September 2019

Summer Swings

We enter the month of September with the S&P 500 at 2926.46 or -3.4% from the all time high of 3027.98, reached in July.

The index SPY is up +2.37% over the past year, while fixed income aggregate AGG is +10.26%, according to Barrons.

Bonds around the world were in the spotlight as sovereign yields plunged.

Defensive sectors of the stock market rose, while economic sensitive and high beta stocks struggled.

As of the end of August, $17 trillion of debt had negative yields. That is 27% of all debt outstanding and 44% of all developed markets debt ex the U.S.

This is a big deal in economic history. Never before have we seen negative yielding bonds persist on such a scale for such a long period of time.

Imagine getting paid for the privilege of holding someone else's money. This sounds like a scene out of that classic film “The Godfather,” directed by Francis Ford Coppola.

Are Governments making investors an offer they can’t refuse?

Switzerland -1.01% for 10-year notes and Germany -0.70% lead the negative yield parade. Japan -0.26%, France -0.40%, Netherlands -0.54% are all on board the train.

Having never seen this film before, we can just ignore it or puzzle over what it means, and how it may affect our investments.

At this moment, we have positive yields in U.S. Treasuries. During August the rate on a 10 year U.S. Treasury note dropped to 1.49%, with 1.96% on 30 year paper. The dividend yield on the SPY is 1.9% by comparison.

Stocks swooned in August trying to make sense of tweets, tariffs, and treasury yield inversions.

Why do 6 month treasuries pay 1.86%, while 10-year notes pay 1.49%? The answer is because investors fear a recession. This is called yield curve inversion.

Why do investors accept negative yields in Germany, Japan, Switzerland, Holland, etc. for so many maturities? The answer is that investors fear a depression!

If the world’s largest economy the U.S. and the second largest China, have a prolonged trade war, perhaps those fears are not misplaced. If the big economic powers slow down, most other economies follow.

Growth in the U.S. has slowed from 3% in 2018 to barely 2% in 2019. This is despite strong employment trends, consumer spending and low rates. China says it is growing about 6%. They are slowing as well.

Most economists forecast no recession in the year ahead, but others now place the probability at 30%. A recession occurs about 22 months after a yield curve inversion on average, according to Credit Suisse.

The U.S. dollar continues to be strong versus a basket of currencies and the Chinese Yuan.

Gold has run up 18.5% year to date in 2019, better than the rise in the SPX. Worries about where to put cash have led to safe haven buying, while Copper is down 13% in the last 6 months. Freight shipments declined in May, June, and July more than 5%.

Central banks have gone to extraordinary lengths to keep economic activity positive, in much of the world. They are now running out of ammunition and ideas to fight the war on deflation. Neither Japan, the ECB, nor the Fed have reached their 2% inflation targets. When rates peaked in 1981, Central Banks were trying to vanquish inflation. Now they are trying to revive it!

The effects of aging populations, advanced technology and sated consumers may have overcome the power of Central banks money creation machines.

We seem to face a binary future. On the one hand trade wars lead to slower growth and likely recession. On the other, a trade truce keeps GDP going and profits flowing. Profits are expected to grow by 2.3%, according to FactSet in 2019.

Riots in Hong Kong appear to be getting worse and that could lead to China’s intervention. This may ironically soften the CCP’s stance on trade, as they want to appear measured and calm after any crackdown in Hong Kong.

Mr. Xi also needs a good relationship with the U.S. We are China’s biggest customer, with $500 billion of imports. China holds $1.2 trillion of our debt and many U.S. companies are part of their domestic supply chain.

We still believe a trade deal is likely before 2020, but markets are skeptical.

Fall is the traditional time for shakeouts and turnabouts. September is often the weakest month for stocks.

Let us root for cooler heads along with cooler weather. Our economy is strong. We have low unemployment, high consumer confidence, and the proven ability to ride out any storm. Stocks generally go up when the Fed eases policy, and more rate cuts are on the way.

As hurricane season is with us, stay safe and keep dry.

Disclaimer: These stock market observations are confidential and proprietary. They are for informational purposes only and are not intended to be used, and may not be used, as investment, legal, accounting, tax, or other advice. No express or implied representation or warranty is being made with respect to their accuracy or completeness. No obligation exists to inform the recipient when the information herein is no longer current or accurate. These observations do not constitute an offer to sell or a solicitation of an offer to buy any securities or interests in any investment vehicles managed by CFA or an associated person or entity, or to provide investment advisory services.

August 2019

Summer Heat - July 2019 Recap

The Federal Reserve moved on the last day of July to cut rates by a quarter of one percent, the first reduction since 2008.

Concerns by investors that this cut may be a "one and done," along with another round of China tariffs the following day, hurt stock prices after a positive July +1.31% SPX.

This is only the fifth time in 25 years the Central Bank switched from raising to lowering rates, according to the Wall Street Journal.

The beleaguered Fed Chairman, Jay Powell, is trying to balance concerns about a weaker global economy and a strong domestic one. The SPX closed on July 31st at 2980, -1.1% on the day, snapping a 36-session streak of less than 1% move in either direction.

10-year US Treasury notes closed July at 2.034%, while the WSJ Dollar Index rose to 91.25 near a 12-month high. Today they trade at 1.85%.

Fed officials said they would end their runoff of the $3.8 trillion asset portfolio two months earlier than planned. In other words, they are no longer tightening monetary and credit conditions.

The U.S. unemployment rate in June was 3.7%, near a 50 year low. The U.S economy grew at 2.1% in Q2-19 seasonally adjusted. Year over year U.S. wages are rising at 3.5%, and the Savings rate is 8% according to Larry Kudlow, the Chief Economic Advisor to the President. Job growth in the U.S. has averaged more than 170,00 new jobs per month. The biggest beneficiaries of these trends are the working population.

Manufacturing is slowing. However, housing is gaining strength in many areas of the country, particularly for the entry level home buyer. Core C.P.I rose only 1.6% for the year ending in June, below the FED's 2% inflation target.

In past cycles, when there was no recession and the FED cut rates, stocks did well the following year. Small rate cuts in both 1995 and 1998, were followed by strong stock market action.

In 2007, the last time we saw the start of a rate cut cycle, FED funds were 5.25%. However, a recession and financial crisis was only a year away.

The odds of a recession going into a Presidential election year are low. Yield curves have inverted, but not at the closely watched 2-year to 10-year Treasury spread level.

With 77% of companies in the SPX reporting EPS so far the earnings decline is -1.0% for Q2-19. Revenues are up 4.1%. Materials have negative growth and Industrials have no growth. All other sectors were up, led by Communications and Health Care.

The forward 12-month P/E ratio on the SPX was 16.8 x the end of July. This P/E ratio is above the 5-year average of 16.5 x, and the 10-year average of 14.8 x, according to FactSet.

With strong gains from stocks, bonds and gold through July, some profit taking in August has already begun, and may continue as trade talks ebb and flow.

President XI seems to be waiting out President Trump's term in office. In the first half of 2019 China dropped to our number 2 trading partner, after Mexico.

Go out and enjoy the summer breeze! We still have the monetary wind at our backs. Our economic sails are at full beam reach and domestic seas are generally smooth.

Don't be surprised if we get a summer swoon in markets after a 19% jump for stocks year to date. August and September are often bumpy.

July 2019

First Half of 2019 - Review

At the end of June, the S&P 500 index stood at 2941.76, +25% from 2346 low 0n December 26, 2018 and just below the October 2018 high of 2944. The Q4-18, 20% decline is a distant memory.

The broader Russell 2000 index still remains 10% below its 1742 high made on August 31, 2018.

Yields on the 10-year U.S. Treasury dropped to 2% on June 30th, well below the nine-year high 3.24% on October 5, 2018.

U.S. GDP is slowing from the revised 3.1% Q1 level but not dramatically. Fear of a global recession permeates government bond markets, in the developed world, with negative rates on $12 Trillion of debt in Germany, Switzerland, Holland, France and Japan.

S&P 500 earnings have increased from $60.80 in 2009 to an estimate of $167 in 2019, according to Yardeni Associates. At 2973 the index sells for 17.8 times forward earnings, with a 5.6% earnings yield. This compares well to the U.S. Treasury "risk free rates" of 1.98% on 10-year notes.

Unemployment is at 3.8%, a 50 year low. Inflation is below 2%.

Mexico and Canada, our largest trading partners, have agreed on a new trade deal. China, Europe and Japan are likely to follow. The U.S. leads the world in technology, food production, energy production and total wealth with merely 5% of the global population.

We are mindful that the economy is in the 11th year of recovery. Valuations depend on earnings and interest rates, and both support current stock prices.

Our markets have outperformed foreign markets, despite values being cheaper abroad. Growth stocks have outperformed value stocks over this cycle. We acknowledge that we trade near the top end of the 10-year valuation range, however stocks remain cheap relative to bonds.

With the SPX up 17.3%, and the DJIA up 14% through June 30th, some believe the market may falter, as earnings comparisons remain difficult for the next few quarters.

The Fed is more accommodative in 2019 versus last year. The market anticipates 2 rate cuts by year-end, starting in July. Some call this market “Goldilocks,” while others the "Twilight Zone,” but it keeps on keeping on no matter what you call it.

Happy July 4th and God Bless America!

Disclaimer: These stock market observations are confidential and proprietary. They are for informational purposes only and are not intended to be used, and may not be used, as investment, legal, accounting, tax, or other advice. No express or implied representation or warranty is being made with respect to their accuracy or completeness. No obligation exists to inform the recipient when the information herein is no longer current or accurate. These observations do not constitute an offer to sell or a solicitation of an offer to buy any securities or interests in any investment vehicles managed by CFA or an associated person or entity, or to provide investment advisory services.

June 2019

June Bounce or Trounce?

Market action in May was interesting to say the least. We started off with a record SPX high of 2964.13 on May 1, then broke through the 200-day moving average by month's end for a 7% drop. The long dated U.S. Treasury bond as measured by the TLT-Ishares ETF rose 3.8%. The 10-year Treasury note ended with a 2.16% yield, the lowest since September 2017. 30-year conventional mortgage dipped below 4%.

Deciding within the final hour to take back certain trade concessions, China was swiftly lapped with 25% tariffs on much of their U.S. imports. For good measure, President Trump proposed a 5% tariff on Mexican imports if Mexico chooses not to provide more border crossing assistance.

The Fed is now forecast to cut rates 2 times in 2019, in an attempt to offset a serious economic slowdown. The Fed Funds futures market predicts a 72% probability of a cut at the July FOMC meeting.

Oil fell to a 3-month low in May and continues lower in June, now down over 20% from the spring peak. German 10-year Bunds yield negative 0.23%. Who would accept a negative return on Euros or Yen for the next 10 years? The Japanese sovereign bonds yield is -0.13%. Swiss 10-year yield is -0.52%. The Dutch have just joined the negative club, -0.06%. Can France be far behind?

Most Western governments have 2% inflation targets, yet growth in the Eurozone hovers just above 1%. Money policy in Europe remains accommodative.

Q1 US GDP was revised to +3.1%, however, forecasters at the World Bank see 2.5% GDP for 2019, down from 2.9% last year. China, the second largest economy is slowing to 6.2% GDP versus 6.6% in 2018. World economies are drifting downwards as central banks cling to QE, as long as it takes.

Earnings are still positive, but the rate of growth has dropped considerably from last year's +23% for the SPX.

FactSet noted the following on May 31:

"On March 31, the estimated earnings decline for Q1 2019 was -4.0%. Eight sectors have higher growth rates today (compared to March 31) due to upward revisions to EPS estimates and positive EPS surprises. Earnings Guidance: For Q2 2019, 84 S&P 500 companies have issued negative EPS guidance and 26 S&P 500 companies have issued positive EPS guidance. Valuation: The forward 12-month P/E ratio for the S&P 500 is 15.9. This P/E ratio is below the 5-year average (16.5) but above the 10-year average (14.8)."

It is hard to forecast earnings with conviction, but today's P/E ratio remains in line with the 5-year average. Goldman Sachs forecasts SPX earnings at $173 for the year.

Trade negotiations and tariff increases could add 1.25% to U.S. inflation according to Goldman Sachs. A combination of slowing growth and rising inflation is not very bullish for stocks.

Consumers and employees are happy with 50 year low levels of unemployment and attractive borrowing rates. CEO confidence has waned as uncertainties rise. We are 10 years into this economic recovery and nervous investors shifted dollars out of stocks in May.

Bonds are a safe haven for now, as the environment is stable but slowing. A recession is possible, but not likely in the next 18 months without an exogenous event. President Trump wants to remain in office and a good economy is required. His Chinese counterpart, Mr. Xi needs +6% GDP to retain his power base.

It is most likely we will get a trade deal or two by year end. Continued tariffs would likely lead to weaker equities. Most investors like higher stock prices as does President Trump. An untimely drop and recession in 2020 would hurt his chances for re-election.

Sell in May and go away seems to have worked for investors in 2019. A June bounce has just begun, let's see if can last. Watch government rates for directional clues.

  

Disclaimer: These stock market observations are confidential and proprietary. They are for informational purposes only and are not intended to be used, and may not be used, as investment, legal, accounting, tax, or other advice. No express or implied representation or warranty is being made with respect to their accuracy or completeness. No obligation exists to inform the recipient when the information herein is no longer current or accurate. These observations do not constitute an offer to sell or a solicitation of an offer to buy any securities or interests in any investment vehicles managed by CFA or an associated person or entity, or to provide investment advisory services.