January 2018

Thoughts and Comments

There is a famous Greek myth in which Icarus and his father Daedalus, a famous craftsman, were imprisoned by the King of Crete (when you have a great craftsman, you don’t like to share him). They escaped by designing wings made from bird feathers affixed to wood frames using wax.

Daedalus warned his son not too fly too close to the sun or the wax would melt, but Icarus, in his ecstasy, forgot his father’s words and ended up plummeting to his death.

It is starting to feel pretty warm up at these levels in the investment markets…

Learning to Fly

Ah, to soar above the clouds. The ease, the grace. When investors fly, they must, like all pilots, learn the rules, understand the risks and follow a flight plan, lest they be caught in the middle of nowhere when they discover they have run out of fuel.

In the investment world, just like in flying, while the basic rules have not changed, when the environment changes, one has to change one’s behavior. Economics is to investing as gravity is to flying and thus, in a time when central banks control so much, successful investors must subtly change their strategies and analyses in order to continue to fly.

As we have discussed before, various fundamental valuations that used to control investments do not have the same impact these days. At some point in the future this may change again, but until it does, using a system that doesn’t work is a losing strategy.

We have developed strategies over the past few years to adjust to the new flying conditions. While this does not mean that we ignore all fundamentals or valuations, it does mean that what we consider, and the degree of importance we attribute to various factors, have changed and that has helped us in managing portfolios successfully.

Checking the Investment Weather

One of the first things a pilot checks before going up is the weather, and while is up there, the pilot continually monitors the weather for changes, as being caught unprepared in a storm can lead to devastating results.

This is true with investing as well. Looking at the 2018 weather so far, it is very easy to relax – everything we are flying through right now looks like perfect weather. The economy is good. Taxes for corporations just got lowered and that will help earnings. The U.S. dollar has been getting weaker and that will help the earnings of many businesses that do business abroad.

The White House is now working on huge economic stimulus through infrastructure spending and has been reducing regulations for a year now. All of which is very positive for earnings.  Interest rates are low, and although they are expected to rise, rates are so low that the impact is more like warm air helping airplane lift.

So, sit back, relax and enjoy the ride….for now.

Potential Storms on the Horizons

Weather patterns and economics, unfortunately, are not quite so simple. The weather is good now, very good. But weather and economics do not move in straight lines, but in cycles, so it is not so much what the weather is right now, but what will it be like in the next day, week, month, three months, etc.  One must analyze and interpret all of the swirling data to really have a picture of the situation. And, of course, what looks good or not so good right now may change, but that means they must be watched, not ignored or dismissed.

Let’s list the items on the radar that bear watching:

1)     The Global Economy is strong. According to data from the OECD (Organization of Economic Development), all 45 countries in their expansion/contraction study were expanding at the same time in 2017. The last time this happened was ten years ago (2004-2007). But this is old news – the question is will it continue? It may, but as the EU and Japan reduce their QE, this may change. Note that the last time OECD reported this, it lasted for 3 years, so it may well last for a while longer. However, it will change.

2)     Tax laws will increase earnings. In addition to lower taxes helping earnings, a number of companies have started paying out small bonuses to employees, along with promises to invest more in the U.S.  All of this is very positive for investments. We must also note that the benefits from taxes will only have an impact for a maximum of a year. After that, the taxes are baked into future returns. And with the markets up over 6% since the law was enacted, it is hard to argue that much of this isn’t already baked into future results.

As for the bonuses, increased wages would be more beneficial and bonuses are only one-time events. As for how much companies actually spend on their U.S. infrastructure and business, this will have to be evaluated over time; certainly, anything that is spent is beneficial.

3)     Weaker U.S. Dollar helps U.S. global companies. Unless the dollar continues to weaken, the impact on earnings is only good for one quarter or two at most. The problem is that if the dollar becomes too weak, then we import inflation and increase trade wars.

4)     Interest rates are rising. Rising rates are not necessarily bad news for a growing economy, in fact, rising rate are to be expected. Rates are coming off abnormally low levels, so it may take longer for markets to respond. However, rising rates may have a dramatic impact, especially when one combines the Fed’s intention to raise rates at least three times in 2018, the weaker U.S. dollar (see #3), and a stronger global economic environment.i.      The reason stocks rose was because income investors could not get the income they needed from bonds. Stocks had higher yields. But now that is no longer true. 2-year Treasuries yield 2.05% and the S&P 500 now yields 1.75%. Even if companies increase their dividends, it will not offset this change.

  • The reason stocks rose was because income investors could not get the income they needed from bonds. Stocks had higher yields. But now that is no longer true. 2-year Treasuries yield 2.05% and the S&P 500 now yields 1.75%.              Even if companies increase their dividends, it will not offset this change.
  • Rates stayed low on long-term Treasuries because the Fed and other central banks purchased so much of the paper that there has been very little availability – supply was down relative to demand, forcing prices up and yields                  down. Now that the Fed has stopped its purchases and the EU is reducing its purchases, demand is going to swing the other way and this could lead to higher rates. Japan isn’t reducing their asset purchases currently, but that is              something to continue to monitor.
  • Rates being so low has kept the deficit from growing as quickly, which is lucky given just how much the deficit has grown over the past nine years. However, with rates up so dramatically on the short end, the interest on the deficit            is going to start to expand exponentially. What happens if the government funds the debt with longer maturities instead of shorter ones? Will that pressure rates higher, and if so, just how quickly does the government lose control          of the cost of their deficits?

5)     Complacency and volatility and other items. Historically, the markets have made 5% corrections about once every 9 months. However, the last time the S&P 500 had at least a 5% correction was over 14 months ago. This complacency is being mirrored by record low volatility in the markets. Both are simply two sides of the same coin. Investors are getting complacent, which reduces volatility and markets seem to only move in one direction – up.

At the same time, there is record leverage in the stock market ($580 billion in November 2017), Advisor Sentiment is at the highest level of bullishness in 30 years (since April 1986), and the contrarian indicator the percentage of bearish advisors is the lowest since February 1987.

None of this can predict when the markets will turn, but what they can, and almost do assure, is that when a turn happens, it will be violent. Investors are not prepared for weaker markets and so are likely to panic when markets get weak. This will then get exacerbated by the huge leverage in the system which will lead to lower lows and quickly.

Our Intended Flight Path (or as we like to say) The Bottom Line…

Given the economy is strong globally and lower taxes, the economy should continue to do well. The weak dollar and growing trade friction along with rising interest rates are the potential fly in the ointment and need to be watched closely.

In order to not fly too close to the sun, we are not letting portfolios get too aggressive, using a number of techniques. First, we want diversity: diversity by asset class and positions. In equity-only portfolios we have been increasing cash on the sideline as money market funds are now yielding over 1%, as a way to protect from any quick retracements. In addition, we are holding higher than normal number of positions, again, to provide protection from surprises.

In fixed income -only accounts we have reduced the average duration of portfolios to under 3 years and have added bonds that have floating rates – rates that rise as short- term interest rates rise. We are sticking with investment grade corporate bonds and typically positions are 3%-4% each.

Finally, we are diversifying by strategy. We are utilizing both growth-focused and value-focused investment strategies, so that we 1) do not become complacent; 2) have securities that typically have low correlations which each other (they don’t all go up and down at the same time under normal circumstances); and 3) some provide more appreciation potential and others a combination of some appreciation and some current yield. Our portfolios that combine these strategies are currently yielding close to 2.8% – well above treasury yields and the yield on the S&P 500.

So far this seems to be working well. Portfolios are up strongly and yet we are not 100% invested, giving clients a little extra protection. We look forward to reporting our progress in April.

Alan E. Rosenfield

January 29, 2018

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