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

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