Tuesday, July 12, 2016

"Looking Up - Straight Up."

From the Desk of Joe Rollins

It seems like we have been avalanched with nothing but bad news since the beginning of 2016. Every day, you pick up the paper and read something negative about the U.S. or the U.S. economy. I am not exactly sure what is bringing about all of this negativity, but there is a presumption that the next person who predicts the stock market crash will become famous. That happened in 1987, but not so much in 2008 when no one predicted it correctly. However, based on the news, it certainly seems to be a very small chance of a major market correction, as far as I can see.

The first six months of the year ended has pretty much been non-eventful. Although the markets have moved around significantly, it can pretty much be said that not a lot is actually occurring. Yes, the market is up but most of the growth mutual funds are actually down for the year. I wanted to report on some of the major market movements during the period, but more importantly, I wanted to reflect on the good news that is coming. Over the last 15 months the market has been substantially flat. I think that is getting ready to change for the better, and hopefully you will be patient enough to still be around when the good times roll again.

Before we dive into stock performance, I thought I would share a picture with you. Here is Ava at the Atlanta Airport, seeming a little jet-lagged. This is what I like to call a 5-year old attitude...

For the first six months of the year, the Standard & Poor’s index of 500 stocks is up 3.8% for the year 2016. For the one-year period, this same index is up 4%; for the three-year period, up 11.7% annualized; for the five-year period, up 12.1% annualized; and for the 10-year period, up 7.4% annualized. As you can see, gains have been significant of the last 10 years, just not so much in the most recent year. For the year ended in June, the Dow Jones industrial average is up 4.3% and up 4.5% for the one-year period, 9% for the three-year period and 10.4% for the five-year period. The NASDAQ composite is still down 2.6 for the year, down 1.7% for the one-year period, up 13.9% for the three-year period, 13.2% for the five-year period and 9.5% for the 10-year period. As you can see, this index is the highest performing index of all the major market indexes, but it is also the most volatile. The Barclays aggregate bond index is up 5.3% for the year, up 6% for the one-year period, 3.9% for the three-year period and 3.6% for the five-year period. Even though the bonds have performed well recently, they are the worst performer of all the major market indexes over the 10-year period.

During the last two weeks of June, the market received a tremendous shock when the countries that make up the UK voted to leave the European Union, which has become known as Brexit. For the two trading days after the vote, the market dropped a dramatic 1,000 points. We received many calls from clients concerned about this major market selloff and the unknown of the future. I never really understood what the confusion or the fear was that was represented by this vote and the stock market reaction. An attempt to try to get a better understanding of exactly what would take place, I read over 100 articles explaining the vote, the economic consequences and the potential fears. What I quickly realized after some of this excruciatingly boring economic commentary, nothing will happen quickly.

It needs to be understood that nothing about this vote will stop trade between Britain and the continent. Both need each other, and therefore that will not change. In fact, it appears to be that the UK will be stronger now that it will not have to support the weak sisters of the EU, such as Greece, Italy, Spain and Portugal. But the main reason the locals in Britain wanted out of the bureaucratic and socialistic rules of the EU was to better control their own immigration. While clearly immigration will go on in the UK, at least they will be in control of it and not the bureaucrats from Brussels. This would appear to me to be a huge economic advantage to the UK after the vote.

The main reason I wanted to learn more about this event is why it would affect the U.S. market. Are the U.S. companies not going to sell the same to the UK? Are the U.S. companies not going to sell the same to the EU? Quite frankly, none of this has any effect on the export sales of either.

I guess an argument could be made that, because of Brexit, the UK could fall into recession, and therefore buy and produce less for their economy. However no one that I read on the subject seems to think that was a given. It was clearly illustrated that nothing is going to happen for two years, and the results of whatever happens will not be known for three or four years, so why exactly did the market selloff 5% overnight? As so clearly illustrated in these pages - traders trade, investors invest, and never the twain shall meet. As the traders thrashed around trying to figure out where to go next, the market returned back to its pre-Brexit levels only a few days after the selloff. So, I guess it could be said that it was a “nonevent”.

I have watched a lot of movies and read many books recently, including The Big Short and Flash Boys, and note the trend of essentially assassinating all investing in the name of bad traders. Further, you cannot be reading any financial press without seeing those same people that have been forecasting “gloom and doom”, repeating those same unwarranted charges of a market meltdown. In fact, there are few investors that have proclaimed the ultimate market demise during my entire investing career. Since I will be closing in on over 40 years of investing, it is absolutely clear that these predictions have fallen upon results that were nothing short of spectacularly good.

When it comes to analyzing asset classes, I am always asked whether we should be investing in stocks, bonds, or some other specialized asset mix. A study recently completed by J.P. Morgan illustrates that point. They indicate that over the last 20 years, the S&P 500 has produced at an annualized return of 9.9%. However, if you were in 60% stocks and 40% bonds, you produced 8.7%. If that is flipped and you have 40% stocks and 60% bonds, it would be 8.1% annualized. Bonds come in during the study at 6.2%, gold 5.9%, oil 5.7% and homes and your principal residence 3.2%. Therefore, clearly as an asset class, stocks have outperformed virtually any of the alternatives. Yet, the pessimism continues to rise and the skepticism in the press is almost deafening; and it is consensus that surely, from a financial standpoint the world is coming to an end.

These pages will try to put a different spin on that presumption. Lately, it seems to me that the market has been firming up nicely and with the backdrop of historically low interest rates, it is hard for me to see the market’s path of least resistance to continue to drift higher. It is remarkable that at the current time, the 10-year Treasury bond has hit an all-time low in rates of return. As I am writing, the 10-year Treasury is yielding an anemic 1.395% 10-year yield. What is interesting about this yield is that the S&P index now has a current yield of about 2.1%, which is well above the 10-year treasury. Everyone keeps asking how the 10-year treasury continues to go down. In the era of fast money, that answer is crystal clear.

The equivalent of the 10-year German bond has a return now of -.1962%, which means that if you invest in a German bond, you get back less money at the end of 10 years that when you actually invested. In addition, the Japanese 10-year government bond has a yield of -0.294%. The exact result of Germany is also reflected in Japan. Around the world, money is flowing into the United States seeking yield. If you are holding a German or Japanese government bond, my suspicion is that you would rather own a U.S. bond paying something rather than those bonds paying nothing (or worse – negative yield). The corresponding result is that every time these investors move from their local currency to the U.S. dollar, it weakens their currency and strengthens the U.S. dollar. I guess no one has really noticed that the Japanese yen is now on par with the U.S. dollar. During the 1970s, when Japanese car builders were considered the best in the world, the yen was 300 to 1; today, it is 100 to 1. All advantages that once were realized by the Japanese in currency have evaporated.

As I mention every time, my three most important major components of investing are earnings growth, the economy, and interest rates. It looks like the current economic results will reflect a GDP growth of roughly 2.5% in the second quarter of 2016. This builds on a roughly 1% growth in GDP in the first quarter and projections now assume a GDP growth of close to 3% in the third and fourth quarter of 2016.

I was somewhat amazed when I picked up an issue of Barron’s the other day which the title read, “Recession is coming!” Since I did not share in that projection, I had a high desire to understand why they were projecting a recession when the economic indicators are so strong in a positive way. You had to read the article to understand, but basically the title was a tease. As the author explained, a recession will certainly be here at some point in the future, just not anytime soon. I concur with that assessment.

With interest rates and the economy in clearly positive ground, you have to be concerned about the third and most important ingredient, which are earnings. It is absolutely true that the S&P 500 earnings have declined over the last year and a half. It is not like companies are not increasing earnings; it is just that, on average, due to the huge hits taken by the oil industries, earnings have declined depreciably. That is all getting ready to change. It is now estimated that earnings will go up in every quarter for the rest of 2016. Based on this consensus, earnings should be up 8.3% in the second quarter, 19.2% in the third quarter, and a whopping 37.4% in the fourth quarter. I am not so naïve to not realize that forecasters work based on assumptions that may or may not be valid. I did not repeat these projections to assume that they are guarantees. I am really not concerned about absolute increase in earnings as I am with the trend. Even if these projections were only 50% correct, the fact that earnings are projected to go up significantly between now and the end of the year should give you encouragement as an investor.

Actual Earnings - black
Projected Earnings - green

Therefore, once again, the three components of higher stock prices are in place at the current time. Interest rates are at an absolute all-time low, the economy is stable and actually moving up, and earnings have reversed the negative trend and are moving up positively. I guess you would have to say, as an investor, it really does not get better than this. In this writing, the S&P is virtually at its all-time high. That is clearly reflected by the better economic and earning results.

I would be the first to admit that the world has a lot of problems. If you watch the news in the morning, by the time it is over, you are almost ready to commit suicide. The drumroll of bad news never leaves the national news. I guess the old axiom “if it bleeds, it leads” should be the real title of any major news program.

It is my job to read and understand the news, but also to reflect the economics behind the news. I have so many clients who express dismay and fear regarding the future based upon the news. I often ask them what this really has to do with stock market performance. Do not tell me what the presidential election will do to you emotionally or mentally, tell me how it affects the economy and I will tell you how the stock prices will go.

Having started in this business with the stock market crash of 1987 and watching the Dow Jones industrial average grow from the low of 1,722 in 1987 to close to 18,000 today, I have to make sure I caution everyone that it would be a severe mistake to ever underestimate the U.S. economy. Today, if you put the 1987 stock market crash and plotted the increase over time, you would note that this correction does not even appear as a bleep in the growth of the U.S. markets.

Going forward we are watching and learning. There is no reason to assume that a huge correction would occur, but that could change at any time. If and when that correction occurs, we will obviously move quickly and decisively to different positions, but for the time being, all is well and we intend to hold the course.

If it is true that the consumer provides the energy for the growth of the GDP, the news is currently outstanding. It is assumed that the consumer sector provides 70% of the growth in any GDP. Recently, it was announced that household debt had been reduced to 10.1% of disposable personal income. Therefore, the U.S. consumer now has less household debt than virtually any time in the history of U.S. finance. In addition, the household net worth is now at its highest level ever. While clearly household net worth took a major hit in 2008, both in assets and in financial investments, all of this has recovered and is higher by roughly 1/3 than it was at the peak in 2007. Therefore, if it is true that the consumer provides the dynamite to blast the GDP higher, clearly, there is enough kindling in this fire to start it roaring again once any type of stability is reached in world problems.

I fully realize that no one cares as much about pets unless they are your own, but I did want to mention that my old Labrador, Daisy, passed away this month. It was time – she was 14 years old, had mothered 20 pups, and had both knees replaced. She was definitely struggling for the past few years. In fact, we added a puppy to the family 2 years ago for Daisy to enjoy a companion for the end of her life. She kept holding on until the very last second.

Daisy was never my favorite dog, but she was always the most loyal – you could not run her off, even if you tried. In fact, she may have been the most educated dog of all time. In the past 14 years, she watched the business news religiously from 5:00 – 7:00 a.m. every day, with absolute religion – as if she had a choice. Name me a companion who would have watched so much financial news – or anyone for that matter!

Daisy’s first litter of puppies was 7 yellow Labrador retrievers, 2 black and 1 chocolate (pictures below). The second litter was 6 blacks, 3 yellow and 1 chocolate. Both litters came from the same parents – father was a black Labrador, while Daisy a yellow. It is a marvel of nature that each of these dogs was absolutely pure in color, and not a spotted one among the group.

This section was not written for sympathy, as Daisy lived a long and fruitful life. Many of you have been to my house and met Daisy at one time or another, so I thought I would let everyone know about her passing.

Daisy - Christmas 2016

Daisy with her first pups

Daisy's First Litter

Daisy's Second Litter

Ava and her pup, CiCi

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

Best Regards,
Joe Rollins

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