2016 3rd quarter Kildare Asset Mgt-Kerr Financial Group client review letter

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The 3rd quarter began as the dust from the Brexit vote was still settling and ended with widespread worries over European banks, when the Federal Reserve would raise interest rates, and the U.S. elections. In between, there were concerns over a slowing U.S. economy, debates on the impact of negative interest rates, and rumors that OPEC would cut production to try to boost the price of crude oil.
U.S. stocks began the quarter by breaking above a 2-year trading range as markets bounced from the Brexit selloff.  After this move, markets traded in one of the tightest ranges in history as we went through a 26 day stretch without a 1% move for the S&P 500.    September saw volatility return at the beginning of the month with a one-day 400 point Dow drop and a partial recovery into the end of the quarter.
Despite the lengthy list of worries, the major averages reached record levels during the quarter – the Dow and S&P 500 in August and the Nasdaq and Russell in September. But these new records don’t equate into a block buster 2016.  It’s important to keep in mind that these all-time highs represent mid-single digit year-to-date returns.
However, these levels are over 20% higher from the February lows.  As a reminder, 2016 was the worst start in history for the stock market as global equities plunged for the first six weeks of the year.  It’s been a remarkable recovery especially in the face of the challenges.
While financial headlines focused on the record levels, the markets offered some subtle changes that may signal a transition of leadership.  Stock indexes have recently been driven by a small group of large cap companies.  This was especially evident in 2015 as the FANG stocks dominated the landscape.
A significant shift took place in the 3rd quarter.  What was lagging in the first six months of the year became the leaders in the 3rd quarter.  Also small was better than big as the Russell and the Nasdaq Composite (both have material small cap components) gained the most in the quarter.  Size even mattered within the S&P 500 as the smallest one-third outperformed and the largest companies.  (Please keep in mind the ‘smallest’ companies with the S&P 500 have market values that exceed $4 billion dollars so they are not small caps.).
Overall, notwithstanding the many cross currents, the 3rd quarter was the best so far in 2016.  Here are quarterly and year-to-date performance numbers for the major averages.
3rd Qtr. 2016      2016YTD
Dow Jones Industrial Average                                 +2.1%            +5.1%
S&P 500                                                                   +3.3%           +6.1%                     Nasdaq Composite                                                   +8.8%            +6.1%
Russell 2000                                                             +8.7%           +10.2%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
Using a size weighted average, here is how the average Kildare Asset Management-Kerr Financial Group client’s account performed. This is calculated after all fees and expenses.
3rd Qtr. 2016            2016YTD                   +3.04%                   +11.08%
Within the specifics of your account, the closed end funds that I covered in your 2nd quarter letter continued to do well.  To review, we took positions in closed end funds that focused on high yield corporate bonds, corporate loans, and taxable municipal bonds.  Some of the names are Blackstone Strategic Credit Fund (BGB), Blackstone Floating Rate Fund (BSL), Blackstone Taxable Municipal Bond Trust (BBN), and the Eaton Vance Senior Income Trust (EVF).  From the cost basis, the yields we are receiving range from 6% to 8%.
We purchased these when they out of favor and were significantly undervalued.  Since then they have appreciated in price with some up around 15%.  This is a very big move for a bond fund (you normally don’t get 2 -3 years of coupon in price increase).  I am monitoring these holdings closely.  Some of the issues include the current valuation after the price advance, the possibility of higher interest rates, and a possible recession.
These valuations are not extremely overvalued given market and economic conditions.  As you know, bond prices move inverse to interest rates.  If rates increase, it may present a headwind for these funds.  Historically, however, this sector of the fixed income market is more influenced by credit risk rather than interest rate risk.  In other words, the ability for the borrowers to service their interest payments to our bond funds is considered strong in an expanding economy.  Higher interest rates are typically a secondary concern to the likelihood of debt service.
Looking forward to the 4th quarter and beyond, there are some very important sign posts ahead.  The U.S. election and the probability that the Fed will increase interest rates in December are foremost.
From a glass half-full viewpoint, the 4th quarter is normally the strongest one.  The 4th quarter has averaged a 2.7% gain dating back to 1928.  Also since 1928, when the S&P 500 is up YTD through September 30th this quarter averages a 4.3% advance and is up 81% of the time.
2016 has been an historic year on many levels.  As we work through its final three months, I will continue to navigate possible negatives from the elections and the Fed within the context of strong seasonal period.  I will be looking for opportunities while trying to manage risk.
Thank you for you continued business and trust.  Please contact me with any questions.

Extra, Extra, Read All About It!

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Charles Dow and Edward Jones started publishing the Dow Jones Industrial Average in their newly formed newspaper on May 26, 1896.  It began by adding the closing prices of twelve large companies that Dow believed to represent the stock market and then dividing that number by twelve.  At the time, The Wall Street Journal was published in the afternoon and cost $5 for an annual subscription.
It’s likely that Messrs. Dow and Jones would not have imagined that their stock market index would thrive for over 120 years.  Nor is it probable that they would predict it reaching 20,000.  Yet, at the end of 2016, the Dow is approaching that threshold.
Of course, we’ve gotten here with the help of a 7% rally in the Dow Jones Industrial Average since election day.  And while industrial and energy companies have gotten credit, the real heavy lifting has been done by the financials.  And among the financials, Goldman Sachs has shone the most muscle.
Goldman Sachs closed last week at $241 – up 32% since from November 8th.  Goldman is the highest priced stock in the index and because the Dow is a price weighted index (as opposed to a market capitalization weighting such as the S&P 500) it has the biggest impact.  Of the 1,282 points that the Dow has risen since the election, Goldman Sachs is remarkably responsible for 408 of them.  The next biggest contributors are United Health Care (112 points) and JP Morgan (103).
Of course, inquiring minds want to know – why the move?  Certainly, Goldman Sachs is a premier organization and a leader in finance and investments.  On top of this, the market is expecting lower expenses for the company due to the materially reduced regulations from ‘Trumpnomics’.
Also, we can’t ignore the impact of algorithms and computer trading.  These systems are often trend following so that once something starts to move higher buyers follow.  The “Goldman Sachs” name has been very visible recently as some in top management are moving 200 miles southwest to be part of the new cabinet and administration.  Algorithms and trading software constantly search the news for active keywords and phrases so this could have contributed bids for Goldman Sachs.
Regardless the reason, Goldman Sachs has recently played a big role in helping the Dow approach 20,000.  Naturally this threshold has the financial media’s attention.  And as of last week’s close, the Dow is only 244 points or 1.2% away.  Last week was the 5th consecutive higher week for the Dow and Friday marked the 14th record close since the election.  During that time the Dow has rallied 10.45% which is the best 5 week move since 2011.  Here are the year-to-date numbers for the major averages.
2016 YTD
Dow Jones Industrial Average                           +13.4%
S&P 500                                                             +10.5%
Nasdaq Composite                                             +8.7%
Russell 2000                                                       +22.2%
Indices are unmanaged, do not incur fees or expenses, and
cannot be invested into directly. These returns do not include dividend.
The bond market has been moving in the opposite direction of the stock market.  The 10-year treasury yield finished last week at 2.46% while the 30-year closed at 3.15%.  These two yields were 1.88% and 2.62% on November 8th.  The TLT is an exchange traded fund that tracks the long bond futures contract and it has plunged 9.6% since the election.  This is a big move for any security in a 5-week period, but it is an especially violent drop for a supposedly stable asset class like bonds.  To put it another way, this drop is 3 years’ worth of interest payments.
Unless the world comes to end, the Fed will raise interest rates on Wednesday.  While this has been discounted by the markets, the statement and press release will reveal more on the expected actions in 2017.  The Fed similarly raised the rate last December which resulted in a strong dollar which caused disruptions in the foreign exchange markets.  The Chinese renminbi weaken dramatically and that caused global markets to drop.  The stock markets fell in January as stocks had the worst start to a year in history.
This year has a different landscape.  While the dollar has been strong, the foreign exchange markets are not as fragile as last year.  Also, commodities have rebounded from last year’s levels which provide some support to the emerging markets.  Even Europe will be trying to normalize monetary policy.
Another stabilizing factor is some good economic reports.  Recent data has indicated that the economy is gaining some strength.  And while these reports have been released after the election, they measure activity prior to November.  As an example, the latest ISM (Institute of Supply Management) report was released last week and it showed an increase from 54.8 to 57.2.  Readings above 50 correlate with an expanding economy.
To be sure, some of this good news has been discounted in the markets.  And while we don’t expect a correction, further upside could be a challenge.  Still with year-end quickly approaching combined with many professionals under-performing their benchmarks, prices might get bid even higher.  That would be a nice Christmas present.
Jeffrey J. Kerr, CFA
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is not indicative of future results. Investing involves risks, including the risk of principal loss. The strategies discussed do not ensure success or guarantee against loss. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is not possible to invest directly in an index. Trading of derivative products such as options, futures or exchange traded funds involves significant risks and it is important to fully understand the risks and consequences involved before investing in these products. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional

It’s the Most Wonderful Time of the Year

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The elves at the North Pole are supposed to busy this time of year as their deadline is quickly approaching.  Wall Street’s elves, on the other hand, usually get a breather around mid-December as the markets often coast from this point through the holidays.  It’s a much different story this year.
Of course, a lot of things are different in 2016.  Concerning the markets, there’s been a full slate of developments to deal with in December.  President-elect Trump is filling out his cabinet and administration and these decisions offer further signs of policy direction.  Given the stock market’s ‘Trump’ rally is largely based on the anticipated economic boost due to the new direction promised by the incoming president, this is important news.
Other nuggets keeping investors on their toes include interest rates moving up to levels not seen in the last 2 years.  Likewise, the dollar has rallied to multi-year levels.  Also, the Federal Reserve held a two-day meeting and raised interest rates.  And, of course, the Dow is on the cusp of reaching the 20,000 level.  This all adds up to a lot of last minute shopping as investors have been too busy.
Although last week’s 25-basis point increase in the fed funds rate was expected by everyone, the FOMC (Federal Open Market Committee) revealed a forecast for 3 rate hikes in 2017.  This was a little more hawkishness than the markets expected and it triggered a broad sell-off for stocks and bonds.
While there was pain across the fixed income market, the brunt of the damage was in the shorter end of the Treasury market.  The 2-year note’s yield closed at 1.239% which is the highest level since 2009.  The 10-year and 30-year yields closed last week at their highest levels since 2014 (2.59% and 3.18% respectively).
Last week’s rate increase is only the second interest rate increase in the past decade!  Further is the only hike of 2016 as conventional wisdom was way off base in predicting 3 or 4 hikes this time last year.  Clearly monetary policy will be tighter in 2017, but how many fed funds rate increases is uncertain.
Below is a chart of the 10-year U.S. treasury and the December 2017 fed funds futures expectations.  As can be seen, the futures market is forecasting a 1.16% fed funds one year from now.  This suggests much, much stronger economic growth.  Importantly, however, this level would only be approximately two 25 basis point increases from here and not the three that the Fed is implying.[i]  The futures have a 73% probability of the first rate hike at the June meeting.
As interest rates rise, the U.S. dollar has strengthened.  The DXY index (a dollar index vs. a basket of currencies) reached levels last seen since 2003.  Some specific levels include an 8-year high against the Chinese renminbi and a 10-month high against the Japanese yen.  Also, the euro has fallen below $1.05 which has been strong support for the past several years.  Dollar – euro parity (1 dollar = 1 euro) is the next big level.
This U.S. dollar rally began in 2014 and there are few reasons to believe that the trend will end, especially in the short term.  However, in the words of Herb Stein, “if something cannot go on forever, it will stop”.  2017 might present some developments that would be a headwind to continued greenback strength.  First, the Trump administration might run into a speed bump or two.  Cabinet appointment delays, potholes in getting legislation passed and implemented, and the president-elect’s Twitter account are a short list of things that could derail a smooth first year.
Also, despite the constant stream of negative headlines out of Europe, some indicators are improving.  The purchasing managers’ surveys released last week for Germany and France pointed to growth with the French index at an 18-month high.  Further the weaker euro will help exports for the EU countries.  Lastly, despite the self-inflected damage, maybe the bureaucrats begin to make a couple helpful decisions which might benefit the economy.
Turning to stocks, it’s a toss-up who is more excited right now – children waiting for Christmas morning or traders waiting for Dow 20,000.  And while the Dow couldn’t get there last week, the S&P 500 reached its own 20,000 level for the first time as the index’s total market cap reached $20 trillion.  During the depths of the financial crisis, the S&P 500’s combined value amazingly plunged to $6.1 trillion.[i]
Once we reach Dow 20,000, what then?   Stocks are extended but these trends usually don’t end in the last half of December.  Here is a chart of the S&P 500 for 2016 plotted against its historical average.[ii]
2016 has remarkably followed the trend but has trailed its average since October.  Rarely is there any large changes of direction in late December.
Further, as shown in this chart, investors are willing to pay higher valuations.  There is confidence that the “E” part of the P/E ratio will increase (lower ratio) in 2017.[i]  Analysts are busy adjusting for increased infrastructure programs and lower corporate tax rates which will increase businesses’ bottom lines.  Nevertheless, it’s not easy to get the magnitude of all these changes correct so there’s some risk of disappointment.
One final chart that compares the current S&P 500 breakout to those in 1980 and 1950.  If the markets follow these trends, it will be a fun trip which could last several years.[i]
As the markets close out 2016, change is coming.  An important one will be a shift from a loose monetary policy with a tight fiscal policy to a tight monetary policy combined with a loose fiscal policy.  The markets have adjusted somewhat to this but there will probably be unanticipated delays and wrinkles which could cause problems.
We don’t expect anything too drastic before year-end, but would be flexible into the New Year.  Reducing risk in the middle to late January might be good timing.  The old Wall Street adage is to “buy the rumor and sell the news” or once the anticipated event happens, it’s time to sell.   The inauguration and first few weeks of the new administration might fit the “news” part of this advice.
We wish everyone a happy holiday season and best wishes in the New Year.
Jeffrey J. Kerr, CFA
[1] GaveKal Capital, December, 2016
[1] The Bespoke Report, December 16, 2017
[1]Topdown Charts, December 16, 2016
[1] Ibid
[1] Ibid

Be Careful What You Wish For, You Might Get It

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We are at the point in the year where the season for giving thanks transitions into a season of wishes. Normally this enjoyable tradition is a thoughtful, well intentioned part of the holiday season.  This year, however, these lists probably have some additional and unique items.
President-elect Donald Trump’s name is likely on many wish lists this year. The range of the wishes associated with Mr. Trump are spread from loathing and disgust to supporting admiration.  Over time these two factions should come closer together as the critics move to Canada and the devotees become disappointed in the pace of change.
Another common wish is among the media and experts who are supposed to offer insight on events such as elections.  They are desperately trying to get one right.  Being totally wrong on Brexit and the U.S. presidential election has left a mark.  And the streak continued the weekend before last with a French primary election having another upset winner.  It has been a very bad 2016 for this group.
The Federal Reserve has some wishes.  They wish to raise interest rates.  Further they would like to see a pick-up in the inflation rate.  They’ll likely get this first wish before Christmas as the FOMC is expected to increase the fed funds rate by 25 basis points at their meeting later this month.  Looking forward, there are predictions for more fed funds rate increases in 2017 and some high profile Wall Streeters are predicting the 10-year note’s yield to exceed 5% (it’s currently at 2.4%).  It’s hard to imagine the U.S. economy withstanding a doubling in yields.
Wall Street has many wishes with a big one being an improvement in its standing.  As evident during the never ending political television ads during the campaign, it is a distrusted and cynically viewed part of our culture.  The legal profession should be grateful as Wall Street has easily (and by a wide margin) replaced lawyers on the bottom of the reputational totem pole.
Another wish from the stock market bulls is for more of the Trump rally.   Other than a slight pullback last week, U.S. equities have surged after the election.  The leaders have been the small cap stocks as well as financials, energy, and industrials.  The S&P 500, Nasdaq and Russell have all reached record levels since the election.  The Dow, with much fanfare, has made new all-time high, surpassing 19,000 while the Russell was up for 15 days in a row.
To help appreciate this spike since the election, we are including “performance since the election” with our regular year-to-date numbers for the major averages.  A significant portion of 2016’s gains have come within the past few weeks.
Since
2016 YTD         Election
Dow Jones Industrial Ave             +10.0%                   +4.5%
S&P 500                                        +7.2%                     +2.6%
Nasdaq Composite                        +5.0%                     -1.2%
Russell                                          +15.7%                   +10.1%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.
A notable number in the above table is the Nasdaq’s losses since the election.  This weakness has been blamed on worries over President-elect Trump’s immigration and trade policies which might increase costs for tech companies.
Valuation is another headwind for tech stocks.  Based on such measures as P/E, EBITDA (earnings before interest taxes depreciation and amortization) ratios, and dividend yields, ‘new’ technology (such as the FANG stocks) is expensive.  Granted these industries have greater growth potential but a good portion of that growth is priced in.
This rotation out of technology goes beyond valuation.  Donald Trump’s presidential victory represents the largest shift in government’s role in decades.  This change should not be underestimated.  As Anatole Kaletsky points out “political events can sometimes have a much greater impact than the monetary and economic “fundamentals” that investors normally consider more important.”[i]
Although the details of Trump’s economic plan are not fully known, generally, a more business friendly landscape is expected. Predictions are for a reduction of regulations (especially in banking and finance) and for increased fiscal stimulus primarily through greater infrastructure spending.
Whether the reason is politics or economics, the capital markets’ aren’t waiting for the inauguration.  They are pricing in stronger growth, higher inflation, higher interest rates, and larger fiscal deficits.  Stocks, interest rates, and the dollar are moving up.
Some are predicting a repeat of the economic cycle that began in Ronald Reagan’s first term.  And while there are some similarities, there are some critical differences.  In 1982, interest rates were at a generational inflection point which turned into 35 years of declining rates.  2016 might be another inflection point but in the opposite direction.  Not only are we without the boost that declining interest rates gave the 1980’s, rising rates will be a headwind.  And likely for many years to come.
In early 1980’s, stocks were despised.  Numerous magazine covers (remember this is before the internet when The Wall Street Journal, Forbes, Fortune, etc. were must have subscriptions) proclaimed the death of equities.  Very few wanted anything to do with Wall Street which translated into insanely low stock valuations and very attractive dividend yields.  It was huge news when the Dow climbed above 1,000!
Looking at the valuations, P/E’s were in the single digits 35 years ago.  In fact, in some cases the EPS (earnings per share) amount was greater than the P/E.  Blue chip dividend yields were also in the upper single digits.  A far different story from today where the S&P 500’s P/E trades at mid to upper teens and the dividend yield is barely over 2%.
Market sentiment changes quickly.  A month ago the market’s feared a Trump win and were declining every time a poll suggested he had a chance.  After the results Wall Street quickly changed its mind.  The biggest moves have been a rally in stocks, a drop in bond prices (higher yields) and a rise in the value of the dollar.
As enjoyable as the rally has been, we must keep in mind that investor sentiment can quickly change again.  While this doesn’t seem likely in December which is historically a bullish month, there is a Fed meeting next week. A 25 basis point hike in the fed funds rate is fully expected so the only surprise would be that the committee holds the rate the same.  Beyond the Fed meeting, the markets have built up some pretty lofty expectations for 2017.  Here’s wishing that the economy can deliver.
Jeffrey J. Kerr, CFA
[i] GaveKal Research, December 2, 2016
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is not indicative of future results. Investing involves risks, including the risk of principal loss. The strategies discussed do not ensure success or guarantee against loss. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is not possible to invest directly in an index. Trading of derivative products such as options, futures or exchange traded funds involves significant risks and it is important to fully understand the risks and consequences involved before investing in these products. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional