July 2016

……………..Thoughts and Comments


Brexit – BigDealxit?

For the past two weeks, everyone has been asking what does Brexit mean to investors?  Our answer has always been the same, “No one really knows, but I am sure that the markets will over-react.”

This has been a pretty accurate answer, so let’s move on to another topic.

Okay, maybe there is a little more to discuss.  First, of all the commentary, by far-and-away the best discussion was written by John Mauldin, a very intelligent and balanced financial writer.  Europe is a Minefield is an insightful discussion of what is really going on behind the scenes in the EU and well worth reading.  I will summarize it here so as not to repeat what has already been very well said.

The bottom line on the vote to leave the EU is all about politics and has little to do with economics.  What was once a plan to make trading between European countries cheaper, faster and easier so that they could better compete with the U.S. has turned into a political game of power.  And the powers-that-be do not like it when people take or try to take that power away.

Free trade issues in the United States have also turned into political gamesmanship rather than a focus on allowing trade to move quickly and inexpensively between countries.  As this is not a political discussion, we will not delve into that matter more here, however, as investors, you better not kid yourself, because politics has become the driving force behind the investment markets (as we have discussed many times) and those who play without understanding the game are assured to get hurt.

So does the UK’s exit mean anything for investors?  In the short term – no.  It gave traders a chance to whip things around, and it gave central bankers (who are, after all, politicians) cover for their massive and growing monetary mistakes.  It will take some time (projections are as long as two years) to fully unravel and renegotiate terms.  However, the U.K. is a large trading partner to the EU and no one is simply going to stop doing business on either side of the Channel.

While everyone has been focusing on the U.K. vote, however, no one seems to have noticed that in the past week, Italian banks suddenly needed bailing out (not a surprise) and nine different real estate funds in the UK have gated themselves because of panic selling and, you guessed it, heavy leverage.  So it seems that the chief effect of the U.K. vote was to raise fear and speculation, which, when markets are severely leveraged and are already in a speculative frenzy, never helps.

Then, just yesterday, Japan’s Abe suggested that Japan will issue their first debt in 4 years in the amount of 10 trillion yen (a little more than $95 billion U.S.) to help stimulate the economy in Japan.  This happened after a “secret” meeting with Ben Bernanke in which he apparently is trying to convince Abe to start dropping helicopter money.

Basically this is just another form of quantitative easing (“QE”) which we already know doesn’t help the economy.  However, it does help stock prices, although for increasingly shorter durations.

Q2 Review

Study the charts below for a moment.

(Charts provided by StockCharts.com)

Notice that from the middle of April through the end of June, bond yields have hit new lows while stocks have gone sideways.  Gold is at four year highs as is silver, but copper is close to its lows.  Oil, having rallied from the February lows and now is moving sideways (very similarly to the S&P 500).

These price movements do not make sense, fundamentally.  Falling interest rates typically indicate a weakening economy.  Yet the S&P 500 was near all-time highs and p/e ratios are at highs.  Gold and silver are up, which typically means the U.S. dollar is weak and there are worries about inflation, yet bond yields are down, and the U.S. dollar is strong.  Industrial commodities should go up if the economy is strong, which would jibe with the S&P going up, but copper is weak, a sign of low demand for building and industrials.

So if none of these price actions make fundamental sense, then something else must be the driver.  In our mind, it is a combination of central bank interference and speculators with cheap money.

Reconsider the data from a different angle.  U.S. yields are low, but European rates are even lower (Germany 10 year is -0.17%, Japan 10 year is -0.29%, Switzerland 10 year is -0.63%). This demand for a positive rate of return leads to increased demand for low yielding U.S. treasuries (two days ago, U.S. 10 year offered a whopping 1.37% yield).  At the same time, gold and silver are up out of fear of negative interest rates.  Copper is down because business is not strong anywhere.  Oil is flat because traders are fighting fundamentals – production is showing signs of rising, summer gas demand is near the end and inventories are high and likely to rise.

Meanwhile stocks have whipped around up and down and up and down only to end where they started – up less than 3%.

The Fed and its global central bank continue to argue that if we just print more money, we will solve the problem.  The markets are telling them that they ARE the problem and the more they pump money, the less it is going to work, and the greater the final capitulation.

Q2 Earnings Preview

Earning will begin in earnest this Thursday.  Here is what we expect.  First, everyone will say they beat expectations but remember that expectations have been coming down (with company guidance) and so beats are of lowered expectations – not anything to be impressed with.


Next, everyone will say, but earnings are better than last quarter, so we have bottomed and the third quarter will be stronger.  That is the talk of sales people, not analysts.  Anyone doing actual analysis won’t believe that growth is around the corner.  China is sinking – their exports are slowing.  The U.S. dollar just jumped vs the Pound – that isn’t going to increase exports.  Europe can’t export to anyone because no one wants to buy.  Where is the growth coming from?

For many quarters companies have been using share buybacks to keep earnings up, even though this is a merely a manipulation.  As we saw last quarter, companies are running out of room for this game and so, in general, we expect both revenues and earnings growth to continue to slow just as it has been doing for the past eight quarters.

(Data provided by S&P Capital IQ)

So far, both Alcoa (AA) and CSX (railroad) have had disappointing reports.  AA “beat” expectations by taking the concept of adjusted earnings to new heights, but revenues were down another 10%.

CSX reported revenues down another 12% in the latest quarter and said they expect most of their markets to decline in Q3.  Transportation is usually a good indicator of economic strength and they didn’t suggest that there was a reason to be bullish.

YTD Results

Our portfolios have been doing quite well.  A mixture of gold mining stocks, short and intermediate corporate bonds and a small smattering of stocks (we added to them when the markets sold off) help keep us from getting whipped around too much.

Going forward we continue to keep our average maturity in the five year range which helps protect us from interest rate volatility.  Even though I do not expect the Fed to raise rates (they have used every excuse possible to not raise rates so that the stock markets stay up), rates are whipping around.  Consider that the 10 year has moved from a 1.85% yield on June 1 to 1.38% yield on July 8 and is back to a 1.53% yield as of yesterday – that is a 25% move down and an 11% move up in a little over a month!

Stocks, which lost 4.7% from June 1 through June 27, rebounded 6.5% through July 8, leaving us about where we began.  Since that time, the S&P 500 and Dow have hit new highs (albeit on very low volume) – no fundamentals changed, but prices sure did.  Unless Europe, Asian and perhaps the U.S. all engage in further money printing (as opposed to threatening to do it), this market is likely to give up the recent gains, leaving investors whipsawed, confused, and nervous.

The Bottom Line…

While we have done a little bobbing and weaving, we basically continue to focus on the following:

1)       The Fed and all central bankers are convinced that if they just print enough money everything will be okay;

2)      Excessive cheap money leads to bad economic decisions which leads to losses that get papered over until it can’t be hidden anymore;

3)      This will lead to zero or negative interest rates in the U.S. and negative returns for most stocks;

4)      Deflation followed by inflation.

Given this scenario, a risk adverse strategy makes sense to us: intermediate, high quality bonds, gold mining stocks, and special situation stocks are likely to provide the best returns with the least risk.  Managing money is like being captain of a ship.  You look at all of the data and try and sail around a storm.  But when you are in the middle of a hurricane, you don’t raise all your canvas and scream, “full speed ahead – we can outrun it!!!”  You drop canvas, batten down the hatches, and protect you and your passengers.

Alan E. Rosenfield, Managing Director

July 2016




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