Tag Archives: economy

Risks to the Market

Two risks to your financial future include inflation and market declines triggered by asset price bubbles.

Inflation has not been a problem in the U.S. for over 30 years. Three of the biggest market declines in the last 100 years included in the Great Depression, the tech bubble and the more recent Financial Crisis. Each of these events was related to price bubbles. High stock valuations preceded the 1929 and 2000 corrections, and real estate speculation precipitated the 2008 crisis.

The fuel for asset bubbles is cheap credit that encourages risky behavior through leverage. Why does this matter? There is widespread concern, not unfounded, about the effect of rising interest rates on stock prices. But presently, short-term rates are still less than inflation. We need a positive real interest rate to support healthy economic incentives and to discourage speculation. Normalization requires more interest rate increases, contrary to President Trump’s tweets. The improving economy supports current market valuations.

The real risk of higher interest rates occurs when it begins to limit investment in otherwise productive projects. The problem with low rates is it encourages bad investment.

Evidence of Growth

As of mid-year, my single variable economic indicator is still going strong. According to the American Association of Railroads, “North American rail volume for the week ending July 14, 2018, on 12 reporting U.S., Canadian and Mexican railroads totaled 374,909 carloads, up 4.6 percent compared with the same week last year, and 374,090 intermodal units, up 4.7 percent compared with last year. Total combined weekly rail traffic in North America was 748,999 carloads and intermodal units, up 4.7 percent. North American rail volume for the first 28 weeks of 2018 was 20,148,123 carloads and intermodal units, up 3.5 percent compared with 2017.” America is on the move. Will tariffs crash the party?

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 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 onboarding 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.

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 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.

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 https://www.aar.org/newsandevents/Press-Releases/Pages/2016-02-17-railtraffic.aspx.

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.

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.

On Raising the Fed Funds Rate

When you’re drinking beer, the goal can be to drink more.  That’s a problem for some people.  They do not recognize their disequilibrium.  Putting the glass down might not bring immediate gratification, but it is simply the right thing to do with any normal, long-term perspective.fredgraph Fed Funds Rate

The Fed needs to get off the sauce.  Current interest rates compromise reasonable capital allocation, and encourages uneconomic decisions.  The longer the distortion persists, the greater the risk.  Any investment decision that gets squeezed out because of a .25% interest rate increase, at current rates, was a bad idea anyway.  That represents net positive for the economy by discouraging inferior projects and speculation.

Interest rates are the cost of money.  It shouldn’t be virtually free.

Dear President Obama:

The Wells Fargo Economics Group summarizes the state of the US economy in its Monthly Outlook, 7-8-2015:

Halfway through 2015, and now six years into recovery, the U.S. economy remains in strange territory. Real GDP growth has proceeded on a narrow path, averaging just a 2.2 percent pace. Even this modest pace, however, has been sufficient to pull the unemployment rate down to levels near most conventional measures of full employment. Despite the low unemployment rate, the economy and labor market are anything but a picture of health. In fact, the feeble gait of this expansion has kept the economy vulnerable to the slightest misstep, be that bad weather, labor strife, or foreign events.

Your administration stands for social justice.  You value taking care of the poor and disadvantaged above all else.  Greedy capitalism that created the financial collapse in 2008 has been met with stiff retribution, penalizing banks and other perpetrators.  Moreover, by your virtual executive fiat, we now have Obamacare.

Giddy liberals deride “trickle-down economics” as failed policy.  By metrics such as income equality, it most certainly was.  Policy may be corrupted by politics, and there are few effective checks and balances for executive compensation.

It is time for a reality check.  Can we afford to subsidize services and extract capital from banks (effectively penalizing innocent investors for someone else’s misdeed’s, and exacerbated by government policy encouraging home ownership), rather than encouraging investment and growth?  Is it unreasonable to focus on creating wealth first, so we have something to fund social programs?  Or should we handicap wealth generation to do good now?  Regardless of your answer, we shouldn’t be surprised by the economic situation summarized above based on policies of the past 6 years.

When the economy falters, the middle class suffers.

How to Prepare for the Next Crash

First let’s define “Crash”.  To most, the term implies a decline of severe magnitude. A key question is the duration of the impairment, or how long might it take to recover?  Another consideration is stock market valuation.

By my observation, there hasn’t been a stock market crash in the US in the last hundred years that began with stocks at historically reasonable valuations that persisted more than 5 years.  The risk of a crash depends on valuation.  The average PE ratio in 1929 was about 60 times earnings. Fifteen or sixteen is widely considered average, and implies a 6.25% to 6.67% earnings yield.  That’s reasonable.  Today, the PE for the S&P 500 is was 18.94 on 9/26/2014 according to the Wall Street Journal, and that’s a little above normal.  It implies expectations that the economy and growth will continue to accelerate from the anemic post mortgage crisis recovery.

So how do you prepare, just in case?  The conventional approach to hedging the stock market is to incorporate bonds to a portfolio.  You own bonds for either of two reasons; either you need income, or you want to reduce the volatility of a portfolio.  Currently the ability of bonds to generate income is diminished by Fed policy.  While bonds may still provide some stability in the event of a crash, it is widely recognized that interest rates are likely to rise and that will reduce the value of outstanding bonds with fixed coupons.  Choose your poison.

An alternative strategy is to focus on the likely duration of a downturn in the stock market, and plan for expected liquidity needs for that amount of time.  A key benefit of financial planning is that it identifies liquidity needs.  During a period of low interest rates, one can substitute a reserve strategy, often called the Bucket Approach, to provide for anticipated liquidity needs for as long as a crash/correction might be likely to persist.  This frees the remainder of the portfolio for management with a longer time horizon, and with focus of fundamental metrics like valuation and macroeconomic factors.