Time to Find a Spot for TIPS

Last November, most financial markets had to quickly re-calibrate to new and unexpected formulas resulting from the election landslide. The stunning rise in yield for the 10 year US Treasury bond from 1.8% to 2.6% in just a few short weeks captures the essence which is centered on the potential for nominal GDP to break on through to higher territory. This higher nominal GDP balloon was filled with the air of moving higher on both its underlying parts: higher real economic growth (real GDP) AND more inflation as more activity could finally get all this money sloshing around.

Fast forward several months and this balloon didn’t as much pop as it did find a slow but persistent leak. A sudden collapse in cell phone prices and oil suppressed by OPEC cheaters and US shale producers has played a role. But so has a reduction in the prospects for the infrastructure spending and tax cuts that led to air in the balloon in the first place. Last week’s continuation of weak inflation has cast more light on the current disinflation trends. However, I believe this is a good spot here in mid – August to take a step back and evaluate – specifically within a fixed income context. Cutting to the bottom line, this is a good spot to have exposure to Treasury Inflation Protected Securities (TIPS).

The Granddaddy of Measuring TIPS  Value….The Breakeven Spread

To begin making any case either for or against TIPS, I must start with break even spreads. Break even spreads are simply a calculation that tells you how much inflation would be required to make the returns on a TIPS bond equal to that of its unprotected (and higher yielding) counterpart. The straightforward calculation is simply the difference in yield between a regular US Treasury bond and one that is of the same maturity but protected by inflation. If a regular old treasury bond yielded 2.0% and a TIPS bond yielded 0.0%, then the break even spread would be 2%.  Thus, if inflation then proceeded to equal 2% over the life of the bond – the investor would “break even” by having an equal return on both bonds.

To take it a step further, we then think about the recent trends (last 5 years charted below) and how TIPS have performed compared to regular treasury by monitoring whether this spread has been moving up or down. As the spread moves up, you are better off in TIPS as it means the yield had to rise faster in nominal bonds (and prices down faster) and vice versa of course on the way down.

Failed to Break Even

TIPS have been the beets in the smorgasbord of bonds. They are certainly on the buffet as an option, but putting them on your plate has done nothing but stink it up.  Like a smorgasbord, you just don’t to take one of everything. I realize this isn’t a perfect analogy since there are plenty of folks (like my 11 year old son) that love beets.  But, you get my point – that for a couple of reasons TIPS just haven’t been the place to be.

The first reason is due to a drop in the pricing of the “I” part of TIPS which can be seen in the chart above shows as the break even spreads fell from a range above 2 to one well below.  Again, the only way this happens is by the prices of regular bonds outpacing those of tips.  Thankfully, in FEG portfolios, we began exiting a rather healthy TIPS allocation in ’12 and were fully out in early 2013. Owners of TIPS got a rather healthy and nice pop during the middle of 2016 before just exploding last November, but generally speaking; they haven’t been the place to be.

The chart below shows it more clearly with the total returns from the major types of bond ETFs over the past 5 years. Investment grade corporates (LQD) have brought home over 20% cumulatively while TIPS are bringing up the rear with barely a positive return!

This leads me to the second source of TIPS underperformance: the “T”.  During relatively healthy economic and financial conditions it pays to earn the corporate spread by taking on credit risk of over just being in treasuries.  Taking it one step further, it pays even more as that spread drops, meaning relative price appreciation for those owners of the bonds.  This is what we’ve seen continue as of late to the point where investors have begun to compete with one another to take on corporate risk, handsomely rewarding their owners (including those in FEG portfolios)

Going Forward

Re-iterating the punchline, most of this has been a recap of the rearview mirror but as of late – TIPS have made more sense to me as of late for a couple of reasons that I will attempt to unpack.  Perhaps not yet to a full blown large position, but it’s time for at least a small, diversifying way. Why? For me, it’s always about the price – the inflation outlook doesn’t have to be great, just better than suggested by the price. And I do think that’s the case here where at least a decent pitch can be made for at least some inflation.  Lastly, it is the razor thin corporate spread to be earned by being in corporates over treasuries. Investors just simply don’t have enough cushions by taking on corporate risk.

Money Supply Should lead to Brighter Outlook

One thing that leads me to believe the inflation outlook should be brighter than currently given credit is going old school and simply looking at broad money supply measures.  As seen on the following chart -throughout the 60’s, 70’s & 80’s – M2 (the macro econ 101 money supply measure counting cash, checking and savings accounts) steadily hovered around 55 to 60%. Just for the econ readers – I think it’s pretty safe to say we can see Milton Friedman’s hands in matching money supply to economic growth.

However, this dropped throughout the 1990’s thanks to a booming productivity and technological advances that could spread money around faster. The Greenspan-Bernanke-Yellen activist central bank regime however has been working ever so hard at taking our money supply to new heights (as a percent of the economy).

What’s this got to do with inflation? Taking the chance to mention Friedman a second time, it was he who taught us that inflation is always and everywhere a monetary phenomenon. After all, in an effort to keep it simple enough – inflation is really just about too much money chasing too few goods. It’s certainly possible this last and big leg up in the money supply could indeed lift inflation. The relatively low money supply in the mid 90’s and early ‘00s was certainly coincident with low inflation.  The following chart is the same as above with M2 as a % of GDP but has an inflation overlay (set forward 5 years under the thought that it takes time in reality for things to run through the economy). Both measures are smoothed by taking a trailing 12 month average.

Using M2 is an inflation predictor is pretty far from perfect. For instance – the money supply can “go up” for odd reasons. 2008-2009 was a classic example as people were selling assets and parking money in their bank accounts which boosts m2.  This isn’t money that is likely to be circulating in the economy and creating inflation. But, nothing is going to be perfect because if there were – we’d be far better at predicting it and profiting from it.

It’s easy to see at least a loose relationship (for the math junkies an R squared of about .3).  I don’t know any more than the next guy if we can break free from this 2% range back to the more historic norm of 3%. Furthermore, we find scant evidence that any of the global deflationary forces (technology, excess capacity) have dissipated. The key for me though is that the market pricing for inflation respects the latter and gives virtually no probability to the former. This is why it’s a reasonable time to grab some protection / diversification through TIPS.

Another worthy criticism of M2 is that it is too narrow in an evolved financial economy for use in an analytical context. I can’t argue with that, but M4 – a measure put together by the Center for Financial Stability – can also be seen to be growing a faster clip recently.

Under the Umbrella and close to the Handle

Going back to the other factor that has kept TIPS a big underperformer has been the corporate spread and the power it has given to the outperformance of corporate bonds. However, that cushion has fallen to razor then levels – with an A rated US corporation providing only 1% more yield than a US treasury. It’s still higher compensation, but there’s also much less cushion for when we get a de-risking and much less upside as it compresses from here. While A rated corporate bonds provide you a protective umbrella, treasuries get you closer to the handle. I can’t tell you what would cause spreads to move back to a more normal level or when that would happen. I can just tell you, the margin for error is small and that it’s at least worth mentioning that the Fed has announced they will begin their Quantitative Tightening program (QT).  Quantitate Easing (QE) could easily be argued as a factor to keeping spreads tight.

Conclusion

This case may not apply to every portfolio, so take it for what it’s worth and what it may mean to you. This case for TIPS is certainly meant to mean more to those that have significant fixed income exposure. Fundamentally – whether it’s here about TIPS value or elsewhere its more about the price and many have given up on TIPS. Said another way another move up on the reflationary trade may not happen (odds certainly don’t look that bright at this point), but the point is you aren’t paying that much for protection if it does.  As a last thought, I think about what it would mean if M2 were to slow way down and revert back to its longer term mean as a % of the economy. If the money supply / inflation relationship were to correct this way, I would certainly worry about the appetite for things further down the risk curve like corporate bonds.

Does Your Advisor Wear A Cowboy Hat?

The financial industry, and the way your money is treated, is about to be forever changed on June 9th.  If this happens to be news to you, rest assured it will be changed for the better in a vast majority of  the cases. Given the sweeping changes caused by what I call “the hat rule” (explanation forthcoming), I felt compelled  to document and share my thoughts on the topic  as it  is  my civic duty to spread awareness   and my role as an advisor to  explain the impact  it will have in my industry.

First, let me provide a little background for the uninformed. Over the years, the Securities and Exchange Commission failed to raise public awareness  or  provide  clarity on the role of a financial advisor (which is no surprise since the SEC is really just an agency ran BY Wall Street FOR Wall Street). This inaction prompted the Obama administration through the Department of Labor (DOL) to enact a law (the “hat rule”) to impose a fiduciary standard on financial advisors working with retirement accounts.   What is shocking about the DOL rule is that it applies only to your retirement accounts (IRA, 401k, etc.), but not necessarily to your other types of accounts in the hands of financial professionals. While this was certainly an odd way to go about it, the ruling is still slated to be fully in force on June 9th.

As is par for the course for my industry, confusion arises simply by having applied fancy names to basic concepts. While financial advisors may carry many different titles, (such as investment advisor, financial planner, account executive or financial consultant)- none of these labels  provide any clarification as to what role they are playing in regards to their service to you.  It could easily be simplified by understanding that ultimately it boils down to wearing one of two hats.

The two hats that can be worn by an advisor is that of fiduciary, which we’ll simply call the “Cowboy hat”, OR that of salesperson which we’ll refer to as the “top hat”. The legal definition of a fiduciary is a person who holds a legal or ethical relationship of trust with one or more other parties. If your advisor is truly an advisor, they will be properly credentialed (as a CFA I am bound to wear the cowboy hat) and will take the responsibility that comes with being a fiduciary.  On the other hand, much like one who would sell a car, a financial consultant that is truly just a salesman (wearing the top hat) will help you pick out colors, features and such and make sure that it’s right for you – but once you drive that car off the lot – it’s yours.

I do want to make it clear that in my opinion, I don’t believe anything is innately wrong with the top hat set up.  Many investors are fully capable to operate as their own fiduciary and make their own decisions but just need a salesman to handle the transaction, not a cowboy to do the work.  The problem is the way it’s implemented in the industry. Most people intuitively understand that a lawyer can’t represent both sides of a lawsuit. Yet, this is exactly what happens in a lot of sales situations in our financial industry.  The account executive that sells you mutual funds or an annuity is paid from that mutual fund or annuity company. Think about that for a second – he’s representing BOTH sides of the transaction! For what it’s worth, I’m not all opposed to brokers receiving commissions for transactions whether it’s for a retirement account or not. It’s the misrepresentation by annuity and mutual fund salesman and the lack of clarity that they are no cowboy that is wrong, in my humble opinion.

My concern with this fiduciary ruling that that falls short in requiring that cowboy hats be worn at all times with all accounts. By pushing it through as a quick fix, it is possible that the law won’t bring about its intended consequences. In fact, if it turns out like most attempts at government intervention- the situation could be made worst. What I see happening for now in some cases is simply more forms, more disclosures and paperwork to “paper over” these new regulations.  They will all have language to indicate (and which the customer will skip over) that they are in fact, not going to put on a cowboy hat. The intent is all good, but the better results will come when we can teach people the simple questions to ask to uncover what type of hat their advisor is wearing. As for me, and all my FEG peers, we are all proud, cowboy hat wearin’ folk. Giddy up.

More Than Size Matters (for indices)

Even the novice investor understands the importance of breaking asset classes into importantly distinctive categories like small and large, growth and value.  After that step though, discarding the various ways in which those categories can be measured by various indices is all too easy.  One might simply think – “A mid cap index is a mid cap index” – (and by “one” at this point I am often referring to me!) And that type of thinking isn’t all bad since we have limited time and resources for gathering information and making decisions, and the asset class distinction itself is nearly always going to be the bigger issue. But, sometimes taking the extra step in being careful as to which index to use can pay extra dividends. This is especially true in small cap stocks where the (much older) Russell 2000 is the granddaddy of indices in this space with the S & P 600 taking on the role of stepchild.

The two indices are measured differently with the Russell 2000 casting a wider net. They both represent similar sizes of companies, with both indices having a median market cap between $1B and $2B. The Russell 2000 methodology, though, is much more apt to catch companies that are on their way down as opposed to their way up.  Think of it this way, companies that are up and coming will at one point be small on their way to being big. Companies that are severely struggling can also be small caps on their way to being non – existent. Those are two clear different paths.  In maybe the clearest difference between the two, check out the profitability profile. Over the trailing 12 months, I find about 18% of the S & P 600 as having negative earnings while nearly 1 out of 3 in the Russell 2000 does so.  For reference, just 11% of the S & P 500 had negative earnings. 

This isn’t to say you always want to own the “higher quality” as anything can be attractive at the right price. When exiting more depressed situations, the Russell 2000 can be more poised to rebound a little harder.  Over the long run, though, the S & P 600 has materially outperformed the Russell 2000, and has done so with less volatility. A study by Morningstar and IFA shows the S & P 600 returning 11.1% from 1994 through 2013 vs. 9.3% for the Russell 2000.  Meanwhile, the standard deviation was slightly smaller in the S & P (18.8 vs. 19.7). (The full article can be found here https://www.ifa.com/articles/Index_SpotlightSmall-Cap_Face-Off_Russell_2000_vs_SP_600/)

 

 

 

 

Who will be the first “Green Chip”?

Has this ever happened to you? You think of what you would describe as a clever term or phrase only to take to the internet and find out you were beat to the punch (and by more than a day or two).  Recently, I was looking through a long list of marijuana related stocks and it soon became clear that there were just a couple of established businesses scattered among acres of unproven, speculative companies that were more akin to a lottery ticket. Light bulb! I began to wonder which of these will be among the first to become a “green chip” stock.  Google results sadly returned the fact that “green chip” was used here and there for environmentally friendly stocks when they surged in popularity a decade ago. But given how nearly every corporation claims to be in the business of sustaining our environment in some way or the other, I would argue the green chip term should be reserved for those that ultimately gain establishment status as among the Cannabis stocks. Plus, I think it’s more amusing to apply to Mary Jane stocks anyhow – so move over First Solar.

The term blue chip stock has some latitude in its meaning, but generally refers to large, financially sound companies that pay steady dividends. With 19 states having legalized medical use and another 8 for legal recreational use, investor attention has been on the rise (at least anecdotally in my case). Many are eager to strike green gold by identifying one of these future green chips and investing in them now.  I can’t call this crazy thinking at all since it’s only a matter of time for the great plains and southern states to catch up to the rest of the country.

Before a couple more thoughts on the investment aspect, I am curious about how the industry will fit within the notion of “socially responsible investing” or SRI.  Maybe it’s just in these southern and plains states that are dragging their feet on cannabis liberalization, but there will be undoubtedly investors who would prefer not to profit from marijuana.  SRI has been one of the most difficult aspects to investing I’ve encountered. Even with geographically clustered clients, you don’t always find ubiquitous ideals or for how those ideals should be reflected in their investments. Furthermore, even if there were ubiquity, a fiduciary’s responsibility is with all clients’ money so how can one let the ideal of client A, B & C impact D’s portfolio?

To make it even harder (for me anyhow), it’s difficult enough finding the commonality within an issue, let alone having it boiled down to the exact common factors to be considered for an SRI portfolio. Here’s an offbeat example that hopefully highlights the difficulty.

Company A: Peddles annuities onto unsuspecting school teachers, in turn smothering them unknowingly with 3-4% vehicles. Not stopping there, they then strand them to make their own investment selections.

Company B: Manufactures plant based therapies to aid those with cancer from their pain and chemo nausea. That plant just happens to be associated with social taboo.

One is a financial cancer and the other one is fighting real cancer. One recently had it easier to do business in the US and the other is still battled by half the country. Clearly some personal bias shines through this slant – but its particular striking to me because I could find company A in just about any investor portfolio, even if they have a “socially responsible” slant. Rarely, if ever, would you financial stocks in an SRI screen yet I would suspect you would find some resistance somewhere to benefiting from cannabis.

SRI is clearly on the rise but is well beyond my scope and I have more questions than answers. I do fully understand and respect those that wish to have their dollars invested in a way that aligns with their values.  It’s simply not in my personal jurisdiction – other than one last suggestion. Academic research has shown that SRI can lead to positive results, but in two ways. The first: Companies that “do good” tend to “do well”. The second: companies shunned as taboo also tends to do well (just take a quick look at cigarette stocks).   That goes right along with sage advice from one of my investing idols, Howard Marks, to “concentrate on the unloved, less-followed and therefore less-efficient sectors”. If, for some reason, investors drag their feet to get on board – marijuana very well could be an area worthy of more focus. I’m not saying this is the case right now but is certainly a possibility going forward.

Assuming the socially responsible bridge has been crossed, marijuana investments on the other side of that bridge range across many industries such as real estate, growing technologies, farms and of course health care. Health care seems like the obvious path for the first green chip, but we shall see. Please make special note that none of this is a recommendation to put money in that area. FEG’s specialty centers on risk management in the pursuit of balancing risk, return and taxes. That isn’t conducive to putting client dollars towards unproven, speculative plays. But, I would certainly encourage you to not dismiss it as the area isn’t one that should be written off either. It does seem to me at least that there is a rather large disconnect between the fact that we are more than halfway home towards nationwide legality but still in the very early stages of investor interest. Those two will reconcile over time and some will be rewarded with healthy profits on their early investment. If you do somehow find motivation to go fishing for green chips yourself – do use caution and do not buy a stock just because it is in a certain business. A good company does not always make a good stock.  But best of luck for turning your greenbacks into green chips

 

 

When the Season is Frustrating

You may have noticed (and it’s without coincidence) the basketball connotation in this blog’s design. From the resemblance to an old wooden gym floor to the name itself, basketball radiates off the page. That comes from the heart given the importance the sport plays in my life; which takes me to my beloved Indiana Hoosiers. I wouldn’t call this a season on the brink just yet, but it unfortunately has turned into a season on the ropes. Losing the last two significant non-conference games and giving up 3 conference losses isn’t where we dreamed this team would be after their illustrious start. Alas, ups and downs are simply part of a normal progression of a season. This progression is not at all unlike the “seasons” of an investment portfolio as well.

After having gone through many a season now, I’ve come to appreciate the randomness in outcomes for a single game or even a small stretch of games.   Water will find its own level after the course of a year, but not necessarily throughout each month.  Some days, the ball just isn’t bouncing your way or dropping through the hoop; while your opponents are finding nothing but net from Curry range.  For the better part of 8 years, every one of the basketball lulls has brought the full force of Hoosier nation down upon Coach Crean’s neck.  This is a fan base that takes hoops very seriously, because to use Coach’s words….”It’s Indiana”.

My point certainly isn’t to reduce expectations – you should expect a lot from Indiana.  You should also expect a lot from your retirement savings. But, in each case, we must pause and evaluate the criterion that indicates success. Doing so will help draw the distinction between short term frustration and longer term flaws. In each case, it’s important to revert back and look at process. You can influence outcomes, but you can’t control them. What you can control is having a sound process.

For anything, much less money, it is easy to get frustrated when the results aren’t there. Even for successful managers, there will be sustained periods of poor performance.  79% of the investment managers who wound up in the top quartile of performance over the entire decade of the 2000s spent at least 3 years in the bottom quartile (Davis Research). This is why it is the process that is to be evaluated as much or more than the results. Stick with a sound process that you continue to grind through and you will eventually find a change in the backdrop and come out stronger on the other side.

In both cases, basketball and investing, it has taken time and experience to understand these principles and not get too overly flustered with each painful game. Being mature isn’t something I’m often accused of personally – but in these two regards – maturity has many advantages.  For my Hoosiers – no Crean hasn’t yet hung a final four banner, but does have a couple of conference titles and are graduating a solid core of principled young men.  At FEG, our investment portfolios have had a season or two on the ropes over the past couple of decades, but we have continued to tweak and improve that process, coming out stronger each season. It is going through those past growing pains that make a good string of successful years so rewarding.

Are Stocks as Overpriced as that Ugly Christmas Sweater?

And if so, is it time to put them away too?

Current stock valuations – or cost per unit of economic value – are not something I usually want to devote a lot of space to as they don’t change that significantly month to month and their short run influence is rather limited. This certainly shouldn’t imply that value isn’t high on my list as an investor, because it is.  Further, valuation input is pretty well established and not subject to a ton of disagreement (if you are in the business, just check your twitter stream).   However, as we move from one market environment and calendar year to the next – here are a few thoughts on the topic.

Two Considerations for Expensive Stocks

The view that US stock valuations are elevated is certainly not a new one and merits little dispute. Yet, I am a firm supporter of the notion that stock valuations shouldn’t be analyzed in a vacuum that only considers past stock valuations and ignores other basic factors like interest rates. Most families for whom my role supports need some combination of growth and income to support them during retirement, with our job at the Financial Enhancement Group being to find that best combination. So, it absolutely matters that the lower forward return expectations that accompany high valuations is accompanied by extraordinarily low bond return expectations as well. That is the first notion to consider when using equity valuations as an investment input.

The second notion accompanies what has now probably become the most popular method of looking at stock values; the Shiller cyclically adjusted price-earnings ratio (CAPE).  The CAPE’s concept of not being overly influenced by the booms and busts of a cycle carries a lot of appeal. Applying the concept though to publicly-traded US equities has one big problem: the way we measure earnings was significantly adjusted in 2001.  For a much better explanation, follow this link to a brilliant piece in 2013 by Philosophical Economics: http://www.philosophicaleconomics.com/2013/12/shiller/.  To put the problem simply, before 2001 was apples and post 2001 are oranges.

Proprietary Solution

My answer to both of these notions was taken into account by what I call the “rule of 25”.  It is built on the framework of Shiller’s CAPE but takes into account these two factors of consideration described above. For this post’s purposes, I won’t fully describe the methodology (and thereby give away too many secrets).  What I will tell you is that as we close out this year, this internally calculated measure now suggests a more balanced view of stocks and bonds than we had as late 2013/early 2014. In 2009 and 2010 as the cycle turned upward, the extremely low stock prices produced very cheap valuations that suggested equities should be very heavily over weighted due to a favorable 5 year forward outlook compared to bonds.  As we lifted off those levels, stocks continued to be favored on a 5 year forward basis but not by as much and increasingly because interest rates kept moving lower.  Where we stand today in this internal rule is a more balanced and neutral view of the allocation to stocks (whatever that means to you).  Again – this is only looking discussing valuation and only one part of the investment input.

Deeper view of current valuation levels

Goldman Sachs recently put out a simple, but rich perspective on current valuations.  It was meaningful because they look beyond one or two measures of value and instead compare across 7 as shown in the table below.

Looking at a composite view is very helpful in looking past any anomalies that can skew one indicator or another. In this case, however, the message across the board is pretty clear that stocks are historically expensive. The one holdout on these is free cash flow yield – which in my role as an analyst has a lead role.  While the initial thought is that is a nice silver lining, another perspective merits strong consideration.

One of the main restraints we have seen in the economy over these past few years is a reluctance of corporate America to invest in their future through capital expenditures (chart below).   Keeping Cap-Ex low has been a boost to free cash flow (which keeps free cash flow yields high). If corporate America jumps on board with the current economic optimism and invests their cash flows – this one silver lining goes away. If they don’t, the lack of investment will further restrain their growth. I can’t tell you which one is better for next couple of years’ stock market, but a release of the cash flow would take away the one hold out from the table above and leave a unanimous view of high historic valuations.

Valuation context and what it means for you

Valuations are most helpful (at least to me) when simply thought of in the context of how markets move from point A to B. The move from point A to point B will always comprise of a change in earnings and a change in the price for earnings (P/E) multiple investors are willing to pay for those earnings. For example, the S & P has moved from 1,518 at the end of 2011 to now over 2,200 – an increase of 45%+. Over this time frame, earnings on the index have increased 13% from 77 to 87. Meanwhile, the (P/E) multiple – investors were willing to pay which has moved up from 16.3 to now over 26 (trailing basis). That expansion in P/E to a very high historical level has served as a major tailwind for stocks – a tailwind we should assume is now likely behind us after having accounted for the majority of the move over the last 5 years.  Of course, it can march on higher but it is most wise to assume that any surge to higher valuation levels would not be permanent and likely quite short lived.

In that sense, it may be helpful to think about the market as a 4 engine plane.  Sure, the “multiples engine” is probably gone – but that doesn’t mean the plane is destined to crash. One of the biggest mistakes I’ve seen investors make (speaking from experience here) is avoiding equities under the risk that stock prices could fall and return valuations to normal. High valuations, in isolation, shouldn’t mean you drop equities all together.  Valuations can just simply hold here near these levels through the rest of this cycle. If we couple that scenario with something like steady 4-6% growth stemming from earnings growth through the rest of the cycle….is that the worst outcome?

At the same time, we have to recognize that we are clearly running with less power with the “multiples engine” offline. If storms pop up (which, for us, include other pieces of our risk barometer), the valuation piece means we have less engine power to get around those storms.  Our sell signals need to be closer by under nosebleed valuations. If we lose another engine – that’s when we are looking for an emergency landing. High valuations will be corrected, but it’s foolish to think we can know how or when.

Update From Summer Bond Risks

This past summer, I put up a (admittedly rather boring) piece on the concerns I had for bond prices.  To be clear, the article contained no prescient points about the ten year returning to 2.2% well before year end! I would like to take credit for such a call, but that was not the case. If it were, the article would have called for a more extreme de-risking in bond positioning – perhaps even to a net short extent.  Instead, the case was based on a few data relationships that suggested the US we were susceptible to a shock in rates.

Recap of the shock risks:

Those three concerns were:

  • Interest rates on 10 year bonds had stretched way below trend in their relationship to (core) inflation – as far off trend as any point going back to 2013.
  • Historically, there is a tight relationship between nominal GDP (the growth rate in the economy before backing out inflation) and the level of 10 year interest rates.
  • Despite the common narrative that the US was a “high yield” play , US real rates were actually lower than they normally were in relation to the EU & Japan on a real interest rate basis.

(For a more detailed account of each of these factors you can click here to read the full blog post   https://adamharter.com/?p=43)

Update to those shock risks:

  • After being stretched to nearly -1% (using core inflation to compute), real yields have bounced back up towards 0. However, real yields would still need to move up about another 30bps to reach their 5 year average.

yields-and-inflation

It should be noted that core prices could easily moderate over the next couple of months and do their part to boost real yields without a further move up in outright level of interest rates.

  • The jump in rates has only made the first step towards converging to its long term relationship with nominal GDP.

nominal-gdp-bond

  • Global yields have moved up in tandem which does not really change the relative value of US bonds to their EU and Japanese counterparts.

 Where does that leave us for positioning?

Longer term – we really do need to be cognizant of the possibility that we are amidst a sea change in market environments. I’m not just talking US politics here and the potential for budget deficits that lead to inflation.  Other factors were already stepping out of the batter’s box.  Namely, as the US retires 10,000 workers a day – those boomers will be shifting from the accumulation phase of finance to the distribution (whether that is through pension or private savings).  These factors, coupled with the underlying relationships above, suggest we may just be through the first 2 or 3 innings of the adjustment process

Shorter term – there hasn’t really been enough time for 2 or 3 innings of the adjustment process and there is plenty of opportunity for things to settle down.   In my estimation, way too much certainty has been quickly built into these probable inflationary/higher rate scenarios. If so, that leaves plenty of short term room for probabilities to adjust, allowing bond investors to stabilize their principal while earning their coupons.  Just maybe, we even get a Santa Claus rally back up in price for bonds.

As we go forward, a lot will depend on what ultimately happens to nominal GDP.  Jeff Gundlach talked in his weekend Barron’s interview about the nominal economy getting back to 4, 5 or even 6%.   The difference between the upper and lower of these levels (4 or 6%) would mean significantly different return outcomes for bonds.  A lot also depends on the amount of time it would take to get back up there.  As of now, in late 2016, I think a key point is that we aren’t going to get there all at once.  We can use the short run to collect coupons, perhaps make a tactical trade to the upside, and prepare the portfolio for the forthcoming innings.

The Pulp Fiction Economic Cycle

Hopefully, you’ve had a chance by now to check out this cult classic from 1994. It isn’t for everyone, but for those with eccentric Tarentino tastes, the script is as close to perfect as you get. The move is packed with interesting dialogue and engaging conversation.  Heck there’s even two great lines on hamburgers alone; “a royale with cheese” and “thaaat is a tasty burger”. But what set the movie apart was the out of sequence fashion in which the movie was shot. With most movies, you follow a time line and you know where you are in the story. With pulp fiction, it’s not until you embrace the fact that you don’t know whether you are in the beginning middle or end that you take in all that great dialogue. What a great analogy for this difficult to track economic cycle.

Murky,

I have been to multiple talks this year highlighted with a discussion about where we are in this cycle and whether it is nearing its end. For a while, I would argue we had something resembling normalcy.  The recession turned through the middle of 2009 with green shoots that turned into a full recovery with steady growth and sustained momentum through 2010.  From then, in a “normal” economic cycle, you would expect optimism to kick in for both consumers and business and push us into a boom phase. But, for the last 5 years we have been stuck in a one step forward, two step back pattern, as every time we think we are on the verge of breaking out (remember the term “escape velocity?!?”), we are disappointed with yet another stalling pattern.

Weak,

Cumulatively, this start/stop pattern has added up to the weakest expansion in the modern era.

gdp-cumulative

But Long Cycle.

The silver lining is that what we are lacking in strength, we are making up for in longevity. Well past 7 years old, this expansion is well past the 4.8 year average and is still chugging along.  It’s easy to make an argument that those are related factors. A recession typically follows an overheating of some sorts – but there hasn’t been a whole lot that can be categorized as overheating?  Longevity matters for a few reasons and I will give a couple of examples. First, losses are what make it so difficult to recover from.  A very long period of sluggish growth is quite tolerable if you don’t have a steep cut somewhere along the way. Second, and a more nuanced, for those that normalize things over a 10 year period, we might very well soon have a 10 year period without a recession. This of course would include the Shiller CAPE ratio.

So where are we in the cycle now?

It’s clear to me (thanks, Mr. Obvious) that we are closer to end than beginning. The unemployment rate is down to 5% (once considered “full employment”), interest rates are on their way up and the yield curve is flattening.  On the other hand, we might just very well be closer to the middle than the end.  It’s incredibly important to have this open mind.  Housing formation – with a gigantic millennial wave – could be one possible catalyst for a tailwind and run at securing a stronger economic growth period. Housing formation could lead to the big ticket expenditures and even credit expansion that could even nudge inflation.  Or we might just stay in this one step forward, one step back pattern for the foreseeable future. That would not be the worst possible outcome.

So What?

Most important though is to take a lesson from pulp fiction and embrace the fact that we don’t know where we are in this story line. I believe a much better question for investors is to ask “what happens when” rather than simply “when”.  At my firm, we have learned to embrace our inability to predict the cycle by relying on our risk barometer. Our philosophy is not built geared towards the avoidance of pullbacks or even corrections. The biggest key for in achieving this is to know our clients very well and to have them in the right strategy for their situation. The next biggest key though is our comfort in the quantifiable components we have incorporated into our risk barometer to guide our portfolios though a true turn in the cycle when the time comes.

 

 

 

Bring Home the Jobs

Bring Jobs Home……….Literally

A Plan to Create 3 Billion Jobs

This is not a political blog, but I feel this opportunity should be used to chime in on a hot economic topic in this election cycle: globalization and the loss of American jobs. Both candidates embrace a posture of fighting the globalization trend and on keeping or even reacquiring American jobs that have been transplanted to other countries like Mexico and China.

My contribution to this debate is why should we stop there? As a Hoosier, I say we contemplate going a step further and focus on Indiana jobs. After all, Carrier has been one of the companies (tossing Hoosier jobs away in favor of Mexican ones) in focus for the Trump campaign.  Maybe we should be focusing as much on keeping any Hoosier jobs in state as we, even if they would happen to be crossing one state line to say, Ohio, as we do keeping jobs in the country.

When I think about it in that case, why don’t I take it one step further and just focus on the Harter household?  I am thinking we can bring back all the jobs we have given to others over the years.  Rather than me produce financial management for households looking to trade other goods and services, perhaps we will now become farmers to grow our own food. We will also make our own clothes and build our own transportation devices. In the Harter household at alone, it seems I can create 100 new jobs by sunrise tomorrow!  Multiply all those new jobs by yours and every other American household and we could quickly get to 3 billion new jobs.

Hopefully, by now it’s obvious that I am being facetious – and egregiously so in order to make a point. Few things are as important to the rise and growth of civilization itself as the division of labor. We benefit by doing things we are good at and trading with others for what they are good at. The more different we are, the greater the benefit from specialization and trade. Furthermore, it is personally very satisfying to have a conversation across the table from someone when realize how mutually thankful you are that you don’t have the other persons job.

This benefits of specialization doesn’t stop with just trading with others in your village, it carries to other states, and other countries as well.  In academia as well as the economics and investing professions, few things are more widely adopted with little debate as to the benefits of free trade. Knowing this makes it very frustrating to see the populist rise against free trade and its benefits. Please don’t think I lack compassion for those that have their jobs displaced by globalization.  I truly feel fortunate for this to not (yet) be me. But, before we get lost in complicated theory or rhetoric I felt it was worth discussing the topic in its simplest form and hopefully illuminated why this is important to the country as a whole.

US productivity is already an uphill battle for a number of reasons.  The declining productivity has kept a lid on US growth and my opinion is that this low productivity would take its biggest blow yet by a reversal of free trade. If we were to take this gigantic step backwards – the consequences to our economy would be horrific.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer.

Investment Settings Shouldn’t Default to Common Sense

“Common sense” when carefully applied can be a useful tool in an often overly complicated world, and sometimes we downright crave a healthy dose. Case in point: Dustin Johnson at this year’s U.S. Open. Now, I come from a golfing family, have played the game most of my life and continue to play any opportunity the family calendar provides.  Yet, I will be the first to say the game of golf represents a reluctance to progress in the worst kind of way.  Many golfing establishments still care what you wear on their course (after perhaps shelling out $100) right down to the point they require your upper garment to be affixed with a collar.  After all, it would be quite a shame for more of your neck to be exposed in public! That sort of nonsense sheds light on how the game would make possible the treatment – completely void of any common sense – Dustin Johnson received at the U.S. Open.  For anyone who didn’t see it, the guy was penalized when ball rolled all of 2 dimples worth clearly due to natural causes.  Fortunately, it did not cost him a major championship, but did send millions of golf fans screaming from mountain tops their pleas for the application of common sense. It could have been a very ugly situation had the match finished closer. (You can check out the clip here if you wish:  https://youtu.be/OUxeuWyFUco)

Danaher spinoff

All of that digression on golf is to say that while we so often want the world around us to just use some common sense, it can often be a detriment to investors. One small example of that can be seen from a long-time portfolio holding of ours, Danaher (DHR).  Danaher has done very well over the years with a successful track record of buying up companies across a number of different industries and making them better. Last year, Danaher management decided that owning all these various businesses under one stock umbrella was restraining their stock price from further appreciation. The belief is/was that the company was relatively more priced for the slower growing industries in its portfolio than for its faster growing ones. Subsequently, by breaking them apart, the market could more easily reward the overall stock price for the faster growth holdings. This playbook has worked very well in several instances over this market cycle.

This past July, Danaher investors had their holding broken into two prices. One stock (still called Danaher) holds the faster growing businesses with popular theses. The other, now called Fortive, holds more of the old school and slow-growing businesses. Common sense suggests that investors hold onto the more appealing stuff that drove investors to Danaher in the first place.

Out of the gate

This was largely the case during the first month for Fortive, where after hitting an intraday high of $54.34 on trading day #1, shares spent most of the time languishing between $48 and $50 while Danaher steadily appreciated. However, as things have since settled, it is the Fortive shares that have outperformed and taken off.

DHR chart

These were the group of assets thought to be left for dead. As with so many things in investing, it’s not just the quality that matters, it’s the price you pay for that quality.  We still have work to do in mapping our strategy for managing the Danaher / Fortive positon, but we knew we weren’t going to just automatically defer to the “more attractive” assets.

Broader significance

This Danaher spin-off is just one small and perhaps temporary example, but the notion of not just defaulting to common sense can be broadly applied to investing.  The European and Japanese movement to take short-term interest rates negative was supposed to lead to increased spending and investment as it discouraged people and companies from just parking the money at the bank. However, savings rates in both European and Japanese cases have been on the move up, not down, in savings rates.  In my opinion, this unintended consequence will be a big deal in the global thinking on monetary policy and its importance from here.

Another significant and recent example was the Brexit vote.  I had a client tell me in early August how she wished she could have somehow gotten advance feedback in late June from a friend “on the ground” in London and in turn clued us in to the ultimate outcome of the vote.  Of course, she was surprised to learn when I explained that even if we could have had that (assumed accurate) information ahead of time – it likely would have worked to our disadvantage as markets shrugged off the initial sell off with a rebound at breathtaking speed. Common sense could easily have sent us running for the hills. Instead, we relied on data and our process and were actually able to take advantage of the Brexit sell off. Herein lies the lesson:  Use common sense when teaching kids, using your computer, or just having some fun on the golf course.  But, rely heavily on the data (whatever your data set may be) whenever possible when investing money.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer.