Should We Sell Stocks Because the Market is Rich?

Grant Bledsoe, CFA, CFP® President & Founder, Three Oaks Capital Management

Grant Bledsoe, CFA, CFP®

President & Founder, Three Oaks Capital Management

As the decorations my wife puts up around our house read: “Happy Fall, Y’all!” The third quarter of 2017 had its fair share of global headlines, starting with a queue of hurricanes ravaging Haiti, Puerto Rico, and a giant portion of the southern U.S. The headlines didn’t stop there, though. President Trump continues to trade barbs with North Korean dictator Kim Jong Un every few hours, Equifax had 44% of Americans’ personal information stolen, and to top it off we’re still uncovering more and more evidence of Russian meddling in our presidential election last year.

So has any of that spooked U.S. equity markets? Absolutely not! Thus far in 2017 we’ve had historically low volatility. Only 5% of 2017’s trading days thus far have seen the S&P 500 move by more than 1% in either direction. This is by far the lowest number ever (since intra-day trading began being recorded in 1982, at least).

While any number of the aforementioned headlines could yet derail our smooth cruise to this year’s finish line, we should remember that we’re entering a historically bumpy time of the year, too. September has been the worst performing month of the year, October the second worst, and November and December the 3rd and 2nd best.

And in case you have difficulty remembering those facts, this October will mark 30th anniversary of the stock market crash of 1987. On top of all this, the fourth quarter is typically a very busy period. We have budget battles in governments (and boardrooms) across the country, the holiday shopping season, and investment managers across the world positioning & trying to manage taxes for year-end.

The most common question I get when highlighting these and other current events is: “OK, great. So if we think there’s a big risk the market could sell off soon, shouldn’t I sell my stocks and wait to reenter after the next crash?”

Let me be clear here. I have absolutely no idea when the market will sell off. Nor does anyone else. I can only tell you that it will from time to time. Will it be President Trump hitting the launch button at the wrong time? Will it be the Federal Reserve tightening monetary policy faster than expected? I really have no idea.

What I can tell you is what the research shows: that you’ll achieve the best investment outcome staying fully invested consistently, through thick and thin, no matter what we think the market will do next.

Because remember, if you’re going to sell, not only must you be correct in timing the next crash. You must also know the right time to re-enter the market. According to a study performed by Dimensional Fund Advisors, the annual return of the S&P 500 was 9.38% between October of 1989 and December of 2016. But if you miss the one best performing trading day each year, your return falls to 8.94%. Miss the five best, and it falls to 7.75%. Miss the top fifteen, you’re down to 5.67%. And miss the twenty-five best trading days? 3.98%. In other words, by missing the top 10% of trading days each year, annual equity returns each year fall from 9.38% to 3.98%. Ouch.


What does this mean for us? It means that if you want to sell stocks now and wait for a correction, you’ll need to be clairvoyant not once, but twice! And if your crystal ball is even the slightest bit cloudy, causing you to miss some of the best days in the trading year, the missed opportunities will probably crush your net returns. The moral here is that even though the markets look pretty spendy, if we have a long-term outlook we’re far better off riding out the next correction and awaiting the subsequent, inevitable rebound.

U.S. Economy

As the third quarter economic data comes out over the next weeks and months, it’s important to remember that everything will be skewed downward as a result of the hurricane damage across the south. But then, as the rebuilding and replacing takes place in the coming months, we should expect a corresponding rebound.


Prior to hurricane season the economy had shown strong growth, with second quarter GDP being revised upward to 3.1% on an annual basis. But unlike prior quarters, inflation has ticked up as well. In the first half of the year, the consumer price index (by and large the most common inflation benchmark) rose a total of 0.5%. This is quite low, and below the Fed’s target of 2.0% per year. While the September numbers aren’t out yet, the CPI jumped during July and August, rising another 0.5% between the two.

Meanwhile, the Federal Reserve has announced that it is beginning to reduce the size of its massive balance sheet. This is a topic I’ve written about extensively in prior editions of Investment Insights. If you recall, during the financial crisis the Federal Reserve purchased huge amounts of U.S. Government securities in order to inject more money into the banking system and support the economy. We still don’t know what the ultimate result of this tactic will be, but so far the strategy seems to have worked pretty well.

The tricky part will be unwinding these purchases. The Federal Reserve currently owns about $4.5 trillion in U.S. Government debt. To get rid of them there are two basic options: sell them on the open market or allow them to mature. The Fed has communicated that starting next month it will opt for the latter. As some of the securities mature each month, the Fed will take the cash received (the principal returned) and retire it from circulation, rather than reinvesting in another debt security.

This maneuver is a tighter monetary policy. By decreasing the money supply circulating throughout the banking system, cash becomes scarcer and interest rates will ease upward accordingly. The challenge is that the Fed is already raising short-term interest rates. This additional mode of tightening will need to be handled delicately. Unwinding too fast could apply too much downward pressure and stamp out potential growth. On the flip side, not unwinding enough could cause the economy to overheat and inflation to spike.

The Fed has said it will begin by allowing $6 billion in Treasury securities and $4 billion in mortgage-backed securities to mature every month. As long as all goes smoothly the bank will pick up the pace over time, not to exceed $30 billion per month in Treasuries and $20 billion in mortgage backed securities. Ideally this “great unwind” will occur in a gradual, boring fashion. But with the CPI gaining speed in July and August, the bank will have certainly its finger on the pulse of inflation.


Global Equities

The steady climb and low volatility in equities isn’t unique to the U.S., either. September marks the 11th consecutive month global stocks have posted gains. This ties the all-time record set during the post dot com bust rebound back in April of 2003.

From an economic standpoint, the global producer’s manufacturing index (PMI) has been in expansion territory for 17 straight months. This index is what’s considered a “leading indicator” of global economic health, meaning that strong numbers normally indicate good things to come. PMI measures the health of the global manufacturing sector, and is based on new orders, inventories, production, supplier deliveries, and the employment environment. Not only has global PMI been on a consistent run, in August the index rose to its highest level since May of 2011.

One international trend that’s on my radar is the growing protectionist sentiment both in the U.S. and abroad. I wouldn’t say the British started the movement, but they certainly played a big hand by deciding to leave the European Union in the summer of 2016. Since then rumors of other potential EU exits have skyrocketed, including whispers that France, the Netherlands, and/or Hungary may also depart.

Adding fuel to the fire, President Trump continues to lean toward a protectionist, “America first” viewpoint. While I’m all for an agenda focusing on American wellbeing, framing the discussion in terms of “winners” and “losers” in trade is short sighted. Free flowing global trade is in everyone’s best interests. It gives global consumers the best opportunity to improve their standard of living, promotes innovation, and can reduce the opportunity for corruption. There are complications, of course (trade is very political). But the takeaway here is the more that countries veer toward this nationalist, isolationist mentality, the farther we stray from integrated, free flowing trade we should be striving for.

Fortunately, the economic numbers don’t reflect the rhetoric (at least not yet). Global export orders (a decent benchmark for global trade) in August grew at their fastest pace since March of 2011. The economic data was matched by strong equity market performance around the globe as well. The MSCI Emerging Markets Index rose 7.89%, and the MSCI World ex-USA Index rose 5.62% in the third quarter.

Looking ahead, the central banks of China and the European Union will be a focus. China has finally cut off banking relationships with North Korea. This will be crippling for the North Koreans, as China amounts to 90% of their foreign trade. It won’t make a dent in China’s output though, with North Korea making up a little less than 0.2% of theirs.

In the EU, most analysts believe the European Central Bank (ECB) will begin tapering their asset purchases sometime in the fall. This means the ECB will begin walking a similar tightrope as the Federal Reserve here in the U.S., where the bank will attempt to tap on the breaks without slamming to a sudden halt.

U.S. Fixed Income

Interest rates increased across the U.S. bond market for the quarter. The yields on 5, 10, and 30-year Treasury notes all rose slightly, to 1.92%, 2.33%, 2.86%, respectively.


In terms of total returns, corporate bonds gained 0.59% on the quarter, while intermediate-term corporates gained 1.05%. One sector of the bond market that’s been particularly strong this year is preferred stocks. Despite their name, preferred stocks are actually long term fixed income instruments. They’re senior to equity holders in a company’s capital structure, but junior to other traditional bondholders. That means that if a company is going bankrupt, traditional bond holders will get their money back before preferred stock holders do. Common stock holders are last in line.

Some types of preferred stocks are convertible into traditional equity shares, as well. For that reason preferreds often exhibit the characteristics of both a debt and equity investment – a “hybrid”, if you will.

Just like bonds, preferred stocks have fixed par values and make coupon payments based on either a fixed or variable basis. Maturity dates of preferred stocks tend to be very long term, too. It’s common to see maturity dates on preferred shares at 30 or more years into the future, or have no maturity date at all. For issues without maturity dates, a company agrees to pay preferred shareholders coupon payments in perpetuity.

With the long maturity dates, preferred stocks tend to be very sensitive to interest rate changes. And since the securities have characteristics of both debt and equities, they tend to be influenced both by moves in long term bond yields and movements in the stock market.

As a sector, preferred stocks finished off the third quarter very close to their all time highs. With long-term Treasury yields still quite low, preferred stock issuers have successfully retired high coupon issues, replacing them with lower coupon offerings. This has led to a steadily decreasing average coupon rate, pushing up prices on the preferred stocks remaining in the market.

When considering preferred stocks for your portfolio, remember that they’re securities better suited for the long-term investor. You may be able to garner more yield out of a preferred share than your typical corporate bond, but there’s an inherent level of interest rate risk you should be aware of. If your strategy is to remain invested regardless of the market climate (which is the strategy we urge our clients to employ), preferred shares will still offer an adequate long-term return and act as a diversifier. But for the short-term investor, be sure to weigh the interest rate risk against their attractive yield.

The Fed's Double Whammy

The Fed's Double Whammy

Greetings!  I hope everyone is having a great start to their summer.  The markets have shown continued strength since we elected Donald Trump as our President back in November.  The Federal Reserve also raised short term interest rates again, and expects to do so once more later this year.

The economy does appear to be strong right now, but politically things are starting to heat up.  Tension with North Korea and Russia continues to grow, and Mr. Trump is consistently finding himself in self-inflicted turmoil.

Despite the political climate, many investors I’ve spoken with recently seem to be “lulled” into a false sense of security.  It’s hard to blame them with the stock market marching steadily upward.  It’s been so long since our last correction that it’s easy to forget the market can go down, too!  

As I touched on last quarter, the stock markets are somewhat expensive right now.  I wouldn’t recommend selling your positions in expectation of a crash.  Instead, recommit now to your long-term investment strategy.  When another crash eventually comes, you’ll know where you stand, and have more confidence in your strategy going forward.

U.S. Economy & Government Bonds

Seems like every time I sit down to write Investment Insights, it begins with an update on the Federal Reserve and a recent interest rate decision they’ve made.  I don’t mean to be redundant, but this is an important theme that investors should be following.  The Fed met on June 14th, and decided to raise short term interest rates to 1%-1.25%.  

The move conveys our central bank’s belief that the economy is strong and will continue to grow.  Unemployment is at its lowest rate since 2001 at 4.3%, as the economy has added jobs for 80 consecutive months.  

What’s also interesting are Fed chair Janet Yellen’s comments about the bank’s balance sheet.  Starting in 2008, the Federal Reserve began buying up assets to inject cash into the banking system and further stimulate the economy. 

You can see in the chart above that asset purchases tapered off in 2014.  The Fed hasn’t bought anything since then, but still holds $4.5 trillion in mortgage backed & treasury securities on its books. 

In her press conference after the Fed’s June meeting, Yellen commented that the bank would begin selling off some these holdings.  Starting at $10 billion per month, the bank would unwind their balance over time depending on the how economy “evolves”.

There are two reasons that these comments are important.  First, just like raising interest rates, asset sales indicate a tighter monetary policy.  By selling off assets, the central bank is inserting mortgage backed and treasury securities into the capital markets.  In return, it’s accepting cash that’s currently circulating through the banking system. 

But rather than reusing that cash, the Fed will simply remove it from circulation.  Less cash in the banking system is a ”tighter” policy, which tends to put a damper on economic growth.  With the interest rate hikes, this means the Fed is employing a tighter policy from two different angles.  It’s a lot like tapping the foot brake and parking brake on your car at the same time.  Slam on them too hard and you’ll skid to a stop.

The second reason this policy is important relates to the markets for treasury and mortgage backed securities.  Of the $4.5 trillion of securities the Fed holds on its balance sheet, $2.5 trillion consists of U.S. treasuries (debt issued by the federal government).  And with around $14 trillion of U.S. treasury securities in existence today, that means the Federal reserve owns 17.7% of all U.S. debt that’s held by the public.

The largest foreign holders of U.S. debt are Japan ($1.1 trillion) and China ($1.09 trillion).  This makes the Federal Reserve a huge portion of the market for our government’s debt. 

So what will happen when the bank begins to sell this debt?  The market for U.S. treasuries is somewhat tenuous, now that we’re in a rising rate environment again.  But when one of the biggest debt holders starts to unload their positions, prices could U.S. treasuries could see additional downward pressure.

Should investors be concerned?  Only if you’re planning on unloading U.S. treasuries yourself in the next 3-5 years.  Most investors hold treasuries until maturity, for security and income purposes.  An unwinding of the Fed’s balance sheet would only affect their market value.  If you own treasury bonds you’ll continue receiving income, as well your principal when the notes come due.  If you plan to sell bonds in secondary market before they mature, just know that you could be competing with an oversupplied market, thanks to the Fed.

Of course, the Fed’s current direction is heavily influenced by its chair, Janet Yellen.  Fed chairs serve four year terms after presidential appointment, and Yellen’s will be up in January of 2018.  President Trump has indicated it’s unlikely that he’ll reappoint her to another four-year term, but hasn’t yet made up his mind.  At this point, Trump advisor Gary Cohn is leading the search for Yellen’s successor.  With no clear frontrunner, there’s no telling whether the central bank’s current course of rising rates & balance sheet reduction will continue at its current pace….or at all.


U.S. Equities

The big news from the stock market recently is Amazon’s agreement to purchase Whole Foods.  I don’t usually comment on individual securities (as I prefer low cost, diversified funds).  I’m making an exception for this deal, though, because of because of the subsequent sell-off in consumer products – Amazon’s direct competitors.

This move seems like a very strategic purchase by Amazon.  Whole Foods gives Amazon an opportunity to gain a larger brick and mortar presence, as well as access to higher-quality fresh foods.  Ultimately, this could be a move toward expanding Amazon’s fresh grocery offering.

Household, personal care, and packaged food stocks sold off in response to the news of Amazon’s intention to purchase Whole Foods on June 16th.  And since then, a slight bit of volatility has returned to the broader market.  Tech stocks hit a speed bump in mid-June, as investors across the world are starting to question the durability of the bull market we’re in.  Since President Trump was elected back in November, the market’s done hardly nothing but push higher, little by little, nearly every day.

One measure of volatility that I refer to somewhat frequently is the VIX index.  This index uses premiums in options contracts of S&P 500 stocks to measure how “calm” the markets are. 

You can see here that when the markets correct, the volatility index spikes.  Notice how the VIX chart above spiked during the last several market crashes: around 40 during the dot com bubble, over 80 during the mortgage crisis, and in the 35 range after Britain exited the EU last year.

Since Mr. Trump was elected back in November, the VIX index has averaged under 12.  Its high point was 16 back in April, and it’s consistently sat in the 10-14 range.  These data points are helpful, but they’re only telling us what we already know: the markets are very calm right now.

I bring this up to remind you that this is not the norm.  At some point the stock markets will correct again, testing your resolve to adhere to a long-term investment strategy.  It’s at that point that you’ll need to keep your focus on the horizon – not what happened to your account over the last week or month. 

Last quarter I wrote about how high the market’s valuations were.  There are many ways to measure how expensive or cheap the market is, but P/E ratio is probably the most common.  By dividing the market’s price by the shareholder earnings produced, we can get a decent feel for where the market sits at any given time. 

The U.S. stock market’s P/E ratio currently floats at about 21 times earnings, using the MSCI USA Index as a proxy.  This is significantly higher than its long-term average.  Why is this important?  Because P/E ratios tend to be mean reverting, meaning that this measure will probably fall back toward long terms norms at some point.

There are two ways this can happen.  First, market prices can fall (see the previous section on volatility).  Second, the denominator (earnings) can increase.  And thus far in the year, corporate earnings have been good.  Last quarter 80% of companies in the S&P 500 beat their consensus earnings estimates.  A lot of this can attributed to the strengthening economy and business cycle…but whoever complains about a tailwind?

In addition to strong earnings, 60% of companies in the S&P 500 beat their revenue numbers.  This is telling.  Earnings can be manipulated somewhat by management, but revenue is harder to influence.  Looking ahead, I’d note that this business cycle cannot last forever.  As the Fed begins to put the brakes on the economy with tighter monetary policy, it will become more difficult for companies – here and abroad – to consistently beat their earnings estimates. 


International Stocks

Economic growth is off to a strong start to the year in the U.S., but it’s a mixed bag globally.  Europe and Japan both had strong first quarters, but the United Kingdom slowed to a 0.8% annual GDP growth rate.  At least some of this slowdown can be attributed to the UK’s exit from the European Union.

In China, first quarter GDP growth was reported at 6.9%, which is above the government’s target of 6.5%.  Since then, economic reports coming from China suggest that their economy is slowing.  Retail sales, industrial production, investment, and aggregate borrowing numbers all came in below economists’ expectations.

If China’s growth continues to decelerate, the ripple effect could impact investors in three distinct ways.  First, an economic slowdown in China would likely spread to other countries.  The U.S. is somewhat insulated, thanks to our diverse economy (even if we do trade a great deal with China).  But countries like Japan and those in the Eurozone are more reliant on the Chinese economy.  Slower growth in China would surely hamstring future earnings for many companies in these countries.

Second, if there is a slowdown, there’s a good chance it’d be concentrated in construction activity.  Government infrastructure in China has grown at an incredible pace that’s unsustainable in the long run.  When it eventually slows, commodities will likely see downward pressure, since this type of construction requires a great deal of oil and natural gas.

Third, if growth slows in China, the Chinese government may react with economic stimulus.  This was their reaction when growth slowed in late 2015 & early 2016.  During that span, the MSCI AC World Index dropped 12% between the beginning of 2016 and when China reinstated stimulus measures – a 29 day period.  If this cycle is any indicator, world markets could sell off if Chinese growth slows again…at least until China’s government announces another stimulus package.



For years, OPEC has pressured its oil producing competitors by continuing to drill during periods of weak prices.  Historically OPEC normally chooses to cut back on new production when the oil markets fall, in order to buoy prices and revenues.  But over the last several years the group has continued to drill, to put pressure on global competitors and new shale producers in the Midwest United States. 

This has proved to be an effective strategy, since OPEC countries typically have lower fixed drilling costs than competitors.  By driving prices lower OPEC has been successful in forcing competition out of the market.  Shale & offshore drilling operations across the world have been abandoned over the last three years.  Very simply, the cost of getting the oil out of the ground is greater than its value on the open market…until prices rebound at least.

While this decision was effective for OPEC in the short run, it wasn’t sustainable longer term.  The cartel’s member countries do ultimately want higher oil prices.  They can only apply pressure to competitors for so long before the harm on themselves becomes too great. 

In May, OPEC changed its strategy and again moved to cut production to support oil prices.  This will likely lead to marginally higher oil prices over the next 6-9 months (even though prices have slipped in the few weeks following OPEC’s announcement).

Longer term it’s not as clear which direction we might see oil take.  Oil prices above $52 provide favorable economics for shale producers, according to the energy analysts I follow.  That means that even though OPEC’s move might boost prices, once they eclipse $52 more producers will re-enter the market.  It takes shale & offshore drillers 6-9 months to get their operations up and running again.

So while prices may continue an upward trend in the short term, it’s likely that once the competition comes back online, they’ll be able to satisfy unmet demand in short order.  With this level of production flexibility, we could be in for a weak oil market for some time.  That’s great news drivers at the gas pump, but not as great for long term investors in the commodity.

Hot Stocks & Rising Rates: Are We Poised for a Sell Off?

Hot Stocks & Rising Rates: Are We Poised for a Sell Off?

Despite the headlines, ruffled feathers, and self-aggrandizing tweets, stock markets have marched upward very consistently since Mr. Trump took office this year. Interest rates on both ends of the yield curve continue to tick higher, and equities in the international and emerging markets have also been strong. At this point, we need to prepare for the inevitable time when the levy breaks. U.S. stock markets are quite expensive on a historical basis, and our current 10-year bull run is one of the longer growth cycles in history.

While I never advocate for investors to time the markets, or change course because they expect a market downturn, we do need to understand that this level of calm is not the norm. I can’t tell you when or how the next market crash will occur, only that it will happen eventually. To prepare, investors should ensure that their strategic asset allocation fits their objectives and comfort with risk like a glove. If you’re uncomfortable with the idea of a stock market crash, it’s probably time to reassess your portfolio.

U.S. Economy & Government Bonds

The Federal Reserve Bank decided to raise short term interest rates again on March 15th, to a range of 0.75%-1.00%. The move was widely telegraphed and expected by the markets. Moving forward, Fed chair Janet Yellen expects two more increases later this year, in June and December.

Yellen has a strong argument justifying the rate increases: the economy is doing quite well. GDP growth is expected to be 2.1% in both 2017 and 2018. Inflation is trending up towards the Fed’s long term target of 2% as well, coming in at 1.9% annually in the most recent measure.

In plain English, this is all good news. The economy is expanding at a strong but steady pace and doesn’t appear to be overheating. Inflation and prices are under control. Corporate earnings growth is strong, and unemployment is down to 4.7%. And by raising rates now, the Fed is essentially adding arrows to its quiver. Whenever the next downturn does occur, the ability to change course and reduce rates again without bumping up against the 0% floor will be very convenient.

So, regarding monetary policy controlled by the Federal Reserve (using short term interest rates and other levers to control the money supply) all is calm on the western front. However, monetary policy is only half the story. Fiscal policy is the complementary factor to our national economic strength. This sister strategy mostly concerns the amount of government spending and our aggregate tax burden, which is largely driven by our president.

Obviously, our current president believes in a smaller size of government. Mr. Trump is attempting to foster a business friendly environment with lower taxes and fewer regulations. Despite strong (and still improving) economic growth, the way Mr. Trump’s fiscal policy plays out remains a big wild card. He’s had an eventful few months in office, and his tax plan has not yet reached the “front burner.”

The chart above shows the current yield levels on U.S. government bonds across varying maturities. This chart uses the current yields of “on the run” treasuries, meaning they’re the most recent securities issued by the government directly to the investing public. 

Notice that the yield curve is upward sloping. Whereas very short term interest rates are set by the Federal Reserve (as an extension of the bank’s monetary policy), 

longer term rates depend more on market forces. When Mr. Trump was elected to office in November, long term rates spiked. The widespread interpretation is that the markets expect Mr. Trump’s potential tax cut (his fiscal policy) to boost growth, and eventually lead to inflationary pressures down the road. 

For investors, it’s an important time to understand the duration risk contained in your bond holdings. When interest rates increase, the market prices of bonds fall. If Mr. Trump continues down the path he promised in his campaign, the current upward trajectory will probably continue. This is a risk for long term bondholders. 


U.S. Corporate & High Yield Bonds

Aside from the trajectory of rates on U.S. government bonds, another question many bond investors are asking is why corporate bond yields are still so low. If long term rates on government bonds are rising, shouldn’t corporate bonds move in lockstep? The answer isn’t so clear cut. 

Returns in riskier fixed income categories, like high yield bonds, have been extremely strong over the last year. In fact, some high yield bond indices have increased more than 17%. As we touched on in the previous section, earnings growth from U.S. corporations is strong. Additionally, default rates of high yield debt are down from 5.1% in December to 4.4% in February. Both these metrics point to an improving business climate. 

With more favorable conditions, investors have become more comfortable “stepping out on the curve” and taking on more risk in their bond portfolios. This higher demand for corporate and high yield bonds has driven prices up over the last year or so. And as we covered above, when bond prices increase, bond yields decrease, and vice versa. 

In other words, even though long term interest rates have increased in general, the high demand from investors has kept downward pressure on corporate bond yields. 

One way that we measure & track changes in the corporate bond market is by assessing the credit spread over U.S. treasuries. Simply put, credit spread is the extra yield an investor receives by lending money to a borrower less credit worthy than the United States government. 

For example, a 10-year U.S. government bond contains hardly any credit risk. Since the bond is backed by the full faith and credit of the U.S. government, there’s an extremely low likelihood of default. On the other hand, a corporation has a higher chance of going broke. The extra return a bond investor receives for taking this risk is known as the credit spread. 

As you can see, credit spreads have narrowed over the last 12 months. The explanation here is that the potential for a more business friendly environment, complete with lower taxes and fewer regulations, has caused an increase in demand for corporate bonds. So, even though longer term rates are going up, the extra demand is holding corporate rates down. 


U.S. Equities

Domestic stocks are off to another strong start, for many of the same reasons that longer-term interest rates are increasing. In general, stock markets like the idea of lower taxes – even if they’re unsure about when or how the concept might play out. Year to date the S&P 500 is up nearly 5%. The Russell 2000 small cap index is not far behind, gaining 2.3% thus far in 2017. 

I often speak with people who lost a great portion of their portfolio between 2007 and 2009, and are fearful that we’re overdue for another catastrophe. While I agree that this bull market is probably little “long in the tooth,” the bounce back since 2009 has truly been ferocious. The charts below show the performance of the S&P 500 large cap index, and Russell 2000 small cap index over 1-year, 3-year, 5-year, and 10-year periods. Note that the 10-year period brings us back to March of 2007, just before everything started to go south. 

Looking at the cumulative returns chart, the both indexes have gained over 100% since March of 2007. This means that investors who’d stayed put throughout the depths of the crisis and simply “stuck with it,” would have gained about 7.5% per year on average. This pretty closely resembles the long-term average market returns. It’s also a testament to the long term buy and hold investment philosophy. 

If you couldn’t already tell, my comments above are partially meant to prepare you for the next major market swing. A ten-year bull market is on the very long end of the spectrum. Again: I don’t pretend to know when or why the stock and/or bond markets might correct next, but I do know that at some point they will. 

Aside from the sheer length of the current bull market, the S&P 500 appears to be quite expensive based on relative valuation metrics. Since 1871, the index’s month over month average P/E ratio is 15.64. Currently this number sits 57% higher, at 24.49. If we were to rank the index’s P/E ratio each month since 1871, we’d currently be in the 94th percentile

How did we get to this point? From a strong and steady march forward since 2009. Aside from a few minor blemishes and bumps in the road, the market’s rise has been extremely consistent. The VIX index measures the market’s volatility, and spikes when the market crashes. Note the high point in the chart below, in early 2009. 

The chart also tells us what we already know – things have been eerily calm over the last several years. We had a blip when Britain decided to leave the EU last year, and another in August of 2015. But more recently, nothing seems capable of derailing or even phasing the market. North Korea is launching missiles, the Federal Reserve is raising interest rates, and political infighting both here and abroad seems endless. But despite all this, the market hasn’t seen a down day of over 1% since October 11th of 2016! 

Could this be the calm before the storm? The valuation numbers say that the next five years of market returns will probably be lower than the last five years. But if corporate earnings growth continues hold pace, we may still be a few years off from a significant correction or crash. 


International Stocks

Stocks have posted solid gains outside the U.S. too, in both developed and emerging markets. The MSCI EAFE index, representing stocks in developed economies, and MSCI Emerging Markets index are up 5.99% and 12.14% thus far in 2017. In the last 12 months, the indexes have gained 12.14% and 16.4%, respectively. 

The theme in 2016 was populist sentiment arising in Europe. Populism has to do with the interests of ordinary people. With the massive exodus from Middle Eastern countries like Syria and Afghanistan over the last few years, this idea has become a key economic influence in Europe. Across the continent, a nationalistic mentality started to spread as hundreds of thousands sought refuge in 2016. With the influx of immigrants, Europeans became less concerned about the greater European Union and more concerned about their home countries. This is one of the factors that led to Britain’s decision to leave the European Union. 

One risk we discussed in prior market updates is that this sentiment will continue to spread, forcing a breakup of the European Union (EU). The theory is that if the EU broke up, significant trade barriers would arise between countries, causing economic growth to suffer. 

This risk seems to have abated. The immigration issue seems to be fueling much of the populism sentiment, and the number of asylum seekers has dropped significantly in the EU thus far in 2017. At the high point, 170,000 people per month sought asylum in the EU. This number has fallen below 75,000 people per month. 

With fewer people fleeing the Middle East for better lives in Europe, the populist momentum may fizzle. Leaving the EU is a somewhat radical idea, and now that immigration has tapered off it seems like populists are starting to back off the ledge. The Netherlands just held a general election on March 15th. The “Party for Freedom”, representing populism, ran on the platform of leaving the EU and halting immigration. The party led for much of the race, but ultimately lost the election handily. There are more elections and referendums later in 2017, including France in April & May and Germany in September. But at this point, the chance of a surprise vote to leave the EU is very low. 

Elsewhere, China finds itself in a tight spot now that the U.S. is raising rates. The People’s Bank of China (China’s equivalent of the Federal Reserve Bank) has for years supported China’s currency, the yuan. By keeping rates higher than the U.S. and elsewhere in the world, China has encouraged capital inflows and foreign investment. 

With the U.S. raising interest rates, China has pressure to follow suit. If they don’t, they risk an outflow of capital from China back to the U.S. But if they do, they risk stifling the economy with expensive borrowing costs. The government has already started to reduce spending on infrastructure, setting the country up for a potential double whammy. 

Thus far, the reduction in Chinese government spending has been backfilled by an increase in private sector construction. Private construction is particularly 

sensitive to interest rates, leaving the People’s Bank of China at quite the crossroad. The bank will need to navigate its positioning alongside the U.S. carefully. If it doesn’t, it’s economic growth could sputter, which would certainly cause volatility to ripple across the globe once again. 


Closed-End Mutual Funds

Closed end funds are professionally managed mutual funds, but are closed to additional investment. In a traditional mutual fund, an investment manager accepts new cash from investors and issues shares of their fund in exchange. In effect, investors transact directly with the mutual fund management company. When a mutual fund closes, the manager stops accepting new cash investments. Investors are instead left to purchase shares in the secondary market from other investors. 

Some closed end funds are leveraged, and borrow money for short periods of time to invest the proceeds in longer dated bonds. Normally closed end funds will borrow money at lower rates, lend at higher rates, and profit from the spread. This strategy works well when the yield curve is upward sloping and long term rates are higher than short term rates (as it is now). When the yield curve flattens, the difference between long term rates and short term rates becomes smaller. This tends to harm closed end mutual funds. Since funds typically borrow at shorter term rates, their borrowing costs increase whenever the Federal Reserve decides to raise rates. 

We currently have an upward sloping yield curve, but it’s clear that as long as the economy behaves, short term rates will continue to rise. This has the potential derail returns from closed end funds. While it’s very possible longer term rates will continue to increase too (preserving spread) we’ve already seen corporate bond yields depressed, which we discussed above. Investors in closed end funds should be aware that a flatter yield curve is possible, which could drive returns on closed end funds negative. 

Turning the Page: What to Expect from the Markets in 2017

Turning the Page: What to Expect from the Markets in 2017

As we close the books on the holiday season and begin looking forward to what 2017 might hold, I always enjoy reflecting on what’s happened in the world over the last 12 months.  Not only for nostalgic reasons, but also to better understand the current state of the markets & how we got where we are today.  I find that using such context always seems to help make sharper investment decisions over the upcoming year.

And looking forward to 2017, there are three themes I see as important for investors to follow.  First, how the U.S. economy will respond to President Trump’s fiscal policies (however they’re implemented).  Second, the growing populist sentiment in Europe, as we saw in the Brexit and more recent Italian referendum.  And third, the increase in internet security breaches and how nations and corporations will respond.



The big economic news of the week comes from the most recent meeting of the Federal Open Market Committee.  It was widely expected that the committee would decide to raise short-term interest rates from 0.50% to 0.75%.  The committee did indeed decide to hike as the markets expected, but also increased its 2017 forecast, from two rate hikes next year to three.  This is a jump in the committee’s expected trajectory of rate increases, and tells us the Fed believes we’ll see more economic growth and potential some inflationary pressures.

In the press conference immediately following the announcement, Fed chair Janet Yellen indicated that some of the committee members incorporated Donald Trump’s expected fiscal policies in their rate projections.  While we don’t know exactly how his policies will evolve after “running the gauntlet” in Washington, I think we can safely expect a more lenient tax structure.  Along with potential revisions in trade deals, it’s clear that the committee expects the economy to pick up steam and that inflation will follow.

Alongside the Fed’s decision and forecast, consumer confidence and investor confidence are both up since Trump’s surprise election win.  The relevant term here (in investment speak, at least) is “animal spirits”.  With the expectation of a more business friendly environment, the public generally tends to grow bolder and increase risk-taking activities.  We often see this play out with more business starts, banking activity, and a pop in the stock market.  While we don’t’ have business starts or banking data yet, we’ve already seen a nice pop in the stock markets, which we’ll discuss shortly.

From my perspective, this kind of fiscal policy should be a shot in the arm to the economy.  There are still reasons to be cautious though - some of which are the same reasons many voters were reluctant to vote for Trump in the first place.  His protectionist viewpoints and potential tariffs could easily harm international trade, and there’s the lingering concern that his approach to foreign relations is a major geopolitical risk.


The U.S. Dollar

Alongside the stock market rally and expectations for economic growth, the U.S. dollar has strengthened since the election.  Typically there are three reasons the dollar might strengthen.  First, since the dollar is the world’s reserve currency it can be used as a flight to quality.  When international investors are fearful of what’s happening globally or in their home country they may seek safety by purchasing more “stable” U.S. dollars. 

A stronger dollar can also be a vote of confidence too.  If economic prospects are better in the U.S. than they are elsewhere in the world, investors around the globe might want to take advantage of the opportunity (think “animal spirits” here) by purchasing U.S. dollar.  Along the same lines, if the economic prospects are better here in the U.S., interest rates are likely to be on the rise.  Fixed income investors looking for yield may want to buy dollars in order to capture soon-to-be-higher rates.  While we rarely have a concrete reason why the dollar strengthens or weakens, my sense is that the recent rally’s been fueled by a combination of all three.  The global economy is pretty dreary in many areas, making U.S. assets an attractive offshore option for many.  With all the strife occurring in the Middle East, mass exodus to the EU, and speculation that China’s debt fueled expansion may be slowing, the U.S. dollar is also the best & most stable currency for many international investors.


International Economy

Britain’s decision to leave the European Union over the summer was a harbinger of growing populist sentiment throughout Europe.  I won’t rehash what Britain’s exit could mean for the economy (see Investment Insights from 7/1/16 for commentary), but frustration with the state of the EU’s economy seems to be growing.  Italy’s referendum in December was a resounding move towards populism, and if another major country departed from the EU it would leave many to wonder whether the organization can still survive.

After the presidential election results here in the U.S., we’ve learned to be skeptical of polls.  Even so, early data indicates that other exits are unlikely.  The next two European elections coming up are France’s in May, and Germany’s beginning in August.  Polls in France and Germany both show that citizens are resoundingly against leaving the European Union in any capacity.  And in Germany, Angela Merkel’s party currently has a 10-point lead over establishment opposition, and a 20-point lead over anti-establishment opposition.  In short, despite the growing sense of frustration it seems unlikely that we’ll see another major economy leave the EU in 2017.


U.S. Fixed Income

The higher risk fixed income asset classes here in the U.S. performed exceptionally well in 2016.  With unemployment low and the economy steadily gaining ground, defaults from high-yield corporate debt and bank loans remained consistently low.

Looking ahead, the fiscal stimulus coming from a Trump white house should continue to bode well for corporations across the country, and certainly the higher risk sectors.  However, the spread of higher risk credits over U.S. treasury securities is somewhat slim, meaning that markets aren’t compensating investors much for taking on the additional risk.  

Preferred Stocks

The interest rate landscape here in the U.S. is a pretty consistent theme across the markets right now.  And since longer dated fixed income securities are particularly susceptible to rate increases, preferred stocks fall into the same boat.  Preferred stocks (even though they share the name “stocks”) are really fixed income securities.  They fall above equities in the capital structure, but below more traditional corporate debt.  This means that if a company ever enters bankruptcy proceedings, corporate debt owners are repaid first, then preferred stockholders, and then common equity shareholders.

The important point to remember about preferred shares is that they typically have very long (if any) maturity dates.  This means that when you buy a preferred stock it’s usually to capture the yield, since you won’t get your principal investment back for many years, if at all.

Because of the longer maturities, preferred stocks have significant duration, or interest rate risk.  And since we’re expecting a rise in interest rates as the economy picks up steam over the next several years, preferred stocks should be considered a high risk asset class.  

In fact, preferred shares were hit hard by the sharp rise in Treasury yields over the second half of 2016.  Since mig-August, the BofA Merrill Lynch Fixed Rate Preferred Securities Index has fallen 7.6%, to its lowest mark since March of 2014.  Over longer time horizons the high coupons often offered via preferred securities will certainly make up for near term interest rate risk.  But for investors with shorter time horizons preferred shares hold a substantial amount of risk.

Emerging Markets

It’s rare that I get through an entire edition of Investment Insights without at least mentioning the emerging markets.  And surprise surprise, this edition will be no different!  Emerging markets are an asset class with one of the highest risk/return propositions.  Emerging economies have a huge opportunity for outsized growth and investment returns, but will also experience growing pains and large, irregular corrections.

Up until 2016, the emerging markets as a whole (using the MSCI Emerging Markets Index as a proxy) have been negative in each of the last three years, and in five of the last eight since the financial crisis in 2008.  The slump finally ended in 2016, with the index gaining 8.5%.  

Volatility in the emerging markets normally translates to inconsistent corporate earnings.  But over the last three years earnings per share have started to stabilize, thanks in part to a rally in commodities over the last 12 months.  Many countries in the emerging markets are closely tied to commodities prices, and with oil & gas and mined metals surging, it’s no surprise that 2016 was a strong year for the index.  Looking ahead, the rally could continue with more strength expected from commodities & metals.

The emerging markets are also attractive from a relative valuation perspective.  The MSCI Emerging Markets Index’s P/E ratio currently sits at a reasonable 14.6, which is below its long term average.  

Commodities are not invulnerable though, and emerging economies will always be susceptible to political risk.  Just in 2016 we saw corruption scandals in Brazil and South Korea, where presidents Dilma Rousseff and Park Geun-hye were both impeached.

Finally, Chinese government debt continues to grow unabated.  Borrowing and spending to fuel economic growth is tricky business (and something we’re quite familiar with here in the U.S.), where taking the foot off the gas pedal at the perfect time is imperative.  Borrow & spend too much and inflation can spiral out of control, while braking too early could squash any forward momentum.  Coupled with the possibility of another yuan devaluation, the risk of a hard landing in China is greater today than it was 12 months ago.  Such an event would be very hard on the emerging markets, and would ripple across the entire global economy.  


Commodities prices across the board saw sizable gains in 2016.  Mined commodities like coal, iron, and copper all had large spikes in price, largely thanks to China’s debt-fueled stimulus.  Approximately 80% of China’s steel is used for investment-oriented activity, making steel and its inputs particularly sensitive to the country’s fiscal policies.  With “all systems go”, there is a huge demand in China for such metals. 

Oil prices have also jumped after several lagging years.  WTI Crude Oil, which began the year at $37.04 per barrel, ended 2016 at $53.72 / barrel, for a gain of 45%.  After 8 years of consistent oversupply, OPEC finally agreed to cut production and stabilize oil prices in late November.  The agreement will remove more than 1 million barrels of oil from world markets per day.  Today OPEC accounts for about a third of global oil production, and this cut signifies about a 3% drop in the group’s daily yield.

Morningstar believes OPEC’s move will cause a meaningful supply deficit in 2017, boosting prices further.  But longer term the company’s analysts don’t think it’ll make much difference in the world’s supply and demand dynamics.  During the supply glut over the last several years, many shale producers here in the U.S. were forced to go offline and basically walk away from fully operational production facilities.  As prices stabilize it won’t take long for them to get the rigs running again. 

As prices stabilize and it again makes economic sense, production capacity here in the U.S. will likely replace what was lost from OPEC’s reduction.  We’ll likely see a nice rise in oil prices again in 2017.  But beyond that any lost supply will probably be easily replaced, meaning our longer term outlook shouldn’t change.


Dividend Stocks

With interest rates at rock bottom lows since the financial crisis, a very popular investment strategy over the last several years has been buying shares with high or increasing dividend yields.  For income oriented investors, dividends can be a good way to replace lost income from depressed interest rates.  Plus, they’re even taxed favorably when they’re considered “qualified” dividends in the eyes of the IRS.

In fact, this strategy has been so popular that shares of companies that pay stable, decent sized dividends have surged in the last several years to the point of being overvalued.  Looking ahead, they could be in for a “mean reversion” slump as interest rates start to creep back up to historic norms.

To reinforce this view, Charles Schwab Investment Management rates all the sectors that comprise the S&P 500 on a continuous basis.  Currently, the only two sectors rated “Outperform” are Financials and Technology, whereas the only two sectors rated “Underperform” are Telecom and Utilities.  Not coincidentally, the Telecom and Utilities sectors are both known for paying high & consistent dividends, and are two of the three sectors with the highest dividend yields in the entire index.

Today, consistent dividends are expensive and investors will be better off looking for short duration fixed income securities.  With the Federal Reserve poised to raise short term rates another three times in 2017, yields on these securities will shortly start to rebound.  They also come without the interest rate risk of longer dated bonds & preferred stocks, or the high valuations dividend paying stocks.


Why We Can't Get Complacent After a Dull Summer in the Markets

Why We Can't Get Complacent After a Dull Summer in the Markets

Since the minor turbulence we experienced after Britain abruptly decided to leave the European Union, the markets were quite calm this summer. The S&P 500 is up 5.67% year to date, and even went over 50 consecutive trading sessions without a decline of more than 1%.

What the Brexit Means for Your Portfolio

What the Brexit Means for Your Portfolio

If you’ve been wondering where the next market shockwave might come from, I think you now have your answer. Last week, Britain voted in a referendum to leave the European Union – a move termed “Brexit” by worldwide media. The outcome of the vote came as a surprise to just about everyone. L

How Foreign Exchange is Affecting the Markets

How Foreign Exchange is Affecting the Markets

2016 has been a tumultuous ride for stocks thus far. The S&P 500 started the year down over 10% through the first six weeks of the year, as persistently low oil prices and concerns about China’s sputtering economy struck fear throughout the markets. Since then, strong economic data in the U.S. has helped stage an impressive comeback, and to date the index has rebounded right back to where it opened the year.

Three Investing Themes For 2016

Three Investing Themes For 2016

Hello and happy new year! As we close the books on 2015, we leave behind a year of stagnant equity returns, a rout in energy prices, and the first rise in short term interest rates in over eight years.

Today investors find themselves in a precarious situation, with stock markets hovering near all-time highs and interest rates poised to rise. From my perspective there are three main themes investors should address as we head into 2016: valuation “dissonance” between domestic and international stocks, weakness in oil prices, and vulnerability in the high yield bond market.

As always, Investment Insights will attempt to filter through these issues and provide actionable, data driven analysis and guidance.