 3%!  Yields on the 10-year would be moving higher, and prices lower, if the bond market was expecting economic growth to continue.

Markets are signaling a high likelihood of ongoing asset price weakness. With each passing day more assets are breaking-down through price support levels.   It is entirely possible all of 2017 gains will eventually be erased although stocks still hold on to most of them at this point.

For this reason, I believe it is a good time to be a bit more defensive and raise cash levels.  Once the market settles down, available cash provides the ability to purchase growth investments at potentially lower prices.  Even if you end up reinvesting at higher levels, that is a price worth paying if it provides peace of mind during a turbulent period in the global economy.

The Big Four Indicators (12/7/18)

The Dshort website (part of Advisor Perspectives) hosts an incredible about of economic and market data.  Periodically I feature some of their work, specifically The Big Four Indicators update.  Taken together, these four indicators covering income, employment, retail sales and industrial production are thought to be an excellent monitor of the overall health and direction of the U.S. economy.

Advisor Perspectives, Jill Mislinski, December 7, 2018

The recovery from the Great Recession has been slow but positive.  The most encouraging development recently has been the strength coming from industrial production (purple line).

Will Higher Interest Rates Derail Stocks?

Continued economic growth has led the Federal Reserve to raise the Fed Funds rate to 2.25%.  This is the biggest issue facing asset markets right now even though the rate remains well below levels that led to recessions twice during the last 18 years.  For that reason, I believe the Fed is going to be cautious with moves above 3%.  Remember, one of their stated goals initially was to be able to “normalize” short-term rates.  I believe they will have accomplished that goal when they reach 3%.

Stockcharts.com, Dightman Capital

The 30-Year Treasury bond broke price support with the latest Fed announcement which pushed up interest rates at the long end of the curve.  The silver lining for the current rate environment is a steepening yield curve.  The interest rate spread (the difference between short-term and long-term rates) makes it possible for banks to borrow at low rates and lend at a higher rate.  A strengthening banking sector should benefit the broader economy.

Here is a look at the Treasury market yield curve and 30-Year Treasury Bond price chart.

Stockcharts.com

Real estate price appreciation should also slow as financing costs rise.  There is some evidence in certain markets that price increases have slowed or stalled.  Stocks too, will compete with higher bond yields as rates move higher (more on this below).

In terms of Inflation, globalization has kept most inflation measurements in check (aside from asset prices like real estate and stocks).  Low inflation should provide the cover the Fed needs to slow rate hikes in 2019-20.  On the operational side, companies do benefit from low and stable input costs, which helps drive earnings growth.  An increase in input costs could result in higher prices.

Trade disputes may influence inflation but it could be temporary in many cases.   There remains a lot of capacity in the world so moving production, for example, out of a country is an option for some.  Other products might require special machinery or expertise and those product markets might see higher prices, potentially much higher.  Those individuals in the market for new electronics might want to make a purchase now if higher prices is a concern.  It is possible we could see higher prices in a wide mix of products from trade negotiations; so far the effects have been negligible.  Early 2019 is when we might start to feel the pricing pressure from ongoing trade disputes.

The U.S. Economy remains healthy; October started with a trio of good news.

  • The ADP payrolls report hit 230,000 in September, beating estimates
  • The Purchasing Managers Index for Services in September came in at 53.5, above the 52.9 consensus
  • September’s Institute for Supply Management hit 61.6 for the service sector, ahead of the view at 58

The U.S. Stock Market continues to like the economic environment.  Three months remain in 2018 and if stocks can hold on to the gains they have generated, it will be a decent year.

It is important to remember a diversified portfolio will have a mix of investment returns.  While certain parts of the stock market are delivering nice returns, some categories are under performing.  Many dividend stocks have not had a particularly strong year.  Bond yields are part of the reason.  The relative safety of bonds, combined with their now higher yields, compete with stock dividend yields.  Also, value stocks are not favored in the current environment; both of those factors should eventually become attractive as market character shifts.

Earnings-Growth Expectations for Q3 remain strong.  The view from FactSet  suggest earnings growth between 20-25% for the period.

So no, I don’t believe stocks are going to be derailed by higher interest rates in 2018.  We remain in a very constructive economic environment despite ongoing trade negotiations.  As we start Q4 stocks have pulled back; expect more selling in the days and weeks ahead.  This is a normal and healthy process which should eventually allow stocks to rally as 2018 comes to a close.  Don’t be surprised if this pullback ends up being 5-10% deep.  Primarily due to interest rates and trade talks.  As of the close on October 8th, the S&P 500 was down less than 2%.

Trade Negotiations & LIBOR Spike

Another round of volatility hit stocks this week, but current support levels remain, and volume has been tamer. The Nasdaq 100’s outperformance YTD remains intact suggesting tech investors are still committed to the sector.

It’s one thing to see stocks under pressure but the recent spike in LIBOR (the rate banks lend to each other overnight) was my focus this week. Fortunately, the banking system remains stable and the rise in LIBOR appears to be the result of an increase in demand from short-term U.S. government funding needs for deficit spending and U.S. corporations pulling offshore money from corporate bonds and putting it into cash for spending. While the spike in LIBOR signals caution, banks impacted by the higher rate are not flashing other warning signs.

For those familiar with the TED Spread, the difference between interest rates on Eurodollar Contracts and T-bills, we are still well below levels that signaled problems in the banking sector back in 2008.

On balance the market is evaluating several concurrent events; higher interest rates, chronic deficit spending and trade policy adjustments are center stage. The economy and corporate sales/earnings are in good shape, so the bias remains to the upside. If a nasty trade war does break out, then we could see more downside pressure on stocks and the economy; we are a long way from that environment and it will be interesting to see how far President Trump will push the Chinese. They have far more to lose then we do in a trade war, but I don’t think the president wants to derail the overall growth environment in the U.S.

There is no such thing as “free trade”. What President Trump is trying to do with trade overall is reduce the concessions we provide our global partners (and reduce outright theft). The goal of spreading wealth via trade rules is a noble one, but the principles that make our country the success it is are free for the adopting too.

You may have heard, today the Dropbox IPO started trading and delivered a gained of 35%. An active IPO market is a sign this market may have more upside. Leading stocks are also holding up well, which is promising.

So far markets are correcting for trade uncertainties following interest rate concerns earlier this year. As uncomfortable as it can be, it’s a healthy process and should allow stocks to resume their uptrend once trade matters are resolved.

Stock Market Anxious & Vulnerable

This was one of the most fascinating weeks in my career as a portfolio manager. Stocks were under aggressive selling pressure most of the week but ended the session on Friday recovering most of the days’ declines. Especially encouraging was the impressive advance Friday from the tech sector and small caps. Overall trading on Friday was supportive but action for the week is another reminder to investors, we have entered a new phase of increased market volatility.

Here is how the S&P 500 traded on Thursday and Friday.

The biggest issue at hand is not President Trump’s steel and aluminum tariff announcement. Time will tell how the policy unfolds. The biggest challenge has more do to with the new Fed Chair, Jerome Powell, providing both houses of congress his first testimony. Unlike prior Fed chairs, Chair Powell appears less concerned about what Wall Street thinks and more focused on executing his monetary policy. Here is what one of my Wall Street trading contacts had to say about the Donny & Jay Team…

“If you think Donny is going to pull back on this major announcement just because the mkt sells off a bit – think again……Like Jay Powell – Donny will not be led around by the nose when traders on Wall St. throw a hissy fit.” Kenny Polcari, Oneil Securities

The market was already anxious and vulnerable so testimony from Chairman Powell on interest rates, which are headed higher, and import tariff policy by President Trump, is bound to rattle markets. From elevated levels in a prolonged bull market, stocks are vulnerable to steep corrections.

I would suggest the interest rate and inflation dynamic is what is driving markets today. My ongoing research has caused me to change my view of whether an increase in rates from current levels can negatively impact the economy and stock market. I have suggested that interest rates rising from such low levels are not likely to have a negative impact our economy or the stock market until they move past normal levels. Most rate hikes in the past that have slowed the economy have occurred at much higher levels. However, a closer look at three different factors facing most central banks in the world has changed my thinking.

Those factors are:

1- Refinancing costs by treasuries (issuing new debt to retire maturing debt)
2- Treasuries issuing new debt to fund budget deficits
3- Central banks selling bonds from their balance sheets

Collectively these three factors represent a massive impact on the bond market. Central bankers and treasury officials do have options for managing these challenges. The Fed will increase their available tools after a few more hikes in the Fed Funds Rate. The playbook seems pretty clear for 2018, the Fed lifts the Fed Fund Rate to around 2% while the economy strengthens on Trump’s economic policies. 2019 is where it will get interesting and the stock and bond markets are already anticipating the environment 6-9 months in the future.

For reference, here is a quick look at the Prime Lending Rate, Consumer Price Index and the S&P 500 over the last 20 years.

Much of the recovery from 2008 involved bond buying by central banks: Bank of Japan, European Central Bank and the Federal Reserve. The Federal Reserve was the first to start selling bonds from their balance sheet last fall. Keep in mind, the bonds on a central bank balance sheet are in addition to bonds a treasury department may issue to fund government operations. Central bank balance sheet bonds are already issued bonds, treasury bonds are newly issued bonds. As I have communicated many times, the world is swimming in debt from decisions made during the last financial crisis and a consumption driven economy.

Japan has even hinted they may stop purchasing government bonds soon. Once a central banks shift to selling bonds from their balance sheets, while government treasuries continue to issue new bonds to fund operations, the supply of bonds very well may push prices down further and interest rates higher. Some traders are expecting the U.S. Treasury to issue substantially more 30-year bonds around this time next year. Combined with ongoing sales from The Fed (which holds several trillion dollars’ worth), some traders believe bond prices will have to be much lower to get new bonds sold, driving interest rates higher. Higher interest rates mean government debt servicing costs are going to rise which will increase the deficit (which shows no end in sight). As I have said before, I would not be surprised if the next crisis comes once again from the bond market. What policy makers are dealing with now is the other side of Quantitative Easing, the strategy used to address the last financial crisis.

The White House is hoping economic growth accelerates and tax revenues increase to cover costs and reduce the deficit. If the economy grows too fast The Fed will be under pressure to raise short-term interest rates, where most of government debt is financed. This will cause debt servicing costs to shoot up. This is another concern I have mentioned in prior commentary. Debt servicing costs as a percent of the Federal Government expenditures is a risk to the economy. Unfortunately there are not many good options for policy makers.

Markets have pretty much priced in 3-4 increases in the Fed Funds rate for 2018. Now the attention is focused on 2019. It should be clear President Trump and Fed Chair Powell have a very delicate balance to maintain but their style of communicating their policy is decidedly different than previous administrations. They can’t really afford to let markets dictate their moves (many analysis and commentators believe The Fed waited to long to raise rates). They have to take actions based on what they believe will be the best path for navigating the U.S. economy through the current challenges.

The key appears to be maintaining a steadily improving economy of moderate GDP growth around 3%. Here is where Economic Cheerleader Trump may run into problems. The harder he pushes for 4% growth the more trouble he may create in debt markets. The good news here is innovation is alive and well at a time where money is plentiful, financing relatively cheap and government policy is generally favorable.

From a portfolio management perspective, there are clearly better areas of the stock market to be invested in right now and even some undervalued assets to consider bringing into portfolios to reduce risk levels. 2018 appears to be delivering a market where investors may be rewarded for making the right changes to their portfolio. Let me know if you are interested in discussing how I handled the 2008 bear market and how I am addressing the current set of challenges and opportunities.

Stocks Finally Correct, What’s Next?

After an outstanding 15-month stock market advance, last week stocks experienced a significant pullback.  The S&P 500 declined 3.9% but all three major U.S. stock indexes remain in positive territory so far in 2018.  After outstanding performance in 2017, U.S. stocks started 2018 on an even more accelerated run with the Dow Jones Industrial Average gaining 7.6% during January, before last week’s pullback.  The stock market rally needed to slow down.

In terms of earnings, Factset reports as of February 2nd approximately 50% of the companies in the S&P 500 have reported actual results for Q4-2017.  Of those, 75% are reporting actual earnings-per-share above estimates compared to the five-year average.  In terms of sales, 80% are reporting actual sales above estimates; the sales and earnings health of U.S. publicly traded companies appears to be good.

The likelihood of additional interest rate hikes in 2018 may have been the trigger for last week’s stock market correction.  Jerome Powell is the new Fed Chair and futures markets are expecting another 75-basis point increase in Fed Funds in 2018, which would bring the rate to around 2%, still below the historical average.  Investors also saw declines in bond prices last week as the 10-year Treasury yield shot up to 2.92%.

The continued improvement in economic numbers along with the overall optimism and rapid pace of innovation currently underway could suggest we are a long way from interest rates causing a sustained decline in the stock market.

Don’t be surprised if stocks are up big on Monday.  We could see more selling but a lot of cash remains on the sidelines and some investors have been looking for an opportunity to enter this market; one of the reasons stocks have not given much ground since President Trump ushered in a new set of economic policies aimed at broad sustained economic growth.

I have said this before and I will repeat it here.  We could very well see the the Dow at 30,000, the Nasdaq at 10,000 and the S&P 500 at 5,000 before we see the next bear market.  For those that do not understand how this could be, let me remind you; stocks went nowhere for 14 years from 2000 – 2013.  In the four or so years since the S&P finally regained a new all-time high in 2013, the stock market spent 18 months in a trading range between 2015-16, as the U.S. teetered on the verge of falling into a recession.

We have a combination of conditions that are conducive to a continued market rally:

  • Low Interest Rates
  • Positive Economic Policy
  • An Innovation Renaissance

Unlike prior market cycles, this one may not last as long as those previously for a couple reasons.  First, this expansion comes on the heels of a recovery that started 8 years earlier.  Second, a tremendous amount of debt was created in the U.S. and globally as the primary policy for recovering from a debt crisis.  If you are shaking your head, you should be.  Eventually we will pay a price for policy mistakes used to address the 2008 financial crisis.  Until then it is a race between economic growth and debt growth.  The next crisis could very well come from a country needing to restructure their debt.

In terms of interest rates, it appears we have some breathing room.  The 10-year Treasury yield remains well below levels of the last 20+ years.

In terms of short-term rates, if the Fed Funds rate were to rise above 3% the economy should be doing exceedingly well.  However, government debt funding is more sensitive to short-term rates, so policy makers are likely to take funding costs into consideration as they move rates higher.  Fortunately, other broad economic factors appear to be holding inflation in check which should allow The Fed to keep short-term funding rates at or below normal levels.

Until The Fed has turn up interest rates to a point of slowing the economy, the stock market is likely to continue rallying…there are amazing investment opportunities in the next generation of biotechnology, materials, software, and much, much more.  It is truly an exciting time to be an investor which is another reason I believe more money will find its way into the stock market over the coming years.

Please let me know if you are interested in learning more about investment opportunities from innovations in finance, travel, technology and more in a risk-managed, proactive approach.

Stock Index Performance Calculations, Stockcharts.com

Yield data from Stockcharts.com, Investors Business Daily.

Tax Cuts and Jobs Act Overview

There are many changes to our current tax system with the recently signed, Tax Cuts and Jobs Act.  It is going to take more time for tax advisers to fully comprehend how the new act applies to individual situations.  In the meantime, the following Tax Cuts and Jobs Act Alert does a nice job of summarizing parts of the old and new law, as well as highlighting other changes.

 

 

Cryptocurrency Resources & Tools

I have received a lot of inquiries about Bitcoin and other “cryptocurrencies” recently.  As a finance related subject, I believe it is important to help individuals educate themselves so I offer the following learning resources.

I am not acting as an investment adviser in ANY capacity regarding information in this communication about  cryptocurrencies (CC).  As a finance topic, I am willing to pass along information to help people educate themselves further.  The information contained herein and referenced externally is not enough information for anyone  to enter the market for cryptocurrencies.  Anyone that does their own research and gets involved with CC will need to stay engaged in the subject as future developments may require their attention.  I am not offering any ongoing assistance in this area at this time.

THE FOLLOWING INFORMATION IS FOR EDUCATIONAL PURPOSES ONLY.

 

Warning, the cryptocurrency market is ripe for scams and there are likely many underway as I type these words.  Proceed with caution and consider working with friends, family members, colleagues, etc. to explore this area together.

Individuals interested in understanding Bitcoin and related CC might want to begin by watching the movie, Banking on Bitcoin.  It it also available on some on-demand networks.  The documentary may help an individual determine their interest level in this subject.  Another important video for understanding the ebbs and flows of the U.S. credit based economy can be found on YouTube, How The Economy Works, by Ray Dalio.

Phone App/Information Sources

A phone app, like HODL, can also be a great resource  where fundamentals, news, charts and posts for different CC can be reviewed.  A good app on your phone that tracks cryptocurrencies is a critical tool and next step for anyone interested in this market but you have to be careful, not all information is the same.  Here are the names of a few respected thought leaders on the subject of CC.

  • Andreas Antonopoulos (Mastering Bitcoin book)
  • Trace Mayer (Bitcoin knowledge podcast)
  • Jimmy Song (Twitter)

Read posts on Reddit/Medium for information and support on many CC subjects ( currencies, exchanges, and wallets).  There are also support forums for technical issues.  There have been many different types of technical issues in the past and they should be expected in the future.

There are also blogs and newsletters dedicated to this topic, some better than others; you should be able to find several dedicated information sources on CC to explore and compare.

Also, when comparing the different CC, you are well served to dig into detail around factors that may have a big impact on the future of a CC.  Here are a few additional topics to become familiar with overtime.

  • Governance – How are decisions made about the future of the CC?
  • Programmability – How easy it is to add features to the blockchain of the CC?
  • Development Funding – How is the CC funding future development, upgrades, marketing, research, etc?
  • Merchant/Payment Tools – How robust are their services and tools for merchants/ecommerce developers?

There are many other subjects to consider (Encryption Type, Hashing Power, Mining Reward, Transaction Validation, etc.) with cryptocurrency and the underlying blockchain supporting it.  This is a very fragmented and rapidly developing technology; the list of subjects above is incomplete but will help you dig into details you will want to understand if you are serious about CC.

Exchanges

A U.S. based exchange is most likely the best choice for U.S. residents although there appear to be some good exchanges in foreign countries.  Exchanges connect with a bank account or credit card and provide the ability to make a CC purchase.  Exchanges offer other features as well, like conversion to other CC.   Beware, transaction fees, trading costs and wide-price spreads can be costly.  Also, exchanges are not connected so the price listed at one exchange can vary dramatically from the price at another exchange, especially during periods of high volatility which have occurred frequently.

Reporting transactions is an important element of the CC market.  The Internal Revenue Service has already come out with notices on the subject referred to as “virtual currency”.  Participants in this market will want to keep good records and work with service providers that include accurate record keeping.

A quick internet search on U.S. cryptocurrency exchanges will provide more resources.  Some exchanges are more sophisticated than others.  One exchange that may be a good starting point for learning more about this service is Coinbase/GDAX but a full review of the competition should be completed before taking any action.

The website of some exchanges will operate on your phone.  Others are better from a tablet or computer.  Some exchanges offer a wallet but a different wallet provider from your exchange may be preferred.

Wallet

A wallet lets you take possession of the keys to your CC on a computer, phone or other personal device.  LOST OR STOLEN KEYS IS A BIG RISK FACTOR WITH CRYPTOCURRENCIES.  Some wallets may also allow you to convert to other types of CC inexpensively by using a feature like Shapeshift.  You don’t need a wallet right away or even at all but it can be nice to have for the reasons mentioned.

THE FOLLOWING INFORMATION IS INTENDED FOR EDUCATIONAL PURPOSES ONLY.  NO INVESTMENT RECOMMENDATIONS ARE BEING MADE.  CRYPTOCURRENCIES ARE HIGHLY SPECULATIVE.  INVESTING INVOLVES RISK, INCLUDING THE TOTAL LOSS OF CAPITAL INVESTED.

Cryptocurrencies

There are a lot of CC and the market is likely to change dramatically over time.  Below is a list of some of the more successful CC at this time and may be worth watching.  To keep track of CC winners and losers, individuals may want to pay attention to market cap, trading volume and price movements in addition to the subjects mentioned above.  The list below will likely change dramatically overtime but here are some of the leading CC at present.

  • BTC – BITCOIN
  • ETH – ETHEREUM
  • XRP – RIPPLE
  • BCH – BITCOIN CASH
  • LTC – LITECOIN
  • IOT – MIOTA
  • DASH – DASH
  • XMR – MONERO

It will be interesting to see how this market evolves.  There is a high likelihood CC will be with us for the foreseeable future; perhaps not in the present form.  The current environment is a little like the “DotCom” era of the 1990’s; the potential for massive change from the current market is high.

The Fallacy of Weak Productivity Growth

Models of the economy are pretty useful tools.  And simple models are some of he most useful.  They help people envision how the world works.  They help organize thinking.

For Example, the model that says the potential U.S. economic growth is determined by “population (labor force) growth” plus “productivity” is an elegant model that shows how adding workers, or having them become more productive, leads to more economic growth.

But, event an elegant model can lead people astray when the inputs are misunderstood.  As they say, [Click To Continue]

Why Inflation Has Stayed So Low

Globalization, demographics, technology have helped to keep inflation low

Key takeaways:

  • Globalization, demographics, technology have been helping to keep a lid on inflation.
  • Continued low inflation could be a headwind for the performance of Treasury Inflation-Protected Securities (TIPS).
  • Low inflation helps to justify above-average valuations for stocks.

In the wake of the financial crisis, the Federal Reserve kept rates low, waiting for unemployment to fall and inflation to rise to the Central Bank’s long-term target.  Several years ago, the unemployment rate passed the Fed’s target, but despite some [Click To Continue]