February 2017

………………Thoughts and Comments


The Next Four Years

The number one question we have been asked for the past four months (since 11/9) is: “What does Trump’s election mean for stocks?” We have taken an extra month to write the “year end” newsletter so that we could see how the first month of Trump’s Presidency would go, so as to assess more information.

Here is what we have learned. The President has tried to follow through with various campaign promises by using Executive Orders. Most of these have not really been orders that will have an immediate effect on regulations, but these do show his intentions. For instance, he has now required that for every new regulation put in place by agencies, two must be removed. However, unlike what the headlines have implied, major regulations like Dodd-Frank (the new regulations covering financial institutions) have not been instantaneously thrown out. Whether Dodd-Frank will be changed, and to what degree, remains to be seen. The same can be seen with Obamacare: the ability to quickly kill and replace it may be overstated. Major changes in tax laws were hoped to be achieved in the first 100 days – now the timeline may be August and the trillion-dollar infrastructure spending effort has been put off until 2018.

Taxes are going to be a complicated issue. A great deal of manufacturing goes on outside of the U.S., and thus any border tax is going to have a negative impact on those companies. On the other side, immediate deductions of capex will be a positive. The bottom line, according to a number of CEOs who have been asked about this on earnings calls, is that they simply do not know what the final impact will be.

What we can infer from the first month, not surprisingly, is that changes are going to take time, and with the in-fighting in Congress as bad as ever, maybe a lot of time. The President doesn’t even have the majority of his cabinet in place, which means nothing in any of those agencies can get done until those seats are filled.

Certainly, the promise of lower taxes and regulation and a major stimulus program are very positive for many parts of the economy and thus the stock markets. However, not only have stocks priced this in (while ignoring many risks), it is becoming quite evident that any such changes are going to take some time – if they happen at all.

On the world monetary policy front, the Fed has suggested that their intention is to raise rates three times this year and continue with this policy for the next several years. The latest form of QE ended last year and the first interest rate increase happened last September.

Chairman Dragi of the ECB (European Central Bank) has announced an extension of his QE but at a lower rate of $60B a month vs $80B. While considered a form of tapering, in our mind spending more money than planned is not a tapering.

Finally, Governor Kuroda of the Bank of Japan is also talking about tapering their QE. Remember, that the BOK already controls, according to some reports, nearly two-thirds of Japanese ETFs and bonds, and is one of the largest shareholders in most Japanese companies.

So from a monetary point of view, the talk around the world is about reducing liquidity. Unless world economies can pick up enough steam to offset this reduced liquidity, current prices will not be supported. This brings right back to where we started: Can Trump achieve his campaign promises?

One last tidbit that needs to be added to this goulash of economic thoughts. Growth in federal tax receipts appears to be slowing, as can be seen by the graph below, and interest rates are rising. This means that there is not a lot of room for interest rates to rise without a rise in tax receipts, and even then, given the absolute size of the federal debt, much of a rise in rates would cause the interest on the debt to outpace GDP.

Federal Tax Receipts, 2011 – 2016 Data provided by St. Louis Federal Reserve

 

The Emperor’s New Clothes

We all know the Hans Christian Andersen story of the Emperor’s invisible clothes that everyone was afraid to question for fear of looking foolish. The markets are acting in much the same manner. Revenues and operating income have been slowing all year, GDP was only up 1.9% in Q4 and 1.6% for 2016 as a whole. While margins are stable, revenue and net income growth slowed again and earnings, if one takes into account all of the manipulations – lowering tax rates (a famous IBM move), borrowing money to buy back stock, taking one-time special charges every year – earnings have not grown for several years.

Trailing Twelve Month Data, through Q4 2016              Data supplied by S&P Capital IQ

The Shiller P/E index is running 28x times versus an average of 16.7x. This ratio is a cyclically adjusted price-to-earnings ratio that is based on data from the S&P 500. Its goal is to provide an indication of valuations based on 10-year average earnings data and adjusted for inflation, so as to remove unusual market moves or earnings adjustments. A look at the graph A below suggests that price levels are extremely high and that expected returns should thus be quite low. At the same time, the VIX, which is a measure of market volatility or complacency, is at 11.57, near long term lows (see graph B).

 

Shiller PE Ratio

Current Shiller PE Ratio: 28.39 -0.02 (-0.08%)

12:49 pm EST, Tue Feb 7

Mean: 16.72
Median: 16.09
Min: 4.78 (Dec 1920)
Max: 44.19 (Dec 1999)

Shiller PE ratio for the S&P 500.

Graph A – Shiller P/E Ratio – provided by www.multpl.com

 

Graph B          VIX 2002 – 2/6/2017 – Data supplied by StockCharts.com

And yet, given all of this the stock market is up 5.0% (the INDU) and at a new high and the VIX is at lows.

Everything is screaming, “Capitulate! Capitulate! Capitulate!” And yet, there is a tiny voice whispering, “Are you insane?”


Portfolio Strategies

So what do we do when nothing makes sense? We hedge our bets. There are two ways to hedge bets. the first is to put hedges in place that reduce returns but, if things come unraveled, help keep the portfolio protected. The second is to put hedges in place as things unravel and hope that you are early enough that you can protect the portfolio from losses.

One is not right and the other wrong: each has its risks to a portfolio. The first method is more dependent on fundamentals as its driving force. In this method, the manager positions holdings to try to balance one another and still provide some upside overall. The second method is more “rules based,” which means that certain things must happen before hedges are put on. Examples could be as simple as a market drop of certain percentage or more complicated, such as that moving averages must cross on at a specified index with volumes meeting certain conditions or that the advance-decline line must drop a certain amount.

The weakness of fundamentally driven hedges is that they tend to underperform while the markets are still moving up, and this can last a long time. The weakness of rules-based hedges is that they tend to be late, as they are signaling events after they have happened, which, depending on how quickly markets drop and depending on how deeply they drop, may mean it is either too late to hedge or portfolios get whipsawed, driving losses while the markets end up flat. This risk is higher now than in the past as it is estimated, according to the Wall Street Journal, that 85% of trading is algo related (computer run trading models). This means computers can move index prices much faster than in the past.

In our portfolios, we have blended the two strategies. We rely primarily on fundamentals when we invest because basic economic principles always drive values in the long-run, even if they are ignored over shorter periods of time. Thus, we invest where the risk-reward issues are suitable and where the economics support and justify those risk-rewards. In many cases, we then hedge these investments by shorting part of the industry or using option strategies.

Current Portfolio Positions and Strategies

We have diversified portfolios for a while now in the same manner: by holding not only stocks, but also bonds and commodities and/or real estate investments. This has further been diversified within each asset class.

Interest rates are rising in the U.S. and have started rising in Europe as well. At the same time, Greece is having debt problems (yet again) along with Spain. Given the issues with immigration throughout Europe, this increases the risk of right of center politicians taking power, which provides an additional risk to the Euro. Finally, inflation is rising more rapidly than expected around the world.

All of these suggest that fixed income is at risk, especially in the longer maturities and thus we have been shortening our maturities and durations over the past eight months. We expect several rate hikes this year unless there is a recession – which at least currently looks unlikely. At the same time, we are reviewing funds that specialize in international hedging to play the volatility of interest rates around the globe.

In the equity markets, earnings have been pretty unimpressive on the whole, although there have been individual companies that have had great results. On the upside, Trump has said he wants to reduce corporate taxes and regulation, although this will take time, at the least this year and maybe next year – if it gets done at all. Thus, it is dangerous to make big bets too early on as the markets have priced perfection in, and thus surprises are likely to be to the downside.

We have been utilizing a combination of individual stock investments combined with ETFs to provide a hedged way to take advantages of the trends, as muddled as they seem to be at this time. At the same time, we are using some hedges to protect against industry shocks (e.g. oil stocks going up while inventories and new productions are hitting highs).

Examples of new positions or those we have added to include the banking/insurance industries and Church and Dwight (consumer non-durables) and natural gas.

We are combining this with rules based investment and hedging strategies that should help us capture upside and still provide protection from either sudden market drops (“black swan” events) or a more slowly moving economic deterioration. Such hedges include shorts on indexes, oil and technology, primarily using inverse ETFS and small amounts of options.

 

The Bottom Line….

People always get greedy at the top. “Why am I making less than that guy?” The fact that stocks are going up doesn’t mean that they reflect rational economic value, merely that someone is greedy enough to ignore the risks. People who have wealth enough to invest in the markets have either been lucky enough to inherit that wealth, or taken risk to create that wealth. In either case, speculating is not necessary nor advisable. Smart investing is recognizing opportunities when others are running in a panic and recognizing the risks when others are charging ahead blindly.

Here at Harmony, we are paid to protect and grow your wealth, not speculate on your dime.

Alan E. Rosenfield, Managing Director

February 2017

 

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