Q2 2017 Commentary: “Stay the Course,” Once Again, Delivers

by Albert Meyer

The title to our commentary, exactly a year ago, was: “Stay the Course.” We had a volatile first half with a sharp sell off at the end of January 2016, followed by a recovery, only to sell off again on the news of the Brexit vote in Britain. We reminded our clients that long-term investors learn to live with these corrections that occur with annoying regularity. The market does not go up in a straight line, but the long-term trajectory strongly favors the bulls. We wrote: “Our advice remains, as we reiterated at the end of the first quarter, do not allow the media and short sellers to distract your attention from the quality of the stocks in your portfolio.” A year later, and our portfolios gained on average more than +25%, while the market’s +15% return was not too shabby either.

The best long-term returns come not from jumping in and out of the market, but rather from a long-term commitment. It is difficult to predict a selloff. Likewise, estimating the duration of the selloff is equally problematic, especially as the media thrives during a time of panic selling and will do all it can to prolong the agony. Those who hold onto their stocks during a trough, benefit from the double-digit dashes to the next peak. Those who participate in the panic selling lament their losses and then postpone their decision to reinvest until it is too late. This is how market timing works.

One pundit warned that we must expect the “dreaded Brexit disease to infect the global financial system.” We expressed our view that despite these calamitous warnings, the bloated bureaucracy in Brussels is unlikely to majorly impact the markets.

Imminent Recession or Longest Recovery Ever? Expect the warnings of an impending recession from the doomsayers to grow louder. They compete for the title of “The One Who Correctly Predicted the Recession.” Their forebodings are invariably badly timed. This continues until eventually a recession occurs. The media usually picks a winner or two and they go on to publish worthless newsletters under the banner of their sterling success in timing the market.

Clearly, the stock market and recessions do not go well together. However, recessions normally last for about two to three quarters. By the time the Bureau of Economic Research officially announces a recession, which by definition equates to two quarters of negative GDP growth, the recession is almost over and done with. Long-term investors have nothing to fear, even though their portfolios will take a temporary hit. The best long-term returns come from holding stocks for a prolonged period, through the peaks and through the troughs.

We have had eight years of economic expansion, the third longest period of economic growth among 12 others since the late 1940s. Back in 2010 and 2011, at least one economic research firm asserted that we did not properly emerge from the 2008/2009 recession. They used the term “double-dip recession.” Some could argue that we have had only five to six years of uninterrupted economic expansion.

The longest expansion occurred in the 1990s and lasted ten years. The second longest, in the 1960s, lasted almost nine years. As we pointed out in last quarter’s commentary, Australia has not had a recession since 1991. Other countries like Taiwan, Singapore, Switzerland and The Netherlands have had similar prolonged periods of economic expansion. Historical comparisons are not that useful but are often used to induce fear.

Another important point to note is that the current expansion has been glacierlike, with yearly gains in GDP growth averaging only +2.1%. GDP increased by +18.0% during the previous expansion that lasted six years, from Q1 2002 to Q4 2007. During the past eight years, GDP growth was a tad higher at +18.2%. It has definitely not been a strong recovery. As Gene Epstein, our favorite economist, points out in Barron’s (June 26, 2017), the previous expansion was also comparatively sluggish. By comparison, the first six years of the 10-year recovery in the 1990s, saw inflation adjusted or real GDP rise by +22.1%. If the current expansion reaches the +22% mark, say by the end of 2018, we could still have four more years of expansion to match the recovery of the 1990s. In the light of the lethargic manner in which this recovery started, we would not be surprised if this becomes the longest recovery in history.

Pundits like Torsten Slok, chief economist for Deutsche Bank Securities, place the odds of a US recession within the next 12 months at about 10%. The economy is running at near capacity with a tight labor market. Furthermore, the Fed has indicated that three more interest rate hikes are slated for 2017, not something they would contemplate if there was any risk of an imminent recession.

According to Slok, the housing, consumer durables and capital expenditure sectors are not overextended. Although the rate of auto purchases has declined, it does not pose a “significant” risk, according to Deutsche Bank’s research note.

A major tax cut for corporations, including the repatriation of foreign profits at an enticingly low tax rate, accompanied by severe budget cuts, for example, terminating our endless wars (supposedly a campaign promise, now sounding hollow) could combine to spark a real economic recovery well into the 2020s. We can only hope.

May 26, 2017, former Speaker, John Boehner, in a keynote address to KPMG’s annual Global Energy Conference, told his audience that tax reform is “just a bunch of happy talk.”

Stock Market The S&P 500 Index gained +2.41% and +8.08% this quarter and for the year to date, respectively. The Nasdaq Composite Index had its best first-half of the year since 1999’s when the dot.com insanity drove the index to a whopping +43.9%, and ultimately to +101.9% for that year. Nasdaq was up +14.1% for the first-half year of 2017, even though June marked its worse monthly performance since October 2016. So far in 2017, the index logged 38 all-time closing highs, the most for the first half of any year since 1986 when it clocked 52 record closing highs.

According to Mike Antonelli, equity sales trader at Robert W. Baird, the market’s first-half performance is not about Trump or the tax cuts, but about underlying fundamentals and the economy.

Only four first-half rallies in the past 20 years have been as widespread or better than the current one, two of which preceded market corrections, while the other two ushered in multiyear bull markets.

The companies in the S&P 500 had a combined market cap of $20.490 trillion at the beginning of 2017. At the end of June, they were worth $22.110 trillion, for a six-month gain of $1.620 trillion. Technology added $680 billion (+15.7% increase) followed by the Healthcare sector that added $400 billion (+14.9% increase). Only two sectors failed to gain any traction, namely, Telecom and Energy, with declines of $6 billion (-11.8% decline) and $170 billion (-11.8% decline), respectively.

Doug Ramsey, at Leuthold Weeden Group, foresees more gains in the second-half of the year due to strong market breadth on the S&P 500 Index and NYSE that made all-time highs on June 19 and 28, respectively.

It has been eight years since global stock markets have enjoyed such a bullish first-half of the year, according to the Wall Street Journal. Of the world’s 30 major indexes, 26 managed to close the first six months in the green.

Stock Market Comparisons Comparisons can be odious, or “odorous” (as in, Much Ado About Nothing), but we will make them anyway. In July 2007, the S&P 500 reached a new high, only to lose -9% in August 2007. A year later, the biggest slide in a century hit the stock market, compliments of the housing bust and the financial crisis. It was painful for the panic sellers, while the steady Eddies who kept their cool, possibly even buying amidst the carnage, enjoyed the benefits of the inevitable recovery.

As far as comparisons are concerned, the market is now again in record territory. However, the leading economic indicators, the credit markets, household and corporate balance sheets, and critical financial ratios at US banks are in much better shape than they were in 2007/2008.

In July 2007, the 12 months’ trailing P/E was 16.2 and the forward P/E 15.0. Shiller’s CAPE ratio stood at 27.4. By comparison, these ratios are currently at 20.7, 17.5 and 29.7, respectively. The market seems to be factoring in a boat load of optimism. As noted above, this optimism is only warranted if Congress legislates a drastic cut in the corporate tax rate – a hope that fades by the day.

It is worth pointing out that the market’s current five-year annualized gain of +14.6% p.a. is comparable to other bull markets, but the current ten-year rate of +7.0% p.a. lags significantly behind the rate that usually accompanies a market peak. It is also 300 basis points behind the historical average. The historical 20-year average return for the S&P 500 is +11.1% p.a. and well above the current run rate of +7.2% p.a.

Stated differently, for a useful perspective, the current one-year performance of the S&P 500, though impressive, only ranks in the 62nd percentile relative to other one-year returns, as measured since the late 1920s. The current 5-, 10- and 20-year returns rank in the 67th, 27th and 8th percentile, respectively.

The new highs in mid to late 2007 were barely above the March 2000 levels of the prior bull market. From a historical perspective, the past 15 years have not been the norm compared to other 15-year periods in the past. The dot.com boom and its aftermath created major distortions and exceptions, as did the Great Recession of 2009.

In July 2007, the yield curve, as represented by the spread between the two- and 10-year Treasury yields, was a couple of basis points above zero. Currently, the spread is a healthy ninety-seven basis points.

By the third quarter of 2007, corporate profits had declined by -9% Y/Y compared to a +22% Y/Y increase, a year earlier. Most analysts are predicting a +10% Y/Y increase for Q2 2017. A cut in the corporate tax rate, would make Y/Y comparisons virtually meaningless. As a consequence of a cut in the tax rate, deferred tax liabilities (an accounting abstraction) would have to be restated at the lower tax rate (akin to debt forgiveness). A reduction in the deferred tax liability will provide a meaningful boost to corporate earnings in the year of the restatement, on top of the lower tax expense.

During the third quarter of 2007, the St. Louis Fed Financial Stress Index sounded warning bells. Currently, the Index signals a near record-low level of capital-markets stress. Junk-bond spreads are near their narrowest of levels, while a decade ago, they began surging dramatically. A mid-2007 oil price of $60 per barrel to $130 by mid-2008, exacerbated the already fragile economic conditions.

Prior to the summer of 2006, the Fed had moved short-term interest rates higher on 17 successive occasions. In September 2007, our central bankers, in their infinite wisdom began to reverse the trend, a trend which ended at near zero percent rates in 2016. Even with the certainty of rate increases in 2017 and beyond, at currently depressed rates, the advent of a more normalized interest rate environment is still only a pipedream.

We did find a couple of similarities between 2007 and 2017, namely, the unemployment rate and the ISM manufacturing index at the time were close to current levels.

Stock Market Predictions/Indicators Mark Hulbert at MarketWatch points out that the Dow Jones Utility Average (DJU) is giving the stock market a bullish signal. This benchmark, which was created 88 years ago, is thought to be a leading indicator of tops and bottoms in the broad equity market. The index reached an all-time high during the first week of July. Historically, the DJU has tended to bottom and top three to six months before the Dow Industrials. If this is any indication, the current bull market has another three to six months to run, that is, if the DJU stops making new highs.

The Dow Theory holds that transportation and industrial stocks must advance in lock-step for the bull market to remain intact; and more so when the two sectors reach record highs simultaneously. If so, then the current bull market, now eight years in the making, still has legs. We saw this phenomenon last October, and a +17% increase in the Dow Jones Industrial (DJI) followed. Currently, the transportation index lags behind the DJI, which hit a record high on June 19, that is, according to the Dow Jones measure. The two sectors, as represented by the S&P 500, posted new highs on the same day, June 19.

The DJI posted new highs in seven of the first 13 days of trading in June. The index rose +17% since November 8 and +9% since January 20 (Trump’s inauguration). The DJI closed above 19,000 for the first time on November 22, 2016 and closed above 21,000 on March 1, 2017. It took just 66 days to climb from 19,000 to 21,000, the fastest 2,000-point increase ever. The S&P 500 and the Nasdaq also set new all-time highs during this period. In dollar terms, the US stock market gained $2 trillion since November 8, 2016, and the market capitalization of the S&P 500 exceeded $20 trillion for the first time in history.

Billionaire investor Ron Baron, who oversees some $23 billion in assets, was very bullish in the last week of June during an interview on CNBC. Arguably, considering his vested interests, such bullishness should not be surprising. The same can be said of us, although it is not so much about bullishness as being committed to the market over the long-term. Baron’s optimism stems from the low interest rates and depressed oil prices that should linger for a “a very long time.” He also foresees stronger economic growth, sufficient to push the Dow to 40,000 by 2030, which only translates to about 5.0% p.a. growth. By the same token, the S&P 500 should be at 4,500.

On May 23, 2017, Nobel Prize-winning economist Robert Shiller told CNBC that investors should continue to own stocks because the bull market may continue for years. “I would say have some stocks in your portfolio. It could go up fifty percent from here. That’s what it did around 2000, after it reached this level, it went up another fifty percent. So, I’m not against investing in the stock market when you consider the alternatives. But I think if one wants to diversify, US is high in its CAPE ratio. You can go practically anywhere else in the world and it’s lower,” Shiller said. “We could even set a new record high in CAPE, that’s not a forecast… We have maybe inspiration from the White House, a businessman president. If factors go right and there are tax cuts for corporations, it’s not that hard to understand that that could happen.”

Shiller developed the “cyclically adjusted price-to-earnings ratio” (CAPE) market valuation measure, which is calculated using price divided by the index’s average historical 10-year earnings, adjusted for inflation. The economist’s research found future 10-year stock market returns were negatively correlated to high CAPE ratio readings on a relative basis. We have commented on the CAPE ratio many times in the past, noting that it invariably points to an overvalued market and would have been a very poor instrument for investors wanting to time their market trades.

Three years before the tech bubble burst, Fed Chairman Greenspan made his (in)famous “irrational exuberance” accusation against investors. Those who ignored his objections and invested in the S&P 500 on that day would still have made +13.3% p.a. on their investment between then and the bottom of the tech wreck. Folks at the Fed have a less than stellar record in calling market tops.

When discussing stock valuations in February 2017, Warren Buffett said, “measured against interest rates, stocks actually are on the cheap side compared to historic valuations.”

Currently the S&P 500 trades at what appears on the surface to be an elevated price-to-earnings (P/E) ratio of 25.7, compared to a historical average P/E ratio of 15.7. The current earnings yield is 3.89% (1/25.7). Earnings yield is the inverse of the P/E ratio. The 10-year Treasury bond yield is a 2.18%. This means the earnings yield exceeds the 10-year yield by 1.71%.

Since 1990, the average rate on the 10-year Treasury was 4.65%. The average P/E and earnings yield over the same period was 23.86 and 4.73%, respectively, for an excess of earnings yield over the 10-year yield of only 0.09%. The stock market moves into overvaluation territory when the yield on the 10-year Treasury exceeds the earnings yield; not even close at current levels.

When the Market Crashes Although we do not foresee a full-blooded market crash, a correction of sorts is always a possibility. However, an exogenous non-financial event could roil the markets.

There is usually a catalyst that precipitates a market crash. Sometimes a crash is induced by a financial event, e.g., the bankruptcy of Lehman Brothers in 2008. At other times, a non-financial event could trigger a frenzy of selling. On October 14, 1987, the Dow Jones Industrial Average (DJIA) dropped 95.46 points (-3.8%) to 2,412.70, and fell another 58 points (-2.4%) the next day, after Iran hit the American-owned (and Liberian-flagged) supertanker, the Sungari, with a Silkworm missile off Kuwait’s main Mina Al Ahmadi oil port. The next morning, Iran hit another ship, the US-flagged MV Sea Isle City, with another Silkworm missile. The US responded by bombing an Iranian oil platform less than 48 hours later.

On Friday, October 16, when all the markets in London were unexpectedly closed due to the Great Storm of 1987, the DJIA fell 108.35 points (-4.6%) to close at 2,246.74 on record volume. In the world of finance, Black Monday refers to Monday, October 19, 1987, when stock markets around the world crashed, shedding a huge value in a very short time. The crash began in Hong Kong and spread west to Europe, hitting the US after other markets had already declined by a significant margin. The DJIA fell exactly 508 points to 1,738.74 (-22.61%), truly a dark day for the stock market.

However, as we always remind our clients, the market recovers 100% of the time. In the summer of 1987, the S&P 500 traded at 304. It then cratered to a low of 217 in October 1987. By April 1988, the index had fully recovered. Those who ignored the panic and remained in the market, from the stock market’s high in the summer of 1987 to date, would currently have more than $80,000 for every $10,000 invested. i.e., a +7.2% p.a. return over 30 years.

Our current involvement in Syria, including actions of war that have not been authorized by Congress in violation of the Constitution, is a reminder of what happened in the Persian Gulf 30 years ago. If the events in Syria spin out of control, we could see the same kind of reaction in the stock market as we saw in 1987, but probably a lot worse.

Recall that when the Soviet Union shot down a U-2 spy plane at the heart of the Cuban Missile Crisis that could have resulted in World War III, President Kennedy understood the risks of unintended consequences when he said, “Well, there’s always some son-of-a-bitch down the line who doesn’t get the message.” Anything could go wrong in Syria. If so, we could be at war with Russia, with few survivors here, there and everywhere. Congress is supposed to reign in the military, call for a debate, and a vote to authorize a new war in Syria. Instead, they turn a blind eye and mission creep is now in full swing. We ought to be very concerned, regardless of our exposure to the stock market.

Doomsayers As the media parades the doomsayers, keep in mind what Scott Nations, author of “A History of the United States in Five Crashes,” wrote: “The world of finance is full of charlatans constantly warning of an impending crash in an effort to sell you gold or get you to subscribe to their newsletter. The result is another human quirk: we tune out the drumbeat of warnings and fail to recognize when we’ve actually joined the herd. Investing has always required discipline, and in the age of 24-hour financial media and Twitter, recognizing the signal amid the noise will require more discipline than ever.”

Market corrections are par for the course. The stock market recovers on average within three to six months. We have had four corrections since 2008: April to June in 2010, April to September in 2011, July to September in 2015 and November 2015 to February 2016.

Trade Restrictions Last quarter, we illustrated the folly of imposing tariffs on Canadian softwood producers. This quarter, the solar industry stands in line for a “favor” from Washington. US manufacturers of solar panels are up in arms. Panel manufacturer, Suniva, now in Chapter 11, invoked an obscure law to initiate a government trade investigation that has the power to cause major disruptions in the $29 billion US solar industry. This particular law gives the president power to unilaterally impose broad tariffs simply if surging imports are hurting US manufacturers. Even though the law has been on the statute books since 1974, companies hardly ever bother to file suit, knowing the president would turn them down. The last successful case, in 2002, levied import tariffs on steel. President Bush endured a lot of criticism at the time. We all know that President Trump has a soft spot for US manufacturers, which gives Suniva perhaps a more than equal chance of success.

Suniva wants import duties of 40 cents per watt for solar cells, which currently sell for 25 cents to 33 cents a watt. This would seemingly benefit Suniva and other local manufacturers of solar panels. It would also be very shortsighted if the president falls for this ploy. Solar panels will become more expensive and this could seriously depress demand for solar power.

The US International Trade Commission will send its recommendation to the president by September 22. Regardless of the outcome of the investigation, the president has broad leeway to act. A tariff on solar import panels would be painted as the honoring of a campaign promise.

It would be a foolhardy way of projecting manufacturing jobs at home. Cheap foreign imports created strong demand for solar panels. This in turn meant a demand for rooftop installers, solar farm developers and other related jobs that comprised 85% of the 260,000 workers in the solar power industry. US solar installation has grown nine-fold over the past five years, thanks to low-cost imports. The Solar Energy Industries Association argues that saving 38,000 manufacturing jobs could cost the industry at least 88,000 jobs in the short-term. US consumers will have to pay more for their solar panels. When prices go up, demand falters. Government interference in the free trade arrangements always has unintended consequences, and consumers always draw the short straw.

On June 10, 2017, Associated Press reported that an Iranian company, Aseman Airlines, finalized a deal with Boeing to buy 60 planes. The planes will be delivered in two batches and the first batch will consist of thirty 737 passenger planes to be delivered in 2019. In December 2016, Iran Air inked a deal to purchase 80 passenger planes from Boeing for $16.6 billion. There are those in Congress who want to reimpose sanctions on Iran. We favor trade with all and sundry, friend or foe, regardless of political ideologies. Trade turns foes into friends. It’s a win-win proposition.

Occupational Licensing Gene Epstein (Barron’s, July 10, 2017), highlights the irrationality of occupational licensing, an initiative that never comes from legislators but always from those who want to limit others from competing in their markets. The whole point of licensing is to establish legal obstacles to those who wish to enter an occupation, in the form of mandatory fees and training. In this regard, Epstein recommends, Brink Lindsey and Steve Teles’ book, The Captured Economy: How the Powerful Become Richer, Slow Down Growth, and Increase Inequality. The authors explain why occupational licensing widens the gap between rich and poor by squelching employment opportunities at the lower end of the socioeconomic scale, and by inflating the compensation of highly skilled professionals at the top of the scale.

Since 1970, the share of workers subject to licensing has jumped from 10% to almost 30%. Epstein argues that there is a long list of occupations that pay reasonably well, and which people at the low end of the income scale might normally be able to fill with a minimum of on-the-job-training. But these jobs maybe out of their reach due to the money and time required to acquire a license: beauticians, manicurists, barbers, preschool teachers, athletic trainers, gambling dealers, bartenders, preschool teachers, interior designers and florists, among others.

Epstein cites an example. Even though Louisiana requires florists to be licensed, unlike Texas, there is no difference between the floral-arranging skills of the licensed professionals in Louisiana versus the unlicensed in Texas. The purpose of licensing is not to enhance skills, but to create barriers to entry. Fifty-five years ago, economist and Nobel Laurate, Milton Friedman, wrote extensively on this topic; not surprisingly, as he was a great proponent of free markets.

In our profession, FINRA is the bouncer that guards the entryway to our exclusive club. Shana Madoff, daughter of Robert Madoff, (brother of and righthand man to Bernie Madoff) and chief compliance officer at the now infamous firm that bore the Madoff name, served on FINRA’s compliance advisory committee, and why not? She was after all a lawyer, compliance officer and married to a former SEC lawyer. Who better than someone with these credentials to bolster the ranks of an indispensable licensing/oversight agency?

Tax Cuts We are shameless proponents of tax cuts for corporations. Sure, such cuts would benefit equity holders like ourselves. It would also benefit the more than 30 million employees working for public companies and untold millions working for private companies that do business with public companies. It would also benefit retirement funds in particular the many public pension funds that are severely underfunded.

Longer-term, though, without spending cuts, these benefits, for the most part, will evaporate, that is, if tax cuts simply mean more deficit spending. Cutting government expenditures makes for good campaign talk, but it seemingly never happens. Think of it, the one area that is ripe for spending cuts, namely the defense budget, received a hefty increase in the most recent budget proposed by the Trump Administration.

If tax is a government cost imposed on taxpayers, then deficit spending means more costs, regardless of the tax cut smokescreen. Deficits translate into more borrowing, which adds to the interest burden. Deficits are monetized by the Fed, which means an increase in money supply, which over time, gives rise to inflation, that is, a reduction in the purchase power of our currency.

In fiscal 2015, 6 percent or $221 billion of the federal budget went to paying interest on debt. This amounts to about one-fourth of the entire defense budget – no big deal, many might argue, forgetting that the Fed’s “accommodating” monetary policies have pushed interest rates down to abnormal levels. Once interest rates normalize, this line item could take up ten to fifteen percent of the federal budget. That’s when the pain of deficit spending becomes unbearable.

To prove the point, consider that at a national debt of $19.9 trillion, each 25-basis point (0.025%) increase in nominal interest rates, assuming a parallel shift in the yield curve, adds approximately $50 billion to government’s annual interest payments. A mere 100-basis point increase in government’s interest cost will add $195 billion to debt servicing, on top of the current $221 billion.

Increased government debt, entices investors to divert capital away from the private capital markets to highly rated government securities. To compete against this capital flow, private sector debt offerings need to carry a higher coupon rate, effectively burdening private entities with a higher cost of capital.

Government spending is always a net-negative, because government’s only source of income is our taxes, money that we could invest and spend more judicially ourselves. If it were not so, the Soviet Union would have been an economic paradise. European governments’ 40%-plus share of their nations’ GDP is one of the main reasons that their economies are struggling to compete with the US economy.

So, yes, cut taxes, but only if it is accompanied by spending cuts of equal magnitude – alas, this is not going to happen. The Senate version of the “new” healthcare bill includes a $200 billion bailout fund for insurance companies. Remarkable for a party who campaigned on a “repeal and replace” platform and claims to be against big government, but then history teaches us that spending balloons under GOP leadership, because both parties are happy to vote for such spending. Under Democratic control, the pretenders suddenly get religion and oppose spending. Washington is an intractable conundrum.

Buffett on Valuation Warren Buffett believes that the most important metric for investors to watch is found in the bond market. “Everything in valuation gets back to interest rates,” Buffett said told Andy Serwer in April. At Berkshire Hathaway’s recent annual shareholders meeting, an investor asked Buffett about the relevance of popular measures of stock market value.

“Every number has some degree of meaning,” Buffett said. “It means more sometimes than others. … And both of the things that you mentioned get bandied around a lot. It’s not that they’re unimportant. … They can be very important. Sometimes they can be almost totally unimportant. It’s just not quite as simple as having one or two formulas and then saying the market is undervalued or overvalued.

“The most important thing is future interest rates,” Buffett said. “And people frequently plug in the current interest rate saying that’s the best they can do. After all, it does reflect the market’s judgment. And the 30-year bond should tell you what people are willing to put out money for 30 years and have no risk of dollar gain or dollar loss at the end of the 30-year period. But what better figure can you come up with? I’m not sure I can come up with a better figure. But that doesn’t mean I want to use the current figure, either.”

Buffet told CNBC’s Becky Quick that, if these rates were guaranteed to stay low for 10, 15 or 20 years, then “the stock market is dirt cheap now… If I could only pick one statistic to ask you about the future, I would not ask you about GDP growth, I would not ask you about who was going to be president… a million things I wouldn’t ask. I would ask you what the interest rate is going to be over the next 20 years on average. The 10-year Treasury note yield or whatever you wanted to do.”

From the Berkshire Hathaway’s 2000 letter to shareholders: “Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.). The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was ‘a bird in the hand is worth two in the bush.’ To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.”

From Buffett’s 2010 letter to shareholders: “To update Aesop, a girl in a convertible is worth five in the phone book.”

Households On June 8, the Fed released its Q1 2017 estimate of the balance sheets of US households. Households’ net worth is at a new high in nominal, real, and per capita terms. Regardless of the anemic recovery over the past eight years, households are better off than ever before and by some margin.

As of March 31, 2017, the net worth of US households (including that of Non-Profit Organizations, which exist for the benefit of all) reached a surprising $94.835 trillion, which is a +$7.3 trillion increase over the past 12 months, a gain of +8.3%, and up +$27.2 trillion since the pre-2008 peak.

Remarkably, household liabilities have increased by a mere +$510 billion since their 2008 peak, for a gain of only +3.5%. The value of real estate holdings is up about +$1.9 trillion (+7.6%) from that of the “bubble” high of 2006. Financial asset holdings have soared by almost $24 trillion (+45%) since pre-crash levels, attributable to significant gains in savings deposits, bonds, and equities. The market cap of all traded US equities has risen by +$8.4 trillion since its pre-2008 high.

In real terms, household net worth has grown at a +3.5% annualized rate for the past 65 years, which equates to a 10-fold gain in wealth through three generations. There is no sign that this rising trend has been lowered in the past decade.

This accumulation of wealth is not the result of a bulging debt bubble as many would want us to believe. Households have cut their reliance on debt by one-third since 2009, when debt to net worth reached a high of 21%. The current 13.8%.

No one denies that the distribution of wealth is heavily skewed in favor of the super-rich, and no doubt an issue that has social consequences. That said, per capita wealth remains a vitally important measure of a nation’s economic prosperity. Regardless of who owns the stock, the factories, the high-rises, etc. the economic benefits of such capital formation benefits all in one way or another.

Warren Buffett recently weighed in on this topic. “The real problem, in my view, is … the prosperity has been unbelievable for the extremely rich people. This has been a prosperity that’s been disproportionately rewarding to the people on top,” Buffett said in an interview Tuesday with PBS. “The economy is doing well, but all Americans aren’t doing well,” he said.

Buffett pointed to the rapid pace of automation and technological advances as one factor, as workers aren’t being retrained fast enough to keep up with the changes. Society can’t afford for those workers to be left behind, he said: “When you have something that’s good for society, but terribly harmful for individuals, we have got to make sure those individuals are taken care of.”

Politicians, especially those who disparage free markets and capitalism, ingratiate themselves to the less well-off voters by promising a more equal distribution of wealth. The fact that their failed policies cannot match the kind of wealth that capitalism creates does not deter them, which reminds us of Winston Churchill’s view on the topic: “The inherent vice of capitalism is the unequal sharing of blessings; the inherent virtue of socialism is the equal sharing of miseries.” The unequal sharing of wealth is undeniable. We will concede that point, but when it comes to the creation of wealth and prosperity, nothing comes close to free markets and capitalism. This too is undeniable, although by no means a universally accepted truth.

Households: Housing Homeownership in the US rose from 64% to 69% at its peak in 2005 and 2006. In the wake of the credit crisis and housing bust, more than 5 million households that once owned homes joined the tenant class, and homeownership among fell again below 64%.

In June 2017, the stocks of homebuilders reached a ten-year high, although the highs from 2005 are still some way off. Homebuilders have to rally another 50%-plus to reach their summer of 2005 price levels.

The National Association of Home Builders (NAHB) has an index that tracks the level of optimism among the nation’s homebuilders. According to the NAHB, homebuilder sentiment fell from a reading of 69 in May to 67 in June. Analysts who follow the industry expected a reading of 70.

On a regional basis, sentiments among homebuilders in the West declined by nine points, while the Midwest picked up four points to a reading of 69. The Northeast was down -1 and the South a tad worse at -3.

Households: Equities According to the latest Federal Reserve data through the end of the first quarter, US households collectively have 39.2% of their financial assets invested in equities. The only other time that this percentage was higher was during the dot.com boom in the late 1990. At that stage, the ratio soared to a record high of 47.7%.

Recall that in April 2011, the S&P 500 came close to the 1,250 level that prevailed before the Lehman bankruptcy that proved the catalyst for the 2008/2009 meltdown. Surprisingly, debt problems in the small European country of Greece, set the market back and eight months later the market finally breached the pre-Lehman levels.

Jobs Economic data, whether compiled by a government agency or a private institution, is at best an approximation. Keep in mind, most data, in the interest of timeliness, is initially provisional and subject to one or two revisions. However, analyzed over time, data reveals a trend that offers useful insights. Stand-alone data is prone to dubious interpretation. Early in September 2011, the nonfarm payroll for August 2011 revealed no job growth. Market moving headlines like “US Jobs Growth Grinds to a Halt,” caused stocks to drop on the news. Revised numbers showed that August 2011 added 110,000 jobs.

On Friday July 7, 2017, the Labor Department reported that in the month of June 2017, the US economy added 222,000. There was also an upward revision of 47,000 jobs of the numbers published in April and May. Economists were expecting 178,000 new jobs, while the unemployment rate was set to remain at 4.3%, a post-financial crisis low. The unemployment rate in June was 4.4%. The uptick in the unemployment rate comes as the labor force participation rate also rose slightly, to 62.8% from 62.7% in May. Average weekly hours worked also rose to 34.5 from 34.4. Average hourly earnings increased by +2.5% over the past twelve months, while average weekly earnings were boosted by +2.8%. Average hourly earnings are a key measure of potential inflation pressures and are closely watched by economists. Wages were expected to rise 0.3% over the prior month and 2.6% over the prior year in June. These statistically insignificant 10-basis point “shortfalls” caused some journalists to headline the labor statistics as “disappointing.” Talking about clutching straws. The stock market had no such delusions and responded positively on the day.

By sector, the bulk of job gains was seen in the services space, particularly health care and social assistance jobs which were up by 59,000 in June. Education and health services employment grew by 45,000 in June, while leisure and hospitality jobs grew by 36,000.

Government employment was also a boost for overall job gains, rising by 35,000 in June after a net gain of just 6,000 jobs for the sector in the prior two months.

The goods-producing sector, which includes coal and manufacturing added 25,000 jobs in June. One thousand jobs were added in the manufacturing sector, 16,000 jobs were added in construction, while eight thousand were added in mining and logging.

Oil Energy comprises 6% of the S&P 500. We currently have no direct exposure to energy, but we watch the sector closely. We might have to rethink our current indifference to the industry if it becomes clear that a rebound is imminent.

Shale-oil production is climbing, but growth is slowing down. The number of US rigs drilling for oil has grown for 23 weeks in a row, based on Baker Hughes data, but new-well oil production per rig among the shale plays has slowed. Oil pundits argue that with some OPEC members sticking to their pledged production cuts and with record refining demand for oil in the US, the amount of oil in domestic storage is on track to drop by 100 million barrels by the end of September, regardless of shale. This in turn could mean a rebound in oil prices in the second half of the year.

Experts believe that the most important factor to influence the price of oil in coming months would be the Chinese Caixin manufacturing PMI. China is the world’s second-largest consumer of oil and one of the largest sources of additional, marginal global oil demand. China has been the largest net importer of petroleum since 2014, when it surpassed the US.

On July 3, it was reported that the Caixin Manufacturing PMI in China unexpectedly rose to 50.4 in June of 2017 from 49.6 in May, beating market consensus of 49.5. It was the highest reading since March, as output and new export orders increased at a faster pace.

Chris Martenson of the Peak Prosperity blog, warns that there is an oil shock looming as early as 2018, in particular, a nasty oil price spike. “There will be an extremely painful oil supply shortfall sometime between 2018 and 2020.” he said.

Global energy exploration and production capital expenditures are expected to fall by -22%, which equates to a $740 billion reduction, between 2015 and 2020, according to a report from Wood Mackenzie issued last year. If one includes cuts to conventional exploration investment, that figure increases to just over $1 trillion. Over the years, oil and gas investment has never seen such declines. Even in 2009, the decline was less than -10%. This trend coincides with a downward trend in oil discoveries.

Discovery of new oil fields is at its lowest level since 1947, as the decline in oil prices cause exploration companies to cut back expenditures. Year to date, West Texas Intermediate crude and Brent crude prices have dropped by roughly -18%.

If Martenson’s analysis hold true, we should see an increase in the price of oil, especially if current demand either holds or increases as the growth in the global economy picks up.

Others in the industry predicts that the oil price will remain lower for longer. For the second month in a row, major investment banks are lowering their price forecasts. According to a Wall Street Journal survey, 14 bank analysts on averaged predict a price for WTI at $52 per barrel for 2017, a decline of $2 from the same survey in May. They foresee WTI averaging $55 per barrel in 2018, down $2 from the May results.

Goldman Sachs dramatically lowered its oil price forecast for 2017, by dropping its prediction by $7.50 per barrel to $47.50. To explain this about turn in previously optimistic forecasts, the investment bank cited higher-than-expected production from Nigeria, Libya and a swift rebound in US shale output. Shale productivity gains and efficiencies could still keep a lid on prices over the long-term, keeping prices at $50 per barrel. Michael Cohen, Barclays head of energy commodities research, is a bit more bullish, predicting “severe” inventory declines later this year, which could lead to a more sustained rally above today’s prices.

At ruling prices, all three major fossil fuels (coal, oil, and natural gas), are priced below their 2009 Great Recession lows. A Federal Reserve induced expansion in money supply of historic proportions was supposed to be inflationary. Add to this anomaly, the fact that China’s economy has tripled in size since 2007.

Advances in technology best explain why energy is so much cheaper today and might well remain so for years.

Technology in the form of fracking has made it more economical to extract fossil fuels, especially in the US where the decades decline in oil and gas production has been reversed. Technology has also made it possible for consumers to use energy more efficiently. Wind and solar have the dented demand for fossil fuels. LED lightning, digital TVs and other energy sapping devices have been reengineered to use less power. Back in 1980, US vehicles consumed on average 24.3 miles per gallon (MPG). This average moved up to 28.4 MPG by 2000 and to $36.4 MPG in 20014. Hybrid vehicles, like the Prius, achieve 58 MPG. Electric vehicles like the Nissan Leaf and Chevy Bolt boast 112 and 119 miles per gallon equivalent (MPGe), respectively.

According to Suhail Al Mazrouei, the UAE Energy Minister, OPEC is not worried about the market recovery and do not plan to discuss deeper cuts, because increased demand in the third and fourth quarters will help to rebalance the oil market.

Gas Prices at the Pump Consumers are enjoying a boost in their spending power at the gasoline pump. According to research firm, Bespoke, since 2005, the average price of gasoline heading into the Memorial Day weekend was $3.04 per gallon. The average year-to-date increase in gas prices measured at the same date was +22.0%. Currently, the comparatives are $2.36 and +1.1%, respectively, on both accounts well below the averages. Since 2005, only in 2005 ($2.12) and 2016 ($2.29) did we see gas prices below the current price. Growth in gas prices is normally weaker in the second half compared to the first, which augers well for consumers for the rest of the year.


Earnings Season Update

by Albert Meyer

Stocks identified by Goldman Sachs as those that would benefit most from the tax policies of the Trump Administration surged in the aftermath of the November 8, 2016 election results. These stocks posted gains of +6.0% by December 1, 2016, while the S&P 500 advanced sluggishly +2.4% over the same period. By the end of the third week of May 2017, the group of tax rate sensitive stocks now only show gains of +3.9%, significantly underperforming the S&P 500’s +8.7% gain posted since the November elections. The reason for this dramatic reversal of fortunes lies in comments from our legislators to the effect that “it ain’t gonna happen.”

We said this before, but nothing would improve the economic fortunes of the US economy more than a drastic cut in corporate taxes. Regardless of one’s political persuasions, it is undeniable that if a company trades at price-to-earnings (P/E) multiple of, say, 20, and a major tax break cuts the company’s tax bill by, say, $400 million, theoretically, over time, the market capitalization of that company will go up by $8 billion ($400 million times 20). Take note: the taxman grabs $1, and shareholders’ net worth declines by $20. This is not politics. This is fact.

The market capitalization of the S&P 500 companies was $21.3 trillion at the end of the first quarter of 2017. Assume the index trades at a P/E of 25. Dividing $21.3 trillion by 25 gives us earnings of $852 billion and pre-tax earnings of $1.217 trillion, assuming an effective average tax rate of 30% ($852 divided by [1-0.30]). More importantly, the difference between pre-tax earnings and earnings of $365 billion is the S&P 500’s tax burden (30% of $1.217 trillion). Assume 20% of these taxes are paid to foreign governments. That would leave us with $292 billion in taxes paid to the Treasury. Would you believe it? Corporate taxes raised $292.561 billion in fiscal 2016, ended September 30, according to the Tax Policy Center.

A 50% reduction in the tax rate would deprive the Treasury of a mere $146 billion, $46 billion of which will be used to fund the projected expenditures of $49 billion for Afghanistan in fiscal 2017. More to the point, a $146 billion tax break will boost the market capitalization of the S&P 500 by approximately $3.650 trillion ($146 billion times 25), or $200 billion more than the GDP of Germany. These numbers are approximations for those who want to dispute their accuracy.

As an aside, the $1.2 trillion (S&P 500 pre-tax earnings) noted above is almost as big as the GDP of South Korea. The GDP of North Korea is less than $20 billion (1.6% of $1.2 trillion) – not exactly what the defense contractors in Washington want us to focus on.

If these tax cuts are no longer on the table, what explains the overall strength of the stock market? Answer: For the most part, corporate earnings. We know Wall Street analysts are notoriously bullish, which means that it is a notable achievement any time a company beats a Street estimate. Out of the total of 2,450 companies that reported first quarter earnings to date (mid-May), 1,500 or 61.2% beat the analysts’ consensus estimates.

One minor factor contributing to this outperformance is the US dollar. The US Dollar, as measured by the US Dollar Index, has given up all of its post-election gains. The large US corporations that dominate the S&P 500 derive a material component of earnings from abroad. These foreign earnings are translated into our domestic currency, the dollar. Earnings take a hit when the dollar strengthens vis-à-vis foreign currencies, and vice versa when the dollar weakens. The most recent fourth quarter’s earnings were negatively impacted by a strong dollar, but with the trend having reversed itself, foreign earnings contributed to the earnings outperformance.

Finally, active investors fall into two camps, those who pursue value stocks and others who favor growth stocks. Growth always comes at a price, which scares off those who scour for value. To this end, the ETF industry offers two funds: The S&P 500 Value index and The S&P 500 Growth index.

For most of 2016, the two funds tracked each other’s performance, but in the four months following the Presidential election, Value significantly outperformed Growth. However, since the beginning of March, Growth has turned the tables on Value. Measured from November 9, 2016 to May 16, 2017, the Growth index is up by +17.5% and Value by +14.3%. Measured year-to-date, the divergence is more conspicuous with Growth posting a +11.59% gain for the first 92 days of 2017 and Value only +2.48%. This spread between the two benchmarks has never been this wide at this point in the year since the indices were created in 1995.

We have seen a significant spike in investor optimism since the election last November, which no doubt translates into buying pressure. This in turn, explains the market’s performance to date, which is stellar compared to a year ago, when investors were stung by the selloff in late January and early February. Ultimately, the best returns come from those who hold onto their stocks (so much more when they are quality stocks), through the peaks and troughs. Perhaps a topic for next month’s submission.