Category Archives: Market commentary

Don’t Fear Higher Interest Rates

Here’s some weekly commentary from Brian Wesbury of First Trust 

The Federal Reserve has a problem.  At 4.1%, the jobless rate is already well below the 4.6% it thinks unemployment would/could/should average over the long run.  We think the unemployment rate should get to 3.5% by the end of 2019 and wouldn’t be shocked if it got that low in 2018, either.

Add in extra economic growth from tax cuts and the Fed will be worried that it is “behind the curve.”  As a result, we think the Fed will raise rates three times next year, on top of this year’s three rate hikes, counting the almost certain hike this month.  And a fourth rate hike in 2018 is still certainly on the table.  By contrast, the futures market is only pricing in one or two rate hikes next year – exactly as it did for 2017.  In other words, the futures markets are likely to be wrong for the second year in a row.

And as short-term interest rates head higher, we expect long-term interest rates to head up as well.  So, get ready, because the bears will seize on this rising rate environment as one more reason for the bull market in stocks to end.

They’ll be wrong again.  The bull market, and the US economy, have further to run.  Rising rates won’t kill the recovery or bull market anytime in the near future.

Higher interest rates reflect a higher after-tax return to capital, a natural result of cutting taxes on corporate investment via a lower tax rate on corporate profits as well as shifting to full expensing of equipment and away from depreciation for tax purposes.

Lower taxes on capital means business will more aggressively pursue investment opportunities, helping boost economic growth and the demand for labor – leading to more jobs and higher wages.  Stronger growth means higher rates.

For a recent example of why higher rates don’t mean the end of the bull market in stocks look no further than 2013.  Economic growth accelerated that year, with real GDP growing 2.7% versus 1.3% the year before.  Meanwhile, the yield on the 10-year Treasury Note jumped to 3.04% from 1.78%.  And during that year the S&P 500 jumped 29.6%, the best calendar year performance since 1997.

This was not a fluke.  The 10-year yield rose in 2003 and 2006, by 44 and 32 basis points, respectively.  How did the S&P 500 do those years: up 26.4% in 2003, up 13.8% in 2006.

Sure, in theory, if interest rates climb to reflect the risk of rising inflation, without any corresponding increase in real GDP growth, then higher interest rates would not be a good sign for equities.  That’d be like the late 1960s through the early 1980s.  But with Congress and the president likely to soon agree to major pro-growth changes in the tax code on top of an ongoing shift toward deregulation, we think the growth trend is positive, not negative.

It’s also true that interest on the national debt will rise as well.  But federal interest costs relative to both GDP and tax revenue are still hovering near the lowest levels of the past fifty years.  As we’ve argued, sensible debt financing that locks in today’s low rates would be prudent. However, it will take many years for higher interest rates to lift the cost of borrowing needed to finance the government back to the levels we saw for much of the 1980s and 1990s.  And as we all remember the 80s and 90s were not bad for stocks.

Bottom line: interest rates across the yield curve are headed higher.  But, for stocks, it’s just another wall of worry not a signal that the bull market is anywhere near an end.

 

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Investing vs. Trading

Market commentary from Brian Wesbury of First Trust.
Are you an investor or a trader? Investors think long-term, while traders focus on short-term price movements.
Trading furs, cloth, commodities, or tulips, has gone back centuries, if not millennium, but was about adding value and moving goods to markets. In other words, through trading many ran businesses that looked a great deal like investing.
The “ticker tape” allowed the trading of financial products, but after the Great Depression many wouldn’t touch stocks for decades. Now, financial market news and quotes are on TV all-day and pushed out over smartphones. This can encourage “trading” over “investing.” Or another way of saying the same thing, the short-term over the long-term.
For example, many people have zero idea what Bitcoin is, why it is needed, or what gives it value, but they are mesmerized by it nonetheless. It’s just digital scrip – an alternative to sovereign currency. It pays no dividend and isn’t widely accepted. No one knows if it will last.
In the meantime, there are monumental events taking place that get missed if one focuses on the trees and not the forest. Horizontal drilling and fracking are one of those.
Remember when the world was about to run out of natural gas and oil? Remember when the Middle East and Russia, because of their energy reserves, could dominate geopolitics?
Well, all that has changed. The US is now the world’s biggest energy producer and, by 2020, the US is likely to become a net energy exporter to the rest of the world. This explains the political upheaval in Saudi Arabia as the royal family moves slowly toward a more free-market friendly environment. Russia faces similar forces that, in the end, will create more global stability.
Because of US supplies, Europe can become less dependent on Russian oil and natural gas. In addition, just like when Ronald Reagan was president of the US, as the pendulum swings toward less regulation, lower tax rates and smaller government, Europe must follow suit.
The combination of these developments causes stronger global economic growth, which is great news for investors. However, the dominance of governments in recent decades, and the reporting of every utterance of Federal Reserve or foreign central bankers, creates anxiety among many investors. Some investors are worried about a flattening, or inversion, of the yield curve as the Fed tightens.
But these concerns are overdone. It’s true that an inverted yield curve signals tight money, but inversions typically don’t happen until the Fed pulls enough reserves out of the system to push the federal funds rate above nominal GDP growth. Right now, that’s about 3.5%, which means the Fed is likely at least two years away. And, the banking system is still stuffed with over $2 trillion in excess bank reserves. Monetary policy, by definition, is not tight until those excess reserves are gone.
Focusing on trading, and not investing, misses these longer-term developments and highlights short-term fears.  Patience, persistence and optimism help avoid the pitfalls of short-term thinking. The current environment will continue to reward those who stay focused on investing.
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The Weekly Market Review

Week of 10/30/17 – 11/03/17:
Last week wrapped up the busiest part of the earnings season with most companies having now reported.  Large caps continued the recent stretch of gains extending the streak of new record highs for the S&P 500, Dow, and Nasdaq.
The Nasdaq led the way last week adding nearly 1% while the S&P and Dow a gained 0.29% and 0.45% respectively.  Small stocks didn’t fair quite as well, own 0.87% as benchmarked by the Russell 2000.
Global stocks recorded gains led by emerging markets, which rallied back from a couple lackluster weeks to add 1.45%.  The ACWI and EAFE closed the week up 0.67% and 0.92%
respectively.
While headlines were primarily focused on earnings releases, investors also continued to monitor the political landscape, especially the announcement of a new Fed chairman –
Jerome Powell.
Rates decreased for the first time in several weeks while the dollar added to it’s recent rally.
The 10 year closed just north of 2.3% while munis and corporates also rallied.  Energy and Technology stocks responded the best to last week’s earnings releases,
while telecoms saw a major decline.
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Foreign markets are soaring

The US markets are reaching new highs daily and many investors are happy with the returns their portfolios have generated.  According to the Wall Street Journal the S&P 500 is up 13.9% year-to-date.

 But some foreign markets are doing even better.

For example, the Hang Seng (Hong Kong) index is up 29.4%.

Chile is up 28%

Brazil up 27.3%

South Korea up 22.1%

Italy up 16.4%

Taiwan up 15.8%

Singapore up 14.7%

As part of our asset allocation strategy we always include a foreign component in our diversified portfolios.  Over long periods of time international diversification has had a positive effect on portfolio performance.  That’s because the US economy is mature.  It’s harder to generate the kind of economic growth that smaller, newer, and less developed economies can generate.

There is, however, a level of risk as well as reward to global diversification.  It’s said that when the US catches a cold, foreign markets get pneumonia.

The U.K. market is up only 5.8% this year, Shanghai +9.1%, Mexico +9.5%, Japan +9.6% and France +10.3%.  It’s difficult for the average investor to do the research to pick and choose their own foreign stocks.  So it’s even more important when investing overseas to use experienced portfolio managers with years of experience and an established track record.

We have done the research and we choose the best mutual funds with experienced managers to give our clients exposure to foreign markets.

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Time To Drain The Fed Swamp

The Panic of 2008 is widely misunderstood.  Part of this is due to the fact that financial issues are complicated.  How many people, after all, know what “mark to market accounting” is?  Part of it is due to politics.  Government policies encouraged home ownership by lowering lending standards, leading to NINA (“No Income No Assets”) loans.  At one time home prices were rising so fast that people believed that no matter what they paid for a house they could always sell it for more.

A thought-provoking article by Brian Wesbury of First Trust expands on this issue.

 Time To Drain The Fed Swamp

The Panic of 2008 was damaging in more ways than people think. Yes, there were dramatic losses for investors and homeowners, but these markets have recovered. What hasn’t gone back to normal is the size and scope of Washington DC, especially the Federal Reserve. It’s time for that to change.

D.C. institutions got away with blaming the crisis on the private sector, and used this narrative to grow their influence, budgets, and size. They also created the narrative that government saved the US economy, but that is highly questionable.

Without going too much in depth, one thing no one talks about is that Fannie Mae and Freddie Mac, at the direction of HUD, were forced to buy subprime loans in order to meet politically-driven, social policy objectives. In 2007, they owned 76% of all subprime paper (See Peter Wallison: Hidden in Plain Sight).

At the same time, the real reason the crisis spread so rapidly and expanded so greatly was not derivatives, but mark-to-market accounting.

It wasn’t government that saved the economy. Quantitative Easing was started in September 2008. TARP was passed on October 3, 2008. Yet, for the next five months markets continued to implode, the economy plummeted and private money did not flow to private banks.

On March 9, 2009, with the announcement that insanely rigid mark-to-market accounting rules would be changed, the markets stopped falling, the economy turned toward growth and private investors started investing in banks. All this happened immediately when the accounting rule was changed. No longer could these crazy rules wipe out bank capital by marking down asset values despite little to no change in cash flows. Changing this rule was the key to recovery, not QE, TARP or “stress tests.”

The Fed, and supporters of government intervention, ignore all these facts. They never address them. Why? First, institutions protect themselves even if it’s at the expense of the truth. Second, human nature doesn’t like to admit mistakes. Third, Washington DC always uses crises to grow. Admitting that their policies haven’t worked would lead to a smaller government with less power.

The Fed has become massive. Its balance sheet is nearly 25% of GDP. Never before has it been this large. And yet, the economy has grown relatively slowly. Back in the 1980s and 1990s, with a much smaller Fed balance sheet, the economy grew far more rapidly.

So how do you drain the Fed? By not appointing anyone that is already waiting in D.C.’s revolving door of career elites. We need someone willing to challenge Fed and D.C. orthodoxy. If we had our pick to fill the chair and vice chair positions (with Stanley Fischer announcing his departure) we would be focused on the likes of John Taylor, Peter Wallison, or Bill Isaac.

They would bring new blood to the Fed and hold it to account for its mistakes. It’s time for the Fed to own up and stop defending the nonsensical story that government, and not entrepreneurs, saved the US economy. Ben Bernanke and Janet Yellen have never fracked a well or written an App. We need a government that is willing to support the private sector and stop acting as if the “swamp” itself creates wealth.

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Recovery of Emerging Markets

The MSCI Emerging Markets Index, up 28.09%, is the best performing major index year-to-date – better than the DASDAQ, better than the S&P 500, better than the DJIA.  That’s an amazing reversal.

Emerging Markets have lagged the other major indexes over the last decade.

  • 2.21% for 3 years (vs. 9.57% for the S&P 500)
  • 5.56% for 5 years (vs. 14.36% for the S&P 500)
  • 2.76% for 10 years (vs. 7.61% for the S&P 500)

Why do we mention this?  A well diversified portfolio often includes an allocation to Emerging Markets.  Emerging Markets represent the economies of countries that have grown more rapidly than mature economies like the US and Europe.

Countries in the index include Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, and the United Arab Emirates.  Some of these countries have economic problems but economic growth in countries like India, China, and Mexico are higher than in the U.S.

Between 2003 and 2007 Emerging Markets grew 375% while the S&P 500 only advanced 85%.  As a result of the economic crisis of 2008, Emerging Markets suffered major losses.  It is possible that these economies may now have moved past that economic shock and may be poised to resume the kind of growth that they have exhibited in the past.  Portfolios that include an allocation to Emerging Markets can benefit from this recovery.

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Market reacts to French election, tax cuts and earnings

The stock market had two back-to-back days with the Dow Jones Industrial Average (DJIA) up over 200 points.  On Monday the market was reacting to the first round of elections in France.

The French election for President is often a two step process.  If a candidate gets over 50% of the vote in the first round of voting he or she is declared the winner and becomes President.  If no one gets to 50%, the two top vote getters face a run-off election which decides the Presidency.

In the first round that just ended, the candidates of the major French parties that had run the country for decades did not make it to the run-off.  Instead, Marine Le Pen (usually described as “Far Right”) and Emmanuel Macron (usually described as a “centrist”) were the two top vote getters.  They will face off on May 7th with the winner becoming President of France.

Macron, age 39, received 23.8% of the vote while Le Pen scooped up 21.4%.  Macron formed his own party, splitting off from the Socialists.  Macron is best known for marrying his teacher, a woman 25 years his senior.

It is generally assumed that Macron will win the next round with the French establishment uniting against Le Pen who wants to stop immigration and wants France to pull out of the EU.  The results of the balloting caused a relief rally in expectation that France will stay the current course and remain in the EU.

The Tuesday market action was driven by exuberance over the Trump administration announcement that they were proposing a reduction in the corporate tax rate from 35% to 15%.  If this passes, next year’s corporate earnings would be higher.

On the earnings front some of the big names in the DJIA reported better-than-expected earnings.  Caterpillar, McDonald, Du Pont and Goldman Sachs were the biggest beneficiaries.

Stay tuned.

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The Trump Trade after three months.

The election of Donald Trump was followed by what many called “The Trump Trade.”  Based on the promises made by Trump during the campaign: to lower taxes and reduce regulations – two factors that inhibit economic growth – the stock market rose sharply.  But it’s going to take time and a lot of hard bargaining to actually get to the point where real economic benefits result.

Brian Wesbury, Chief Economist at First Trust:

As we wrote three months ago, it’s going to take much more than animal spirits to lift economic growth from the sluggish pace of the past several years. Measures of consumer and business confidence continue to perform much better than before the election. But where the economic rubber hits the road, in terms of actual production not so much.  It looks like real GDP growth will clock in at a 1.3% annual rate in the first quarter.

He says that we still have a “Plow Horse Economy” and it will take time to unhitch the plow and saddle up the “Racehorse.”

Trump has signed a number of executive orders that will have an impact on regulation, but the bureaucracy is still staffed with the last administration’s appointees and the pace of approving new appointments is glacially slow.

Waiting is the hardest part.

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The Plow Horse is Dead – Long Live the Race Horse

Race horse

We have referred to the economy over the last decade as the “Plow Horse Economy.”  There has been a huge increase in technology available to the economy over that period of time.  “Fracking” has unlocked huge oil and gas reserves in the energy sector.  The “Internet of Things” is tying our appliances together, automating our homes, even allowing us to control them with voice commands.  Self-driving cars are becoming a reality faster than I believed possible.  3D printing is revolutionizing production processes.  Yet despite this dazzling technological revolution, the economy is only managing 1.2% GDP growth.

Why?

Many analysts believe that if we compare the economy to a horse, we have a thoroughbred economy that’s plodding along like a Plow Horse.  The problem is that the rider is too heavy.    That rider is the government.  It’s holding growth down.  In the year 2000 government was 17.6% of Gross Domestic Product (GDP).  In 2016 it was 21.1% of GDP, an increase of 20%.  That’s a big move from the private sector to the public sector.

Keep in mind that government doesn’t manufacture anything.

On top of that, government today regulates virtually everything, generating a hidden cost to producers and consumers.  Some analysts think it’s a miracle that the economy actually grew despite increased borrowing, taxes and regulation.

The incoming Trump administration has a staunchly pro-business agenda.  The focus on jobs and economic growth is front and center.  A new executive order instructs federal agencies to halt the issuance of more regulations, and the new President has indicated a desire to reduce them by 75%.   Another executive order has frozen hiring of federal employees, opening the door to replacing government employees with technology, something that has happened in the private sector.  Yet other executive actions advance the approval of the Keystone XL and Dakota Access oil pipelines – using American steel – creating new high-paying construction jobs and indicating an interest in making America energy independent.  Reducing tax rates, especially the high corporate tax rate, is another Trump administration objective.  It’s the carrot to encourage companies to build here, even as he waves the stick of high tariffs for goods brought in from overseas.  It’s getting a respectful hearing from otherwise skeptical business leaders.

These actions are not going to be enough, but they are indications that the new administration is determined to streamline government and incentivize private industry to grow.  According to Brian Wesbury, Chief Economist of First Trust, the earning per share of the S&P 500 is estimated to be $130, an increase of 20% in 2017.  Growth in earnings of that magnitude can justify an increase in market valuations and add a few percentage points to the annual GDP.

To get back to our horse analogy, it looks as if the jockey riding the horse will be put on a diet.  If that happens the thoroughbred who was a “Plow Horse”  may become a “Race Horse.”

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Dow Breaks the 20,000 level

The Dow Jones Industrial Average reached another milestone today.  The Dow broke through 20,000 as traders cheered.

For a little perspective here’s how the market reached past milestones.

dow-jones-milestones

A few points to remember.  There have been long periods when the Dow treated investors like riders on a roller coaster:  lots of swoops and slides only to end up where you began.  During those periods people made money with astute stock selection, not by buying “Mr. Market.”  We believe that those times will come again.

  • It took from 1929 to 1954 for the Dow to regain its previous high.
  • It took ten years – from 1972 to 1982 – for the market to break through the 1,000 level.

Keep in mind that the 1,000 point move in the Dow at the current level is just a little over 5% and is therefore not nearly as meaningful as a move from 1,000 to 2,000, a move of 100%.  But it’s still an important psychological barrier that had to be broken for the market to move higher.

The move makes sense from both a technical and fundamental standpoint.  Both retail and institutional investors are positive, as we have noted in the past.

The incoming Trump administration has moved with amazing speed to demonstrate their desire to increase the level of economic growth as a way of increasing job and wage growth.  They have expressed policy preferences for lower taxes, reducing regulations that stifle business development, and have been encouraging companies to build their businesses in the United States rather than overseas.

The trend is clear.  The only thing that could derail this train is a massive change in consumer sentiment or an external factor such as a war or other calamity.  The latter are known as “Black Swan” events and we must always keep in mind that they can occur.  We manage our portfolios with those possibilities in mind.

Eventually, valuations will get too high and the inevitable correction will occur.  In the meantime, we enjoy the ride while keeping a close eye on events.

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