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

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