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.

 

Economy

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

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.