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Water Cooler Wisdom

Water Cooler Wisdom:
Breathe. Repeat.

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As you can tell from the title, this quarterly opinion letter should be the “fluff” part of your ad hoc reading list. Otherwise, buyer beware.

Last quarter we talked about the “Trump bump” and I’m delighted that most of the U.S. equity gains have remained and the larger growth stocks have risen to match the “bump” seen by smaller value companies last quarter. Now the current price-to-earnings ratios (“P/E”) as a percentage of the 15-year average P/E range from 112.5% to 123.6% (see “Returns and Valuations by Style”). In short, everything is overpriced now.

The next six months in the U.S. stock market look rocky as the new administration struggles to fulfill their campaign “promises” and we try to sort fact from fiction daily. The consensus is that any change is going to take longer than expected and obfuscation is the norm. On the positive side of the ledger, consumer confidence is high, and Americans are hard-working and hopeful. Confidence is a lagging indicator but I’m still part of the hopeful bunch.

On a drearier topic, the growth in the working-age population (see “Long-term drivers of economic growth”) is a topic of concern. You should not hear Americans complain that an illegal immigrant stole their job because the labor force isn’t growing fast enough to fill the current jobs and growth is projected to drop by another 50% in the next decade. What does that mean for our GDP? Not good. If there is no growth in workers we are all going to have to be a bit more productive. That might push me out of the hopeful bunch.

Yet there is a drearier topic (see “Federal finances”). The Congressional Budget Office forecast an increase in the Federal net debt from 77.5% to 88.9% by 2027 due, mostly, to our aging population. “In particular, spending as a share of GDP increases for Social Security, the major health care programs (primarily Medicare), and interest on the government’s debt.”1

At this point you must wonder who is going to build the wall and pay for it. Perhaps the millennials will move out of the basement, build it, and pay for it. Go Texas, Arizona, California, and New Mexico. There is lots of potential population growth in the border towns. It’s going to be bigly.

Then there is one topic that doesn’t show up in the charts that I’ll end with. Love. We don’t measure it, nor its impact, but we know it exists.

In Paul’s words. “4 Love is patient, love is kind and is not jealous; love does not brag and is not arrogant, 5 does not act unbecomingly; it does not seek its own, is not provoked, does not take into account a wrong suffered, 6 does not rejoice in unrighteousness, but rejoices with the truth; 7 bears all things, believes all things, hopes all things, endures all things.”2

Love does, in fact, endure all things and that keeps me in the hopeful bunch.

1 httpss://www.cbo.gov/publication/52480
2 I Corinthians 13:4-7 (New American Standard Bible)

©2017 Castle Rock Investment Company. All rights reserved. Please share your insights and comments with us at Info@CastleRockInvesting.com

Water Cooler Wisdom: Fourth Quarter 2016 The “Trump Bump”

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The U.S. stock market soared after Trump’s electoral victory.  Investors and traders put bets on his pledge to reduce corporate tax rates, pull back regulations and increase infrastructure spending. As seen in the chart on the right, fourth quarter returns for the U.S. stock market were higher for small companies and value-oriented stocks. Looking forward, the common theme among market forecasters is a low to moderate US stock market return (mid-single digit). This may be due to current valuations (see chart below) with price to earnings ratios well above their historical norms and an underlying fear of bubbles resulting from the Great Recession.

During a market update call on January 10th, an adviser asked if the “Trump Bump” could really be paid for by the President-elect.  The market strategist explained it may be possible through reducing corporate tax rates and that every 1% drop in the effective corporate tax rate potentially generates an additional $1.50 of earnings for the S&P 500, currently at $115 per share (see attachment “Corporate profits”).
“If Trump dropped the current effective tax rate from 26% to 18%,” the strategist hypothesized, “earnings per share would increase to $128 and pay for the rally.” Ironically, “in each year from 2006 to 2012, at least two-thirds of all active corporations had no federal income tax liability…for tax years 2008 to 2012, profitable large U.S. corporations paid, on average, U.S. federal income taxes amounting to about 14 percent of the pretax net income that they reported in their financial statements (for those entities included in their tax returns).”[1]

So, what do we know?  There is a general concern about a continued decline in Treasury prices that coincides with the expectation of three Federal Reserve rate hikes in 2017. Also, leading economists like Trump’s commitment to infrastructure spending and believe it will boost non-college wages and jobs while, at the same time, they strongly disagree with his isolationist policies and deregulation of the energy industry.[2]

What we don’t know?… the price of populism. I could not find an estimate on the timeframe or projected cost to Americans that economists fear.  By the time you read this, America will have inaugurated Donald Trump as President of the United States and we will be embarking on his “100-day action plan to Make America Great Again” (attached). Whether it’s due to economic insecurity or a cultural backlash, Europeans and Americans have voted for protectionist leaders that have made big promises of change. Perhaps America will be the model for Brexit.

[1] GAO-16-363:  Published:  March 17, 2016 “Most Large Profitable U.S. Corporations Paid Tax but Effective Tax Rates Differed Significantly from the Statutory Rate”

[2] httpss://www.igmchicago.org/surveys/100-day-plan

Water Cooler Wisdom: Third Quarter 2016

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By Mack Bekeza

The Presidential Election and What to Know

Despite the pleasant performance in the stock market for 2016, investors are becoming more doubtful about the global economy as a whole in regards to how “pleasant” future growth will be. On top of that, The U.S is having one of the most interesting presidential elections in history. With both of the leading candidates making big promises to the public, how will these proposed actions affect the economy as a whole? But perhaps the biggest question and misconception that U.S investors have is “How does the President affect the economy?”

For our response, we want to point out 3 big myths about how the President affects the economy

            1. Capital Markets perform better when Republicans are in the White House:  

Although many consider the Republican party as the “pro-business” party, if you look at the returns of the Dow Jones Industrial Average since 1897, the markets do not give a hoot about who is president.

2. Major pieces of legislation get passed once the new President assumes office:

With the exceptions of the Affordable Care Act and Dodd-Frank, The United States rarely makes major policy changes in one major swoop, rather in small increments.

3. The President has as much of an impact on the economy as consumers and businesses:

     Although the media places major scrutiny on the President over the U.S Economy, government spending only accounts for 17.7% of total GDP, while the remaining 82.4% comes from consumer spending, private investments, and foreign trade.

So… will this presidential election completely change the way we invest? More than likely no. However, it is important to note the U.S GDP is expected grow between 1.5 to 2% over the next decade. This is primarily due the recent and projected dismal growth in the U.S labor force along with over $30 trillion in private wealth being transferred to younger generations. In other words, it is more crucial to observe how Millennials begin to take charge of the U.S Economy rather than who becomes president.

Attached are slides that provide more detail regarding presidential elections and major leading economic indicators.

©2016 Castle Rock Investment Company. All rights reserved. Please share your insights and comments with us at Mack@CastleRockInvesting.com.

 

Water Cooler Wisdom: Second Quarter 2016

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Is the U.S the only place for long term returns?

Although the United States has experienced one of the best bull markets in terms of duration and returns, investors have been wondering what is next. This past year has not been as invigorating as the prior few years and, on top of that, economists are predicting U.S GDP growth to be at around 1.5% for the next few years. You may have also been hearing from either presidential debates or that “one guy” at the bar that everything is going down the tubes and that we have seen our best days. Are they right? The answer is, we do not know.

What we do know is this, even though the U.S is still considered the safest place for investors, that doesn’t necessarily mean we should only be invested in American securities. Did you know that the rest of world accounts for 95.5% of the human population, nearly 75% of the global GDP, and nearly 60% of the total stock market? On top of that, international securities are not perfectly correlated with the U.S markets so they can be used as a very effective diversification tool for people of all age groups and time horizons. So why don’t people invest outside of the U.S?

There a couple of reasons:

  1. Many people have a bias towards their home country
  2. Many people fear that investing internationally is unbearably risky

To respond to those two reasons, there is nothing necessarily bad about being biased toward your home team but there is also nothing wrong with tapping into other developed countries and even emerging markets such as China and India to name a couple. And for people fearing that going international is overly risky, that is not necessarily true. Although volatility is more prevalent, that does not mean that international securities are a sure way to lose money. In fact, it is the volatility that will allow more buying opportunities which in turn can boost returns for people like you and I.

So despite what happened this past quarter (Brexit, continued negative interest rates in Europe, along with current slow global growth), we should still expand our horizons into the international markets and tap into the opportunities they present.

Attached are a few slides about global markets for the past quarter.

Water Cooler Wisdom: Fourth Quarter 2015

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“What, if anything, can the rest of the world do to mitigate the volatile China impact?” – Anonymous client

Great question…and unfortunately, I don’t know the answer. Free trade is a basic American principle than underpins our capitalist system (my editor removed “mostly capitalist”). Of course, we all know that free trade isn’t truly “free” and America still operates from an unfair position with China. This is not new in 2015 but what’s changed over time is how quickly information is disseminated to “investors,” (human or not) and the speed at which our intermediaries can transfer funds.

Watching China move from a manufacturing to a service economy is like watching an awkward teen move into adulthood. You can’t hasten the pace, or make them mature overnight, since some things just take time. China implemented market circuit breakers on the first day of trading in 2016 that were tested that same day. Trading was suspended for 15 minutes when the market (CSI300 Index) dropped 5% and halted the rest of the day after the market dropped 7%. The circuit breaker was deactivated later that week after halting trading twice and exacerbating the market sell-offs it was designed to limit.

Back at home, the U.S. economic numbers generally look sound but there’s nothing to get excited about. We are missing that one glaring opportunity to spur inflation and, in turn, wage growth. Long-term GDP growth of 1.5% is a yawner, labor force participation is down to 62.5%, and we know the graduating class of 2015 is the most indebted class ever.  In other words, they’ve already consumed a larger part of their future income than previous graduates. Talk about a drag…on the economy.

It is ironic but a drop in the value of the U.S. dollar, an increase in interest rates, and a drop in the supply of oil actually sounds good right now (see “Oil Markets”). It makes me long for the days of 13% interest rates and long lines at the gas pump when you could only fill up on odd or even days (depending on the last number on your license plate).

But then again…stagflation is depressing. I’d take today’s economy over the 1970’s any day. Economists disagree on whether there will be three or four Federal Reserve rate hikes in 2016 (see “The Fed and Interest Rates”) and in spite of a 0% return in money markets, we have almost $12 Trillion in cash (notice the capital “T,” see “Cash Accounts”).

Conclusion
As usual, we recommend a balanced portfolio with a risk profile suitable for each investor’s tolerance and goals. 2015 seemed to play out the new normal of volatility, but we should continue to invest wisely, steadily and with discipline. Volatility is here to stay.

Water Cooler Wisdom – First Quarter 2015

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Most of the significant economic elements from the end of 2014 carried into the first quarter of 2015, including the abnormally low price of oil, a strong U.S. dollar, and the ongoing financial experiment of the Federal Reserve. The European Central Bank’s decision to implement a negative deposit rate (-0.10%) last June has become kitchen table talk and began to foster some growth in the European economy.

Returns and Valuations by Style
Since the S&P 500 return was sideways in the first quarter, investors who were willing to take on more risk in the U.S. small
capitalization growth style equity market generally fared better than their large capitalization “value” style peers. The difference in performance by size and style was a reversal from the trend in 2014.

Energy Supply Demand and Prices
The price of oil, hovering around $50 per barrel, has continued to dominate the headlines and impact GDP forecasts. On the slide, you’ll see U.S. productionincreasedby20.8%since2013whileconsumptiononlyincreasedby2%. The oversupply from the U.S. is projected to continue despite the absence of marginal producers that could not compete in the current marketplace. Generally, economists were expecting a 1% bump to GDP from the stimulus created by lower oil prices but the meteoric rise in the value of the dollar is already causing a drag on exports and the economy.

Global Equity Markets
Last year, we talked about the drag a strong U.S. dollar had on international equity investments when reported in U.S. Dollars. In the bottom half of the slide, you’ll see a striking difference in performance of each country’s equity index when shown in the “local” currency versus U.S. Dollars. In just the first quarter of 2015, the German DAX 30 Index gained 22% but, as a result of the weaker euro, it gained just 8.4% when measured in U.S. Dollars. Big exporting firms outside the U.S. are benefiting from the U.S. dollar strength as well as low oil prices for heavy users of energy.

Manufacturing Momentum
The Purchasing Managers Index (Manufacturing PMI) is used as an indicator to compare manufacturing momentum internationally. There are a handful of countries that are still weak but, in aggregate, the global growth is noticeable and strong. The U.S., U.K., Ireland, and Mexico stand out as the strongest while Russia, Brazil, Indonesia, and Australia are losing momentum.

Conclusion
With offsetting factors dominating the forecasts for GDP growth, it is no surprise that the minutes from the Federal Reserve Open Market Committee show a divergence of opinions on whether a rate hike would be warranted as early as the June meeting or delayed until September. As usual, we recommend a balanced portfolio with a risk profile suitable for each investor’s tolerance. Loss aversion continues to weigh heavily in portfolio construction.

Water Cooler Wisdom: Fourth Quarter 2014

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Water Cooler WisdomMajor events at the close of 2014, specifically the fourth quarter of 2014, included: the abnormally low prices of oil; the unique position of the Federal Reserve and the US dollar; US Treasury Rates poised (still) to rise; and American manufacturing ramped up to march on ahead of other world leaders, while an embroiled Europe awaits the coming year.

“Returns and Valuations by Style”

Significantly improved from the previous quarter, overall market growth was strong in the final quarter of 2014; though the annual return was less than half of the growth from 2013’s phenomenal success.

“Energy Price Impacts”

By a landslide, the most compelling story of the closing chapter of 2014 was the low oil prices brought upon by OPEC with ferocious Saudi leadership striving to re-establish control of global oil markets. Oil production outpaced consumption, therefore supply outpaced demand, and led to a build in inventories. The supply is not uniformly distributed, though, and the United States is responsible for the fastest supply growth since 2013; however, consumption in the US did not grow nearly as much, and China continues to contribute to the most global demand growth. Notably, Europe and Japan’s consumption declined.

The population most effected by gasoline prices, of course, is the lowest quintile of the population. If oil production declines, and global demand growth picks up, then oil prices could move higher, but if the demand trends persist, and supply growth remains robust with neither the US nor OPEC yielding any production, then oil prices could move further down. Economists overall are split either way, but most agree that the current low prices are abnormal. The Federal Reserve expects that any resulting deflationary pressure from current low oil market prices will be transitory, rather than permanent, and that the economy will achieve the 2% target inflation over time.

“The Fed Rate and Interest Rates”

The Fed seeks to satisfy its dual mandate of full employment and price stability. The current conditions of the Federal Reserve are historic. First, notice the size of the Federal Reserve balance sheet and its evolution over time. After many years of stable Fed assets and, consequently, liabilities, the Federal Reserve embarked on an unprecedented balance sheet expansion: by buying US Treasuries and Mortgage-Backed Securities in an effort to suppress long-term rates and foster long-term recovery. Second, the liability side of the equation experienced corresponding growth, but notice how excess amounts of vast reserves are held at the banks at the Fed rather than as currency in circulation. On the right hand side of the page are projections for when the short-term rates might rise. The Fed is pursuing a policy designed to foster expansion that their economists anticipate will lead to moderate long-term growth in accordance with their goals as described in the Fed Funds Rate Expectations chart.

The table at the bottom right shows the median of policymakers’ expectations for when and how much the rates might rise along with a summary of other economic projections. These projections include GDP, unemployment rate, and inflation. The future path of interest rates will be closely linked to how the economy evolves compared to Fed expectations and also how Feds forward guidance evolves in response to these and many other variables.

JPMorgan’s Chief Economist, Dr. David Kelly, anticipates the Federal Reserve under Janet Yellen to maintain a less than average frequency increase for the Fed Funds Rate (typically an increase of 25 basis points per quarter). As 2015 continues, we can anticipate Ms. Yellen and the Board of Governors to pursue a more hawkish policy than in previous years.

“Fixed Income Yields and Returns”

One of the more interesting segments of the markets that we have been discussing is the Fixed Income Markets. The table on the right side of the page highlights the effect that a one percent rise in interest rates (federal fund rate) will have on different Fixed Income categories. One might notice how High-Yield and Floating-Rate bonds don’t drop in price as strongly as 10-year Treasury bonds, which is a useful trait when interest rates rise.

For example: all else being equal, a 1% rise in interest rates translates to a 9% price decline in a 10-year Treasury, as compared to a much less severe decline in High-Yield and Floating Rate bond prices. Importantly, these numbers do not include the coupon return on these securities, or other factors such as sensitivity to an improving or deteriorating economic environment.

“Manufacturing Momentum: Industrial and International Context”

The Purchasing Managers Index (Manufacturing PMI) is used as an indicator to compare manufacturing momentum internationally. The breakup of the major international monetary/banking/economic problem child, aka the Eurozone, may occur this quarter: Germany is not the powerhouse of previous years, and Greece’s election polling numbers do not indicate a strong preference to stay in the Eurozone much longer. A Eurozone in which Germany does not perform is one in trouble. Over the past couple of years, Germany’s manufacturing momentum has fallen, and there is talk that now is the moment that the Eurozone may break with Greece, its greatest liability for the last decade. Popular language coins the term ‘Grexit’ and considers the Greek elections on January 25 the decision-making moment.

Conclusion

Russia was in many ways the major story of 2014, and reminded many investors that it was not a minor market and not an emerging economic actor. Russian GDP is clearly tied to oil prices and production – so is it time for the Kremlin to consider going green?

Yet the hero of the year, and the most certain economic success story, was the US dollar, which succeeded in avoiding the turmoil that captured Europe, and did not extinguish investment in US markets.

Water Cooler Wisdom

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Water Cooler Wisdom

September 30, 2014

Nothing is private anymore: celebrity photos are leaked across the Internet, everyone knows that Ben Bernanke was unable to refinance his mortgage and we can even follow professional football players’ misconduct. This technology, which allows us to follow the economy more closely than ever, shows that our economy is growing. Over the last quarter, the economy grew 4.6% and it is poised to continue this growth in the long run.

Here is what we expect: the US economy will continue to grow in the short and long term, interest rates will eventually rise (which is a good thing!), and you will be able to manage your money more effectively in a stable U.S. economy.

The economy is ready for strong short-run growth.

During the third quarter 2014, we saw attractive returns and valuations (see Returns and Valuations). In the chart, you’ll notice how different size equity asset classes performed over various timeframes. Over the past twenty years, the value stocks cost more per dollar of earnings than the average for companies of all sizes (large-, medium- and small-cap). Large cap growth stocks are trading at the largest discount below their historic price-to-earnings ratio of all domestic asset classes (around 14% lower).

One thing that is unique in our current economic climate is that while high stock prices are historically met with high interest rates, this is currently not the case with a prime rate at 3.25%. We expect that interest rates will start to rise in appropriate measure to stock prices.

Interest Rates are poised to rise.

As Ben Bernanke found out, mortgage loans are scarce. Without long-run inflation and the associated rising interest rates, banks do not have the incentive to make mortgage loans more available at this time. Mortgage rates and average payments are well below the historic averages. Average mortgage payments are 13.4% of household incomes, compared to the historic average of 20.4%. Household debt is low, while household net worth is at an all-time high of $82 trillion. However, interest rates will eventually increase, which will create more space for loans.

Despite concerns that high interest rates will kill consumer spending, they will likely increase the availability of loans. If households maintain high levels of investment in interest-bearing assets, they may benefit from an increase in interest rates as well, especially since household assets often have a shorter duration than their liabilities

The Fed and others expect low long-run growth.

The Federal Reserve’s numbers (from September 18, 2014) paint a rosy picture for future growth that agrees with the promising trajectory represented in our data. The Fed’s recent GDP projections align with the majority of economic expert opinions and everything seems set for the last Treasury purchase to be in October 2014. However, it does anticipate some level of intervention until 2016 to manage fed funds rate adjustments to a long-run equilibrium of 3.75%. It anticipates inflation for 2014 at 1.6% but it is already at 1.7%. J.P. Morgan expects the Fed’s projection of 1.9% inflation to be reached in 2015 rather than in 2016.

U.S. growth in exports is largely due to rising demand for U.S. shale gas and improved capital spending that prepares us to increase consumption over the next year or so. Manufacturing momentum explains how the US economy is growing relative to the rest of the world (see Manufacturing Momentum. The growth over the last couple of years, along with future higher interest rates, does have some negative implications for investing abroad in the short run, and the strengthening dollar will disguise return on international stocks. For example, Europe is in a second recession and signs of recovery will be eaten up by exchange rates, especially if our domestic economy is more productive than theirs.

Inflation is low and cash holdings are high.

The Consumer Price Index (CPI) is at 1.7%, considerably below the historic average of 4.1%. Low inflation contributes to significantly higher levels of cash holdings, which is around 11 trillion US dollars, because the value of the dollar feels pretty much the same month-to-month, and perhaps because future implications from Money Market fund regulations has investors questioning the stability of cash-equivalent investments. It is important to remember that a more diversified portfolio with less cash holdings has delivered higher average annual and cumulative returns over the last decade (see Asset Class Returns).

Conclusion

So what should we conclude? Invest broadly and confidently, prepare for growth, and don’t be surprised by increases in interest rates or inflation that typically coincide with economic success.