August 2017

Thoughts and Comments

Market Overview

In general, the second quarter provided smooth sailing. The indexes continued to hit new highs, with the S&P 500 up 2.6%, the Dow up 3.3%, and the Nasdaq up 3.9%. The EuroNext 100 was flat and the Nikkei was up 5.9%.

The dollar was weaker by 6%, gold was volatile but traded in a range and ended the quarter down 0.7%, oil was down 11.2% for the quarter but continues to trade a ~$42-$50 range, and the 10-year Treasury was all over (a high of 2.42% and a low of 2.15%) but ended at 2.31%.

Technically speaking, again, all was well. Advance-declines continued to climb, and leadership continued to be strong although it has narrowed. The VIX, a measure of volatility, until two days ago, was hitting lows not seen in 20 years.

Economic Overview

Economic news in Europe and the U.S. was generally good, though mild in degree. Inflation (as measured by the Fed) is near 2% but still quite muted (the latest numbers for the PPI just came out this morning and they were negative for the first time in a year).

While Consumer Confidence readings hit 16 year highs, it was based on current market conditions, not based on future expectations. And while payrolls are growing slowly, (much of this due to minimum wage hikes) spending is not.


Debt levels on both the corporate and personal level are high and bear watching.

Increased savings will help to offset consumer debt, but that can slow the economy, so that should be scrutinized in an economic expansion that is the second longest in U.S. history and close to being the longest.

Corporate debt is a bigger concern because it influences personal income as well as future corporate growth. Corporate debt levels are not historically high, but they are back to pre-2008 levels. The concern is that rather than the debt capital being used for business expansion or research and development, most of the debt has been used to repurchase stock and pay dividends. While dividend growth is good, dividend growth that is due to borrowing rather than increased cash flows is not. In other words, much of the corporate debt expansion of the past almost eight years is for stock price manipulations, not long-term economic expansion. As debt must be repaid (along with interest), this becomes a headwind – especially if revenues and earnings slow or contract.

For the past two years, revenues and earnings for the S&P 500 have been slowing. This was, at least in part, due to the strength in the U.S. dollar. The dollar, however, weakened during the second quarter, falling about 6%. This has continued in the third quarter, dropping another 3% in the past month. This has been a boon to U.S. companies selling abroad and is evident in second quarter earnings results (we are in the middle of earnings reporting season as we write) and should continue to help quarterly reports in both the third and fourth quarters should the trend stabilize or continue. However, dollar volatility can change on a dime and growth due just to this should be discounted just as would be true in reverse.

The Fed and Interest Rates Overview

The Fed has raised the fed funds rate three times in the past seven months (December, March and June). The markets have taken this in stride and while long term rates are up from their lows, they are well below historical norms and below rates from just 12 month earlier. In fact, as can been in the graph below, the yield curve has been flattening substantially.

U.S. Treasury Yield Curve – Data provided by S&P Capital IQ

We expect the Fed will start to reduce its portfolio of approximately $4.6 trillion in the next month or two. While this should work like an interest rate hike, it is likely to impact the longer end of the curve more than the short end due to the longer maturities of treasuries and mortgages that the Fed owns (they purchased them to keep interest rates for borrowers low). However, they are talking about moving very slowly.  So slowly that even at their fastest sales plan, it would take over five years to reduce the portfolio by $1 trillion. It took them less than that to increase it by almost triple that amount.

In addition, unless there are significant changes to spending and taxes, with the current government debt, the Fed really doesn’t want long rates to rise too much as the interest on the debt with the 30-year bond at 4% (half the historical average and only 1% above where we are today) would overwhelm this country’s GDP.

Thus, while many are concerned that high interest rates are on the horizon, it is unlikely that the Fed will be comfortable with such a scenario. Notice, I did not say, “they will not allow it to happen.” This is important to understand because the Fed may very well find itself in the situation where it no longer controls interest rates like everyone believes they can.

Political Outlook

Washington continues to provide headlines and noise, but little is actually getting accomplished. Hope for quick movement in healthcare, taxes and an infrastructure spending plan has turned to hope that something happens some time. The market’s early euphoria for these speedy changes, which never really made much sense, has given way to reality – nothing in Washington happens fast.

In addition to healthcare and taxes, Congress needs deal with the issue of raising the debt ceiling. I would expect the media to keep this in the headlines in the weeks to come.

Internationally, OPEC has not been effective in slowing the growth of U.S. shale oil, which has kept a lid on oil prices. The latest report shows that OPEC members are starting to cheat on their production levels, which will add even more production. This has both positive and negative effects – good for inflation, bad for the Fed, good for companies that use energy to build things, bad for the drillers.

North Korea has recently threatened to bomb Guam and the White House threatened to annihilate North Korea. Iran is harassing the U.S. in the Mediterranean and China is threatening everyone in the South China Sea.

In addition to these potential conflicts are the added threats of trade wars. All of these things should be leading to increased volatility and in fact, the past two days have we have seen a spike in such measures.  However, we need to see if this continues or we slide right back into complacency.

Portfolio Strategies

So the outlook is quite clear, “clear as mud,” as they say. There are plenty of reasons to be nervous, but plenty of reasons to be invested. Given the third quarter is often weak; that the fight to raise the debt ceiling is coming up in October; that we have not had a 5% correction since June 2016, we would not be surprised to see some weakness in the coming weeks.

Reviewing the issues briefly:

1)     P/Es are high

But a weaker dollar has benefited 2nd quarters earnings and should positively impact earnings for the next quarter or two and thus P/Es are not as high as they look. A strong dollar would be a sign to reconsider P/E rates.

2)     The Fed will continue to raise interest rates

Higher interest rates benefit financial stocks, and do not necessarily mean doom for stocks in general. However, if the 10- year treasury moves above 2.80% this could lead weakness in stocks.

3)     There is excessive leverage in the markets

Margin debt is at all-time highs. Historically, it is not high margin but the speedy deleveraging of that leads to bear markets. Watching the 10-year as noted above could signal when we could see deleveraging.

Balancing the risks and the opportunities is what portfolio management is all about. Having laid out what we are watching, let’s now discuss what we are and want to be doing.

For more conservative investors, diversity, blends of equities and fixed income that have attractive dividend or interest yields and some cash should allow us to ride through any sell off.

We are keeping average durations of the fixed income side of the portfolio to under four years as this will provide upside if rates drop and protection if they rise.

Focusing on stocks that still have strong fundamentals, pay dividends and are reasonably priced and those companies that are out of favor or outside of most analysts’ coverage should help protect the downside. Higher than typical amounts of cash (in short term funds) are in order as it not only provides a hedge, but provides capital to put to work if we do get a correction.

For more growth-oriented, more aggressive portfolios, we have reduced the fixed income portion because the easy money has been made. If we get pull backs in industries that make debt attractive as stock alternatives, we will again add debt investments.

We have raised some cash over the last few months as the indexes hit new highs just to be able to make sure we can take advantage of any sell offs. In addition,

have been adding some hedges that will add value in weak markets and will be another source of cash but with profits, when we get opportunities to go long.

The Bottom Line…

There is no question that there are risks to the stock and bond markets. The bull market is long in the tooth, a combination of leverage and central bank manipulations have driven stocks to dubious levels, rates need to normalize, and the world is full of turbulence.

However, there are opportunities and many of the issues mentioned (the Fed and world turbulence) are not likely to change except over a long period of time. Given these point and counter-points, a cautiously optimistic point of view is reasonable and advisable.

Alan E. Rosenfield, Managing Director

August 2017


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