Thursday, August 8, 2019

"Good judgement comes from experience, and a lot of that comes from bad judgement." - Will Rogers

From the Desk of Joe Rollins

The title of this blog has a lot of meaning to someone like me who has been in this business for over 40 years. So many of the decisions that we make here on a daily basis are not driven by the headlines or the heated conversations we hear on the nightly news. Many are based solely on the wisdom gained through experience (40 years in my case). You learn that many of the headlines have nothing to do with actually creating wealth, and more to do with influencing trading. We are investors, certainly not traders.

There was so much I wanted to discuss this month, but I had to completely rewrite the blog after the news at month’s end. July was an excellent month from an investment standpoint, but as the month closed, the news changed all of that, creating volatility and uncertainty. I often wonder who the trolls are that sit around their computers in the middle of the night trading futures and trying to influence true investors. I frequently watch as the news is reported, and the instant change in the futures by hundreds of points is baffling. Surely, these people have not had the time to evaluate the news in such a short period of time to reflect a true evaluation. I intend to discuss how these wild moves in valuation of the futures is not indicative of true economic performance.

Before I discuss all of those extraordinarily important and interesting topics, I have to cover the financial news for the month of July. Once again, the critics argued that the month of July would clearly be a slow moving and highly volatile time due to people being on vacation and not at their trading posts. The one thing that has proven to be absolutely true is that so much of the market movement is now on autopilot and not controlled by the traders. As an example, since the advent of passive investing, more and more investors only invest in indexes that are not affected by the wild movements of the traders. So, during the month of July, the indexes proved to be very resilient to volatility and continued to move higher.

Employee of 35 years, Mia Musciano-Howard's
twins Marti and Mitch (age 15) with Ava and Savvy, Ava's cousin

The Standard and Poor’s Index of 500 stocks was up 1.4% during July and sits on a sterling year-to-date increase of 20.2%. The one-year performance of that index is 8%. The NASDAQ Composite was up 2.2% during July and sits on a year-to-date gain of 24%. The one-year performance of the NASDAQ Composite is 7.8%. The Dow Jones Industrial Average was up 1.1% during July and is up an excellent 16.7% in 2019 and is up 8.2% for the one-year period ended July 31, 2019.

Barclays Aggregate Bond Index was up 0.3% in July, is up 6.3% in 2019 and is up 8.2% for the one-year period ended July 31, 2019. For the first time in recent memory, the Barclays Aggregate Bond Index actually had a higher yield than the S&P 500 for the one year period. This, of course, is due to the massive selloff in stocks in the 4th quarter of 2018. However, it is certainly not characteristic of the index, given the 10-year annualized returns of the S&P 500 is 14%, while the 10-year annualized returns on the Barclays Aggregate Bond Index is 3.7%. Certainly, over a short period of time bonds can actually outperform stocks, but over a longer time period the performance of bonds is not even close to the value of index returns. Bonds are at all-time highs, not good.

It was an interesting month from an investment standpoint. As expected, the Federal Reserve reduced their short-term interest rates by a quarter of 1% on the next to the last day of the month; but in the course of doing so, Federal Reserve Chairman Jerome Powell made an announcement that the interest rate was a “midcycle adjustment.” As those words left his mouth, the market sank hundreds of points - not for any particularly good reason, but just because the Federal Reserve did not guarantee additional rate cuts. Recognizing how silly that selloff was, the very next day the markets turned around and rallied up to and above the level of the selloff. Everything was looking extraordinarily positive since Federal Reserve rate cuts almost universally lead to higher stock prices.

However, at 3 o’clock in the afternoon, President Trump tweeted out that the United States would soon levy additional tariffs on China since China had failed to negotiate any form of trade relief. With that statement, the markets sold off dramatically and they continued to do so through the weekend. Just as it has done in the past, China immediately met the increased tariff by devaluing their currency, effectively making the tariff neutral. With that action, for reasons that defy good economic judgment, the market sold off even more.

Let us go back and review what exactly has happened to the markets since the President first announced new tariffs. The first tariffs were announced in January 2018 after the markets had a 20% gain in 2017. At this announcement, all of the economists and stock traders predicted total chaos and the market went down 10%. A few months later, the markets completely recovered that 10% loss and were having a sterling year through September of 2018 when, once again, the President announced a 10% tariff on additional Chinese goods. As we all know (and suffered through), the market went down an ugly 20% over a period of 90 days, but quickly recovered. You may even recall that in May of 2019 the market went down 6.6% when the President announced new tariffs on Chinese goods of 25%. However, during the month of July all of the major markets traded back up to their all-time highs so these declines were nothing more than movements to a market, leading to higher valuations. The tariffs have had zero real effect on the markets to date, and here we go again.

This is why I pointed out in the beginning that good judgement over time is so much more important than reacting to everyday news. What affects markets has nothing to do with tariffs or international news, but rather everything to do with recession. If you properly evaluate where the economy stands on a daily basis, you do not need to know any other news in order to determine which direction it is moving.

Back in January of 2018, when the first tariffs were proposed, economists everywhere warned of the dangers that these tariffs would bring to the U.S. economy. I vividly remember reading that there was absolutely no question that these tariffs would lead to more inflation in the United States. Which would also lead to a slower economy that would almost universally predict recession in the United States - people would be out of work, breadlines like those during the Great Depression would form, and pure chaos would overtake the U.S. economy. And what was the outcome in the 1.5 years since the tariff increase? Virtually no effect on the U.S. economy at all.

Savvy (age 16) and Ava

On Friday of last week, the Treasury announced that the increase in GDP for the second quarter of 2019 was at 2.1%. In fact, the report on the GDP was actually much better than the headline number indicated. While the GDP was down from the first quarter’s excellent growth of 3.1%, this quarter was hampered by a significant move down in the value of inventories, which if properly evaluated would have actually put the GDP growth at 3% again this quarter. Also, it indicated that personal consumption was higher, and we all know that the consumer controls 75% of the GDP anyway. And what about inflation one and a half years after the first tariff increase? Based upon this report, the Federal Reserve announced a 1.4% increase in inflation, well below the 2% level they desire. So basically, the economists that projected total chaos in the U.S. economy were clearly incorrect regarding growth and inflation. But what about employment, surely it was down?

For the month of July, employment continued to grow at a very healthy rate. The U.S. economy added 164,000 jobs and unemployment remained at 3.7%. Remember that unemployment here in the United States is at a 50-year low and even more importantly, the underemployment rate also fell to 7% during the month. This is the lowest level since December 2000, which was after the incredible boom in the dot-com era when the entire economy grew super-hot and beyond its abilities to sustain that growth. As you can see from the figures above, those so-called expert economists were absolutely wrong when they predicted (1) that the economy would fail, (2) inflation would soar, and (3) unemployment would be widespread, bringing the economy down. They are batting 0 for 3 and will be wrong again, as I am predicting in this posting.

One of the things that has always baffled me about the tariff debate is what exactly do we import out of China that is a necessity in our everyday life? The numbers alone are clearly compelling. U.S. exports are only 12% of the U.S. economy and therefore not a significant number that would dramatically affect the economy one way or the other. Imports are only 15% and therefore, once again the effect is only minimal. While the President always likes to say that the Chinese themselves are paying the tariffs, that is clearly not the case. It is the people purchasing the goods from China that are paying the tariff through an increase in cost. To a large degree, these costs have been neutralized by the Chinese decreasing the value of their currency, therefore keeping the cost at a low level. So net effect after currency adjustments, big fat zero.

However, the above does not actually illustrate the effect on consumers. For the most part, we only import things of low value from China. Sure, we import coffee makers, microwave ovens, etc. but these are not items necessary in everyday life. These are also items that can be imported from other countries such as, Indonesia, Vietnam, Mexico, etc. And did you know that China is not even the #1 importer of the United States? China has fallen to #3 with both Mexico and Canada importing more goods into the United States than China itself. The effect of the U.S. consumer having the ability to transfer those purchases to other countries certainly validates the concern that the President has. If an item becomes too expensive because it is imported out of China, the consumer will simply not purchase it. In fact, very few items could only be manufactured in China and not in other countries. As more and more companies move their manufacturing facilities out of China, the effect of the tariffs on final goods is significantly reduced. Since these items are not critical, the consumer does without.

But what exactly is it that we export to China? Semiconductors produced in the United States are produced nowhere else in the world. This technology drives virtually every component of our high-tech life. Even the Chinese smart phone manufacturers use chips that are produced in the United States. Are you under the assumption that China could do without semiconductors produced in the United States? That is impossible to assume. Yes semiconductors are assembled in Asia, but the software is all U.S. based, and critical.

I concur with the President’s assumption that China must be brought on board to comply with the world’s protection of technology. For many years, the Chinese have indicated that if you manufacture in China, then you must turn over your technology to them. That is clearly in violation of the rules of global commerce and the Chinese must be held to the same standard. While the actions of the President are extreme in some cases, it appears that they might in fact be working and I agree they are way past due. For decades, U.S. Presidents have ignored the effects that China has on the transfer of technology and we can no longer do so. While we can clearly do without toasters, blenders and microwaves, they cannot do without U.S. technology. By limiting what they buy, we will slow their economy a lot faster than just limiting how many blenders they actually produce.

So, we headed into 2019 with “fears” of corporate earnings crashing and burning, soaring interest rates and disastrous earnings. None of these predictions have taken place. After the announcement of the one quarter of 1% rate cut by the Federal Reserve, interest rates on ten-year treasury bonds didn’t rise, but actually fell. At the close of business at the end of July, the ten-year treasury was at 1.8%, which was the lowest level it had been since the beginning of 2017. These low interest rates will almost assuredly reinvigorate the housing market and the investing market. Both of these low interest rates are very good for the economy. As pointed out previously, employment remains extraordinarily strong and interest rates are low and the economy is stable. As we can see, the trifecta of components for higher stock prices is in place. None of us can forecast the future and none of us know exactly what will happen with this increased threat of tariffs, however, with history as your judge, you can see that the effect on the economy thus far has been very muted.

If we were to see a major reduction in earnings as we move forward, I would be concerned; however, the current projections actually show exactly the opposite. We were told that earnings would suffer a major decline in 2019 because of the tariffs. In fact, it looks like for the second quarter of 2019, earnings will have increased by 2.1%. While 2.1% is not a huge increase, you need to put into perspective that this is against all-time high earnings from the previous year. What is fascinating about the discussion of comparative earnings is that they are up against a quarter when the effect of the tax decrease was not even in play. The actual accounting for the lower end of corporate tax rates did not occur until the fourth quarter of 2018. Therefore, the accumulative effect of the comparison in earnings where apples equal apples and tax rates are low for both quarters will not occur until the fourth quarter of 2019. If the projections for fourth quarter earnings are correct, the year-over-year increase would be a staggering 23.6%. No one absolutely knows what will occur in the fourth quarter of 2019, but even if that percentage is wrong by a factor of one half, a 10% increase in earnings year-over-year cannot be anything other than a positive effect to the economy. Do not let the media confuse you on economic terms.

As I started this blog, I pointed out that experience brings knowledge. So much of the knowledge that we have today is because of mistakes we have made in the past. Hopefully, you learn daily by prior mistakes. I am often amused when I read about people nowadays who portray themselves as being financial consultants. I read that life insurance agents, stockbrokers and young kids right out of college consider themselves to be financial analysts and consultants. I would argue that you can learn to be a stockbroker in a year or two, but you cannot learn to be a financial consultant in 20. It takes many years of analyzing data and seeing the effect of the markets to really know what to expect. After 40 years of actually investing money for clients, maybe we have seen more and done more than the average financial advisor and therefore maybe we do it better. That is my story and I am sticking to it.

I fully expect that for the rest of the summer and the first month of fall that we will see high volatility. There will be days the market will move dramatically one way or another without rhyme or reason. The reason I think we are going to get this volatility is that the pros have not made much money in 2019. The market has vastly outperformed most everyone’s projections and therefore the pros have underperformed. The only way to make money is with volatility. They do not care which way the markets move; they just make them move. While I think this volatility will be heightened as the year progresses, I do not anticipate that it has any long-term effects and the year will still end up being quite satisfactory as we projected.

Joe and Ava enjoying some time in the ocean

At the beginning of this year, based upon the analysis that I prepared at the end of 2018, I projected that the S&P 500 would reach a level of 3,000 at the end of 2019. Since we have already exceeded that level of 3,000, I would say that that projection needs to be updated. Based upon all of the information I have now, it would appear to me that the S&P should end the year at 3,100 and therefore, even though we should suffer high periods of volatility, the trend is clearly up and not down.

The sad news about tariffs is that only one man, the President, controls them, He can, at any time, make them go away with one signature. So politics then turns into this game of chicken. I will give you another projection; I think the tariffs will be settled immediately before the next election, about this time next year. The sad part is that no one will care if it is a good deal or bad deal, it will be celebrated either way. I hope the President does the honorable thing and makes the Chinese do what is right before settling. Whether he does or not, the media will love it and the economists that have been so wrong so often in the matter will line up and tell you “I told you so.” Only here did you get the real facts about tariffs and not the opinions that were wrong.

I have been asked by several readers to retell the story of my father and the history of my upbringing. My father was a big influence on me, although we were never close on a personal level. Since he was a minister, it seemed that he had a meeting of some sort or another at the church every day of the week. Obviously, I was gone during the day at school and he was rarely home at night. In fact, he never saw me play basketball until I was on a college team. But he was truly an inspiration for his intellect and his career.

As I have often relayed, my father graduated from the University of Tennessee with a master’s degree in electrical engineering. Anyone aware of the demands of electrical engineering understands the rigid requirements. To his bad luck, he graduated during the great depression and of course there were no jobs available. It was not that he did not seek out a job, there were simply no jobs available to anyone.

He returned to his home in Chattanooga and after not finding work, he took a remedial high school teaching job where he taught both mathematics and his first love, building things in the shop. His entire life he loved working with wood and he thoroughly enjoyed teaching it to high school students.

His father, my grandfather, was always very active in the church and since the church was only a short walk from his house, they attended often. My father fell into the Ministry, which would end up being his lifelong job and he never returned to electrical engineering. I have often said that my father could do absolutely everything and that was very much the case. One of the interesting aspects of my father was that when we were in Abingdon, Virginia, he became a district superintendent to 114 churches. He did not have a specific church to work at any given day, but he had managerial responsibility over 114 of them. Most of these were very rural churches, sometimes only having 20-30 total parishioners. I spent many of my formative years going with him to these churches, where he worked out the economics of a small church and would always preach the service.

Another lifetime remembrance I have is that he was the only white minister in town at that time that would marry a black couple. In Abingdon, Virginia during the early 1960’s it was a very segregated community. Obviously, the number of black ministers was limited and they all knew my father would marry black couples at any given time. I spent many of my Saturdays and Sundays opening the door for young black couples wanting to get married. I also remember that my father oftentimes would come in from the garden covered in mud to prepare the service. No one ever called to make reservations; they would just show up any time - day or night. I also recall that the compensation for the service was exactly one dollar. That one dollar always went to my mother to be spent on her children. My mother never spent any money on herself; it was always money for the children. My father and mother managed to send 5 children through college without loans when the most he ever earned as a minster was $14,000.

My father’s last assignment was in East Ridge Tennessee. At that time, East Ridge was principally white, but the segregation of the city was ongoing. There was a complete war within the city limits of East Ridge regarding the integration of churches and my father became a central figure in the controversy as he openly campaigned for new members, regardless of their color. The stress and controversy over this took a major toll on his health and he died of a heart attack at age 67, when I was only 25. Maybe he did not need to fight that war, but he always did what he believed to be the right thing. He could have made a lot more money in business, but this was his calling.

At that time, I had already moved to Atlanta, but I went back for the funeral. What made a large impression on me was that members of the various churches where he had preached made the pilgrimage to Chattanooga. People I had never even met and members of the churches he had been 15 or more years removed from showed up at the funeral. The church was overflowing with people who came to express their condolences and I had no recognition of ever meeting most of them. The inspiration to do good and work hard, and in turn be an influence in someone’s life was not lost on me. We should all be so lucky.

On that note, come 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.



CiCi at the beach

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

Best Regards,
Joe Rollins