Tuesday, March 5, 2019

"Stocks off to best start in 28 years." - Barron's, March 4, 2019

From the Desk of Joe Rollins

It is really kind of hard to believe how well the stock market has done through the first 2 months of the year. We have had the best stock market since 1991 amid the most negative and derogatory news cycle in my professional career. How is it that stocks could perform so well during a new cycle that is so negative? Well, there is a simple answer to that question. Blame the “goldilocks” economy, not too hot and not too cold, just right.

I have a lot of things I would like to cover in this posting that I find of interest. First, I would like to go through some of the economic evidence and perhaps give you some ideas about why textbook economics does not work in this environment. Also, it seems that the current media darlings are the socialists that are hoping to see the U.S. economy convert into a socialistic one. I suspect that most readers of this posting really do not understand what a socialist economy is, so I would like to take the time to explain it. Also, I would like to give you examples of socialist economies and their ultimate failures.

It is very interesting to see potential presidential candidate, Bernie Sanders, and the star of the media, Alexandria Ocasio-Cortez, with their new proposals regarding the economy. Alexandria is too young to have a history of prior quotes, but Bernie Sanders is 77 years old and has many. I will give you some of his past quotes to demonstrate the absurdity of his current proclamations regarding the economy.

However, I must first start out with reporting the excellent month of February. The Standard & Poor’s Index of 500 stocks was up 3.2% during the month of February and is up 11.5% for the 2019 year. For the one-year period, it is up 4.7%, for the three-year period it is up 15.3% and the 10-year period it is up 16.7%. Quite excellent numbers across the board. The NASDAQ Composite was up 3.6% for the month of February, up 13.7% for the year 2019, also up 4.7% for the one-year period and up 13.1% for the 5-year period and up 19.9% for the 10-year period. The Dow Jones Industrial Average was up 4% for the month of February, up 11.6% for the year 2019 and up 6% for the one-year period ended February 28, 2019. For the 5-year period, that index is up 12.4% and for the 10-year period it is up 16.8% annually.

I always like to compare stocks with bonds so that you can get a feel for how different the indexes really are. For the Barclays Aggregate Bond Index, it was actually down -0.1% in February, although for the year 2019 it is up 0.9%, for the one-year period it is up 3.1% and the five-year period 2.3% annualized and 3.6% for the last 10 years. For those that thought bonds would have protected you in the selloff of the fourth quarter of 2018, you can see that stocks vastly outperformed bonds over any relative time frame.

The Rollins Group Partners -
Danielle Van Lear, Robby Schultz, Joe Rollins, Eddie Wilcox

It has actually been an amazing economy recently, even with the tremendous selloff in the fourth quarter of 2018; which, as I reported here, had absolutely nothing to do with the economy, earnings or interest rates. That selloff occurred because of the hysteria regarding the ill-placed and ill-advised concept that the Federal Reserve would continue to raise interest rates and throw the economy into a recession sooner rather than later. That concept was so ridiculous as to not be taken seriously, but yet the market sold off regardless.

It has been an impressive run by the economy and undoubtedly there are parts of the economy that are beginning to slow. We are seeing industrial production down and, of course, new home sales have tapered off. Not that this is a negative, in fact, it is very much so a positive. The economy reported a GDP recently in the fourth quarter and was up 2.6% for the quarter. Quite frankly, that is an impressive number. Plus, it is not so hot to force the Federal Reserve to increase interest rates, but also not so slow for them to cut rates.

The general consensus by those who forecasted the GDP for the first quarter of 2019 are currently forecasting it to be below 1% growth. While it is historically normal for the first quarter GDP to be slowed, this one was particularly affected by bad weather. Having the worst weather in decades in the North has slowed production and obviously brought construction to a halt. We should expect a significant rebound in the second quarter of 2019, as the weather improves and people are able to work outside.

The decline in the economy in the first quarter will have major positive impacts. With the Federal Reserve basically on hold, there is growing likelihood that their next rate change might be down rather than up. I cannot even explain to you how bullish a change down in interest rates would be for stock market performance.

Just the other day, President Trump tweeted that the only thing holding back the U.S. economy was the strength of the U.S. dollar and the Federal Reserve. The reason that the U.S. dollar is strong is that we have the highest relative interest rates in the world. Our ten-year Treasury bond yield is roughly 2.759% which is the highest rate among developed economies. In the United Kingdom the ten-year Treasury yield is 1.299%, in Germany an unbelievable 0.189% (basically 20% of 1%). Even better yet, in Japan the ten-year treasury rate is -.09%. As you can see, in Japan you have to pay the government to hold your money for 10 years. The economic effect of all these low interest rates is pretty simple. Money goes where it is best treated, which is currently the United States.

Money flows throughout the world, finding the U.S. as a safe haven with higher interest rates. This leads to countries selling their local currency and buying U.S. dollars. This effect strengthens the U.S. dollar against the rest of the world’s currencies, making U.S. exporters less competitive. What President Trump did not say in his tweet, but really meant, was that if the Federal Reserve would cut interest rates, making the U.S. dollar less attractive, the value of the U.S. dollar would be reduced, making U.S. manufacturers more competitive. While it is unlikely that the Federal Reserve would not react to anything resembling political pressure, it is probable that they have secretly considered that thought. If, in fact, the Federal Reserve would cut interest rates from the low level they already stand today, it would be an enormous boom to the stock market and it would move even higher than it is today.

Therefore, notwithstanding the negative news by the media, it is the best of time to invest in the stock market. We have an economy that is not too strong, but not too weak either. It is a time where earnings continue to be excellent, interest rates continue to be low and the economy is just right. We have now recovered virtually all of the down swing brought about by the stock market in the fourth quarter of 2018 and remain only a few percentage points from an all-time high. Fortunately, we have stayed invested during this entire cycle and it has been quite beneficial to our clients.

I am often asked why the younger generation supports a socialistic economy. The answer is pretty simple. If you think about it, socialism sounds very attractive to anyone. Just think of the concept of everyone being equal. There are no rich, there are no poor, no worries about incentives or greed - everyone is exactly the same. There are no hungry people, everyone has a job and everyone earns the same amount. Essentially, it is a concept of collective ownership. Everybody owns everything and of course this means that the government owns all businesses and there is not competition since everything is owned by the government. Also, you have maximum social welfare. All medical insurance is free.
CiCi and Ava on Valentine's Day

CiCi photobombing Ava and Carter

Basically, the government provides for your every need and it provides free education for all. If it was not for my 40 years of studying economics and economic trends, then I would have to say that sounds pretty good. No longer do you have to beat the guy next door, because he makes exactly what you make, and they make the same in Georgia as they do in New York. Equality abounds throughout the economy, and that is the way that socialism is taught in schools. In fact, that is exactly how it works. All for one, one for all and everyone has the same. Sounds pretty good to young minds that do not have the experience of reality.

When you hear Alexandria Ocasio-Cortez talk about her Green New Deal, you have to sit back and really understand exactly what she is talking about. She is talking about universal Medicare and social welfare for everyone. As you can imagine, this program would cost umpteen trillion dollars. Not billions, but trillions. Would everyone be better off because of this free concept? Let us evaluate what takes place in Cuba.

In 1959 Fidel Castro essentially took over the state of Cuba with the intention of building the perfect socialistic economy. Of course, his concept was built on the Communist concept of Socialism where there is not representative government, but rather a dictator that dictates the economy and controls all of the systems.

In Fidel Castro’s world everyone is paid basically the same. Yes, it is true that some citizens make more than others, such as doctors - rather than making $50 a month, doctors may make $70 a month. Education is fully provided for and healthcare is free to all. All businesses are owned by the government and free enterprise is essentially not allowed. It is the strictest definition of socialism in every regard. Now exactly how has that worked out?

The problem with socialism is that it does not provide any incentive for people to succeed. In fact, it provides a disincentive for people to succeed. If you make exactly the same amount of money working hard in the fields harvesting sugar cane as the guy sweeping the streets of Havana, would you choose the more difficult job or would you select the easier of the two. Private businesses are not allowed, the government owns all of the enterprises, the hotels are in disrepair and there is essentially no manufacturing on the island. What is the incentive for an entrepreneur to come up with an idea, if he makes the same amount of money as a street cleaner?

So, what has happened in Cuba is what has happened in every socialistic country from the beginning of time. Slowly the economy deteriorated and the majority of people with skill left. So, in Cuba, their citizens leave the country as soon as their education is completed, leaving a state of only young people and old people and no economy to generate the taxes needed to support the country. There is virtually no agriculture in Cuba, and roughly 80% of their food products are imported. The reason is that even though Cuba has abundant, fertile fields for growing food, no one has the desire to work hard in the sun when they could get the same benefits as those that do not.

This is the reason why socialism does not work, there is no incentive. The same thing happened in Russia. Even though it was a Socialist economy in 1989 with the Reagan buildup in military arms, it was essentially bankrupt. They converted to a somewhat representative government, but the economy has not expanded greatly. Unfortunately, the government sold off all businesses to political figures that became rich beyond anyone’s belief, but the average Russian has not benefited. Even today with the discovery of huge natural resources in Russia, their economy lags behind unproductive countries such as Italy and others.

What is even more amazing is that presidential candidate, Bernie Sanders, who is a self-described Socialist, is not even educated by history. He would love to convert the U.S. economy to a socialistic economy, not withstanding the fact that socialism has never really worked. He is also so blind to the obvious that he cannot dismiss his prior comments as being absurd. Bernie Sanders has been infatuated with the so-called socialist dream for nearly a decade, and potentially longer. He posted an article on his website entitled “Close the Gaps: Disparities That Threaten America” back in August of 2011, which contained a quote that reads, “These days, the American dream is more apt to be realized in South America, in places such as Ecuador, Venezuela, and Argentina, where incomes are actually more equal today than they are in the land of a Horatio Alger.” Sanders categorized this article as a “must read.”

This quote from the article that presidential candidate Bernie Sanders posted, can be reviewed by looking at current day’s activities. Venezuela, which was governed for many years by Hugo Chavez, has drifted into total chaos. Essentially, the economy is not working at all and they cannot even provide food to their citizens. Inflation is running at 1,000% annualized and even though the country has massive economic resources and vast supplies of oil, it does not have any economic resources or technology to abstract it from the land.

While Argentina is somewhat better, it too has fallen into a bad economy and a poor standard of living for its people. Ecuador may be even worse than the previous two. In retrospect, the American dream in Bernie Sanders' eyes is better realized in those countries that have virtually no economy, no technology to speak of and frankly limited future. Their governments are controlled by quasi dictators and they do not allow external capital to exploit their resources.

Bernie Sanders may think the United States economy would be better suited where everyone made the same as they did in these South American countries, but clearly it would not work. Take the classic Socialist example of Cuba and why such a vibrant country with such vast natural resources has fallen into essentially bankruptcy with no ability to feed its people or to provide a robust economy. As compared to the United States, where we have the strongest economy in the world, ample incentives for entrepreneurs, and the place where most everyone wants to work. As the old politician said, “United States is the country everyone hates, but the country where everyone would prefer to live.”

As you can tell, many of the current media stars today are born again socialists. I do not question the reasons why the media gives these socialist super stars such glowing praise except I blame the education they received. They do not have the experience of watching socialism fail in every country where it has been practiced.

I often have many people tell me that China is a Socialistic economy, but they are wrong. It is true that China has a Communist government, but its economy is extraordinarily capitalistic. Yes, government gets involved in businesses, but there is clear differentiation between the rich and the poor. Businesses are owned by Chinese nationals and the economy is controlled by their successes or failures. China is clearly not a socialistic economy, as is Cuba today and Russia before it failed.

Other countries like Sweden, Norway and Denmark practice a form of socialism and supposedly have the happiest citizens on earth. However, it is also true that these countries have the highest tax rates of any country in the world but it really does not make much of a difference considering nearly everyone there works for the government. It is a form of socialism, but not as extreme as practiced in Cuba and formerly in Russia. As mentioned above, socialism is rampant in South America today but is an outright undeniable failure. Is that really what Bernie Sanders and Alexandria Ocasio-Cortez want for America? You judge for yourself.

I try to stay away from political matters in this blog, but there is one that needs to be discussed so that you get a feel for the current political environment. Under general economic principles, it has often been said that huge government deficits are very much a negative for the U.S. economy. Under economic theory, if the government is issuing bonds to finance deficits then the government issuing these bonds would crowd out the private investor, creating inflation in a negative economy. The idea being that as more and more government bonds would be issued then they would have to pay more and more interest on those bonds and therefore the deficits would not be reduced, but rather increased. The huge ongoing governmental deficits would create an unconstrained inflation and essentially throw the country into insolvency. That is the theory, let us talk about the reality.

Often times in economic classes they would cite the economy in Germany during World War II. It is pretty simple to understand exactly what the theory was if you think about the German economy. Germany was essentially a very small country that elected to fight the entire world in World War II. Obviously, they did not have the financial resources to declare war across the world since their economy at that time was extraordinarily small. But they had one important attribute that made it possible. Germany had the ability to print Deutsche Marks with abandon. So, in order to finance their economy, they printed billions and billions of Deutsche Marks to buy military armaments and pay their soldiers. In essence, the war was fought with huge negative deficits backed up by the printing presses that printed money so that they could carry on with their military efforts.

To draw a parallel, the United States did the same thing during World War II. Many of you have probably seen the old war bond efforts where famous actors and actresses would promote war bonds during World War II so the government could finance the war effort. While the U.S. was also able to print money to support the war effort, it was obviously never on such a scale as Germany. In fact, even though FDR was given credit for turning the economy around from the Great Depression in the 1930s, it was not until the early 1940s that the economy turned around with the deficit spending for the war effort. Due to the huge deficit of spending during the war to build military armaments, the economy improved thus leading to a good economy for many years to come. Germany, on the other hand, did not experience the same outcome.

Josh and Charles Barkley

In Germany, they were printing so many Deutsche Marks, that inflation became rampant. No other country would accept this currency given the fragile nature of the German economy. It was led to believe that the German army was literally paid every single day because the currency was so worthless that by the second day it would already be devalued again. So as the war progressed, the German economy was run on deficits and the printing presses for the Deutsche mark. The economic failure of Germany can closely follow the decline in the military effort. Since the soldiers could not use the money that they were being paid, and Germany could not buy products from different countries because the currency was worthless the country fell into economic despair, which was certainly one of the contributing factors to its failure in the second World War.

So, what does all of this have to do with the U.S. at the current time? During the 8 years of the Obama administration, the United States ran up the largest deficits ever in history. During the Obama years, he accumulated more deficits than all of the previous presidents combined. President Trump has also not been exactly great with deficits and we are now approaching one trillion dollars annually in federal deficits, yet we are experiencing the exact opposite in the economy of what happened in Germany.

As compared to Germany, our interest rates have not accelerated and, in fact, stand at almost historic lows. We are now at a 10-year treasury rate that borders on the lowest rate ever in the history of American finance. How can you explain the fact that we are running huge federal deficits and issuing huge amounts of government bonds to pay for this deficit, but yet interest rates have not gone up?

Even more importantly, contrary to the predictions of so-called experts in the field, inflation has not gone up at all. Inflation is extraordinarily tame at this time, which is very important to the economy. In addition, unemployment today at around 4% is even lower than the 5% that so-called experts refer to as full employment. So, we are clearly in a conundrum. We have huge deficits, but yet we have low interest rates and virtually no inflation. I assume that someday someone will write a history book on why the U.S. did not realize the negative economic impacts of the currently huge deficits.

They may have their negative impacts in the future, but really not today. So once again, as illustrated above, the U.S. economy remains robust, interest rates are low and inflation is constrained. More importantly, corporate earnings are the highest ever in the history of American finance and while they may be slowing, they are still quite robust. It is the “goldilocks” of all economic factors that increase stock prices. Not too hot, not too cold, just right.

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, February 5, 2019

"The case for raising rates has weakened somewhat...We had the luxury of patience." Federal Reserve Chairman, Jerome Powell, explaining the decision to leave rates unchanged.

From the Desk of Joe Rollins

The month of January was quite extraordinary from a financial standpoint in virtually every respect. It is hard to imagine that as bad as December was, January almost made up the losses for all of 2018. While the S&P was down 4.4% for 2018 the Standard and Poor’s Index of 500 stocks was actually up 8% for the month of January. In fact, it was the best January for the S&P since 1987. Even more interesting, it was the best month for this index since October 2015. From the day after Christmas through January 31, 2019, stocks appreciated 15.9% and have already accrued $4 trillion in additional wealth for investors. What could possibly have created this huge reversal of fortune for the equity markets? I will try to explain that phenomenon later in this posting.

I have many things to cover that I found interesting this month. One of the beauties of writing about finances is that you get to criticize the politicians who should know better. Also, I need to explain why employment continues to get better and the effect it has on the U.S. economy. Despite all the negativity we have heard during the month of January, the market has continued to move higher and the world has gotten better economically. Throughout this blog, I will explain this phenomenon, as well as why you should not fear the machines, and why the world’s economies are slowing down (don’t worry, that’s a good thing).

Our client, Dr. Lloyd King, riding a camel! 

Before I cover all of the terribly interesting economic events of the month, I must report on how excellent January was. Although the one-year numbers continue to be negative, they are only slightly so. Even with the disappointing 2018 numbers, the ten-year numbers are all double digits and quite excellent. For the month of January 2019 Standard and Poor’s Index of 500 stocks was up a sterling 8%, while the one-year returns were - 2.3%, with the ten-year average return up 15%. NASDAQ Composite was up even better at 9.8% for the month of January and only a -0.7% return for the one-year period then ended. For the ten-year returns, the NASDAQ Composite was up 18.6% annually. The Dow Jones Industrial average was up 7.3% during January, down 2.2% for the one-year period and up 15% for the ten-year period. For comparison, the Barclay’s Aggregate Bond Index was up 1% for the month of January, up 2.3% for the one-year period and has ten-year average returns of 3.6%. The difference between the bond index and the equity index illustrates how extreme the differences are between the equity markets and the debt markets.

I would have to describe the 2018 4th quarter equity market action as total chaos. I am not sure that the information flowing from the financial journals and commentaries was “fake news” per se, but I would like to emphasize again, as I did during that quarter, that it was definitely exaggerated and unrealistic. For some reason financial commentators believed that the Chairman of the Federal Reserve, Jerome Powell, was on autopilot with every intention of increasing interest rates to the point of throwing the country into a recession. I never understood exactly why they came to that theory, given these are very learned professionals who understand economics and certainly have no intention of hurting the U.S. economy.

All of that changed once Jerome Powell indicated that no interest rate hikes were likely needed and that any future rate increases would be data dependent. The equity markets then settled down and moved higher. Rather than seeing at least two rate increases in 2019 as originally projected by the Federal Reserve Board, the futures now reflect no rate increases in 2019. In fact, those same futures indicate we are as likely to see a decrease in interest rates as we are to see an increase. The importance of this change in policy by the Federal Reserve cannot be underestimated. Those of us who have been around the financial markets for decades understand the importance of keeping the Federal Reserve on the sidelines.

I witnessed the ups and downs of the financial markets under Federal Reserve Chairman, Alan Greenspan, many times during my life. I vividly remember when he came into office originally in 1987 and his first act was to immediately increase interest rates, creating the largest selloff ever in the equity markets. I also remember in the mid-90s when he increased interest rates 17 times in a row for no apparent reason, which forced the markets into another downturn during the turn of the century. I would like to think that with the help of sophisticated computers, economic forecasters are more accurate than the days when Mr. Greenspan predicted trends on a yellow legal pad.

The best case for those investing in the equity markets would be for a non-existent Federal Reserve. It is sort of like a football official. If they haven’t been mentioned by the end of the game, they must have done a good job. There is no reason for the Federal Reserve to want to hurt the economy. Don’t forget that the mandate of the Federal Reserve is two-fold and neither one have anything to do directly with the economy. The role of the Federal Reserve is to control inflation and maintain full employment.

Today we have inflation well under control and the number of people employed in the United States is at a one- hundred-year high. Even during January, a period which is historically slow due to bad weather and the decline of the retail industry after the holidays, the economy added over 300,000 jobs. The fact that the unemployment percentage nudged up to 4% from 3.9% is of no concern given that the employment percentage was diminished by new employees entering the workforce. The participation rate for employment is improving, which indicates that more people have found work or are actively looking to enter the workforce, therefore helping the economy.

During the fourth quarter of 2018, there also was a huge level of concern from the financial markets regarding the slowing of the worldwide economy. While unquestionably it is true that the economy in China is slowing, it still has a reported GDP of 6% or greater. Also, we saw the economy in Germany slow and the European economies in general breakeven. While there has not been any noticeable decline in the U.S. economy, the rest of the world’s declining economies have raised concerns about the earnings of U.S. corporations.

Ava & CiCi

While it may be true that foreign countries would buy less from the U.S., it would also be true that the slowing would basically put the brakes on the Federal Reserve. The last thing that the Federal Reserve would want to do would be to further diminish the opportunity for the U.S. economy to expand when the rest of the world is slowing. The desired result of any Federal Reserve, and what is certainly best for investing in our equity market, is for the world to grow at a moderate pace; just like a Goldilocks economy, “not too hot, not too cold”. If it is true that Europe is slowing and Asia is slowing, this will have a natural moderating effect on the U.S. economy, which in turn will keep it from getting too hot and having to be slowed by monetary means. I think that is exactly what Jerome Powell was saying when he expressed the lack of need for interest rate increases going forward. All of that is absolutely good for investing.

With the beginning of 2019 we are witnessing a new Congress and a new group of politicians that often speak without really understanding economic theory. During the 2016 election, many of my son’s friends, who were in college at the time, were huge supporters of Bernie Sanders. Not that they really understood anything that Senator Sanders was saying, other than the concept of free higher education. While that certainly sounded really good to people currently in college, there was really no realistic proposal on how to finance such free education. It is certainly easy to spend money you do not have, but to impact the economy for generations certainly requires a better understanding of past economic events.

Who could not be impressed by Alexandra Ocasio-Cortez? It seems like she is on every news program we see and she is certainly the new superstar of this new congress. Not to mention, she is proposing a 70% marginal tax rate for certain high-income taxpayers. We also saw a new proposal for a 77% estate tax from Bernie Sanders this week, and, of course, the ever-present Medicare for all and increased Social Security payments for the masses; all very interesting proposals that will certainly garner votes in their next elections. However, the impact of income taxes on the economy is crystal clear.

Three times in my lifetime have sitting presidents actually decreased income taxes and dramatically improved the economy. John Kennedy did it in 1962, Ronald Reagan in 1980 and Donald Trump in 2017. Do these politicians now think that history does not mean anything? It is interesting that in each of these cases the politicians, while defining their position as progressive, realistically are moving to a more socialistic economy. As I mentioned to my son’s friends in 2016, “If you want to see how well socialism works, go visit Cuba, Venezuela, or Argentina.” People forget that Russia had a socialist economy and a communist government during many of the years of the Cold War. But those same people have forgotten that in 1989 the Berlin Wall fell and while communist Russia became very capitalistic, their importance in the world has since dwindled over the years with a GDP today not even as high as Italy. The truth of the matter is that socialism has never worked anywhere in the world and these politicians who think now it will, are clearly misinformed.

Last month I wrote a blog regarding the machines that were controlling the ridiculous buying and selling during December. After that post, I had many clients and others inquire how they could protect their retirement from these evil machines. I tried to explain that one of the positive aspects of the machines is that they cannot “short” the market forever. Even they have limited capital and they would eventually have to sell the shorts in order to buy. Don’t forget that the machines were an integral part of the market’s increase from 2009 through 2017. While it was clearly a case of the machines going crazy during the fourth quarter of 2018, this 2019 rally has proven they too had to cover their short positions.

My argument then continues to be that you cannot worry about machine trading – worry only about the economy, interest rates, and earnings. If you have a working knowledge of each of these components, the movements on the market should not concern you. Fundamentals outweigh every other factor in investing. So many times during the fourth quarter of 2018 we had clients question whether they were invested properly during this downturn. Yes, it was painful, and certainly we did not enjoy it any more than you did, however, given the higher fundamental belief that the economy was good, interest rates were low and the future was bright, we continued to be fully invested and were rewarded when the market moved higher in 2019.

It seemed like there was an avalanche of negative financial news during the last part of 2018 and also during January 2019. And every time I read all of those negative headlines, I would worry about the invested public being misinformed. The fact is, financially things are much better throughout the entire world today than only a few years ago, but if you only read the financial headlines you certainly would not believe so.

Just how cynical progressive financial news has become was apparent in this week’s Barron’s article regarding advice published in the New York Times. A college student wrote to the New York Times and asked what would be the best way for him to invest the nominal sum of $1,000 in order to begin growing his investments. As quoted by the New York Times, “Investing is flaying yourself to whims of Capitalism. You’re a chump to them.” Have we actually become so cynical as to recommend that investing is a fool’s game? It clearly appears that the progressive New York Times, or certainly this particular columnist, has lost his grip on reality to offer such poor advice to our youth.

I ran across a very interesting article recently that was posted in the Wall Street Journal. Basically, this article set out many of the facts that I reported when I did the book review on Factfulness. Basically, what that book said was regardless of the negative whims of financial reporting, the world was actually getting better everywhere. Not only in the United States, but all-around world. As reported by Greg Ip, “the world was getting quietly, relentlessly better” and as recently as 1980 half the world lived in “extreme poverty.” Basically, that means that based on 2011 dollar values, 50% of the world’s population in 1980 lived on less than $1.90 a day. Today, the proportion of people living in extreme poverty fell to an estimated 8.6% last year and in all likelihood has even improved since then.

As of September, more than half the world - 3.8 billion people - are middle-class or wealthier. Another very interesting reason for this increase in wealth in the world is that child mortality, illiteracy and deaths from violence have all plummeted, and life expectancy has gone up. One of the examples they gave was that Nathan Rothschild was the richest man in the world when he died in 1836. He died from a common infection, a condition that can now be treated by antibiotics for mere pennies a day. Even though he had the greatest wealth in the world, he did not have the medicine to prolong his life, which today even poor nations have.

Ava drinking from the dog's water (age 1)

The basic truth in why the world economy is better and everyone’s lives have improved is that when you create wealth there is the effect of a rising current that lifts all boats. As I have pointed out so often, having people work creates a trickle down affect to improve the lives of many people. In China, as an example, roughly 30% of the population has moved from severe poverty to middle class in the last decade. That is not because someone handed them wealth, it is because they moved from the fields to the manufacturing factories, increasing their standard of living.

All of this raises the concern of why the news and the financial reporting are so negative. It is quite clear that most of world has improved economically, yet the criticism is never-ending. As pointed out in this article, “for most Americans life is getting better, median incomes are rising, average health is improving and violent crime, divorce and teen pregnancy are all trending down.” I wish that more people really understood the positive economic effects of increasing people’s standard of living and the downflow of this wealth through many generations, improving conditions for all. We are right in the middle of the greatest spread of wealth ever in the history of the world and yet reading the financial news would indicate otherwise.

So where do we stand today and what are the economic forecasts for going forward? There is no question that the worlds economies are slowing, but that’s a good thing since it will slow increases to interest rates. It is also true that earnings will only rise moderately in 2019. But even a moderate increase in earnings already at historical levels is still a good thing. It is also a good thing that as employment continues to rise and the standard of living goes up, we are not seeing any increase in inflation. And it is a great thing that interest rates are remaining low as it appears that the Federal Reserve is on hold for an extended period.

As I have said so many times before, those forecasting recessions in 2019 did not have a full grasp on reality. Whether it was intentional remains unclear, but what is awfully clear is that they were wrong. While it is perfectly possible that we might enter into recession in the United States in the second half of 2020, it is also clear to me that the moves made by the Federal Reserve this month might postpone that recession into 2021. In any case, the economy is great, earnings are great and interest rates are low. That is the trifecta of positive news that almost always leads to higher stock prices in the future.

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

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