October 2015

……………..Thoughts and Comments

Investing is like a jigsaw puzzle:  you have an idea of what you are trying to achieve, but you have to look at all the little pieces and figure out how they go together to actually get the picture.  The only difference is, with investing, you don’t always have all the pieces so you have to make a decision based on incomplete data and you wait and see if the pieces that show up later confirm your picture or not.

So let’s build a jigsaw puzzle!

Piece #1 – S&P 500 Q2 Earnings

Revenue growth for the five quarters has been slowing, with growth now having dropped from 5.5% to 4.29%.

Gross margins have dropped by about 2%, taking margins back to their 2011 levels.

Net income slowed for the fifth quarter in a row; from 12.16% a year ago June, to 4.29% in Q2 2015.

Net margins have dropped back to 2011 levels, dropping by 9% since September 2014.

The strong dollar created a headwind that averaged 6% – 8% during the second quarter.

Share buybacks are accelerating as earnings and revenue growth declines.

Piece #2 – Economic  Reports

GDP – Q1 was only 0.6%.  The reasoning, according to the Fed was because of the weather.

GDP – Q2 was much stronger (up 3.9%), but a great deal of it was inventory and the new double-seasonal adjustments.  Inventory growth is not bad as long as that inventory is cleared out quickly.  But as the Business Inventories-to-Sales Ratio shows below, that is not the case.

GDP – Q3 – estimates according to the Atlanta Fed is only 0.9% (and that was before the latest slew of economic news showing the economy is slowing from three months ago.


Business Inventories are climbing, yet sales are slowing.



Personal spending is flat, but below levels of a year ago.  Oil prices are down, which so far, have gone into savings, not additional spending.



Non farm payrolls were surprisingly low in September and in the meantime, a number of companies have announced layoffs since July:

Hewlett Packard (30,000 announced, 55,000 planned)

Great Atlantic & Pacific Tea (“A&P”) (8,500)

Caterpillar (5,000 announced – 10,000 planned)

FMC Corp (800 – 850)

Haliburton (3,800)

Jo-Ann Fabrics (103)

Microsoft (7,800)

Monsanto (2,600)

Qualcomm (4,500)

Twitter announces 8% layoffs (336 jobs)

US Military (57,000)

Of course, Europe, Asia and the Emerging Markets are struggling as well.

Piece #3 – The Fed and Interest Rates

I was sure the Fed was going to raise interest rates in September – so sure that I bet a friend – and lost (at least we had a really good meal).  I was sure because while earnings and economic reports were less than exciting, the Fed has been holding rates too low for way too long and they needed to get off of zero just to try and move the economy back onto its own feet.  Besides, with a recession becoming more possible (see pieces # 1 and #2), the Fed needs the ability to lower rates later on.  In addition, when out of arrows, one has to fake it.  In the Fed’s case, this means talking up the economy so that everyone believes that the economy is getting better and that higher rates will not be a bad thing.  With the 2nd quarter GDP report so surprisingly strong (ignoring all the manipulation), I was sure that they would jump.  But Janet Yellen is simply too meek, and then August and September happened.

1) China started to visibly lose control of their economy.  Their stock market plummeted (due to rampant speculation and leverage that makes our markets look almost tame).  The stock market was going to be investors’ savior because they had lost so much in the real estate market, but that did not turn out to be the case.  The panic was so vast that the Chinese government started threatening investors with jail time if they shorted or said anything negative about their stock market.

2) Traders started reducing their leverage added to the pressure on U.S. stocks leading to a 12% correction for the first time in almost four years.  The S&P 500 peaked on May 21 and closed at its low on August 25 for a total drop of 12.35%.  It closed on September 30 for a 9.7% drop from the May high, and a 6.75% loss for the quarter.


Chart provided by StockCharts.com

Frankly, I believe the Fed blew it by not raising rates.  They had their chance, and they have probably missed it.  As noted in above, employment is not growing as much.  Moving forward, I expect employment to get weaker due to the number of layoffs being announced by corporations.

On September 17, the Fed reported that they had decided not to raise interest rates but that they were very close. In their policy statement they said, “The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring developments abroad.”

In the press conference following the release, and in numerous Fed speeches in the three weeks since the meeting, Yellen and other Fed members continue to suggest that the vote was close and that the Fed is very close to raising rates, most likely this year.

In discussing their decision, Yellen explained at the press conference following the meeting (bolded portions are my emphasis),

“Since the Committee met in July, the pace of job gains has been solid, the unemployment rate has declined, and overall labor market conditions have continued to improve. Inflation, however, has continued to run below our longer-run objective, partly reflecting declines in energy and import prices. While we still expect that the downward pressure on inflation from these factors will fade over time, recent global economic and financial developments are likely to put further downward pressure on inflation in the near term. These developments may also restrain U.S. activity somewhat but have not led at this point to a significant change in the Committee’s outlook for the U.S. economy… net exports were a substantial drag on GDP growth during the first half of the year, reflecting the earlier appreciation of the dollar and weaker foreign demand… in light of the heightened uncertainties abroad and a slightly softer expected path for inflation, the Committee judged it appropriate to wait for more evidence, including some further improvement in the labor market, to bolster its confidence that inflation will rise to 2 percent in the medium term…To be clear, our decision will not hinge on any particular data release or on day-to-day movements in financial markets. Instead, the decision will depend on a wide range of economic and financial indicators and our assessment of their cumulative implications for actual and expected progress toward our objectives.”

So let’s go through the points:

1)      The vote was very close. In numerous speeches since the meeting (it feels like a PR campaign), Fed members keeps saying the vote was close and they are so close to raising rates.  In reality, the actual vote was 9 to 1 to keep rate steady.  That is not very close.

2)      Job gains have been solid. With the number of large companies announcing layoffs, job growth may slow from here.

3)      Inflation is low due to lower oil prices and import prices. If interest rates are raised, the U.S. dollar will get stronger, which will decrease imports even more and typically will lead to lower oil prices as well (although this is not the case 100% of the time).

4)      In order for import prices to rise, either a) the dollar must drop in value; or b) foreign currencies must rise in value. For foreign currencies to rise in value, their interest rates will have to rise, but they are negative currently.  For rates to rise, foreign economies must get stronger, which means that the Fed is expecting (or hoping) that foreign economies will start to grow soon.  However, economic reports in Europe, Asia and most of the Emerging Markets are weakening, not strengthening.  In addition, signs from the bond markets are suggesting that economies may be weakening a lot.

5)      The Fed does not worry about what the stock market is doing. Yellen admitted that they watch the markets carefully.  Fact – The S&P dropped the most it has in four years coming into the last Fed meeting.  It has since regained almost half of its losses.  The markets do not want higher interest rates, and so far, the Fed has listened.

6)      The Fed holds by the belief that the abnormally low interest rates of past seven years has not been a contributor to the income inequality in the U.S. Anyone that relies on their savings to support themselves can decide whether they agree.  What this suggests is that the Fed is willing to do more of the same if they need to in the future because they don’t believe that there are any consequences.

Piece # 4 – Yet to Come

So what we have is a very mixed bag of information.  The economy in the U.S. is, at best, getting better slowly, but the new jobs are not necessarily good jobs.  According to the US Census Bureau, the median income in the U.S. is 6.5% below levels in 2007, which suggests that the new jobs don’t pay as well as the old ones.

The strong dollar will not help corporate results, and while it is too early to analyze Q3 earnings, the few that are out have been mostly weak.  This does not bode well for a stock market selling at ~17 times earnings.

So now, we have to consider possible outcomes – the pieces of the puzzle that we don’t have yet.  Once we add those pieces, we can develop or redevelop our investment strategies.

Possible Piece #4a:  The Fed raises rates and the economy continues to grow, albeit, sluggishly.

In this scenario, the dollar gets stronger.  With margins already having peaked, corporate revenues and net income would likely slow down more.  While this does not mean companies are losing money, it means they aren’t making as much as they were.

Bull Case

  • If Europe’s and/or Asia’s economies get stronger, then the USD may not get stronger, even with a rate rise.
  • If the USD does not strengthen, but maybe even weakens relative to the growing economies abroad, then foreign sales could rise, increasing corporate margins, increasing hiring and increasing wages, leading to increased consumer spending and further increasing corporate revenues and earnings.
  • Banks would make more money because of rising interest rates and demand for borrowing could increase, further stimulating the economy.
  • Rising interest rates hurt bond investors, but help retirees living off their savings.
  • Commodities typically rise in value as the USD weakens and vice-versa.  However, if global demand is increasing, most basic commodities probably rise due supply/demand and being over-sold.
  • Net-net, the stock market would rise in the long run, but might drop in the short run as margin levels are reduced.

Bear Case

  • Given that Europe and Asia are showing signs of weakening, not strengthening, the more likely effect would be a stronger USD, leading to weaker foreign sales, lower corporate margins, which should reduce hiring, which in turn, should reduce consumer spending.
  • A stronger dollar would weaken commodity prices, as would demand due to the weak global economy.
  • Given the heavy levels of margin in the US stock markets, this should be a negative for stocks.
  • Higher interest rates when the economy is weakening typically leads to an inverted yield curve (long rates are lower than short rates).  Given how flat the yield curve is this inversion would be limited.  However lower or continued low-interest rates will continue to make retirees struggle to afford everyday necessities as their incomes are flat to down.  This would continue to keep a lid on the economy.
  • Slower revenues are not good for bonds and rising interest rates are not good for bond either.  With the heavy debt levels in the U.S. there would be a chance that there would be more bond defaults – look to energy, automobiles and housing to find the heaviest leverage.
  • Net-net, the stock market would drop due to margin and lower corporate returns.  Bonds would be weak as well.


Possible Piece #4b – The Fed does not raise rates, and the economy continues to grow sluggishly

Bull Case

  • Stocks rise as speculators add risk again due to cheap borrowing costs.
  • Corporations continue to buy back stock with borrowed money because of the short term cost benefit.  This continues to make earnings look like they are rising.
  • Investors will move even further out the risk curve to get a return, buoying prices in stocks and keeping interest rates low.
  • Commodities stay flat due to supply and demand, but may bounce due to the weaker USD.
  • Net-net – markets rise but then are flat.  Bonds rally as people try to get any kind of yield.

Bear Case

  • Stock rise is limited because growth is limited.
  • Corporate share buybacks become less effective and require even more money, putting corporations in even more strained financial shape.
  • Commodity prices stay low due to lack of demand and over-supply.
  • Interest rates will come down as investors move out the risk curve seeking a return.
  • Volatility increases as liquidity decreases.
  • Net-net – markets are flat until a black swan sends investors into a panic.


Possible Piece #4c – The Fed Raises Rates, and the economy slows

This becomes a very interesting scenario and deserves careful consideration because it will lead to the Fed feeling they have to do something to save the day.  The question is what do they do?

One scenario is that they drop interest rates again back to where they are now.  However, if the economy here and/or abroad (more likely and) are slowing, then the stock market is likely to be falling as well for the reasons noted in #4a and #4b bear cases and which we can summarize in one word – over-valuation and leverage (yes, I was trying to add a little levity to a scary situation). Thus just lowering rates back to zero is very unlikely to help.

A second scenario is that they do a new QE (Quantitative Easing) program of some type.  However, in a white paper written by St. Louis Federal Reserve Vice President Stephen D. Williamson, the efficacy of QE is questionable at best.

A third scenario is not getting much play in the press, but has been getting discussed by the Fed – going to a negative interest rate policy (NIRP).  In fact, Yellen was asked about this during the press conference after the September meeting (I have bolded sections for emphasis).

“MICHAEL DERBY. Mike Derby with Dow Jones Newswires. One of your colleagues in the dot plots said they’d like to see negative interest rates—didn’t expect to see that. What do you make of negative interest rates as a potential source of new stimulus if the Fed were to have to do something more, you know, as opposed to maybe going to QE? Does negative interest rates have any part—does it—is it—should it be part of the Fed’s toolkit, essentially?

CHAIR YELLEN. So, let me be clear that negative interest rates was not something that we considered very seriously at all today. It’s—was not one of our main policy options. But one participant in the Committee would like to see additional accommodation, is concerned by the inflation outlook, and thinks that we need additional stimulus, additional accommodation to provide that, and proposed doing so by moving interest rates negative. That’s something we’ve seen in several European countries. It’s not something we talked about today. Look, if—I don’t expect that we’re going to be in a path of providing additional accommodation, but if the outlook were to change in a way that most of my colleagues and I do not expect and we found ourselves with a weak economy that needed additional stimulus, we would look at all of our available tools, and that would be something that we would evaluate in that kind of context.”

And then again, in a speech given by Chairwoman Yellen, on Thursday 24th at the University of Massachusetts, she spent a great deal of time discussing negative interest rates.

“Inflation that is persistently very low can also be costly, and it is such costs that have been particularly relevant to monetary policymakers in recent years. The most important cost is that very low inflation constrains a central bank’s ability to combat recessions. Normally, the FOMC fights economic downturns by reducing the nominal federal funds rate, the rate charged by banks to lend to each other overnight. These reductions, current and expected, stimulate spending and hiring by lowering longer-term real interest rates–that is, nominal rates adjusted for inflation–and improving financial conditions more broadly. But the federal funds rate and other nominal interest rates cannot go much below zero, since holding cash is always an alternative to investing in securities.9 Thus, the lowest the FOMC can feasibly push the real federal funds rate is essentially the negative value of the inflation rate. As a result, the Federal Reserve has less room to ease monetary policy when inflation is very low. This limitation is a potentially serious problem because severe downturns such as the Great Recession may require pushing real interest rates far below zero for an extended period to restore full employment at a satisfactory pace.10 For this reason, pursuing too low an inflation objective or otherwise tolerating persistently very low inflation would be inconsistent with the other leg of the FOMC’s mandate, to promote maximum employment.11

“9. Because of the inconvenience of storing and protecting very large quantities of currency, some firms are willing to pay a premium to hold short-term government securities or bank deposits instead. As a result, several foreign central banks have found it possible to push nominal short-term interest rates somewhat below zero.

10. For example, Curdia and others (2014) estimate that stabilizing the economy during the last recession would have required lowering the real federal funds rate to negative 10 percent for a time; by comparison, the average value of the real federal funds has been only negative 1-1/4 percent since early 2009. Of course, the FOMC was able to use other policy tools, such as large-scale asset purchases, to put additional downward pressure on long-term interest rates after the nominal funds rate was cut to near zero; however, those policies had potential costs and risks that made them an imperfect substitute for traditional interest rate policy. See Krugman (1998), Reifschneider and Williams (2000), and Eggertsson and Woodford (2003) for discussions of the effects that low inflation and the zero lower bound on nominal interest rates have on a central bank’s ability to stimulate the economy during economic downturns. In addition, see English, Lopez-Salido, and Tetlow (2015) and Engen, Laubach, and Reifschneider (2015) for model-based analyses of the effectiveness of the Federal Reserve’s large-scale asset purchases and forward guidance in mitigating the effects of the zero lower bound. Finally, for a discussion of the costs and benefits of employing large scale asset purchases, see Bernanke (2012) and Yellen (2013).”

Is it possible to get zero or negative interest rates here in the U.S.?  If so, how could it be effected?  As to the first question, the answer is not only, yes it is possible, but it has already happened.  The three month bill at the last auction (10/8/15) went issued at a 0% yield.  Currently, as I write, the interest rate on the 1 month T-Bill is -0.01%, the 3 month is at 0.003% and the six month is at 0.076%.

The second question, how would the Fed effect a negative interest rate policy, was discussed in the chairwoman’s September 24 speech.  “…the FOMC was able to use other policy tools, such as large-scale asset purchases, to put additional downward pressure on long-term interest rates after the nominal funds rate was cut to near zero.”  By limiting the supply of treasuries and other debt (by buying it themselves), they can get rates negative, just has been done in Europe.  Thus, if the Fed went to NIRP, they would also expand their balance sheet, which effectively means doing another QE, just like in second scenario.

So in this scenario, what could be the outcome?  What is our Bull and Bear case?  This is harder because a world where everyone had negative interest rates has never occurred before.  However, walking through the steps is worthwhile:

-          The Fed would likely only go to negative interest rates if the economy weakened and they were losing perceived “control” over the economy.  So we will assume that the economy in the U.S. weakens.

-          This would reduce economic demand in Europe and Asia, further weakening their economies.

-          Weak world economies would lead to weakness in the Emerging Markets, many of which have serious debt issues.

-          With economies weak, valuations and leverage high, stocks would likely fall.

-          With rates going negative, fixed income that wasn’t perceived to be risky would appreciate, moving to interest rates lower.  This would likely happen quickly, so those that owned them early would see appreciation, those that didn’t would find they could earn even less on their money.

-          With most markets returning negative returns, investors would sit on the sidelines as would spenders.  This would weaken corporate earnings even more.

-          Weaker corporate earnings would lead to more layoffs also reducing spending.

-          Most commodities would weaken due to lower demand.  What of precious metals?  It is possible, that a loss of faith in currencies (as all would have negative returns) might lead to demand for precious metals.

-          With negative rates, banks would not want to hold deposits and would not lend money.  Those with debt would find that on a real basis, debt was even more expensive and this would lead to even less spending.  In over-levered situations, this would likely lead to defaults.

This of course would lead to panic at the Fed who then likely come up with another QE program to buoy the markets. The question however, is what do they spend their newly printed dollars on, stocks, a “tax” rebate to everyone (also known as “helicopter money”)?

If they were to do one of these things, at what point do we end up with skyrocketing prices even while there is no demand due to all the money printing?

The Final Piece – the elusive investment piece, #6

Before we go too far and our heads collectively explode (yes, I have had to stop many times and take aspirin), how do we invest given the pieces we have on the table?  While there is rarely an obvious investment solution, given the current pieces, it is harder than normal.  Yet, there are options (a good thing).

The first decision, regardless of where you see the pieces, is that the worst-case scenario leads to hell – so we don’t need to worry about that.  If that is where we end (which hasn’t happened in the history of the world so far), then what we do doesn’t matter.  So let’s ignore the extremes – it is a waste of energy and will lead to a depression that even chocolate can’t help – and THAT is a world I do not wish to contemplate!

So what are the rest of the choices?  They are all mixed and none seem to lead to an obvious home run.  In a game where the teams are very evenly matched, the best strategy is to go for singles and don’t make mistakes.  In the investment world, that means stay focused on investment rules, stay patient as impatience leads to breaking rules to get a quick win, and stay diversified.  Look for singles, not home runs as the risks of striking out are too high.  There is an old saying, “he who fights and runs away, lives to fight another day.”  For investors, this saying would be, “he who saves his capital by running away from excessive risk, has capital to invest another day.”

So, stay diversified:  In terms of stocks, stay focused on companies that are growing, that have low debt, that are not playing games with their earnings.  For example, Johnson and Johnson reported yesterday and appeared to beat by $0.04.  Then when you look at the details, you find out that they changed their tax rate from 30% to 18%.  If they used they typical tax rate they would have seen earnings drop precipitously.  That is not an honest earnings report.  Instead they announce a $10 billion share buyback.  Buying stock at the high is a waste of good money – they should take that $10 billion and do something constructive – not try and manipulate their earnings.  What that signals to me is that they don’t have any plans on how to grow their business – so why own them?

In terms of bonds, stay with quality, as you are not getting paid enough interest to take on the risk of defaults in junk debt.  Diversify by maturity.  Some longer maturities will defend against negative interest rates, while shorter maturities defend against an interest rate hike.  However, I think the likelihood of a significant interest rate hike is between slim and none.

A position in precious metals probably makes sense now.  High quality miners who pay a dividend as that may help offset the fact that this could be dead money for some time.  However, most of these stocks are at multi-year lows so the downside is probably fairly limited.

Hedging can make sense but is difficult, often expensive, and too often does not work out the way anticipated.  If that were not so, then why are most hedge funds doing so poorly?

Alternative investments, such as real estate or private investments can have a place in a portfolio, but those are all impacted by the economy as well and are typically illiquidity, so again, be careful not to be over-exposed.

Like the Grimm’s fairy tale about the Oak versus the Reed, in the face of a violent storm, lowering one’s reward demands will lead you to survive better than pushing the limits and breaking.

Alan E. Rosenfield, Managing Director

October 2015


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