Thursday, January 3, 2019

Don't let the machines lie to you - Trust the fundamentals, not the hype!

From the Desk of Joe Rollins

Back when I wrote the blog on November 6, 2018, Everyone loves a great conspiracy theory, I have one…, I really did not have an answer to the market’s volatility. I suspected (and expressed so in the blog) that there were forces creating the volatility that made no sense and certainly did not represent the fundamentals of the U.S. economy. I was not given the answer until December 26, 2018, the day after Christmas, when the Wall Street Journal published information that supported the theory that I had previously proposed.

Yes, it was a very disappointing year from virtually all financial aspects. Even though the U.S. economy was strong and continues to express strength going forward, the major market indexes finished negative for the year. And yes, I recognize that this negative performance was well below my forecasted gains for 2018. I believed then, and I believe now, that the fundamentals were very strong and will continue to be strong into 2019. What I did not adequately forecast, nor had any reason to believe, is that the machines would spoil our Christmas season by creating losses that were unwarranted by the fundamentals. Hopefully, I can explain all of this to you in this blog, not in the spirit of sour grapes, but rather as an educational process to learn more about how the markets react to given conditions rather than react to basic fundamentals.

Lucy & Harper Wilcox with Santa

Robby, Danielle, Caroline & Reid Schultz

On a seasonal basis, the period of time from November through May of any given year is historically supposed to be the best time of the year to invest. That is particularly true for December, mainly due to pension funds reallocating their assets and putting money into plans to meet their year-end funding requirements. For that reason, it is particularly unusual to see such a huge draw down in the markets for the month of December.

In fact, it is now said that December 2018 was the worst December in the equity markets since 1931. To really understand how absurd that comment is, you would have to compare the economics from today with those from 1931. This year, we are enjoying 3.7% unemployment, while in 1931 and 1932 the unemployment was 15.82% and 23.53%, respectively. GDP in 2018, the difference in those numbers is not even close. It is anticipated for the entire year of 2018 that the GDP will grow roughly 3%. In 1931 and 1932, the GDP was -6.5% and -13.1%, respectively.

So, in 2018, we had truly extraordinarily high growth numbers and low unemployment, while in 1931 and 1932 we had huge unemployment numbers and negative growth. To assume they are even comparable certainly creates a conundrum in my mind.

As I scan through the financial advertising that you see on the internet, I am always baffled by the headlines that attempt to scare investors into investing in safe products by stating that stocks could go down 75% next year. As I read those advertisements, I reflect on the fact that over the last 16 years the market has only been negative two times. If you do the math, that is a win rate of close to 88%. Given the chart, where the compounded annual rate of return over the last 16 years has been 8.96% and the average at 10.33%, I always wonder why clients have such fear of the equity markets. Clearly, over this timespan, no asset class has even come close to performing as well as equities.


After an outstanding year in 2017 with the S&P 500 up 21.8%, I guess you could expect a pullback in the performance. This really happened with vengeance in the fourth quarter of 2018. There is nothing good to say about this performance since several of the indexes fell into bear market territory and a selloff occurred in all asset classes. The Standard and Poor’s Index of 500 stocks ended the year down at 4.4% for 2018. The NASDAQ Composite ended the year down 2.9%. The Dow Jones Industrial Average was down 3.5% for 2018. Since the 2018 numbers and the one-year period are identical, you end up with exactly the same numbers for the one-year period then ended. If, however, you stretch out to the three-year period, the S&P ends up with an annual return of 9.3%, the NASDAQ Composite up 11.1% annualized and the Dow Jones Industrial Average up 12.9%. Just for the purpose of comparison, the Barclay’s Aggregate Bond Index was exactly even for 2018 and has only realized a 1.9% annualized gain over the preceding three years.

As pointed out previously, the markets have only been down twice over the last 16 years. However, the fear expressed in the financial publications would lead you to believe a much higher percentage of losses. As indicated in the chart above, do not be misled by the hype, but rather evaluate the actual numbers and see that over the last 16 years you had an 88% chance for profits.

Needless to say, I was really disappointed to see the markets sell off during the final quarter of 2018. At the end of the third quarter, the market was up a sterling 10.6% and it looked like we were on track to have another great investment year. However, in the first of October, the Federal Reserve Chairman gave a speech that rattled the markets. In his speech, he indicated that he would like to bring interest rates up to a neutral level. And what really rattled the markets was when he said, “We’re a long way from neutral...” At that point, despite the very positive fundamental aspects of the U.S. economy, the markets sold off indiscriminately. As I then pointed out, I was not exactly sure why the market was going through such huge swings, but now we have an answer.

In an article published on December 26, 2018, the Wall Street Journal quoted the following: “Behind the broad, swift market slide of 2018 is an underlying new reality: Roughly 85% of all trading is on autopilot – controlled by machines, models, or passive investing formulas, creating an unprecedented trading herd that moves in unison and is blazingly fast.” So, as my post on November 6th was speculating, there was in fact a true conspiracy theory that was affecting the markets. I highly recommend that you read this article and others on the subject. It is very important to understand that this type of trading has nothing whatsoever to do with fundamentals, but rather momentum. So, when we had the original sell-off at the beginning of October 2018 with a sharp move down due to the Chairman of the Federal Reserve’s comments, the program machines kicked into action trading on the momentum. As the Wall Street Journal quoted, “When markets turn south, they’re programmed to sell. And if prices drop, many are programmed to sell even more.”

So, as I suspected during this time of high volatility, we were seeing massive program trading affecting the market rather than there being some actual fear of recession or any other type of financial concerns in the economy. As I expressed in the blogs during that timeframe, there clearly just was not any type of reasonable fear for recession in 2019 and all other major fundamentals of stock market investing continued to be strong. I guess I have to admit that this type of program trading clearly interrupted what would have been otherwise a fabulous investment year and scared our clients into believing that something more dangerous was at hand. Remember that the machines do not trade based on fundamentals; they trade based on momentum. Since momentum and direction were down in the fourth quarter, huge sell programs overwhelmed the market that had low volume and participation during the holiday season and created huge swings both up and down, but the upside was much less regular.

Another thing that really irritates me about the performance in 2018 is that I was not wrong. I correctly assessed the economy and correctly evaluated all of the components of higher stock prices and reported them to you. What I did not and cannot project is how the machines will react to current information. You cannot reason with a machine – it trades because it is programmed to do so, not because of the strong fundamentals of the economy. However, with that said, it gives me a new opening to project strong earnings for 2019. 2018 was a year when interestingly cash exceeded the performance of all other asset classes. That has actually only happened four times in modern history.

CiCi and Ava on Christmas morning

It is very rare indeed that both bonds and equities would fall in the same year, but 2018 was that year. Interestingly though, when you have that unusual circumstance of cash outperforming other market indexes, it bodes well for strong performance the following year. In fact, average performance in the 12 months that follow cash exceeding all other asset classes have averaged a total return of 15.7%. Even more interesting, there is a 75.9% frequency of those gains actually happening. It does not mean that the market will be 15.7% better in 2019 than it was in 2018, but it does mean that gains we should have realized in 2018 will rollover and be fully transparent in 2019. That is exactly what I predict going forward.

I generally do not like to bog down these postings with lots of numbers that make the readers’ eyes glaze over. However, it is important to understand the fundamentals of investing, something in which the machines have no interest. The major component of valuating whether prices are reasonable is the multiple of current earnings. At the current time, the Dow Jones Industrial Average is selling at a multiple of 13.6 based on 2019 earnings. The Standard and Poor’s index of 500 stocks is trading at 14.5 based on 2019 predicted earnings. Both of those multiples are significantly below the multiples realized over many years of investing.

If you read all of the projections of the eminent disaster that were reflected in the financial news over the last quarter, you would assume that earnings for 2019 would be falling off a cliff. In fact, earnings are actually projected to increase next year, defying those projections that are so often wrong. At the current time, earnings for 2018 are projected to finish out at 156.97 for the S&P 500. Projected earnings for 2019 are currently at 172.10. Simple arithmetic indicates that the Standard and Poor’s corporation is projecting earnings to increase 9.6% in 2019. Certainly, if anyone was forecasting a recession or any type of downturn in the economy, it would be unlikely that this growth in earnings would be realized.

A more normal multiple of earnings over the last 75 years is somewhere between 17 and 18. If you assume the halfway point between those two numbers, which is 17.5 times projected earnings of 172.10, you would be looking at a year-end projection next year of 3,011. If you take the difference between that number and the closing of the S&P 500 on December 31, 2018 at 2,507, you see that the market has the potential to go up 504 points during 2019, simple arithmetic indicates that is a return of 20%. Maybe that is high, but still higher.

Now, is it realistic that the market could go up 20% in 2019? Arithmetic is a set answer, but obviously none of us know what the machines are thinking. If it does go up 20% as projected, I think the more realistic answer would be that this is a two-year return, not a one-year return. Since the machines forced 2018 into a negative year, the rollover of that gain that we should have realized in 2018, along with the gain in 2019, might very well reflect this type of 20% gain in 2019.

Painting of Ava by Stevie Streck,
one of our talented clients

Currently, there is a lot being said currently about the worldwide downturn in the economies. Certainly, China is realizing a downturn due to the issues regarding tariffs and internal political issues. If you look at the rest of the world, much has actually improved over the last several years. It has been several years since the emerging markets have been a positive influence for performance. For 2019, I see these emerging market countries will get on firmer economic ground and their stock market performance should improve. I do not see a recession for Europe in 2019, and clearly, China is just at a slowdown and not a recession. If, as I anticipate, the tariff issue is resolved in the first half of 2019 and China uses its economic power to stimulate their own economy, you could see a major upcoming turnaround in Asia. I am very optimistic about the U.S. economy, and in my way of thinking, the world economy will be dragged by the U.S. kicking and screaming. So, I see the 2019 year being extremely profitable in the U.S. and it also looks like the international community could follow. Strictly on a valuation basis, the international markets are cheaper in the United States but as was reflected in 2018, the U.S. financial markets outperform the world markets by a significant percentage.

The most dangerous market in the world might very well be what an average investor might consider the safest. The U.S. Treasury bond market is considered by most to be the safest investment that you could make. Although it is absolutely true that you will get your money back, it is not necessarily true that you can make money on the investment. The most important bond issued by the Federal Reserve is the 10-year Treasury note. On December 31st, that rate closed at 2.686 %, which was one of the lowest rates of the year. Interestingly, as recent as October, the same bond traded at 3.248%, and therefore suffered a significant decline during this 90-day cycle. That type of decline in the benchmark 10-year Treasury is unusual and should be analyzed.

As mentioned above, the machines were heavy sellers during the fourth quarter of 2018. The typical trade would be to sell out of equities and move into Treasury bonds. You saw this occurring during the entire fourth quarter of 2018 when the equity markets moved down and the yield on the 10-year Treasury also moved down. When you have a large demand to buy the bonds, as we had in the fourth quarter, you see the rates move down accordingly.

What is unusual about this movement of the 10-year Treasury is that the Federal Reserve has actively moved up the federal funds rate throughout 2018 and has indicated a desire to move up twice in 2019. So, the short-term Treasury fund rate is moving up to the mid 2.25% level, when the 10-year Treasury is only yielding 2.686 %. Much has been said this quarter regarding the inverted bond-yield, but my assessment is that this 10-year Treasury is unreasonably low and is likely to move higher. There is no question that the move down in the price of oil has positively impacted inflation for 2019, but in my opinion the price of oil is only temporarily depressed. Therefore, if the 10-year Treasury begins to move higher as I project, many investors relying upon this level of financial security will see heavy losses. I also see that happening in the high-yield bond market, which is vastly overextended, and in other types of investments that rely on interest rates, such as utilities and real estate funds. I am thinking that in 2019 there is a high likelihood of a reversal of rates that would impact all of these asset classes negatively.

You do not have to be a Philadelphia lawyer to realize what occurred in the fourth quarter. A substantial sum of money moved out of equities and into bonds during this quarter. If I am correct and these trades were based upon the quantitative analysis of the machines, the trade is very likely to reverse in 2019 if the market moves higher. It is only common sense that if machines trade on momentum to the downside (as they did in the fourth quarter), there is a high likelihood that the machines will trade to the upside if this movement occurs. In order to exploit that move, they will clearly have to sell bonds to buy equities. While it appears to me that the equity markets are underpriced, I fear the Treasury market might be the real upcoming loser.

From my son, I received the latest book written by John McCain, The Restless Wave, which was written right before his death. I have never been a huge fan of John McCain, and I certainly do not agree with all of his politics, but parts of his book were very interesting. He described in detail the problems in the 2008 election when he ran for President of the United States and the mistakes that were made. It is pretty interesting to hear his reflection on what we on the outside perceived as being total chaos. He also went into detail regarding his sickness, which ultimately led to his death last year.

The only reason I mention this book is that there is a section on immigration that is worthy of your reading. It is a mystery to me why politicians cannot get this very important subject under control. I recognize the fact that the Democratic Party would prefer that we have open borders, not for any reason that makes sense to me other than it is assumed that such a minority would vote Democratic, and therefore it would be beneficial to their political goals. On the other hand, Republicans are just as obstinate on the subject, refusing to accept the fact that many of the illegal aliens that are living in this country have been here for at least a decade and are hardworking, taxpaying citizens. It is hard to believe that the two parties cannot reconcile these opposite opinions, so we continue to have total chaos on the border where the laws are uniformly ignored and the politics make matters worse.

For those of you who do not recall history, one of the staunchest Republicans of all time issued a blanket amnesty in 1986. Ronald Reagan realized that it would be impossible to deal with immigration issues since many of the undocumented immigrants had been living in the United States for many years. Even though he supported tough immigration laws, he realized that dealing with the people that were already residing in the United States could only be dealt with where they would register and become citizens based upon several criteria. At that time, it was believed that there were 4 million illegal immigrants living in the United States and roughly 3.2 million of those applied for immigration with various levels of success.

Today, it is believed that there are 11 to 12 million unregistered immigrants in the United States at the current time. The problem since 1986 is that the enforcement of immigration has basically been a joke. There are certain administrations that have practically ignored the laws, and then there are certain cities that allow for sanctuaries for illegal immigrants, even though they are clearly in this country unlawfully.

Regardless of how you feel about the matter, at some point, we have to deal with the issue. I thought John McCain had a very reasonable explanation that might actually work. Essentially, it allowed undocumented workers that had already been here for 10 years, that had not committed any crimes, to apply for citizenship, pay back taxes, and basically to get right. There was also a very interesting part about a temporary work permit. Basically, this work permit would allow for a three-year trial period whereas they could work in the United States and be accounted for, but would have to return after three years. I am not exactly sure why this plan did not pass in Congress, but it certainly seems to be a reasonable approach to the immigration issue in America today.

One of the most annoying aspects of immigration to me is that we really do not even attempt to deal with the issue. We all know that there are millions of undocumented workers in America that are hardworking, taxpaying citizens. Of those millions, the number that are criminals and against the American public is a small percentage. It would not be that difficult of a matter to close the borders to future immigration, but dealing with the people that live here would be a monumental feat. What is more baffling than all of that is the inability for Congress to even have a basic discussion on the topic. If you get a chance, read these few chapters on immigration and see if you agree with the policy that is laid out. I am sure the hardliners would say no amnesty under any circumstances and the liberals would offer blanket amnesty. Obviously, the answer is somewhere in between and must be addressed from a system that is fair, yet can administratively be dealt with.

Despite being a steadfast conservative, even Ronald Reagan realized that a compromise to solve the issue was required. Designing of the immigration amnesty was revolutionary in its concept and application. At least Ronald Reagan had the good sense to compromise on the matter. However, enforcement of the laws is worthless if we do not stop illegal immigration.

There will always be illegal immigration in this country, as there has been since the beginning of time. It is good, it makes us better and certainly the laws exist that would allow it. What we cannot deal with is open borders where anyone can enter the United States at will, without authorization. Maybe the bill that John McCain proposed would actually accomplish that goal.

I am very optimistic for 2019 – not based on what I expect the machines to do, but rather on the fundamentals. You cannot invest based on the wild fluctuations that the machines bring us. Over time, fundamentals always win, and currently, the fundamentals are quite excellent. While we certainly have no way of knowing what will happen when the machines start to do their thing, as was evident in 2018, we do know that eventually fundamentals will outperform all other types of valuation of future stock prices.

As always, we encourage you to come in and visit with us and discuss your goals and financial plans. If you are interested in discussing your specific financial situation, please feel free to call or email.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins




Wednesday, December 26, 2018

SIMPLIFIED TAX PROVISIONS? NOT SO MUCH!

As everyone is aware by now, the tax reform package that became law at the very end of last year contained numerous provisions, some that will most likely affect your income tax situation in one way or another and some just to make our jobs a little more…exciting! While we have spoken to many of you over the course of the year to determine what changes, if any, you should make for some of the items, we wanted to take a minute to revisit just a few of the tax law provisions that will affect most of you and give you a few last minute suggestions.
 
• Most of the tax brackets have been lowered for 2018, which is great news for the majority of you. Please keep in mind that these reduced tax brackets took effect near the beginning of 2018. So, W-2 wage earners have already realized these benefits during the year with reduced withholding from paychecks and correspondingly more take-home pay. This should balance out, in theory, on your tax returns. If you have not already done so, you should really consider maximizing your retirement contributions for 2019 given the extra bump in net pay.

• Our traditional tax planning for small business owners should still be considered. In that regard, we would recommend deferring business income for the next few days, if possible, and accelerating any expenses that you can into this year. We would recommend paying any expenses that you would otherwise pay during the first 15 days of January before the end of December; that does not mean that the check has to clear, you just need to send it off. You will receive the tax benefit one full year in advance if you report on the cash basis, which most of you do. And, of course, you have the desperately complicated (I mean “simplified”) 20% pass-through entity business income deduction that will likely be beneficial to a lot of you with flow-through entity income. They are still hammering out the final guidance on those rules (imagine that!), but the basics are in place, and we have factored that into our projections this year.
 
• As seemingly negative as the inexplicable market sell-off has been these past few weeks, it does present an opportunity to now harvest any capital losses to offset those capital gains you probably realized in the earlier part of the year. If you have outside investments, this would be worth considering over the next few days.

Caroline & Reid Schultz
 
• Many more of our clients will find themselves using the standard deduction this year rather than itemizing their deductions for several reasons:
  • The standard deduction has virtually doubled for 2018 from the prior year. For single filers, it will be $12,000 and for married couples filing jointly, it has increased to $24,000.
  • The elimination of Schedule “A” miscellaneous itemized deductions. The deductions that are no longer allowable include, but are not limited to, unreimbursed business expenses for W-2 taxpayers, investment management fees and tax return preparation expenses. We have advised W-2 income earners to try and work with their employers to arrange a business expense reimbursement plan. If you were not able to do that this year, you might consider that approach in 2019.
  • Schedule “A” state and local income tax and property tax deductions are limited to $10,000. Therefore, unlike all other past years, very few of you will benefit from paying your 4th quarter state estimated tax payments early. Hold on to your money for a little bit longer and pay your estimated tax payments by the actual due date, January 15, 2019. Also, we would recommend not prepaying any other type of taxes either as it will likely not be beneficial to do so.
  • Mortgage interest deductions are limited to $750,000 of principal residence and second home debt. This debt limit was previously $1,000,000 with a home equity line kicker of $100,000, but that home equity line kicker no longer exists. Therefore, if your debt is greater than $750,000, you might consider ways to pay down your principal or talk with us about ways to potentially make the remainder of your interest deductible in some other capacity.
• If you are teetering somewhere between using the standard deduction and itemizing your deductions, you might accelerate charitable gifts that you would otherwise make over the next few days to push you over the threshold. Charitable giving is one of the only itemized deductions that has not lost any of its value for taxpayers.

• Speaking of charitable giving in combination with the standard deduction, if you are over 70 ½ and take a required minimum distribution (RMD) from an IRA, you should plan to give directly from your IRA. This will directly reduce the taxable amount of your RMD and will not affect your standard deduction at all.

• In 2019, the estate tax exemption will be a whopping $11.4 million per person. That remains a significant hike over the amounts from 2017 and can still be transferred to your spouse upon death for a collective estate tax exemption of $22.8 million. In that regard, we would encourage you to keep playing the lottery! The annual gift exclusion will remain at $15,000 per person per recipient, as it was for 2018. If you have been meaning to give a non-taxable gift this year, you have a few more days to take advantage of the annual exclusion for 2018.

• 529 accounts can now be used to save for elementary, secondary and higher education. Consider making contributions and having family members make contributions. The amounts that you can withdraw for lower level education are limited, so please discuss with us before doing so.

• Since there is no exemption allowance in 2018, those of you with children will likely see an increased child tax credit. It doubled to $2,000 per child under 17 years of age. And it will be available to more filers as the income threshold to receive the credit has been bumped for joint filers who make up to $400,000.

• Likely, a lot less of you will be hit with the AMT in 2018 since the exemption amounts and the phaseout thresholds have been increased. We know a lot of you are excited about that one!
 

One more item to note. Do not be surprised when you open your tax package this year and see a very different looking tax return. With the “simplifications” in the tax law, the lawmakers also decided to simplify the individual tax return to postcard size. Many items from the old tax return format are consolidated or shifted to schedules. So, while the first two pages of your tax return may now be the size of a postcard, you might see a lot more schedules in the body. See, we told you this was fun! We wish you all a very happy holiday season and a happy 2019!
 
 

Thursday, December 20, 2018

Wishing you a season filled with merriment!


In celebration of the Christmas holiday, the offices of Rollins Financial and Rollins & Van Lear will be closed on Monday, December 24th and Tuesday, December 25th. Our regular office hours will resume on Wednesday, December 26th.

AND, in celebration of the New Year holiday, our offices will be closed on Monday, December 31st and Tuesday, January 1st. We will resume normal office hours on Wednesday, January 2nd.




If you have a matter that requires immediate attention while our offices are closed, please contact Joe at jrollins@rollinsfinancial.com.

You can also contact Eddie Wilcox at ewilcox@rollinsfinancial.com, Robby Schultz at rschultz@rollinsfinancial.com or Danielle Van Lear at dvanlear@rollinsfinancial.com.

The Partners at Rollins Financial and Rollins & Van Lear wish you a Wonderful Holiday and a very Happy New Year!

Best Personal Regards,
Rollins Financial, Inc.

Tuesday, December 18, 2018

I am tired of all the negative news, let's report the positive. Happy Holidays to one and all!

From the Desk of Joe Rollins

It is somewhat ironic to me that we are in the “joyous” holiday season, yet the airwaves are flooded with negative comments. Many of these comments relate to geopolitical events that have absolutely nothing to do with the economy. Such negative sentiment always runs the risk of becoming a self-fulfilling prophecy. There is much more positive news, which you may not be reading, that overwhelms the negative forecasts so I thought I would devote this blog to pointing those out to you.

There is no question that this has been a disappointing year from a financial standpoint, but it certainly has not been disappointing from an economic perspective. While the stock market has bounced around in all types of starts and stops, the economy has been outstanding. With the economy growing 2.9% in 2018 and unempolyment being reported at the lowest level in the history of employment in the United States, it is hard to fathom that the stock market could underperform. It looks like the traders and speculators on Wall Street are trying to talk you into believing the negative headlines.

Josh & Ava 

Josh, Joe, Ava, Dakota & Carter with Santa

Ava in her Christmas dress!

I will report on all of this very interesting information, but first I must report the activity and performance for the month of November. After an almost devastating selloff in October, the markets rebounded somewhat in November before the volatility struck again the first of December. For the month of November, the Standard & Poor’s Index of 500 stocks was up 2%, up 5.1% for the year-to-date, and for the one-year period ended November 30, 2018 was up 6.3%. The NASDAQ Composite squeaked out a small gain of 0.5% for the month of November, is up 7.2% for 2018 and is up 7.7% for the year then ended. The Dow Jones Industrial Average was up 2.1% during November, up 5.6% for the year-to-date and up 7.6% for the one-year period then ended. Just for comparison, the Barclay’s Aggregate Bond Index was up 0.6% for November, but is down 1.9% for 2018 and down for the one-year period ended November 30, 2018 at -1.4%.

During the month of November, the market vacillated back and forth on 3 basic points. First, there is the ever present concern about the Federal Reserve increasing interest rates to the point of forcing the country into a recession. The second of these was the trade conversation between the entire world and the United States, as promoted by President Trump. The third, which seems to be on everyone’s mind, is whether earnings are rising or falling in the future if the economy sinks into a recession sooner than anticipated. Of course, there are always the extraordinary headlines regarding geopolitical events that really have nothing to do with anything other than polluting the airwaves with needless information. All of these items have affected the market and I want to address them in this posting.

It seems the markets have worked themselves into an absolute frenzy over what is really going on with the economy. Every day, I read extensive articles by so-called “experts” on just how poorly the economy is performing and how they believe 2019 and 2020 will play out. While it is always interesting to hear commentators express their views on what is taking place, what I find much more important is what the experts are actually forecasting. Is it really possible that the economy that is growing at such a pace in the United States could turn on a dime to recession and reflect a negative performance in 2019? In a word, so as not to waste space, NO.

Of course, with the hustle and bustle of the holiday season, you probably haven’t kept up with the reporting of the Atlanta Federal Reserve and its anticipation of gross domestic product going forward. You may recall that the last 2 quarterly GDPs have been excellent and certainly the economy continues to be expanding as we enter into the holiday season. Retail sales are growing nicely, and as I sit here on Sunday morning at 11:30 watching traffic line up to go to Lenox Mall, there is certainly no concern for consumer spending during the holiday season.

On December 7th, the Federal Reserve of Atlanta projected that the GDP would grow in the fourth quarter at a 2.4% pace. While certainly not extraordinary, quite a desirable growth of 2.4% would be a good quarter. However, on December 14, 2018, the Atlanta Federal Reserve increased its anticipated growth rate to 3%. Isn’t it interesting that over that one-week period, the Federal Reserve would increase the projected growth rate while the market makers on Wall Street forced stocks down by billions of dollars? As I have been pointing out in these posts, there is a complete disconnect on Wall Street regarding the reality of the underlying economy, which in reality is excellent.

So, we can all concede that the economy in 2018 has been nothing short of spectacular. The economy has continued to grow throughout the year, employment remains strong, and even hourly earnings are starting to grow. That is the perfect recipe for a strong economy, but what about 2019?

In order to try to determine what exactly we should suspect in 2019, I reviewed all of my available resources to see what the experts have proposed. At the low end, some see a growth next year of roughly 2.3%, while the more optimistic have projected a 3% growth in 2019. The actual growth reported by the Federal Reserve in its most recent update projects the economy at 2.5% in 2019, a slight decline from the previous projection. In any case, even if you take the low growth rate, it would still be quite excellent and certainly above average growth rate for the last several decades. So how on earth could the so-called “learned person” of Wall Street project a recession in 2019 when all of the economists project otherwise? Also, just what economic event would turn around the strongest employment ever in the history of America in 2019 to create an economy where unemployment was rising rather than falling, like it is today? Just about no one can project any kind of negative economic event that would turn the strong battleship of financial performance around in such short time.

So, if the economy is not going to reverse in 2019, there must be something else that is leading to the extraordinary volatility that we are seeing on Wall Street. Maybe the underlying fear is that tariffs will actually convert the economy from growing nicely, to negative. Maybe those projections are not based on current reality. If you have been watching closely, you will note that a trade deal has now been entered into and signed with Mexico, Canada and South Korea. In each of those cases, although not a great deal was changed to any of the existing agreements, the changes that were made were favorable to the United States economy.

So, basically what fear lies in the new tariff war is with China. Is it possible that any deal with China, or failing to make an arrangement with China, could bring down this U.S. economy? As I have pointed out so often in these pages, the U.S. buys roughly $650 billion worth of goods from China, but only sells less than $200 billion worth of goods to China. If it came to a showdown of no trading between the countries, clearly China would be the loser. It has already been well documented that the Chinese economy is slowing, which is only self-evident when you consider their major trading partner is the U.S. Maybe you did not realize, or see the reporting, that China is now back buying agricultural products in the way of soybeans from the United States.

One of the major risks to the Chinese economy due to their inability to make a deal with the United States, is that many of the supply lines will be disrupted and moved from China to other countries. Currently, Vietnam, Indonesia, Malaysia, and India have become major players in supply line suppliers to the U.S. manufacturing. If the Chinese wait too long to make a deal, the supply lines may be too far along to move back to China once resolved.

I have great respect for our President for fighting this war. It is a war that needed to be fought 25 years ago but no other president has been willing to stand up to international pressures to try and level the playing fields. My prediction is that there will be a deal with China during 2019. At the end of the day, it will not change much, but it will at least benefit the United States and create a more level playing field. In the meantime, all of this volatile trading on Wall Street related to a potential deal with China is just a smoke screen to shake your confidence in the actual strength of the U.S. economy. The reason the Chinese will agree to a deal and the reason that President Trump will accept it is quite clear: the Chinese recognize that their economy cannot continue to grow without sales to the United States. They will make a deal not because they want to but because they have to. At the end of the day, they will not risk the effect on their economy just to play hard ball with the current U.S. president.

Of the major concerns that affect the market place and the stock market, the first two are the potential for inflation and the risk of tariffs. As explained in the paragraphs above, I find both of those fears to be misplaced and only a short-term concern. Why would any long-term investor trade around these risks knowing that each or both could be resolved within the next couple of weeks? The one major concern that maybe has some economic effect would be the risk that the Federal Reserve could actually move beyond neutral with interest rates, and therefore put the country into a recession sooner rather than later.

The Rollins family, ready for the holiday season!

The actual selloff of the markets began in October when the newly appointed Chairman of the Federal Reserve expressed with some sort of authority that their intention would be to increase interest rates to a point of being neutral and we were a “long way” from being neutral. At that point, the jittery stock market determined that maybe this newly appointed Federal Reserve was much more hawkish than the previous Federal Reserves, and therefore would increase interest rates to the point that the economy would reverse quickly and would return to a recession sooner rather than later.

Even though the Federal Reserve’s Chairman later corrected that statement when he exclaimed that “interest rates were currently near neutral,” the markets refused to accept his explanation. I think even now the Chairman of the Federal Reserve would agree that the statement on October 1st was truly a rookie mistake. While he certainly wanted to express an opinion that he would be a supporter of the economy, he quickly realized that his exclamation of exactly what their intentions were going to be was misinterpreted by the investing public.

Just to be absolutely clear, no Chairman of the Federal Reserve has any desire to throw the U.S. economy into recession. Anyone who actually believes that really does not understand political appointees. The other thing that was baffling is that no Chairman of the Federal Reserve really wants the stock market to implode. There is very much a “wealth effect” in this country. The “wealth effect” is when the market is high, investors will sell their investments and use those proceeds to buy consumer goods. They buy a new house, a new car, a new toy or go on vacation. When the market sells off, investors are not likely to spend money and are not likely to use that money to prop up the economy.

For that very reason, no Chairman of the Federal Reserve wants to see a major market selloff. Their preference would be for the markets to be stable and not to bounce around wildly based upon comments by politicians. It is clear that this Chairman of the Federal Reserve had neither a desire to create recession, nor a desire to deflate the markets. Given that he had only been in office a couple of months, you have to rack these comments up as a simple mistake.

But the more important consideration is exactly what has taken place since his original October comments. At that time, it was perceived by the markets that there would be an increase in interest rates in December and three or four rate increases in 2019. Given the flat yield curve that we see today, if that forecast had come true, there would have been absolutely zero question that the short term rates at the end of 2019 would have exceeded the long-term rates. As often is the case when exaggeration leads to forecasting, no reasonable economist could have projected that the inverted bond yield scenario as proposed by investors was realistic.

What we now see is that quite almost assuredly there will be a rate increase in December. There is a high likelihood that in 2019 only one or maybe two rate hikes will be in store. If that projection holds true to form, there is absolutely no chance that the increase in the interest rates by the Federal Reserve in 2019 will force the economy into a recession. One more actual fear defeated by the truth.

During the month of November, it was projected that the entire world was falling into recession or clearly a slowdown. The catalyst for this opinion is that during the quarter, Germany and Japan both suffered declines in GDP. Even though there were solid reasons for the negativity in these countries, investors sold before they thought. In Germany their largest industrial production, by far, is automobiles. During the third quarter, there was a severe drop in automobile production in Germany due to the model changes over the years and the adjustment to the new admission standards. As has long been the case for the entire month of August, usually Europeans vacation rather than work. While clearly a decline in GDP for the quarter, it was one that was easily explainable and not likely to occur.

Likewise, in Japan, they had severe weather and earthquakes, which slowed their economic growth. However, this week they are proclaiming that Japan’s 10 year growth cycle has one of the strongest in their financial history. And certainly inflation, while it can always be a factor in future economic growth, the fact that energy has fallen nearly 30% over the last 90 days should dispel any type of fear of future inflation.

Isn’t it interesting that when President Trump pushed the Saudis to produce more oil in order to reduce higher energy costs, the price of crude oil fell over 30% in 90 days? Maybe that tells you something about how highly inflated energy prices are today. It probably has gone without notice, but the U.S. is now the largest oil producing country in the world. The United States produces almost enough oil to be totally self-sufficient in that category. The revolutionary concept of shipping liquified natural gas is just now starting and the U.S. will be the largest ever exporter of it within the next few years. For those that do not believe in the ingenuity of U.S. engineers, just contemplate the ability to take a clear gas and convert it into a liquid that can be shipped around the world and then turned back to a gas in order to heat homes, etc. – it is conceptually mindboggling.

Everywhere I look I see only good news, except when I watch national broadcasts. I guess it is baffling to not only me, but to my readers as to why Congress refuses to do anything proactive. If it is the goal of the minority in Congress and clearly the goal of every news cycle and news channel we see to have the President removed, why is it that they do not focus on not having him at the polls in 2020 rather than trying to attempt to remove him before then? There is no conceptual way that a President can be removed against his will prior to the elections in 2020, and therefore why even try. It would seem to me that if Congress had any inclination or desire to actually help the U.S., they would focus on that rather than these incredible time-wasting and expensive investigations, conversations, and allegations. But then again, the nightly news would have nothing to report on, so…

For those of you who have not been a long time reader of my financial reports, you probably did not realize that I was a firm and longtime critic of former Federal Reserve Chairman, Alan Greenspan. While so many people were praising his genius, I was criticizing his faults. I thought he was so wrong during the 90s in virtually all of his actions and most of his speeches. I thought he made a tragic mistake when he was chairman in 1987 with the big market correction that year and I thought he handled the economy in the 90s and early turn of the decade poorly, as well.

So, I could not have been happier to see him give one of his famous quotes recently. Former Federal Reserve Chairman, Alan Greenspan, explained, “ We are moving into a state of stagflation we haven’t seen in this country in quite a while. It’s slow. It’s progressive.” It really cheered my heart to see him once again express a negative thought about the U.S. economy. There really could not be a stronger contrarian call of the markets than having Alan Greenspan himself express the negativity. He had been so wrong so many times in my economic past that it cheered me to hear his voice once again, and to know how likely it is that he would be wrong again.

In this holiday season, I hope you spend more time with your family, enjoy the season, and worry less of the fears on Wall Street and have conviction in the reality that the economy is great, interest rates are low and earnings are increasing. All three of these will lead to higher markets, and I am not sure whether that is today, tomorrow, this week or next, but I do know with absolute assurance that the markets will be higher years from now than they are today.

As always, we encourage you to come in and visit with us and discuss your goals and financial plans. If you are interested in discussing your specific financial situation, please feel free to call or email.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins


Tuesday, November 6, 2018

Everyone loves a great conspiracy theory, I have one...

From the Desk of Joe Rollins

There is no way to put it mildly – from a financial standpoint the month of October 2018 stunk. I never want to minimize a downturn in the financial markets since people lose money, but this one defies the imagination. During the month of October, the NASDAQ had its worst month since October 2007. I intend to illustrate how completely implausible that correlation is. In addition, I also want to point out the astonishing positive economic evidence that forecasts that the markets will, in fact, recover and soar to new heights shortly. With such overwhelming favorable economic news, how the market can sell off in such a pronounced fashion is mind-boggling. Perhaps I have the answer in the form of a conspiracy theory, backed up by hard economic evidence.

Before I launch into that far-reaching and most interesting explanation, I have to cover the dismal economic performance of the financial markets during the month of October. The Standard and Poor’s Index of 500 stocks sold off to the tune of -6.8% during the month, yet it is still up 3.0% for the year 2018 and up 7.3% for the one-year period then ended. The NASDAQ Composite showed a dismal performance of -9.2% during the month of October but is still up 6.7% for the year 2018 and up 9.8% for the one-year period then ended.

The Dow Jones Industrial Average lost -5.0% during the month of October, yet it remains up 3.4% for the year 2018 and is up 9.9% for the one-year period then ended. If for any reason you thought that you would have been safe in bonds during the month of October, they also lost money, but at a much lesser percentage since they were down -0.7% for the month of October, but they remain down -2.5% for the year 2018. For the one-year period ended October 31 2018, the Barclays Aggregate Bond Index is down -2.1%.

There is just no way to sugarcoat the performance during the month of October, it was just downright terrible. What is fascinating about this performance is that it is not based on economic evidence but rather on the fear that the Federal Reserve is out of control and lacks the common sense to stop the hike in interest rates. I find this perception, that the Federal Reserve does not understand the impact of higher interest rates, both naïve and totally misplaced. I hope to better explain this matter below.

Caroline and Reid Schultz,
with Ava Rollins

Ava Rollins

Ava and Dakota Rollins at the beach

I have written about my father in past postings, but this month brought to mind a very important lesson that he taught me long ago. As I pointed out, my father was brilliant in many aspects. He had a master’s degree in electrical engineering from the University of Tennessee, but had the misfortune of graduating during the Great Depression in the 1930s and was unable to find work. He had drifted into the ministry and remained there the rest of his life. However, I was always amazed by the broad range of subjects that he spoke of and the knowledge he held on virtually all of them.

One of the things I always marveled at was his ability to give his sermons each Sunday almost seemingly without notes. He did, however, maintain a black book that contained sermon notes throughout his entire career in the ministry. When I was in high school, I would sometimes sneak into his office to read the black book. Each sermon was noted by the date and the church where it was given, going back close to 40 years. What was amazing to me was that there were only three or four items actually noted, including a simple phrase or two as a reminder of what to emphasize.

As a preacher, my father was a very dynamic and forceful speaker, but removed from his element, he was not one for small talk. We never had conversations about his profession, except the one day when I caught him in a rare moment of reflection. I asked him how he was able to give a 45-minute sermon based only on the three or four notes in his sermon outline and I will never forget when he replied, “Someday, you too, after 40 years of experience, will know what to say from only a few notes.”

I guess I have to admit that after 40 years of analyzing the financial markets, you find out fairly quickly what is important. You cannot allow yourself to be influenced by all of the talk on the financial news and the predictions of financial chaos that show up in the headlines on a daily basis. You must rely upon what you know about the economy and finance rather than hollow headlines that reflect bias in one direction or another.

This leads me to the great conspiracy theory for October 2018. It is interesting that as indicated in my blog last month , we had just finished the best quarter in the financial markets since 2013. We also reported the lowest unemployment rate in 49 years. How with such sterling financial performance could we suffer the worst market pullback since 2007? Perhaps I have the answer.

It has been long perceived that the month of October is bad for stocks. However, it is not typically the worst month of the year, as September claims that unique negative recognition. However, over the years there have been many noted downturns in the market during the month of October and as we were heading into the month, all of the negative forecasters were pointing this out. Of course, there are a lot of negative headlines surfacing with the midterm elections coming up, along with problems in Italy, Saudi Arabia and other parts of the world. But the principal reason for my opinion focuses on an interview given by the Chairman of the Federal Reserve, Jerome Powell, which coincidently occurred on October 3, 2018. In an interview with PBS, during an offhanded Q&A session, he said the following: “The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore. They’re not appropriate anymore. Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.”

With those words, the perception of the investing community was that this Federal Reserve Chairman was totally out of control and would increase interest rates regardless of the economic circumstances at that time. Despite inflation being very well contained and the economy strong, but not overheating, would this new Chairman of the Federal Reserve increase interest rates to the point where the bond yield would become inverted and create a recession in America? This actually happened in 1987 when the newly appointed Chairman, Dr. Alan Greenspan, did exactly that, creating a loss in the stock market of 22% in one day, which coincidently occurred in October 1987.

This point centers on my conspiracy theory! For the last several years, the performance of hedge funds and institutional investors has not kept up with the overall market. The hedge fund industry, which performs well in the down markets, isn’t much of a performer during the up markets. Is it possible that they, as a group, decided that it was appropriate to move the market down, even with such great economic results, in order to improve their performance for 2018?

Joe and CiCi studying the stock market

What seems strange about this sell-off was that it occurred virtually at the beginning of October and ended almost instantaneously during the last couple trading days of the month. There is no question that the momentum traders also participated in this sell-off. As the market continued to fall and support was broken at the 200-day moving average, the momentum traders kicked in their algorithms, which indicated that the market would trend down instead of up, and selling was exaggerated. I have often wondered if many of these momentum traders and hedge fund investors meet up and make a decision to buy or sell as a group. It is like a game of chicken as they short the market as a group and then wait and see who should cover their shorts first. In either case, the market went down without any common logic during the month of October and we all sustained losses because of it.

So, what do you do in the face of these overwhelmingly negative financial markets? The only thing I know to do is to take my father’s advice and use my 40 years of watching financial markets to predict the future. As I have pointed out in so many postings in the past, there are basically only three things that control whether the markets go up or down; the economy, earnings and interest rates. Last Friday the unemployment report came out for the month of October and it showed that there were 250,000 new people added to the payroll during the month, well above any consensus estimate. The unemployment rate remained at 3.7%, the lowest rate since December 1969, the best in 50 years.

But the absolute crushing number was the over 711,000 new people added to the payroll and over 600,000 of those new entries into the employment market found jobs. As I have pointed out many times in the past, the secret of the economy is keeping people working. More people working means more people paying taxes and more people contributing to the economy. Right now, there are more people employed in the United States than ever in our history. Did you realize that over the last one-year period the unemployment rate has fallen close to ten percent? There are close to 3 million more people working in America today than were working only one year ago. These 3 million people support 10 million Americans.

It was recently reported that the GDP went up 3.5% during the quarter ended September 30th. It is currently projected that the GDP for the fourth quarter of 2018 would be in the 2.5%-3.0% range. While not as high, certainly more than acceptable. When you compare that the NASDAQ was down the most since October 2007, you need to review your history. In October 2007 this country was in a major market meltdown. The GDP for that quarter was down -8.2% in 2007 as compared to up 3.5% in 2018. First time unemployment applications in 2007 were in the 800,000-900,000 per month range, as compared to 2018, where employees are actually being added.

You may not recall this, but there was a time in 2007 when the Federal Reserve had to guarantee the money market funds since it was suspect whether those funds would be able to even return the money to investors. The entire country was in a financial meltdown, with foreclosures dominating the news. You compare that horrendous economic performance to 2018 when the economic evidence could not be greater and you just cannot fathom how the markets could report negative numbers. Therefore, my analysis is that the economy is great and strong and certainly there are no recessions in sight during the next couple of years.

The next major component of determining market value is earnings. In order to reassure myself regarding earnings, I went back and looked at the increase in earnings over the last several years. For the year 2017, S&P 500 earnings were up 24%, it is estimated now that earnings in 2018 might be up 22% when finished. Projected earnings for 2019 are certainly slowing, since there will be no tax changes in 2019, yet they are still projected to be up 11%. The increase in earnings therefore has been 57% in the last 3 years. On a compounded basis that is 68%. Wow! What is even more interesting is that as these earnings continued to go up, contrary to the market reaction in October of 2018, the price/earnings ratio has actually gone down. For the last 25 years the Standard & Poor’s Index of 500 stocks has had a price/earnings ratio of 19.2, on average. As we currently stand, the price/earnings ratio is at 18. So, for anyone to tell you that this market is expensive relative to prior years is basically expressing their uninformed opinion.

The earnings for the third quarter of 2018 were nothing short of spectacular. However, I still hear all of the financial commentators and their terribly misinformed views on such. I think it is important to understand the direction of earnings but I also think it is important to understand absolute earnings. When you see stocks you have never heard of go up 20% or 30% in a day based solely on showing a profit you have to evaluate the actual level of those profits before you invest. To express how misinformed financial information can be, let me give you a real-life example of the earnings report from Berkshire Hathaway. For the quarter ended September 30th they reported excellent numbers wherein they earned $6.88 billion in operating earnings (not including financial gains), which was basically double their earnings of $3.44 billion last year. As I watched this commentary, one after another so-called “expert” expressed his and her opinion on the quarter and one, Bill Smead, said “This is absolutely one of the greatest quarterly earnings reports that have ever come out of a United States corporation.”

I reflected on that for a second and compared it with the report the previous day from Apple. As all of you know, that stock sold off close to 7% this past Friday due to so-called negative earnings reports. I saw one commentator after the other criticize the company and its earnings report for close to three hours, citing their financial knowledge on the financial strength of this company. However, after closer inspection I found out that Apple reported an earnings report for the quarter of $14 billion and is by far the most profitable company in the United States - and probably the entire world. Even social media outcast, Facebook, showed a profit of over $5 billon for the quarter and they have no tariff restrictions. Certainly, Berkshire Hathaway profits were excellent, but to refer to them as the best ever demonstrates the bias that financial news brings.

So the first two components, the economy and earnings, both are beyond excellent and frankly are trending higher. Which leads us to the most important component that affected the markets during October – interest rates. Is it possible, that the Federal Reserve could be so inept as to increase interest rates in the face of an economy so strong that it would turn it into a recession essentially overnight? I am amazed that investors and commentators would be so naïve to think any politician would take such action knowing the dire consequences.

I question whether interest rates are even high today, much less too high to destroy the economy. The Federal Reserve has basically two mandates. The first mandate is that it is to keep employment high so that the economy remains strong. The other mandate is that it must control inflation so as the inflation does not get out of control. Based on the information above it is clear that employment is high, in fact, it is at the highest level in 50 years. Clearly, that mandate has been satisfied by the Federal Reserve. The more important component is whether the Federal Reserve is doing its part to tame inflation. I would argue at the current time that interest rates are not high at all. At the current time the inflation index reflects a current reading of 2.17%. If you compare that with the target on the federal funds rate which is set at 2.2%-2.25% you will note that the actual interest rate after subtracting inflation is essentially zero. Rather than expressing alarm, just consider that for a minute.

In order for a saver to actually earn money, they must earn in excess of the current rate of inflation. If you invested money today at a rate less than the inflation rate, then at the end of the term, whatever that may be, you would have actually lost money. If the Federal Reserve would intend to keep the interest rates in line with inflation, then at all times it must be trading above the current rate. If the Federal Reserve was attempting to slow the economy, the current rate would be at least double the current inflation rate. If you saw a federal funds rate that was 2% points higher than the rate of inflation then you would know that it was a concerted effort by the Federal Reserve to slow the economy. Since we do not currently see the Federal Reserve interest rates exceeding the rate of inflation, to argue that the Federal Reserve is attempting to restrict the economy is just uninformed. We may get there in the future, but we are currently not there today.

So, based on my 40 years of experience in this business, during the month of October we did virtually nothing. The three major components of higher stock markets were all firmly in place. The economy was great, earnings were high and accelerating, and interest rates restrained. Therefore, nothing financially led the markets lower. Whether it was a concerted effort on the part of professional traders or just an over exaggeration of the current political environment, I really do not know. The only thing that you can do when in doubt is invest with your experience, and that experience led us to do nothing during October.

We also know that historically the best months of the year are November through May and I would continue to expect the market to move higher after the midterm elections and reach my year end goal of the S&P at the 3,000 level, which is approximately 9.2% higher than it is today.

As always, we encourage you to come in and visit with us and discuss your goals and financial plans. If you are interested in discussing your specific financial situation, please feel free to call or email.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins


Tuesday, October 9, 2018

Best quarterly stock market since 2013!... Lowest unemployment rate in 49 years... It just does not get any better than this!... Why are Americans feeling so bad?

From the Desk of Joe Rollins

As the economy continues to post exceptional numbers and the major market indexes have reached new highs, I am still completely baffled by the absolute negativity exuding from the American population. Rather than out in the streets celebrating an extraordinary economy and the continuation of impressive corporate earnings, all you hear are negative comments that, to me, appear irrelevant to the big picture. So, I thought I would devote this posting to addressing your concerns by providing you with all of the positive economic information out there which should allay your fears.

As always, before I begin, I need to report the results of the month and year on the major market indexes. Although the performance for the month of September was flat, the performance for the quarter was the best in over five years. Many of you have heard of the old Wall Street saying, “sell in May and go away”, well that was not evident this year as the third quarter of 2018 was nothing short of spectacular.

Ava ice skating


Joe and Josh at a Braves playoff game - Braves won!


Ava (age 7)

For the month of September, the S&P Index of 500 stocks was up 0.6%, year-to-date that index has posted a 10.6% return and for the one year ended that performance has been 17.9%. As mentioned, the last quarter was extraordinary and this index posted an increase of 7.7% during the quarter. The Dow Jones industrial average returned a respectable 2% increase in September and is up 8.8% for the year 2018 and has a one-year performance at September 30th of 20.8%. The NASDAQ Composite lost 0.7% during the month of September; however it is up 17.5% for the year 2018 and is up 25.1% for the one-year period then ended. The NASDAQ Composite showed a 7.4% return during the third quarter of 2018, while the Dow Jones industrial average leapt 9.6% during the quarter.

For those of you who insist on investing in bonds come rain or shine, the Barclays Aggregate Bond Index was down 0.6% for September, down 1.7% for the year 2018 and for the one-year then ended was down 1.4%. As you can see, the trend in bond investing is negative and is likely to stay there. For those of you more interested in long-term performance, rather than just recent performance of bonds, the 15-year return on the Barclays Aggregate Bond Index is 1.8%. If you look at the same time period for the S&P 500 index, it was up 9.7% for the last 15 years. There is absolutely no short-term reason to be investing in bonds and, as illustrated, even the long-term performance of bonds is nothing to write home about.

1. TARIFFS

You may recall that in February 2018 the financial markets sold off drastically with the anticipated fear of the tariffs President Trump was going to place on many countries. The so-called financial experts were screaming that tariffs would throw the U.S. economy into recession, create vast unemployment in America and pure chaos in our economy and that of other countries around the world. But not me. As is often the case when economists speak, they were just wrong.

Let us evaluate where we stand on tariffs eight months after the original proclamation. It did not take long before South Korea agreed to the terms of a new deal with the United States for the very basic reason, they had no choice. To the surprise of many, both Mexico and Canada readily agreed to completely redo the NAFTA agreement and have now agreed to terms more favorable to U.S. imports and exports. There were many who said that Canada would back the U.S. into a corner before agreeing to reduce their import duties on milk and other dairy products. I guess they hit a wall, so to speak, as they readily agreed before the October 1st deadline.

It will only be a matter of months, in my opinion, before Japan agrees, as well as the European Union. It is pretty simple to figure out why agreement will be forthcoming. Do they want to sell their products to the United States or just build them solely for their own respective country? The answer is so crystal clear that no explanation is needed. Both Japan and the European Union will be in full agreement before the end of 2018.

So exactly what happens with China? I guess the more accurate question is who really cares. As mentioned so often in these postings, China needs the U.S. a lot more than the U.S. needs China. There is absolutely no question that this would create disruption of the supply chains and many companies that manufacture in the United States, but while disruption will occur, it will not be damaging. Many companies are moving their manufacturing from China into other parts of Asia, such as, Vietnam, Malaysia, Indonesia and India; however, it will hardly affect corporate earnings. The bigger question that remains to be seen is whether China will continue to resist fair tariffs and risk letting their jobs evaporate to elsewhere. I will discuss China in greater detail later in this posting.

2. THE SKYROCKETING PRICE OF OIL

As I am sure you are aware, the price of oil has gone up fairly dramatically this summer. There are many reasons given, but frankly those reasons do not survive the “smell test.” The most important reason is that on November 2, 2018 the U.S. will sanction oil that is shipped from Iran. These sanctions will be devastating to the Iranian economy since, unlike before, the U.S. will hold any country that imports Iranian oil accountable. In an act of absolute brilliance, the current President has made these sanctions very simple. If you want to trade with the United States, then you will not import oil from Iran. Take it or leave it. You can either trade with us, or you can trade with them, but you will not trade with both. Never before have sanctions so affected the Iranian export of oil. Already European companies are pulling out of Iran manufacturing and Europe has already canceled long-term contracts to buy oil from Iran. No question that China will fight this policy and buy oil from Iran, but the rest of the world buys oil at their own risk.

What is interesting about this concept is (for reasons totally unclear to me) the price of oil has gone up in the United States by 30%. Do you know how much oil we have bought from Iran over the last 10 years? None! So, the price of oil in the United States has nothing whatsoever to do with the sanctions on Iran. I have been watching the oil markets my entire professional career, which spans over 40 years. What is absolutely clear in the oil market is there is total collusion when it comes to pricing. If one oil company increases the price at midnight on Christmas Eve all the others will simultaneously increase it by the same percentage. There is nothing economically justifying the price of oil at the current time other than the price of oil has been too low for too long and it is now time for catchup. You should read nothing economically into the price of oil at the current time.

However, the positive impact of increasing the price of oil is that shale manufacturing will explode. With the price of oil up, exploration can continue and as this happens the shale fields will become increasingly profitable, putting more people to work at high paying American jobs. It is amazing to me that the financial press cannot understand how the sanctions of Iran have absolutely no negative impact on the United States and that the increased price of oil actually helps the U.S. economy rather than hurts it. So, if this is one of your concerns going forward, that concern is misplaced.

Our awards displayed on our front doors


3. INVERTED BOND YIELD

There has literally been tons of ink spilled on the subject of inverted bond yields over the last 12 months. It is true that an inverted bond yield is an early signal that there might be a recession coming into the economy. It has been an indicator that has proven to be correct numerous times over the last few decades. If short-term interest rates exceed long-term interest rates then businesses will not invest since it benefits them to wait until the future, when these rates are lower. This timetable of waiting to invest slows the economy and for all practical purposes leads the country to recession. As you can see, with higher short-term rates than long-term rates, companies are unwilling at the current time to borrow money to invest in their plant equipment since it would be cheaper to wait until the rates fall.

What is rarely reported regarding an inverted bond yield is that there is a long, inconsistent lead time between the time the bond yield inverts and before the economy actually falls into recession. Over time, that lead time has proven to be in excess of two years. So even if you had an inverted bond yield today, which you do not, it would most likely be over a two-year cycle before you actually saw it affecting the financial markets.

So much has been said about the inverted bond yield but there is very little information given to the real numbers. As I have pointed out for years, one of the reasons why the 10-year Treasury is held back is due to the low 10-year Treasury rate in other countries. As an example, the 10-year Treasury in Germany is at 0.576%. In Japan, the 10-year Treasury is at 0.147%. In the United States, the 10-year Treasury is 3.233% as I write this. Therefore, because the rates are significantly higher for our 10-year Treasury rather than the Treasury of these developed countries, money will move to the U.S. to take advantage of the higher rates. That movement hurts the currencies in both Germany and the European Union, and of course Japan. The most important aspect of this occurrence is that all of the money flowing into the United States Treasury market from around the world keeps the interest rate on the U.S. bond rate lower than it actually should be given normal economic circumstances. This is a good thing since it reduces the cost of capital for home building and the purchase of automobiles in America.

There is no question that higher interest rates will impact the economy since virtually any debt maintained on a variable rate will go up, costing consumers more money to service this debt. But as I write this posting, the 10-year Treasury is at 3.233% and by no definition does that denote any type of inverted bond yield. Therefore, if one of your concerns continues to be fixated on the potential inverted bond yield, we are not even close to that at the current time. Even if we had such a yield, it would be years before it affected the financial markets. Rather than focus on the fact that 10-year Treasury rates are going up and the effect that it might have on the future earnings of consumers, it is much more important to focus on the reason why they are going up. 10-year Treasury rates would not be going up if it was not a result of the realization that the American economy is increasing in value. As a general rule, interest rates fall as the economy declines and goes up when the economy improves. This week, the chairman of the Federal Reserve Jerome Powell said, “There’s really no reason to think that this cycle can’t continue for quite some time, effectively indefinitely.”

4. THE STOCK MARKET VALUATION IS TOO HIGH

I wish I had a nickel for every time I heard this statement from so-called experts on the financial news. They keep quoting that the stock market valuation is too high, and therefore they would not invest new money. The first thing you have to realize is that, by historic standards, today’s stock market is different than prior years. With the advent of 401(k) plans back in the 1970s, that vehicle has become the standard for retirement in America today. The actual pension plan, as we know it, virtually does not exist any longer. Americans, from the very young to the very old, invest money in their 401(k) plans on a weekly or monthly basis directly from their paychecks. It is presumed that roughly $2 billion per day flows into American 401(k) plans. This money is not concerned about market valuations since facts indicate that markets go up over time regardless of good or bad economic projections. Therefore, as an anchor on the market, this money continues to flow regardless of projections by so-called experts.

So, is the market overvalued or are those projections just released to promote whatever product they happen to be selling on any given day. The sure way to find out is to look at the earnings of the S&P 500 index as projected for 2019. As of the date of this posting, they are projecting earnings for the S&P 500 for 2019 as $176.52. If you will look at my year-end projection, I forecasted that the S&P 500 would end this year at the 3,000 level. That is up roughly 3% from where we ended the month of September. If you divide 3,000 by 176.52, you get a price-earnings ratio of 17. Do you want to know an interesting fact? The price-earnings ratio for the last 75 years in the stock market has been 17. Therefore, to argue that the stock market is overvalued at the current time clearly indicates an unawareness of the facts.

Then again, I also hear on a daily basis that we are on a “sugar high”. There is no question that the earnings have increased dramatically because of the reduction of income taxes. But the one thing that people cannot seem to grasp is that taxes are not going back up for years to come. Therefore, it is not expected that these earnings would go down in the second year of income tax reductions. In fact, with an extraordinarily strong U.S. economy and growing optimism by consumers, the more likely the trend for 2019 and 2020 is up rather than down. Therefore, if one of your concerns focuses on the already fully priced stock market, you can discard that concern as being inaccurate.

5. THE ECONOMY

I keep hearing so many clients say that we will go into recession shortly given the outstanding performance of the economy so far. There is absolutely no historical precedent for an economy going from 4% to recession in a short time period, short of economic disaster or a worldwide economic event such as war, etc. As mentioned in the title, with unemployment at its best in 49 years, more Americans are working today than ever before in the United States. More people working means more people paying taxes and more people contributing to the economy. We had a 4% GDP in the second quarter of 2018 and the Federal Reserve Bank of Atlanta now forecasts the third quarter GDP at an increase of 4%. There is no economic standard or preamble to the future that would indicate that any recession in the U.S. economy is anywhere in sight.

I do, however, agree with the assessment that in all likelihood the U.S. economy should fall into recession in the second half of 2020. This is based on the Federal Reserve’s desire to keep a level economy and prevent it from overheating. However, at their rate of a quarter of 1% increase in interest rates per meeting, it is not likely to occur for at least two years. So, if your argument is that the U.S. economy is going into recession, I would concur. However, that potential recession is over two years from today, so why anyone would make changes in their portfolio to provide for a recession two years out does not warrant discussion.

To invest in bonds at the current time, as interest rates go up, is not likely to be profitable. I often ask clients why their portfolio is currently invested in bonds. Even after I go through a lengthy explanation of why it is almost a certainty that bonds will produce a negative rate of return, they continue to express their desire to be so invested. In my opinion, this is sort of like stepping in front of a train. You know disaster is coming but you don’t know when. The time to invest in bonds is not during an economic boom like today when interest rates are increasing but rather when the Federal Reserve is trying to stimulate the U.S. economy by decreasing interest rates. That date is likely two years from now.

6. CHINA

Is your concern that China may in fact economically overwhelm the United States, and therefore you do not want to invest in the U.S. stock market because of this fear? There is no question that the Chinese stock market is the cheapest in the world. By any valuation standard, stocks are dirt cheap in China. Would I invest there today? Absolutely not.

Let me give you a quote that I think about often times when the discussion of China occurs. In many eyes, China has performed miracles by converting their economy from basically a very small middle-class to a middle-class population today that exceeds the population of the United States. They have brought people in from the fields and trained them in manufacturing and made these workers the envy of the world in creating products that can be used in the U.S. and other countries. However, they are playing economic roulette with this middle-class. You cannot create a middle-class that wants higher and higher wages without passing on that cost to the consumer. However, China has not done so. In the last 15 years, average export prices to the United States have been unchanged. Basically, think through that statement. For the last 15 years, prices in the U.S. have been stable in U.S. dollar terms. Except, if you consider that in China, the average wages have gone up over six times. How can a country continue to increase the compensation to their employees but yet their pricing remains stable?

Economics would contend that China is a country headed for economic chaos if their costs continue to go up but their prices continue to go down. One way they have been able to accomplish this is by manipulating their currency and by borrowing an excessive amount of debt to finance their economy. Once again, a risky move from an economic standpoint. Even though their economy continues to grow, it is currently declining. As I write this posting, I note that China has actually taken extraordinary measures to increase their performance. This is a direct action to circumvent the tariff costs of their products shipped to the United States.

It is clear that the Chinese government recognizes the perils of reducing their currency and flooding the economy with more money to offset the negative effects of the tariffs to the United States. A much bigger fear should be that due to this increased cost, their supply lines are being replaced by other countries and this business is lost to the United States forever. Over the weekend, China reduced the amount of cash that the banks are required to reserve for future growth, therefore weakening the banking system. They have dramatically decreased the amount of reserves these banks hold, and therefore are pushing the banks to lend more to the economy. In addition, they are flooding the banking system with new cash to the tune of $109 billion in order for banks to have the excess capacity to loan more.

If you assume in China, as in the United States, that $1 creates $7 in GDP, this is flooding the economy with close to $700 billion of fresh money to create GDP. Those of you who remember the 2008 financial disaster, the TARP at its maximum would have only been $700 billion but in fact less than $300 billion was actually injected into the banking system. It is not often reported, but all of the TARP dollars were repaid with the Federal Reserve actually making a profit on the transaction from TARP. Yes, there were defaults on debts, but the debts earned so much for the Federal Reserve that it did more than offset the losses.

There is no question that you will see the Chinese devalue their currency to offset the price of tariffs in order to remain competitive. It is also crystal clear they are concerned about their economy or they would not be injecting so much money into their banking system. Would I invest in China today? No, I would not; they are looking at hard times for as long as they fight the tariffs in the United States. So, I will say like I have said before – China will agree to the tariffs for one very simple reason, they have no choice.

7. EMERGING MARKETS

At the current time, we are moving our emerging market investments, not that I do not expect them to do well over the next year or so, but because their volatility and unknown nature is unnerving to investors. In fact, many of the emerging markets will greatly benefit by the increase in the price of oil. However, at the current time, currencies in these emerging markets are cratering as compared to the U.S. dollar solely for the reason that the U.S. economy is so strong and their economies are so weak. With so many of the emerging markets’ economies dependent upon selling to the United States, as their economies decline and the U.S. dollar goes up, they get a boost in productivity due to the currency exchanges. I fully expect that emerging markets will regain their footing over the next year as earnings go up and their economies stabilize. If I have to invest in one market at the current time, it would be the U.S. We will let the volatility of the international and emerging markets stabilize before moving assets back in that direction.

I have tried above to address all of the issues I think you could raise when deciding whether or not to invest. It is absolutely overwhelming to me how much cash is sitting in investors’ banks accounts earning zero. I get so many reasons why that money is not invested, many of which are itemized above. I am not going to say that I am always right, nor have I been 100% correct over time. However, for the last eight years I have been advising, if not even begging, clients to invest their excess cash as the markets were moving higher. I guess from that perspective, that has been a crystal-clear winning recommendation. But if you continue to resist investing, I would like for you to consider the reasons as itemized above and assume that whatever your argument is for electing not to invest could be answered with a positive response above.

As always, we encourage you to come in and visit with us and discuss your goals and financial plans. If you are interested in discussing your specific financial situation, please feel free to call or email.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins