The State of the Yield Curve

The yield curve is getting a lot of attention because it has flattened 65 basis points this year. Although the yield curve is a good indicator of where we are in the economic cycle, it does not indicate a recession is likely. Fundamental data are supportive of economic expansion.

(Source: Bloomberg, NBER, GSAM, as of 11/30/2107)

The Risk of Cash

The S&P 500 is up 21.54% (Morningstar, intraday 11/8/2017) since the Trump rally began one year ago. While corporate earnings are up, price multiples have also expanded with growing optimism of policy reforms that could further improve earnings growth. This leaves many investors wondering if they should simply go to cash to lock in the gains.

For a long-term investor, someone who doesn’t plan to use the money for at least 5 years, this might not be a clever idea. To illustrate, let’s assume that we perceive an elevated risk of a 15% correction to get back in line with normal growth from where we were a year ago. From that level, we might expect 8% to 10% average annual growth. If we are correct, and the market goes down 15%, and then grows at 8% per year for 3 years, it would still be worth more than if it were left in cash.

To illustrate, a $100 investment that declines by 15% is worth $85. Then if it grows by 8% per year for 3 years (85 x 1.08^3), it would be worth $107.07. That implies cash would have to earn 2.3% per year to keep up, and that is not available in today’s low-interest rate market without material risk.

As a short-term tactical move, cash can serve as an effective hedge against a falling market, but only if an investor has the fortitude to use it and invest when fear is at its height.
Perhaps the greatest risk for a long-term investor is selling out, not taking advantage of a market correction, and then reinvesting when higher prices signal all clear. It happens all the time.

How High is too High?

What difference 3 quarters makes! The S&P 500 is up 14.2% year-to-date, and 4.5% in the 3rd quarter. After the initial Trump rally, nearly everyone, myself included, expected some type of correction. The market continues to brush-off geopolitical concerns. While North Korea might make for scary headlines, the markets are voting that it is unlikely to have a real adverse impact on corporate earnings.

Stocks sell at a multiple of current earnings. The multiple depends on how the market views future earnings. The question of how high the market can go is to ask how much the businesses in the index are worth.

The good news is that there really is not a limit. If a working man puts $5 in a jar every day and does not die, how much is the jar worth? I can calculate how much you should pay for this man’s savings today, but over time, the answer is unlimited.

This is not to suggest the market can’t be overvalued because it can be. Rather, there is no number that represents an absolute limit. I believe the market is moving higher because we have an administration that is pro-business and focused on tax reform. Fiscal spending is also becoming a factor.

There is room for further gains, but corrections will happen. Volatility is the price of equity returns, and that’s been missing for the most part. Stay the course but plan for liquidity.

The Oracle of Charlotte

It’s been eight years since the market hit bottom.  As Morgan Housel of The Motley Fool wrote, “If you went back to 2008 and predicted that over the following eight years the stock market would triple, unemployment would plunge to 1990s levels, oil prices would fall 80%, and inflation would stay tame even while interest rates stayed at all-time lows — I’m telling you, not a single person would have believed you.”

Ok, I didn’t say that exactly, but I got the part right that mattered most.  It was in December 2008.  I was on- boarding a new client.  His portfolio was in cash equivalents.  I believed that while we were in the midst of a financial crisis, stocks were oversold compared to intrinsic value.  I told my new client that I believed he had a unique opportunity to triple his money in 5 to 8 years.  Few people are so fortunate as to find themselves with cash at the bottom of a market.

in April of 2009, he fired me.  My mistake was to buy equities in the last days of February, within a week of the absolute bottom.  In retrospect, my timing was nearly perfect, but he couldn’t handle it.  I called him a couple of years ago.  He told me firing me was the biggest mistake he ever made.  I’m guessing it hasn’t gotten any better for him.

Beware the Pundits

Not much has changed since my last blog post, and I don’t have any revelations to share. Trump is still talking about the same issues he mentioned in his campaign. Real change happens slowly. But the drift is real, and that has unleashed animal spirits in the markets.

The gains to-date are not purely about valuation. Currently, 70% of companies have reported 4Q earnings, and 2/3 have beaten estimates, according to Forbes. Earnings are improving and the real question is how steep and how long the trend will run.

Carnac the Magnificent

All things being equal, higher valuations increase risk. If price-to-earnings multiples expand faster than earnings growth, the risk of a correction increases. Without calling names, geopolitical risk seems to be an ongoing factor, so it seems a matter of time until a crisis scares the bejeepers out of the market and everyone scurries to cash.

A Buffet saying comes to mind, “Be fearful when others are greedy, and greedy when others are fearful.” I’m sensing an increase in the greed factor as investors hate missing a rally. This might be a good time to think about harvesting positions you wouldn’t buy at today’s prices, and be very picky about your reinvestment options. Dry powder can go a long way in a correction.

Longer term, the table is set for sustained, and perhaps accelerating, earnings growth. In the 90’s, everyone thought the market would average 12% forever. Now the pundits agree 8% seems ambitious. When have the pundits ever gotten it right?

Finally, recognize that volatility is the price we pay for equity returns. Plan accordingly and stay the course.

Post Election Outlook

The election is finally over.  Markets are beginning to price in the upside potential of a shift to a pro-growth government led infrastructure-led fiscal spending.  This is something I have cited over the past couple of years as the missing piece of policy that could stimulate the economy, given that monetary policy has run its course.

Trump didn’t include a lot of detail in his campaign rhetoric.  Maybe he doesn’t know the details, but we can certainly ascertain his drift.  We do know an administration is a lot more than one person, and collectively, these others will bring the expertise to Trump’s agenda.

We can expect an increase in infrastructure spending.

Trump White house, 2018

Trump White house, 2018

Trump is known for putting his name on large buildings.  Just imagine if he were President.  According to Capital Group, the spending he has suggested would add up to half a percent per year to GDP over the next four years.

Trump has pledged to lower tax rates for individuals and corporations.  One way to pay for cuts would be to expand the amount subject to tax, which points to a deal for repatriation of the estimated $2 trillion of US corporate earnings held overseas.

Trade is the area most directly controlled by the President.  Trump’s threats to bully concessions from trading partners might work, but also carry the risk of starting trade wars or worse.  However, as occurred with Brexit and Grexit, the votes and threats created leverage, and pressure for concessions.  Perhaps he can negotiate a better deal.

Trump likes to negotiate from a position of strength and has emphasized the need for a strong military.  Increased defense spending to beef up homeland security and offensive capabilities should benefit defense contractors and industrial suppliers.

Health care is another area of focus.  Trump campaigned on repealing the Affordable Care Act.  It is unlikely the 20 million people added to health insurance rolls will be dumped, but the program will be rebranded and modified to reduce the worst imbalances.  Insurance companies will muddle through changes and pharmaceutical companies will still contend with pressure for price regulation.  While more positive than we would have expected a Clinton administration, the outcome is not clear.

He says he wants to repeal Graham-Dodd.  Banking regulation has placed serious regulatory burdens on financial companies.  Some question whether the regulations are adequate, but there is evidence of overreach and unnecessary compliance overhead.  It would be nice to see fewer rules based institutional regulations and more principles-based enforcement of laws to control individuals that compromise the public interest.

It might be best to view the Trump impact as a change in drift, not a full overhaul.

Managing Volatility in Growth Portfolios

In normal times you might own bonds for either of two reasons.  You might enjoy the regular Buckle Upincome from interest payments, or you might own them for the stability they add to an equity portfolio.

Neither of those reasons carry the usual appeal with today’s ultra-low interest rates.  If you’re counting on bonds for income, you are going to need to own a lot more bonds.  While bonds add stability, the total return will be reduced when interest rates eventually move to higher, normal levels.  Neither reason is particularly compelling these days, although the stability factor is more compelling given stability in a quick equity correction.

The bond market is not uniform.  Some parts of the bond market have less exposure to interest rate risk.  Additionally, the proliferation of alternative strategies offers investors a wide array of tools for managing risk in today’s macro driven investment climate.

Much has been written about various types of risk, and that is not the focus of this essay.  My purpose is to explain an approach to managing equity market risk in the current low-interest rate environment.

Liquidity is important.  Let’s take the case of the Brexit induced market decline that began last Friday.  Over two days the Dow lost about 900 points as stunned markets went into “sell first, ask questions later” mode.  If you believed, as I did, that the world economy was not poised for mass suicide, and that cooler heads would prevail as hysteria faded, you might have been inclined to sell some of those bond positions to buy equities at distressed prices.

If those bond or alternative positions were in mutual funds, the cash would not be available for trading until the next day.  Using margin is not a bad strategy, since you can execute a purchase locking the price before the bond fund sale is complete.  If you wait until the next day, the price could be higher.  It could have gone lower too, but that’s speculation.  If you want to control the trade, you want to make timely buy and sell decisions.

Using hedge positions in ETF format eliminates the liquidity problem.  Unfortunately, many of the better bond funds and hedge strategies are based on active management, and hence not available in ETF format.  There is no perfect solution.  If the main objective is performance relative to a benchmark, for a fixed/alternative portfolio component, then the mutual fund liquidity problem can be overcome with judicious use of margin.  If the objective is to hedge a richly valued market in a world fraught with macro risk, then bond sector ETF’s can fit the bill.

Then again, in a rich market, cash is an attractive asset class.  To paraphrase Charlie Munger, a good way to get rich is to put $5 million in a checking account and wait for a good crisis.

When Regulations Become Tyranny

The U.S. Treasury Department introduced new regulations targeted at theHammer and Sickle Pfizer – Allergan deal, which was designed to capture tax benefits by inversion. Pfizer planned to adopt Allergan’s domicile for tax purposes. The new regulations are crafted to specifically address this deal, using a 3 year look-back to qualify how capital is represented for the purpose of qualifying for the inversion.

Regulations with look-back provisions are typically not retroactive, but give guidance for future decisions. The U.S. Treasury is going after, and trying to publicly humiliate, 2 companies that are making rational decisions in the legal framework the Government established. Pity investors that invested in these companies based on the legal, economic and regulatory framework only to have the Government change the rules (without due process)!

Sure the incentive for the deal was tax reduction. Obama says the companies want the benefits of being in the U.S., but don’t want to pay their fair share. Maybe the broken tax code is the problem? Why do we have to pass regulations to keep companies in the U.S? Isn’t that the way totalitarian governments operate? If the laws aren’t working, fix the laws, or the tax code; but don’t pass retroactive regulations to persecute specific companies. THAT, seems un-American.

As noted by Ian Reed, Pfizer CEO:

If the rules can be changed arbitrarily and applied retroactively, how can any U.S. company engage in the long-term investment planning necessary to compete? The new “rules” show that there are no set rules. Political dogma is the only rule.

– Pfizer (NYSE:PFE) CEO Ian Read

A Vital Sign for the Economy

When the stock market gets stressed by a correction, emotions are magnified. Commentators attribute daily swings to the headline of the day.


One data point worth reviewing is from the American Association of Railroads (AAR). The AAR publishes weekly data on rail traffic.

According to the report for the week ending February 13, 2016, “total U.S. weekly rail traffic was 505,148 carloads and intermodal units, down 3.8 percent compared with the same week last year.” Total freight cars and intermodal units are down 5.8 percent compared to last year for the first 6 weeks this year. But of the 10 carload commodity groups, miscellaneous was up 27.4 percent and motor vehicles and parts were up 12.6 percent.

The sectors posting decreases compared to the same period in 2015 included, “coal, down 32.5 percent to 75,249 carloads; petroleum and petroleum products, down 23.4 percent to 11,303 carloads; and metallic ores and metals, down 15.4 percent to 19,196 carloads.”

The data points to a fairly healthy consumer sector and a supply correction in raw materials commodities. As supply adjusts to demand, prices stabilize and rebound. These are healthy adjustments for an economy on course for the old normal.

For the full AAR press release, click

Random Thoughts on Investing and Politics

Which way is the market going?  If you listen to the news, you will be a pessimist, since most news is negative.  But if you pay attention to quarterly earnings reports and long-term earnings trends, you will be an optimist.

Golden pendulum swinging

Businesses are organizations of people who get up every day to create value for customers, with profits flowing to the owners of the company as the reward for their ingenuity and placing capital at risk.  If and when profits decline, the owners and management take corrective action.  In the extreme, they might liquidate the business to avoid further loss of capital, freeing capital and labor resources for redeployment in more productive enterprise.

In 1776, Adam Smith coined the term “Invisible Hand” in a book “An Inquiry into the Nature and Causes of the Wealth of Nations”.  In it he wrote, “Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally neither intends to promote the public interest, nor knows how much he is promoting it … He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that it was no part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.”

Government intervention often impairs the efficient deployment of resources and the creative destruction of inefficient enterprise.  Subsidies and taxes distort economic incentives and reduce the efficient allocation of resources.  The invisible hand is not an outdated classical concept.  It is the natural phenomenon that guides free markets.  Capitalism drives scarce resources to their most productive use.

Socialism short circuits the resource allocation process of capitalism, removing the invisible hand from sectors of the economy.  Without a profit motive, inefficiencies tend to grow unchecked.  While segments of society may be protected, you end up with a smaller pie.

The political pendulum swings between the left and the right.