December 2017

Thoughts and Comments – Year End 2017

The Bottom Line…

I had expected a strong 4th quarter rally, especially as we got into the final month of the year. However, the markets didn’t wait for December to start celebrating; the major indexes are all up about 3% in just the past week. Expect the rest of this year to continue with a positive bias. However, just as if one drinks too much Kool-Aid, you are bound to get a bad stomach ache, investing without fear can lead to a much worse stomach ache.

We never did get any kind of correction as often occurs in the last month of Q3 and the first month of Q4. Instead, we have gone straight into a year-end rally, and news of any type leads to only higher highs. So, while we decreased cash positions early in the quarter, we are becoming more cautious and our models have reflected this by increasing our cash positions to between 10% and 15%, while our fixed income portfolios have reduced average durations to under three years.

Longer term, this euphoria is very unsettling, much like the speed-drunk driver hurling along at top speeds feeling relaxed because everything looks great in the rearview mirror. To see what is keeping us up, and what we plan to do about it, read on.

 

Get Rich This Christmas

(To the tune of Sleigh Bells Ringing)

Just hear our money jing-jingle-ing

Bitcoins tingle-ing too

Come on, it’s lovely weather

Let’s get rich together, me & you

The markets will never fall

The bears are crying “Boo Hoo”

Come on, it’s lovely weather

Let’s get rich with no risk Woo Hoo!

Giddy-yap giddy-yap giddy-yap
let’s go
There’s nothing to know

We’re forever going to be rolling in doe

The markets are nice and rosy
And comfy cozy are we
We’re snuggled up with the Fed like two
Birds of a feather we’ll be

Stocks will always rise before us
Buy the dips, we’ll do

Come on, what can go wrong

Investing is easy to doooo!

 

Remember that scene in your favorite war or cowboy movie, you know, the one where someone comments while peering out into the dark, “It’s quiet….too quiet…” and then all hell breaks loose? That is how the markets feel to me right now.

The Positive News: The Economy Stupid

The global economy, especially in the U.S., is stronger than it has been for some time (U.S. GDP was just reported up 3.3% for Q3 – 2nd revision). Unemployment is low, inflation is relatively low, and company profits are stronger than we have seen in several years. The Senate and House still must negotiate a final tax package, but that is likely to happen. Investor sentiment is strong and the markets, as we expected, are very strong going into the close of the year.

Third Quarter Earnings are almost completely behind us and the numbers were quite good.

Average revenue growth in Q3 2017 (Chart 1) was down from Q2 but was still a robust 8.1%. EBITDA growth (Chart 2) was even stronger, averaging 12.8% growth. Median growth in both cases was lower, which means there is a wide range in the growth rates, but still these numbers are very good. Net Income (Chart 3), which is typically more volatile, grew by 3.2%, but that was a big drop from Q2’s 8.6% growth.

Chart 1 Data provided by S&P Capital IQ

 

Chart 2 Data provided by S&P Capital IQ

 

Chart 3 Data provided by S&P Capital IQ

 

 

 

Margins continue to remain strong and are at 8-year peaks and cash generation is quite strong. The one thing on our radar is interest expense. As rates have risen, so has interest expense. This can have an impact on cash flow and net income, so it bears watching (see charts 4-6).

Chart 4 Data provided by S&P Capital IQ

 

Chart 5 Data provided by S&P Capital IQ

 

Chart 6 Data provided by S&P Capital IQ

 

What Makes Us Nervous

On the flipside of the coin, speculation is running rampant and market breadth is weak and leadership may be deteriorating. We have not had a 5% correction since early 2016. Furthermore, the Fed has said that they are starting to reduce their assets and will raise interest rates again this month and at least three times in 2018. The EU is threatening similar action in the not-too-distant future as well, although that is more talk than action at this point.

Given that central banks are discussing taking the punchbowl away, you would expect the markets to be turning somewhat cautious rather than becoming more euphoric.

In fact, if investors paid any attention to details, they just might wonder why they were partying so hard.

John Mauldin, an astute economist (I know, they are rare) and rather rational human being, has gotten so concerned that he was the only one worried about anything he reached out to number of well-respected investor friends to see what kept them up at night. His friends came back with a very long list which he recently published in a post entitled, “Bonfire of the Absurdities” which you can read in its entirety here. For brevity’s sake, I have summarized it below:

1)     Central bank assets as a % of GDP

Now the Fed is talking about reducing these assets. What if any of these other also start selling?

2)     Artificially low interest rates around the world.

Currently, the U.S. 10 Yr treasury yields 2.42%. The EU’s 10 Yr yields 0.37%, Japan’s 10 Yr is at 0.05% and Switzerland’s 10 Yr -0.11%!

Rates are low because, again, the major owner of debt are the central banks, which has forced everyone else to speculate by buying junk paper or stocks. What happens if the central banks stop buying or start selling? Interest rates should reflect the risk of the underlying borrower combined with inflation. What happens when risk is actually reflected in fixed income?

3)     Median Household income

 

Remember that median means the middle – half of the household incomes are higher and half are lower. What I expect we would find if we got more detailed is that the top 5% are earning a lot more thanks to the markets, but no one else is. This is another result of central bank manipulations.

4)     Stock market valuations

Markets are up to very speculative levels. If median income is down so far, stock prices should not be up at peaks unless there is interference – gasp!

5)     33% of the S&P 500 gains for 2017 come from 10 stocks.

And now let me add two of my own:

6)     None of the above information is new

Everyone is busy rolling their eyes right now and thinking, “Alan, you have been saying this over and over and over for years now.” No one even blinks an eye. Risk is not even a distant thought anymore because anyone who worried about it ended up feeling stupid as the markets rose and they just watched.

7)     Bitcoin

Bitcoin seems to be the top story with the news media. In the past few days, I have seen at least 4 different articles on this “marvelous investment. My favorite comes from the the front page of the Wall Street Journal from last Thursday (11/30/17):

Bitcoin Mania: Even Grandma Wants in on the Action

“Rita Scott’s grandson convinced her in mid-November to get in on the latest investing sensation and buy bitcoin. ‘I thought it was a big coin,’ the 70-year-old said…”

Bitcoin his is an example of speculation gone wild – stocks are crazy enough, fixed income is price down to fantasy levels of risk, but now people are finding even more hair-brained places to gamble and call it investing. I don’t any better way to define irrational than to look at how people are acting today, and all of this while the Fed is saying they plan to continue to raise rates.

Portfolio Strategies

Our equity strategies have been increasing positions into the end of October but now are slightly pulling back. Cash levels have moved from an average of 5%-10% to 10%-15%.

In fixed income portfolios, we have been reducing our average duration from just under four years to under three years.

We continue to monitor both fundamentals and technicals for signs of market weakness in this aging bull market. If we start to see negative breadth and leadership, or signs of reduced margin exposure, these would be early signs that the bull might be ending.

All of this should allow us to 1) protect ourselves from a correction and 2) ensure that we have cash available to make purchases when prices become more attractive.

Alan E. Rosenfield, Managing Director

12/4/17

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