Posts tagged ‘Federal Reserve’
The Scary Blip
I hated it when my mom reminded me when I was a younger, but now that I’ve survived into middle-aged adulthood, I will give you the same medicine she gave me:
“I told you so.”
As I cautioned in last month’s newsletter, “It’s important for investors to remember this pace of gains cannot be sustainable forever.” I added that there were a whole bunch of scenarios for stock prices to go down or “stock prices could simply go down due to profit-taking.”
And that is exactly what we saw. From the peak achieved in late January, stock prices quickly dropped by -12% at the low in early February, with little-to-no explanation other than a vague blame-game on rising interest rates – the 2018 yield on the 10-Year Treasury Note rose from 2.4% to 2.9%. This explanation holds little water if you take into account interest rates on the 10-Year increased from roughly 1.5% to 3.0% in 2013 (“Taper Tantrum”), yet stock prices still rose +20%. The good news, at least for now, is the stock correction has been contained or mitigated. A significant chunk of the latest double-digit loss has been recovered, resulting in stock prices declining by a more manageable -3.9% for the month. Despite the monthly loss, the subsequent rebound in late February has still left investors with a gain of 1.5% for 2018. Not too shabby, especially considering this modest return comes on the heels of a heroic +19.4% gain in 2017.
As you can see at from the 22-year stock market chart below for the S&P 500, the brief but painful drop was merely a scary blip in the long-term scheme of things.
Whenever the market drops significantly over a short period of time, as it did this month, conspiracy theories usually come out of the woodwork in an attempt to explain the unexplainable. When human behavior is involved, rationalizing a true root cause can be very challenging, to say the least. It is certainly possible that technical factors contributed to the pace and scale of the recent decline, as has been the case in the past. Currently no smoking gun or fat finger has been discovered, however some pundits are arguing the popular usage of leveraged ETFs (Exchange Traded Funds) has contributed to the accelerated downdraft last month. Leveraged ETFs are special, extra-volatile trading funds that will move at amplified degrees – you can think of them as speculative trading vehicles on steroids. The low-cost nature, diversification benefits, and ability for traders to speculate on market swings and sector movements have led to an explosion in ETF assets to an estimated $4.6 trillion.
Regardless of the cause for the market drop, long-term investors have experienced these types of crashes in the past. Do you remember the 2010 Flash Crash (down -17%) or the October 1987 Crash (-23% one-day drop in the Dow Jones Industrial Average index)? Technology, or the lack thereof (circuit breakers), helped contribute to these past crashes. Since 1987, the networking and trading technologies have definitely become much more sophisticated, but so have the traders and their strategies.
Another risk I highlighted last month, which remains true today, is the potential for the new Federal Reserve chief, Jerome Powell, to institute a too aggressive monetary policy. During his recent testimony and answers to Congress, Powell dismissed the risks of an imminent recession. He blamed past recessions on previous Fed Chairmen who over enthusiastically increased interest rate targets too quickly. Powell’s comments should provide comfort to nervous investors. Regardless of short-term inflation fears, common sense dictates Powell will not want to crater the economy and his legacy by slamming the economic brakes via excessive rate hikes early during his Fed chief tenure.
Tax Cuts = Profit Gains
Despite the heightened volatility experienced in February, I remain fairly constructive on the equity investment outlook overall. The recently passed tax legislation (Tax Cuts and Job Act of 2017) has had an undeniably positive impact on corporate profits (see chart below of record profit forecasts – blue line). More specifically, approximately 75% of corporations (S&P 500 companies) have reported better-than-expected results for the past quarter ending December 31st. On an aggregate basis, quarterly profits have also risen an impressive +15% compared to last year. When you marry these stellar earnings results with the latest correction in stock prices, historically this combination of factors has proven to be a positive omen for investors.
Source: Dr. Ed’s Blog
Despite the rosy profit projections and recent economic strength, there is always an endless debate regarding the future direction of the economy and interest rates. This economic cycle is no different. When fundamentals are strong, stories of spiking inflation and overly aggressive interest rate hikes by the Fed rule the media airwaves. On the other hand, when fundamentals deteriorate or slow down, fears of a 2008-2009 financial crisis enter the zeitgeist. The same tug-of-war fundamental debate exists today. The stimulative impacts of tax cuts on corporate profits are undeniable, but investors remain anxious that the negative inflationary side-effects from a potential overheating economy could outweigh the positive economic momentum of a near full-employment economy gaining steam.
Rather than playing Goldilocks with your investment portfolio by trying to figure out whether the short-term stock market is too hot or too cold, you would be better served by focusing on your long-term asset allocation, and low-cost, tax-efficient investment strategy. If you don’t believe me, you should listen to the wealthiest, most successful investor of all-time, Warren Buffett (The Oracle of Omaha), who just published his annual shareholder letter. In his widely followed letter, Buffett stated, “Performance comes, performance goes. Fees never falter.” To emphasize his point, Buffett made a 10-year, $1 million bet for charity with a high-fee hedge fund manager (Protégé Partners). As part of the bet, Buffett claimed an investment in a low-fee S&P 500 index fund would outperform a selection of high-fee, hot-shot hedge fund managers. Unsurprisingly, the low-cost index fund trounced the hedge fund managers. From 2008-2017, Buffett’s index fund averaged +8.5% per year vs. +3.0% for the hedge fund managers.
During scary blips like the one experienced recently, lessons can be learned from successful, long-term billionaire investors like Warren Buffett, but lessons can also be learned from my mother. Do yourself a favor by getting your investment portfolio in order, so my mother won’t have to say, “I told you so.”
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (March 1, 2018). Subscribe on the right side of the page for the complete text.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Glass Moving from Half-Empty to Half-Full
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (February 1, 2018). Subscribe on the right side of the page for the complete text.
Economic growth accelerated in 2017, the unemployment rate is sitting at a 17-year low, housing prices are up significantly, Consumer Confidence is near the highs of 2000, corporations are doing cartwheels thanks to tax cut legislation, and the stock market has recently set new records. Not a bad start to the year, eh?
Fat Wallets & Stuffed Purses
The strength of the economy, coupled with the optimism of business and consumers, has resulted in a financial boon for Americans, as shown in the chart below. Not only have financial assets and real estate gone up significantly since the 2008-2009 Financial Crisis, but household debt has also remained relatively stable. The combination of these factors have American households sitting on almost $1 trillion in household value, a new record.
Source: Calafia Beach Pundit
As we move ahead through the first month of 2018, the +5.8% gain in the Dow Jones Industrial Average, and the +5.6% advance in the S&P 500 index have further fattened wallets and stuffed the purses of equity investors. On an annual basis, the results only look even better, with the Dow up +32% and the S&P +24%. Given the sharp appreciation in value, casual observers might expect a flood of new investors to pile into stocks and equity mutual funds…not true. Actually, this buying phenomenon has yet to occur. However, it is true investor sentiment has begun shifting to a “glass half-full” perspective due to the vast number of positive economic headlines. Nevertheless, it’s important for investors to remember this pace of gains cannot be sustainable forever.
There is no theoretical limit on the number of potential market moving events. The stock market could temporarily get rattled by another North Korean nuclear test, a terrorist attack, a geopolitical standoff, an inflammatory tweet, an infinite number of other unforeseen events, or stock prices could simply go down due to profit-taking (i.e., investors sell to lock-in gains). Regardless, the economic momentum is palpable and the president did not waste any time at the recent State of the Union address to remind Americans.
Currently, there are limited signs of euphoric stock buying, but there will be a point in time, as in all economic cycles, when investment excesses will overwhelm demand and will therefore lead to a recession. Let’s not forget, an overzealous monetary policy (i.e., too many rate increases), led by a new Federal Reserve chief (Jerome Powell), is another scenario which could slam the breaks on an overheated economy.
Follow the Money
In attempting to read the tea leaves about the future direction of the stock market, we are inspired by the famous quote from the 1976 film All the President’s Men, “Follow the money.” Actions speak louder than words in our book, which is why at Sidoxia Capital Management (www.Sidoxia.com), we track the money buying and selling actions of investors. There is never a shortage of information, and the professionals at the ICI (Investment Company Institute) are kind enough to publish the Weekly Fund Flows data (see chart below), which details the amount of dollars funneling in and out of stock and bond funds. Despite the stock market more than tripling in value, and contrary to common belief, more than -$200 billion has poured out of domestic stock funds and ETFs (Exchange Traded Funds) from 2015 through early 2018.
Source: ICI through 1-17-18
How can this counterintuitive money exodus transpire during a bull market? Quite simply, corporations have been using record piles of cash to buy trillions of dollars in stock through “stock buybacks” and “mergers & acquisitions” activity. All this corporate stock purchase activity has offset the money flowing out of funds, which has helped catapult stock prices higher. History tells us, that before this long-term bull market that started in 2009 ends, flows into U.S. stock mutual funds and ETFs will turn significantly positive after years of hemorrhaging.
Many speculators and traders waste time on a plethora of unreliable sentiment surveys and indicators (e.g., CBOE Volatility Index, AAII Sentiment Survey, Put-Call Ratio, etc), but my 25+ years of investment experience tells me the fund flows data works much better as a longer-term contrarian indicator. To put “contrarian” investing in English, famed billionaire investor, Warren Buffett, summed it up best when he said, “Be fearful when others are greedy and greedy when others are fearful.”
Sharing the Wealth
Speaking of greed, corporations have been greedy capitalists as they have watched profits surge to record levels. Yet many of these greedy corporations have decided to share some of the spoils garnered from the recent tax legislation with rank and file employees. For instance, consider the small sampling of the following large corporations that have decided to pay their employees bonuses:
Overall, even though trillions of savings remain in cash and money is still flowing out of US stock funds, the investment glass is shifting from a glass half-empty perception to a glass half-full impression. A time will come when the masses will believe the glass half-full will turn to a glass over-flowing. I don’t think anyone can predict with any certainty when that time will arrive, but I will continue doing my best to drink as much water as possible before it spills.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in T, CMCSA, DIS, and certain exchange traded funds (ETFs), but at the time of publishing had no direct position in AAL, BAC, JBLU, LUV, USB, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
The Summer Heats Up
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (August 1, 2017). Subscribe on the right side of the page for the complete text.
The temperature in the stock market heated up again this month. Like a hot day at the beach, the Dow Jones Industrial Average stock index burned +542 points higher this month (+2.5%), while scorching +2,129 points ahead in 2017 (or +10.8%).
Despite these impressive gains (see 2009-2017 chart below), overall, investors remain concerned. Rather than stock participants calmly enjoying the sun, breeze, and refreshingly cool waters of the current markets, many investors have been more concerned about getting sunburned to a geopolitical crisp; overwhelmed by an unexpected economic tsunami; and/or drowned by a global central bank-induced interest rate crisis.
Stock market concerns rise, but so do stock prices.
The most recent cautionary warnings have come to the forefront by noted value investor Howard Marks, who grabbed headlines with last week’s forewarning memo, “Here They Go Again…Again.” The thoughtful, 23-page document is definitely worth reading, but like any prediction, it should be taken with a pound of salt, as I point out in my recent article Predictions – A Fool’s Errand. The reality is nobody has been able to consistently predict the future.
If you don’t believe my skepticism about crystal balls and palm readers, just listen to the author of the cautionary article himself. Like many other market soothsayers, Marks is forced to provide a mea culpa on the first page in which he admits his predictions have been wrong for the last six years. His dour but provocative position also faces another uphill battle, given that Marks’s conclusion flies in the face of value investing god, Warren Buffett, who was quoted this year as saying:
“Measured against interest rates, stocks actually are on the cheap side compared to historic valuations.”
Rather than crucify him, Marks should not be singled out for this commonly cautious view. In fact, most value investors are born with the gloom gene in their DNA, given the value mandate to discover and exploit distressed assets. This value-based endeavor has become increasingly difficult as the economy gains steam in this slow but sustainably long economic recovery. As I’ve mentioned on numerous occasions, bull markets don’t die of old age, but rather they die from excesses. So far the key components of the economy, the banking system and consumers, have yet to participate in euphoric excesses like previous economic cycles due to risk aversion caused by the last financial crisis.
Making matters worse for value investors, the value style of investing has underperformed since 2006 alongside other apocalyptic predictions from revered value peers like Seth Klarman and Ray Dalio, who have also been proved wrong over recent years.
However, worth stating, is experienced, long-term investors like Marks, Klarman, and Dalio deserve much more attention than the empty predictions spewed from the endless number of non-investing strategists and economists who I specifically reference in A Fool’s Errand.
Beach Cleanup in Washington
While beach conditions may be sunny, and stock market geeks like me continue debating future market weather conditions, media broadcasters and bloggers have been focused elsewhere – primarily the nasty political mess littered broadly across our American shores.
Lack of Congressional legislation progress relating to healthcare, tax reform, and infrastructure, coupled with a nagging investigation into potential Russian interference into U.S. elections, have caused the White House to finally lose its patience. The end result? A swift cleanup of the political hierarchy. After deciding to tidy up the White House, President Trump’s first priority was to remove Sean Spicer, the former White House Press Secretary and add the controversial Wall Street executive Anthony Scaramucci as the new White House Communications Chief. Shortly thereafter, White House Chief of Staff Reince Priebus was pushed to resign, and he was replaced by Secretary of Homeland Security, John F. Kelly. If this was not enough drama, after Scaramucci conducted a vulgar-laced tirade against Priebus in a New Yorker magazine interview, newly minted Chief of Staff Kelly felt compelled to quickly fire Scaramucci.
While the political beach party and soap opera have been entertaining to watch from the sidelines, I continue to remind observers that politics have little, if any, impact on the long-term direction of the financial markets. There have been much more important factors contributing to the nine-year bull market advance other than politics. For example, interest rates, corporate profits, valuations, and investor sentiment have been much more impactful forces behind the new record stock market highs.
Federal Reserve Chair Janet Yellen may not wear a bikini at the beach, but nevertheless she has become quite the spectacle in Washington, as investors speculate on the future direction of interest rates and other Fed monetary policies (i.e., unwinding the $4.5 trillion Fed balance sheet). In the hopes of not exhausting your patience too heavily, let’s briefly review interest rates, so they can be placed in the proper context. Specifically, it’s worth noting the spotlighted Federal Funds Rate target is sitting at enormously depressed levels (1.00% – 1.25%), despite the fact the Fed has increased the target four times within the last two years. How low has the Fed Funds rate been historically? As you can see from the historical chart below (1970 – 2017), this key benchmark rate reached a level as high as 20.00% in the early 1980s – a far cry from today’s 1.00% – 1.25% rate.
There are two crucial points to make here. First, even at 1.25%, interest rates are at extremely low levels, and this is significantly stimulative to our economy, even after considering the scenario of future interest rate hikes. The second main point is that that Federal Reserve Chair Janet Yellen has been exceedingly cautious about her careful, data-dependent intentions of increasing interest rates. As a matter of fact, the CME Fed Funds futures market currently indicates a 99% probability the Fed will maintain interest rates at this low level when the Federal Open Market Committee (FOMC) meets in September.
Responsibly Have Fun but Use Protection
It’s imperative to remain vigilantly prudent with your investments because weather conditions will not always remain calm in the financial markets. You do not want to get burned by overheated markets or caught off guard by an unexpected economic storm. Blindly buying tech stocks exclusively without a systematic disciplined approach to valuation is a sure-fire way to lose money over the long-run. Instead, protection must be implemented across multiple vectors.
From a broader perspective, at Sidoxia we believe it’s essential to follow a low-cost, diversified, tax-efficient, strategy with a long-term time horizon. Rebalancing your portfolio as markets continue to appreciate will keep your investment portfolio balanced as financial markets gyrate. These investment basics have produced a winning formula for many investors, including some very satisfying long-term results at Sidoxia, which is quickly approaching its 10-year anniversary. You can have fun at the beach, just remember to bring sunscreen and a windbreaker, in case conditions change.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Hot Dogs, Political Fireworks, and Our Nation’s Birthday
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (July 3, 2017). Subscribe on the right side of the page for the complete text.
The 4th of July has arrived once again as we celebrate our country’s 241st birthday of independence. Besides being a time to binge on hot dogs, apple pie, fireworks, and baseball, this national holiday allows Americans to also reflect on the greatness created by our nation’s separation from the British Empire.
As our Founding Fathers fought for freedom and believed in a more prosperous future, I’m not sure if the signers of our Declaration of Independence (Below [left to right]: Roger Sherman, Benjamin Franklin, Thomas Jefferson, John Adams, and Robert Livingston) envisioned a world with tweeting Presidents, driverless Uber taxis, internet dating, biotechnology medical breakthroughs, cloud storage, and countless other innovations that have raised the standard of living for billions of people around the world.
(These Founding Fathers may use different pictures for their Facebook profile, if they were alive today.)
I tend to agree with the wealthiest billionaire investor on the planet, Warren Buffett, that being born in the United States is the equivalent of winning the “Ovarian Lottery.” The opportunities for finding success are exponentially higher, if you were born in America vs. Bangladesh, for example. Surprisingly, the U.S. only accounts for about 4% of the global population (325 million out of 7.5 billion world total). However, even though we Americans make up such a small portion of the of the people on the planet, we still manage to generate over $18 trillion in goods and services, which makes us the world’s largest economy. As the #1 economy, we account for almost 25% of the world’s total economic output (see table & graphic below).
| Rank | Country | GDP (Nominal, 2015) | Share of Global Economy (%) |
| #1 | United States | $18.0 trillion | 24.3% |
| #2 | China | $11.0 trillion | 14.8% |
| #3 | Japan | $4.4 trillion | 5.9% |
| #4 | Germany | $3.4 trillion | 4.5% |
| #5 | United Kingdom | $2.9 trillion | 3.9% |
Source: Visual Capitalist
How do we create six times the output of our population (i.e., 4% of world’s population producing 25% of the world’s output)? Despite the nasty, imperfect, mudslinging politics we live through daily, the U.S. has perfected the art of capitalism, which has landed us on top of the economic Mt. Everest. Although, there is always room for improvement, culturally, the winning “entrepreneurial” strain is born into our American DNA. The recent merger announcement between Amazon.com Inc. (AMZN) and Whole Foods (WFM), the leading natural and organic foods supermarket, is evidence of this entrepreneurial strain. Amazon has come a long way and gained significant steam since its founding in July 1994 by CEO Jeff Bezos. Consequently, the momentum of this internet giant has it steamrolling the entire retail industry, which has led to a flood of store closings, including department store chains, Macy’s, J.C. Penney, Sears and Kmart. The Amazon-Whole Foods merger announcement was not a huge surprise to my family because we actually order more than half of our groceries from AmazonFresh (Amazon’s food delivery program). What’s more, since I despise shopping, I continually find myself taking advantage of Amazon’s “Prime Now” 2-hour delivery option to my office, which is free to all Prime subscribers. It won’t be long before Amazon’s multi-channel strategy will allow me to make same-day orders for groceries, electronics, and general merchandise from my office, then pick up those items on my way home from work at the local Whole Foods store.
Leading the Pack
Replicating this competitive advantage around the world is a challenge for competing countries, and our nation remains leap years ahead of others, regardless of their efforts. However, the United States does not have a monopoly on capitalism. We are slowly exporting our entrepreneurial secret sauce abroad with the help of technology and globalization. Just consider these three Chinese companies alone are valued at almost $1 trillion (Alibaba Group $360B [BABA]; Tencent Holdings $340B [TCEHY]; and China Mobile $220B [CHL]), and the largest expected IPO (Initial Public Offering) in the world could be a Saudi Arabian company valued at $2 trillion (Saudi Aramco). When 96% of the world’s population lies outside of the U.S., this reality helps explain why exporting our advancements should not be considered a bad thing. In fact, a growing international pie means more American jobs and more dollars will flow back to the U.S., as we export more value-added products and services abroad.
Even if other countries are narrowing the entrepreneurial competitive gap with the United States, we still remain a beacon of light for others to follow. Despite what you may read in the newspaper or hear on the TV, Americans are dramatically better off financially over the last 20 years. Not only has net worth increased spectacularly, but consumers have also responsibly reduced debt leverage ratios (see chart below).
Source: Calafia Beach Pundit
If you were a bright CEO working for an innovative new start-up company, would you choose to launch your company in a closed, censored society like China? How about a fractured Britain that is pushing to break away from the European Union? Better yet, how about Japan with its exploding debt levels, a declining population, and a stock market that is about half the level it peaked at 28 years ago? Do emerging markets like Brazil with widespread corruption scandals blanketing a new president (after a recently impeached president) seem like the best location for a hot new venture? The answer to all these questions is a resounding “no”, even when compared to the warts and flaws that come with our durable democracy.
Political Pyrotechnics
Besides the bombs bursting in air during the 4th of July celebration, there were plenty of political fireworks blasting in our nation’s capital last month. No matter what side of the political fence you stand on, last month was explosive. Consider ousted FBI Director Jim Comey’s impassioned testimony relating to his firing by President Donald Trump; the contentious Attorney General Jeff Sessions Senate Intelligence Committee interview; the politically driven Republican baseball shooting; and the Special Counsel leader Robert Mueller’s investigation into Russian interference and potential Trump administration collusion into the 2016 elections.
Despite the combative atmosphere in Washington D.C., the stock market managed to notch another record high last month, with the Dow Jones Industrial Average index advancing another 340.98 points (+1.6%) for the month, and +8.0% for the first half of 2017. As I have written numerous times, the scary headlines accumulating since 2009 have prevented investors, strategists, economists, and even professionals from adequately participating in the almost quadrupling in stock prices since early 2009. Unfortunately, to the detriment of many, large swaths of investors who were burned by the 2008-2009 Financial Crisis have been scarred to almost permanent risk aversion. The fact of the matter is stock prices care more about economic factors than political / news headlines (see Moving on Beyond Politics).
The bitter, vitriolic political discourse is unlikely to disappear anytime soon, so do yourself a favor, and focus on the more important factors driving financial markets to new record highs – mainly corporate profits, interest rates, valuations, and sentiment (see Don’t Be a Fool). During this year’s 4th of July, partaking in hot dogs, apple pie, fireworks, and baseball are wholly encouraged, but please also take the time to celebrate and acknowledge the magnitude of our country’s greatness. That’s a birthday wish, I think we can all agree upon.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in AMZN and certain exchange traded funds (ETFs), but at the time of publishing had no direct position in WFM, BABA, TCEHY, CHL, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
No April Fool’s Joke – Another Record
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (April 3, 2017). Subscribe on the right side of the page for the complete text.
Having children is great, but a disadvantage to having younger kids are the April Fool’s jokes they like to play on parents. Fortunately, this year was fairly benign as I only suffered a nail-polish covered bar of soap in the shower. However, what has not been a joke has been the serious series of new record highs achieved in the stock market. While it is true the S&P 500 index finished roughly flat for the month (-0.0%) after hitting new highs earlier in March, the technology-laden NASDAQ index continued its dominating run, advancing +1.5% in March contributing to the impressive +10% jump in the first quarter. For 2017, the NASDAQ supremacy has been aided by the stalwart gains realized by leaders like Apple Inc. (up +24%), Facebook Inc. (up +23%), and Amazon.com Inc. (up +18%). The surprising fact to many is that these records have come in the face of immense political turmoil – most recently President Trump’s failure to deliver on a campaign promise to repeal and replace the Obamacare healthcare system.
Like a broken record, I’ve repeated there are much more important factors impacting investment portfolios and the stock market other than politics (see also Politics Schmolitics). In fact, many casual observers of the stock market don’t realize we have been in the midst of a synchronized, global economic expansion, helped in part by the stabilization in the value of the U.S. dollar over the last couple of years.
Source: Investing.com
As you can see above, there was an approximate +25% appreciation in the value of the dollar in late-2014, early-2015. This spike in the value of the dollar suddenly made U.S. goods sold abroad +25% more expensive, resulting in U.S. multinational companies experiencing a dramatic profitability squeeze over a short period of time. The good news is that over the last two years the dollar has stabilized around an index value of 100. What does this mean? In short, this has provided U.S. multinational companies time to adjust operations, thereby neutralizing the currency headwinds and allowing the companies to return to profitability growth.
Source: Calafia Beach Pundit
And profits are back on the rise indeed. The six decade long chart above shows there is a significant correlation between the stock market (red line – S&P 500) and corporate profits (blue line). The skeptics and naysayers have been out in full force ever since the 2008-2009 financial crisis – I profiled these so-called “sideliners” in Get out of Stocks!.
As the stock market continues to hit new record highs, the doubters continue to scream danger. There will always be volatility, but when the richest investor of all-time, Warren Buffett, continues to say that stocks are still attractively priced, given the current interest rate environment, that goes a long way to assuage investor concerns.
Politically, a lot could still go wrong as it relates to healthcare, tax reform, and infrastructure spending, to name a few issues. However, it’s still early, and it’s possible positive surprises could also occur. More importantly, as I’ve noted before, corporate profits, interest rates, valuations, and investor sentiment are much more important factors than politics, and on balance these factors are on the favorable side of the ledger. These factors will have a larger impact on the long-term direction of stock prices.
With approval ratings of Congress and the President at low levels, investors have had trouble finding humor in politics, even on April Fool’s Day. Another significant factor more important than politics is the issue of retirement savings by Americans, which is no joke. As you finalize your tax returns in the coming weeks, it behooves you to revisit your retirement plan and investment portfolio. Inefficiently investing your money or outliving your savings is no laughing matter. I’ll continue with my disciplined financial plan and leave the laughing to my kids, as they enjoy planning their next April Fool’s Day prank.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in AAPL, FB, AMZN, and certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Wiping Your Financial Slate Clean
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (January 3, 2017). Subscribe on the right side of the page for the complete text.
The page on the calendar has turned, and we now have a new year, and will shortly have a new president, and new economic policies. Although there is nothing magical about starting a fresh, new year, the annual rites of passage also allow investors to start with a clean slate again and reflect on their personal financial situation. Before you reach a desired destination (i.e., retirement), it is always helpful to know where you have been and where are you currently. Achieving this goal requires filtering through a never-ending avalanche of real-time data flooding through our cell phones, computers, TVs, radios, and Facebook accounts. This may seem like a daunting challenge, but that’s where I come in!
Distinguishing the signals from the noise is tough and there was plenty of noise in 2016 – just like there is every year. Before the S&P 500 stock index registered a +9.5% return in 2016, fears of a China slowdown blanketed headlines last January (the S&P 500 fell -15% from its highs and small cap stocks dropped -26%), and the Brexit (British exit) referendum caused a brief 48-hour -6% hiccup in June. Oil was also in the news as prices hit a low of $26 a barrel early in the year, before more than doubling by year-end to $54 per barrel (still well below the high exceeding $100 in 2014). On the interest rate front, 10-Year Treasury rates bottomed at 1.34% in July, while trillions of dollars in global bonds were incomprehensibly paying negative interest rates. However, fears of inflation rocked bond prices lower (prices move inversely to yields) and pushed bond yields up to 2.45% today. Along these lines, the Federal Reserve has turned the tide on its near-0% interest rate policy as evidenced by its second rate hike in December.
Despite the abbreviated volatility caused by the aforementioned factors, it was the U.S. elections and surprise victory of President-elect Donald Trump that dominated the media airwaves for most of 2016, and is likely to continue as we enter 2017. In hindsight, the amazing Twitter-led, Trump triumph was confirmation of the sweeping global populism trend that has also replaced establishment leaders in the U.K., France, and Italy. There are many explanations for the pervasive rise in populism, but meager global economic growth, globalization, and automation via technology are all contributing factors.
The Trump Bump
Even though Trump has yet to accept the oath of Commander-in-Chief, recent investor optimism has been fueled by expectations of a Republican president passing numerous pro-growth policies and legislation through a Republican majority-controlled Congress. Here are some of the expected changes:
- Corporate/individual tax cuts and reform
- Healthcare reform (i.e., Obamacare)
- Proposed $1 trillion in infrastructure spending
- Repatriation tax holiday for multinational corporate profits
- Regulatory relief (e.g., Dodd-Frank banking and EPA environmental reform)
The chart below summarizes the major events of 2016, including the year-end “Trump Bump”:
While I too remain optimistic, I understand there is no free lunch as it relates to financial markets (see also Half Trump Full). While tax cuts, infrastructure spending, and regulatory relief should positively contribute to economic growth, these benefits will have to be weighed against the likely costs of higher inflation, debt, and deficits.
Over the 25+ years I have been investing, the nature of the stock market and economy hasn’t changed. The emotions of fear and greed rule the day just as much today as they did a century ago. What has changed today is the pace, quality, and sheer volume of news. In the end, my experience has taught me that 99% of what you read, see or hear at the office is irrelevant as it relates to your retirement and investments. What ultimately drives asset prices higher or lower are the four key factors of corporate profits, interest rates, valuations, and sentiment (contrarian indicator) . As you can see from the chart below, corporate profits are at record levels and forecast to accelerate in 2017 (up +11.9%). In addition, valuations remain very reasonable, given how low interest rates are (albeit less low), and skeptical investor sentiment augurs well in the short-run.
Source: FactSet
Regardless of your economic or political views, this year is bound to have plenty of ups and downs, as is always the case. With a clean slate and fresh turn to the calendar, now is a perfect time to organize your finances and position yourself for a better retirement and 2017.
Wade W. Slome, CFA, CFP®
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in FB and certain exchange traded funds (ETFs), but at the time of publishing had no direct position in TWTR or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Half Trump Empty, or Half Trump Full?
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (December 1, 2016). Subscribe on the right side of the page for the complete text.
It was a bitter U.S. presidential election, but fortunately, the nastiest election mudslinging has come to an end…at least until the next political contest. Unfortunately, like most elections, even after the president-elect has been selected, almost half the country remains divided and the challenges facing the president-elect have not disappeared.
While some non-Trump voters have looked at the glass as half empty, since the national elections, the stock market glass has been overflowing to new record highs. Similar to the unforeseen British Brexit outcome in which virtually all pollsters and pundits got the results wrong, U.S. experts and investors also initially took a brief half-glass full view of the populist victory of Donald Trump. More specifically, for a few hours on Election Day, stock values tied to the Dow Jones Industrial Average index collapsed by approximately -5%.
It didn’t take long for stock prices to quickly reverse course, and when all was said and done, the Dow Jones Industrial Average finished the month higher by almost +1,000 points (+5.4%) to finish at 19,124 – a new all-time record high (see chart below). Worth noting, stocks have registered a very respectable +10% return during 2016, and the year still isn’t over.
Source: Investors.com (IBD)
Drinking the Trump Egg Nog
Why are investors so cheery? The proof will be in the pudding, but current optimism is stemming from a fairly broad list of anticipated pro-growth policies.
At the heart of the reform is the largest expected tax reform since Ronald Reagan’s landmark legislation three decades ago. Not only is Trump proposing stimulative tax cuts for corporations, but also individual tax reductions targeted at low-to-middle income taxpayers. Other facets of the tax plan include simplification of the tax code; removal of tax loopholes; and repatriation of foreign cash parked abroad. Combined, these measures are designed to increase profits, wages, investment spending, productivity, and jobs.
On the regulatory front, the President-elect has promised to repeal the Obamacare healthcare system and also overhaul the Dodd-Frank financial legislation. These initiatives, along with talk of dialing back other regulatory burdensome laws and agencies have many onlookers hopeful such policies could aid economic growth.
Fueling further optimism is the prospect of a trillion dollar infrastructure spending program created to fix our crumbling roads and bridges, while simultaneously increasing jobs.
No Free Lunch
As is the case with any economic plan, there is never a free lunch. Every cost has a benefit, and every benefit has a cost. The cost of the 2008-2009 Financial crisis is reflected in the sluggish economic growth seen in the weak GDP (Gross Domestic Product) statistics, which have averaged a modest +1.6% growth rate over the last year. Scott Grannis points out how the slowest recovery since World War II has resulted in a $3 trillion economic gap (see chart below).
Source: Calafia Beach Pundit
The silver lining benefit to weak growth has been tame inflation and the lowest interest rate levels experienced in a generation. Notwithstanding the recent rate rise, this low rate phenomenon has spurred borrowing, and improved housing affordability. The sub-par inflation trends have also better preserved the spending power of American consumers on fixed incomes.
If executed properly, the benefits of pro-growth policies are obvious. Lower taxes should mean more money in the pockets of individuals and businesses to spend and invest on the economy. This in turn should create more jobs and growth. Regulatory reform and infrastructure spending should have similarly positive effects. However, there are some potential downside costs to the benefits of faster growth, including the following:
- Higher interest rates
- Rising inflation
- Stronger dollar
- Greater amount of debt
- Larger deficits (see chart below)
Source: The Wall Street Journal
Even though President-elect Trump has not even stepped foot into the Oval Office yet, signs are already emerging that we could face some or all of the previously mentioned headwinds. For example, just since the election, the yield on 10-Year Treasury Notes have spiked +0.5% to 2.37%, and 30-Year Fixed Rate mortgages are flirting with 4.0%. Social and economic issues relating to immigration legislation and Supreme Court nominations are likely to raise additional uncertainties in the coming months and years.
Attempting to anticipate and forecast pending changes makes perfect sense, but before you turn your whole investment portfolio upside down, it’s important to realize that actions speak louder than words. Even though Republicans have control over the three branches of government (Executive, Legislative, Judicial), the amount of control is narrow (i.e., the Senate), and the nature of control is splintered. In other words, Trump will still have to institute the “art of the deal” to persuade all factions of the Republicans (including establishment, Tea-Party, and rural) and Democrats to follow along and pass his pro-growth policies.
Although I do not agree with all of Trump’s policies, including his rhetoric on trade (see Free Trade Boogeyman), I will continue paying closer attention to his current actions rather than his past words. Until proven otherwise, I will keep on my rose colored glasses and remain optimistic that the Trump glass is half full, not half empty.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
When Genius Failed
It has been a busy year between work, play, family, and of course the recent elections. My work responsibilities contain a wide-ranging number of facets, but in addition to research, client meetings, conference calls, conferences, trading, and other activities, I also attempt to squeeze in some leisure reading as well. While it’s sad but true that I find pleasure in reading SEC documents (10Ks and 10Qs), press releases, transcripts, corporate presentations, financial periodicals, and blogs, I finally did manage to also scratch When Genius Failed by Roger Lowenstein from my financial reading bucket list.
When Genius Failed chronicles the rise and fall of what was considered the best and largest global hedge fund, Long Term Capital Management (LTCM). The irony behind the collapse makes the story especially intriguing. Despite melding the brightest minds in finance, including two Nobel Prize winners, Robert Merton and Myron Scholes, the Greenwich, Connecticut hedge fund that started with $1.3 billion in early 1994 managed to peak at around $140 billion before eventually crumbling to ruin.
With the help of confidential internal memos, interviews with former partners and employees of LTCM, discussions with the Federal Reserve, and consultations with the six major banks involved in the rescue, Lowenstein provides the reader with a unique fly-on-the-wall perspective to this grand financial crisis.
There have certainly been plenty of well-written books recounting the 2008-2009 financial crisis (see my review on Too Big to Fail), but the sheer volume has burnt me out on the subject. With that in mind, I decided to go back in time to the period of 1993 – 1998, a point at the beginning of my professional career. Until LTCM’s walls began figuratively caving in and global markets declined by more than $1 trillion in value, LTCM was successful at maintaining a relatively low profile. The vast majority of Americans (99%) had never heard of the small group of bright individuals who started LTCM, until the fund’s ultimate collapse blanketed every newspaper headline and media outlet.
Key Characters
Meriwether: John W. Meriwether was a legendary trader at Salomon Brothers, where he started the Arbitrage Group in 1977 and built up a successful team during the 1980s. His illustrious career is profiled in Michael Lewis’s famed book, Liar’s Poker. Meriwether built his trading philosophy upon the idea that mispricings would eventually revert back to the mean or converge, and therefore shrewd opportunistic trading will result in gains, if patience is used. Another name for this strategy is called “arbitrage”. In sports terms, the traders of the LTCM fund were looking for inaccurate point spreads, which could then be exploited for profit opportunity. Prior to the launch of LTCM, in 1991 Meriwether was embroiled in the middle of a U.S. Treasury bid-rigging scheme when one of his traders Paul Mozer admitted to submitting false bids to gain unauthorized advantages in government-bond auctions. John Gutfreund, Salomon Brothers’ CEO was eventually forced to quit, and Salomon’s largest, famed shareholder Warren Buffett became interim CEO. Meriwether was slapped on the wrist with a suspension and fine, and although Buffett eventually took back Meriwether in a demoted role, ultimately the trader was viewed as tainted goods so he left to start LTCM in 1993.
LTCM Team: During 1993 Meriwether built his professional team at LTCM and he began this process by recruiting several key Salomon Brothers bond traders. Larry Hilibrand and Victor Haghani were two of the central players at the firm. Other important principals included Eric Rosenfeld, William Krasker, Greg Hawkins, Dick Leahy, Robert Shustak, James McEntee, and David W. Mullins Jr.
Nobel Prize Winners (Merton & Scholes): While Robert C. Merton was teaching at Harvard University and Myron S. Scholes at Stanford University, they decided to put their academic theory to the real-world test by instituting their financial equations with the other investing veterans at LTCM. Scholes and Merton were effectively godfathers of quantitative theory. If there ever were a Financial Engineering Hall of Fame, Merton and Scholes would be initial inductees. Author Lowenstein described the situation by saying, “Long-Term had the equivalent of Michael Jordan and Muhammad Ali on the same team.” Paradoxically, in 1997, right before the collapse of LTCM, Merton and Scholes would become Nobel Prize laureates in Economic Sciences for their work in developing the theory of how to price options.
The History:
Founded in 1993, Long-Term Management Capital was hailed as the most impressive hedge fund created in history. Near its peak, LTCM managed money for about 100 investors and employed 200 employees. LTCM’s primary strategy was to identify mispriced bonds and profit from a mean reversion strategy. In other words, as long as the overall security mispricings narrowed, rather than widened, then LTCM would stand to profit handsomely.
On an individual trade basis, profits from LTCM’s trades were relatively small, but the fund implemented thousands of trades and used vast amounts of leverage (borrowings) to expand the overall profits of the fund. Lowenstein ascribed the fund’s success to the following process:
“Leveraging its tiny margins like a high-volume grocer, sucking up nickel after nickel and multiplying the process a thousand times.”
Although LTCM implemented this strategy successfully in the early years of the fund, this premise finally collapsed like a house of falling cards in 1998. As is generally the case, hedge funds and other banking competitors came to understand and copy LTCM’s successful trading strategies. Towards the end of the fund’s life, Meriwether and the other fund partners were forced to experiment with less familiar strategies like merger arbitrage, pair trades, emerging markets, and equity investing. This diversification strategy was well intentioned, however by venturing into uncharted waters, the traders were taking on excessive risk (i.e., they were increasing the probability of permanent capital losses).
The Timeline
- 1994 (28% return, 20% after fees): After attempting to raise capital funding in 1993, LTCM opened its doors for business in February 1994 with $1.25 billion in equity. Financial markets were notably volatile during 1994 in part due to Federal Reserve Chairman Alan Greenspan leading the first interest rate hike in five years. The instability caused famed fund managers Michael Steinhardt and George Soros to lose -$800 million and $650 million, respectively, all within a timespan of less than a week. The so-called “Mexican Tequila Crisis” that occurred at the end of the year also resulted in a devaluation of the Mexican peso and crumbling of the Mexican stock market.
- 1995 (59% return, 43% after fees): By the end of 1995, the fund had tripled its equity capital and total assets had grown to $102 billion. Total leverage, or the ratio of debt to equity, stood around 28 to 1. LTCM’s derivative contract portfolio was like a powder keg, covering positions worth approximately $650 billion.
- 1996 (57% return, 41% after fees): By the spring of 1996, the fund was holding $140 billion in assets, making it two and a half times as big as Fidelity Magellan, the largest mutual fund on the planet. The fund also carried derivatives valued at more than $1 trillion, all financed off a relatively smaller $4 billion equity base. Investors were loving the returns and financial institutions were clamoring to gain some of LTCM’s business. During this period, as many as 55 banks were providing LTCM financing. The mega-returns earned in 1996 came in large part due to profitable leveraged spread trades on Japanese convertible bonds, Italian bonds, junk bonds, and interest rate swaps. Total profits for the year reached an extraordinary level of around $2.1 billion. To put that number in perspective, that figure was more money generated than the profits earned by McDonalds, Disney, American Express, Nike, Xerox, and many more Fortune 500 companies.
- 1997 (25% return, 17% after fees): The Asia Crisis came into full focus during October 1997. Thailand’s baht currency fell by -20% after the government decided to let the currency float freely. Currency weakness then spread to the Philippines, Malaysia, South Korea, and Singapore. As Russian bond spreads (prices) began to widen, massive trading losses for LTCM were beginning to compound. Returns remained positive for the year and the fund grew its equity capital to $5 billion. As the losses were mounting and the writing on the wall was revealing itself, professors Merton and Scholes were recognized with their Nobel Prize announcement. Ironically, LTCM was in the process of losing control. LTCM’s bloated number of 7,600 positions wasn’t making the fund any easier to manage. During 1997, the partners realized the fund’s foundation was shaky, so they returned $2.7 billion in capital to investors. Unfortunately, the risk profile of the fund worsened – not improved. More specifically, the fund’s leverage ratio skyrocketed from 18:1 to 28:1.
- 1998 (-92% return – loss): The Asian Crisis losses from the previous year began to bleed into added losses in 1998. In fact, losses during May and June alone ended up reducing LTCM’s capital by $461 million. As the losses racked up, LTCM was left in the unenviable position of unwinding a mind-boggling 60,000 individual positions. It goes almost without saying that selling is extraordinarily difficult during a panic. As Lowenstein put it, “Wall Street traders were running from Long-Term’s trades like rats from a sinking ship.” A few months later in September, LTCM’s capital shrunk to less than $1 billion, meaning about $100 billion in debt (leverage ratio greater than 100:1) was supporting the more than $100 billion in LTCM assets. It was just weeks later the fund collapsed abruptly. Russia defaulted on its ruble debt, and the collapsing currency contagion spread to global markets outside Russia, including Eastern Asia, and South America.
The End of LTCM
On September 23, 1998, after failed investment attempts by Warren Buffett and others to inject capital into LTCM, the heads of Bankers Trust, Bear Stearns, Chase Manhattan, Goldman Sachs, J.P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley Dean Witter, and Salomon Brothers all gathered at the Federal Reserve Bank of New York in the heart of Wall Street. Presiding over this historical get-together was Fed President, William J. McDonough. International markets were grinding to a halt during this period and the Fed was running out of time before an all-out meltdown was potentially about to occur. Ultimately, McDonough was able to get 14 banks to wire $3.65 billion in bailout funds to LTCM. While all LTCM partners were financially wiped out completely, initial investors managed to recoup a small portion of their original investment (23 cents on the dollar after factoring in fees), even though the tally of total losses reached approximately $4.6 billion. Once the bailout was complete, it took a few years for the fund to liquidate its gargantuan number of positions and for the banks to get their multi-billion dollar bailout paid back in full.
- 1999 – 2009 (Epilogue): Meriwether didn’t waste much time moping around after the LTCM collapse, so he started a new hedge fund, JWM Partners, with $250 million in seed capital primarily from legacy LTCM investors. Regrettably, the fund was hit with significant losses during the 2008-2009 Financial Crisis and was subsequently forced to close its doors in July 2009.
Source: The Personal Finance Engineer
Source: The Personal Finance Engineer
Lessons Learned:
- The Risks of Excessive Leverage: Although the fund grew to peak value of approximately $140 billion in assets, most of this growth was achieved with added debt. When all was said and done, LTCM borrowed more than 30 times the value of its equity. As Lowenstein put it, LTCM was “adding leverage to leverage, as if coating a flammable tinderbox with kerosene.” In home purchase terms, if LTCM wanted to buy a house using the same amount of debt as their fund, they would lose all of their investment, if the house value declined a mere 3-4%. The benefit of leverage is it multiplies gains. The downside to leverage is that it also multiplies losses. If you carry too much leverage in a declining market, the chance of bankruptcy rises…as the partners and investors of LTCM learned all too well. Adding fuel to the LTCM flames were the thousands of derivative contracts, valued at more than $1 trillion. Warren Buffett calls derivatives: “Weapons of Mass Destruction.”
- Past is Not Always Prologue for the Future: Just because a strategy works now or in the past, does not mean that same strategy will work in the future. As it relates to LTCM, Nobel Prize winning economist Merton Miller stated, “In a strict sense, there wasn’t any risk – if the world had behaved as it did in the past.” LTCM’s models worked for a while, then failed miserably. There is no Holy Grail investment strategy that works always. If an investment strategy sounds too good to be true, then it probably is too good to be true.
- Winning Strategies Eventually Get Competed Away: The spreads that LTCM looked to exploit became narrower over time. As the fund achieved significant excess returns, competitors copied the strategies. As spreads began to tighten even further, the only way LTCM could maintain their profits was by adding additional leverage (i.e., debt). High-frequency trading (HFT) is a modern example of this phenomenon, in which early players exploited a new technology-driven strategy, until copycats joined the fray to minimize the appeal by squeezing the pool of exploitable profits.
- Academics are Not Practitioners: Theory does not always translate into reality, and academics rarely perform as well as professional practitioners. Merton and Scholes figured this out the hard way. As Merton admitted after winning the Nobel Prize, “It’s a wrong perception to believe that you can eliminate risk just because you can measure it.”
- Size Matters: As new investors poured massive amounts of capital into the fund, the job of generating excess returns for LTCM managers became that much more difficult. I appreciate this lesson firsthand, given my professional experience in managing a $20 billion fund (see also Managing $20 Billion). Managing a massive fund is like maneuvering a supertanker – the larger a fund gets, the more difficult it becomes to react and anticipate market changes.
- Stick to Your Knitting: Because competitors caught onto their strategies, LTCM felt compelled to branch out. Meriwether and LTCM had an edge trading bonds but not in stocks. In the later innings of LTCM’s game, the firm became a big player in stocks. Not only did the firm place huge bets on merger arbitrage, but LTCM dabbled significantly in various long-short pair trades, including a $2.3 billion pair trade bet on Royal Dutch and Shell. Often the firm used derivative securities called equity swaps to make these trades without having to put up any significant capital. As LTCM experimented in the new world of equities, the firm was obviously playing in an area in which it had absolutely no expertise.
As philosopher George Santayana states, “Those who fail to learn from history are doomed to repeat it.” For those who take investing seriously, When Genius Failed is an important cautionary tale that provides many important lessons about financial markets and highlights the dangers of excessive leverage. You may not be a genius Nobel Prize winner in economics, but learning from Long-Term Capital Management’s failings will place you firmly on the path to becoming an investing genius.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), DIS, JPM, and MCD, but at the time of publishing had no direct position in AXP, NKE, XRX, RD, GS, MS, Shell, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page
What Do You Worry About Next?
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (November 1, 2016). Subscribe on the right side of the page for the complete text.
Boo! Halloween has just passed and frightened investors have still survived to tell the tale in 2016. While most people have gotten spooked by the presidential election, other factors like record-high corporate profits, record-low interest rates, and reasonable valuations have led to annual stock market gains. More specifically, values have risen in 2016 by approximately +4% (or +6% including dividend payments). Despite last week’s accelerating 3rd quarter GDP economic growth figure of +2.9%, which was the highest rate in two years and more than doubled the rate of the previous quarter (up +1.4%), there were still more tricks than treats during October. Recently, scary politics have shocked many Halloween participants into a zombie-like state, as evidenced by stock values declining around -1.7% during October.
This recent volatility is nothing new. Even though financial markets are significantly higher in recent years, that has not prevented repeated corrections over the year(s) as shown below in the 2009 – 2015 chart.
In order to earn higher long-term returns, investors have to accept a certain amount of short-term price movements (upwards and downwards). With a couple months remaining in the year, stock investors have achieved gains through a tremendous amount of economic and geopolitical uncertainty, including the following scares:
- China: A significant fallout from a Chinese slowdown at the beginning of the year (stocks fell about -14%).
- Brexit: A 48-hour Brexit vote scare in June (stocks fell -6%).
- Fed Fears: Threatening comments in September from the Federal Reserve about potentially hiking increasing interest rates (stocks fell -4%).
With the elections just a week away, political anxiety has jolted Americans’ adrenaline levels. The polls continue to move up and down, but as I have repeatedly pointed out, the only certain winner in Washington DC is gridlock. Sure, in a Utopian world, politicians should join hands and compromise to solve all our country’s serious problems. Unfortunately, this is not the case (see Congress’s approval rating). However, there is a silver lining to this dysfunction…gridlock can lead to fiscal discipline.
Our country’s debt/deficit financial situation has been spiraling out of control, in large measure due to rapidly rising entitlement spending, including Medicare, and Social Security. Witnessing all the political rhetoric and in-fighting is very difficult, but as I highlighted in last month’s newsletter, gridlock has flattened the spending curve significantly since 2009 – a positive development.
And although the economic recovery has been one of the slowest since World War II and global growth remains anemic, the U.S. remains a better house in a bad global neighborhood (e.g., Europe and Japan continue to suck wind), as evidenced by a number of these following positive economic indicators:
- Employment Improvement: Unemployment has fallen from 10% to 5% since 2009, and more than 15 million jobs have been added over that period.
- Housing Recovery Continues: Home sales and prices continue their multi-year rise; housing inventories remain tight; and affordability remains strong, given generationally low interest rates.
- Record Auto Sales: Car sales remain near record levels, hovering around 17 million units per year.
- Consumer Confidence on the Rise: Ever since the financial crisis, consumer sentiment figures have rebounded by about 50%.
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Record Consumer Sales: Consumer spending accounts for approximately 70% of our economy, and as you can see from the chart below, despite consumers saving more, stronger employment and wages are fueling more spending.
Source:Calculated Risk
Absent a clean sweep of control by the Democrat or Republican Presidential-Congressional candidates, our democratic system will retain its healthy status of checks and balances. Based on all the current polling data, a split between the White House, Senate, and House of Representatives remains a very high likelihood scenario.
The political process has been especially exhausting during the current cycle, but regardless of whether your candidate wins or loses, much of the current uncertainty will likely dissipate. As the saying goes, at least it is “Better the devil you know than the devil you don’t know.”
After the November 8th elections are completed, there will be one less election to worry about. Thankfully, after 25 years in the industry, I’m not naïve enough to believe there will be nothing else to worry about. When the financial media and blogosphere get bored, at a minimum, you can guarantee yourself plenty of useless coverage regarding the next monetary policy move by the Federal Reserve (see also Fed Fatigue).
Whatever the next set of worries become, U.K. Prime Minister Winston Churchill said it best as it relates to American politics and economics, “You can always count on Americans to do the right thing – after they’ve tried everything else.” If Churchill’s words don’t provide comfort and you had fun getting spooked over the elections on Halloween, feel free to keep wearing your costume. Behind any constructive economic data, the prolific media machine will continue doing their best in manufacturing plenty of fear, uncertainty, and doubt to keep you worried.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Fall is Here: Change is Near
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (October 1, 2016). Subscribe on the right side of the page for the complete text.
Although the fall season is here and the leaf colors are changing, there are a number of other transforming dynamics occurring this economic season as well. The S&P 500 index may not have changed much this past month (down -0.1%), but the technology-laden NASDAQ index catapulted higher (+1.9% for the month and +6.0% for 2016).
With three quarters of the year now behind us, beyond experiencing a shift in seasonal weather, a number of other changes are also coming. For starters, there’s no ignoring the elephant in the room, and that is the presidential election, which is only weeks away from determining our country’s new Commander in Chief. Besides religion, there are very few topics more emotionally charged than politics – whether you are a Republican, Democrat, Independent, Libertarian, or some combination thereof. Even though the first presidential debate is behind us, a majority of voters are already set on their candidate choice. In other words, open-minded debate on this topic can be challenging.
Hearing critical comments regarding your favorite candidate are often interpreted in the same manner as receiving critical comments about a personal family member – people often become defensive. The good news, despite the massive political divide currently occurring in the country and near-record low politician approval ratings in Congress , politics mean almost nothing when it comes to your money and retirement (see also Politics & Your Money). Regardless of what politicians might accomplish (not much), individuals actually have much more control over their personal financial future than politicians.
While inaction may rule the day currently, more action generally occurs during a crisis – we witnessed this firsthand during the 2008-2009 financial meltdown. As Winston Churchill famously stated,
“You can always count on Americans to do the right thing – after they’ve tried everything else.”
Political discourse and gridlock are frustrating to almost everyone from a practical standpoint (i.e., “Why can’t these idiots get something done in Washington?!”), however from an economic standpoint, gridlock is good (see also Who Said Gridlock is Bad?) because it can keep a responsible lid on frivolous spending. Educated individuals can debate about the proper priorities of government spending, but most voters agree, maintaining a sensible level of spending and debt should be a bipartisan issue.
From roughly 2009 – 2014, you can see how political gridlock has led to a massive narrowing in our government’s deficit levels (chart below) – back to more historical levels.This occurred just as rising frustration with Washington has been on the rise.
The Fed: Rate Revolution or Evolution?
Besides the changing season of politics, the other major area of change is Federal Reserve monetary policy. Even though the Fed has only increased interest rates once over the last 10 years, and interest rates are at near-generational lows, investors remain fearful. There is bound to be some short-term volatility if interest rates rise to 0.50% – 0.75% in December, as currently expected. However, if the Fed continues at its current snail’s pace, it won’t be until 2032 before they complete their rate hike cycles.
We can put the next rate increase into perspective by studying history. More specifically, the Fed raised interest rates 17 times from 2004 – 2006 (see chart below). Fortunately over this same time period, the world didn’t end as the Fed increased interest rates from 1.00% to 5.25% (stocks prices actually rose around +11%). The same can be said today – the world won’t likely end, if interest rates rise from 0.50% to 0.75% in a few months.
The next question becomes, why are interest rates so low? There are many reasons and theories, but a few of the key drivers behind low rates include, slower global economic growth, low inflation, high demand for low-risk assets, technology, and demographics. I could devote a whole article to each of these factors, and indeed in many cases I have, but suffice it to say that there are many reasons beyond the oversimplified explanation that artificial central bank intervention has led to a 35 year decline in interest rates (see chart below).
Change is a constant, and with fall arriving, some changes are more predictable than others. The timing of the U.S. presidential election outcome is very predictable but the same cannot be said for the timing of future interest rate increases. Irrespective of the coming changes and the related timing, history reminds us that concerns over politics and interest rates often are overblown. Many individuals remain overly-pessimistic due to excessive, daily attention to gloomy and irrelevant news headlines. Thankfully, stock prices are paying attention to more important factors (see Don’t Be a Fool) and long-term investors are being rewarded with record high stock prices in recent weeks. That’s the type of change I love.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
