Life is a clue in a crossword

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

August 13, 2018 – DJIA = 25,313 – S&P 500 = 2,833 – Nasdaq = 7,839

 

“Life is a clue in a crossword”[i]

Current economic and capital market analysis is like doing a crossword puzzle.  Some developments have multiple intersections with other events and are intensely linked.  At the same time, some news, while important, is a little economically distanced with only peripheral connections.

For example, a six letter word for a tax or duty to be paid on a particular class of imports or exports is “tariff”.  The “r” could intersect with either “r” in “trade war”.  And the other ‘r’ in “trade war” could intersect with the “r” in “dollar”.

Or a 14 letters (2 words) for the calculation of dividing the number of unemployed individuals by all individuals in the work force.  This is obviously the “unemployment rate” and it is connected to “interest rates”.  Bonus points would be awarded for getting the clues for BREXIT, cultural division, inverted yield curve, and $1 trillion market cap.

The obvious point is that the capital markets are at a high degree of interlinkage and it’s hard to stay on top of all of the relationships.  The not so obvious point is that these relationships are dynamic with wide reaching influences.

For example the stock market doesn’t like lower profits – that’s easy.  And tariffs can cause higher expenses and potentially shrinking net income.  But what if the exporting country’s currency drops in value relative to the U.S. dollar.  Does this foreign exchange development reduce the price for the foreign seller to a point where they maintain their sales in the U.S.?  This appears to be the case with the Chinese yuan as recent the fall in its value is offsetting the impact of higher tariffs.

Another important piece of our financial crossword puzzle is “earnings season”.  With the reporting of second quarter results coming to an end, earnings have been good.  Of all of the companies releasing 2nd quarter numbers, 65.6% of these reports have beaten consensus earnings expectations.  Further, 67.5% of companies exceeded the consensus revenue forecasts.  While both of these are good, they are below the previous two earning seasons.

The stock price’s reaction to these reports can be just as important as the numbers themselves.  As expected, good news was rewarded and bad news was punished.  For the second quarter numbers, the average 1-day % change for the stock price of a company after their earnings release was +0.45%.  Dividing this into the number of companies that beat earnings estimates and those that missed earnings estimates, stocks of companies that exceeded earnings estimates averaged a 1-day 1.8% increase in their stock price.  On the other hand, stocks averaged a 3.6% one-day drop for those that missed earnings estimates.[ii]

Within this group of misbehaving companies who experienced a stock market ‘time out’, there are some unexpected name.  This year’s biggest winners ran into some speed bumps in the second quarter.  Not that their earnings and sales numbers weren’t exceptional – they were.  But apparently they weren’t good enough as the market gave them a clear thumbs down.

For example, Netflix (symbol = NFLX) which describes itself as “the world’s leading internet entertainment service with over 130 million memberships” reported a 40% surge in year over year revenues  together with an amazing 482% jump in net income.  Total subscribers grew almost 30% from 2017’s second quarter.  Hard to criticize these numbers and a natural assumption would be for a higher stock price.  Surprisingly it fell over 10% or $50 per share.  Management lowered the forecast of future subscriber growth and current subscribers viewing hours and that’s not something the market was looking for.

Some other FANG (Facebook, Amazon, Apple, Netflix, and Google) stocks suffered similar unexpected reactions to their second quarter earnings.  Facebook tumbled on its release as users spent less time on the website.  Also management reported that expenses would increase as the company enhanced infrastructure and security to deal with their issues concerning privacy.

Amazon’s 2nd quarter revenues increased 39% year-over-year yet its stock price declined.  Apple saved the day with an earnings estimate beat.  Its stock price rose and Apple became the first company to exceed $1 trillion market capitalization (total value in the stock market).

Despite Apple’s accomplishment, it hasn’t been a good stretch for these stock market leaders.  Prior to this earnings season, the FANG stocks have been responsible for a large portion of the stock markets’ year-to-date returns.  Naturally, Wall Street, never missing an opportunity to sell a new product, developed a FANG index.

The FANG + index is “an index that provides exposure to a select group of highly-traded growth stocks of next generation technology and tech-enabled companies”.[iii]   The FANG + index’s components are Facebook, Apple, Amazon, Netflix, Google, Alibaba, Baidu, NVIDIA, Tesla, and Twitter.  These have been investors’ favorites in 2018 and seemingly could do nothing wrong.

However, the weakness in these stocks after their earnings reports could be a sign that too much good news had been priced in.  At the end of last week the index has declined 6.78% since making a 52-week high in late June.  And much of this drop has occurred since Facebook’s earnings release.  With these market darlings selling off, it’s kind of like the popular kids got sent to detention.

Here are the year-to-date performance numbers as of last Friday for the more conventional indexes.

2018

Dow Jones Industrial Average                                                                           +2.4%

S&P 500                                                                                                                 +6.0%

Nasdaq Composite                                                                                               +13.6%

Russell 2000                                                                                                         +9.9%

Another part of the FANG + index, Tesla (symbol = TSLA), is a crossword puzzle on its own.  Or, better yet, a reality show.  The electric car maker has a controversial history with many critics believing that the company has over promised and vastly under delivered.  Tesla has never been profitable and has an annual cash burn rate measured in the billions.

The company’s C.E.O., Elon Musk, has been at the center of the storm that has surrounded this company. Supporters view him as a visionary genius while his detractors claim he is a fraud.  He has fueled the fire with an ongoing soap opera on Twitter. To be sure, there a lot of Twitter soap operas, but the Tesla dialogue has to be near the top.

For example, on April 1, he posted a picture on Twitter of himself passed out against a Tesla car with the post “Tesla goes bankrupt”.  As a reminder, this year’s April Fool’s Day fell on a Sunday which happened to be Easter Sunday.  The peculiar timing increased questions of Mr. Musk’s stability and focus.

Another controversial moment occurred during the company’s first quarter conference call when Mr. Musk rudely dismissed an analyst’s question.  Again this unprofessional conduct brought criticism and questions regarding the conduct of a C.E.O of a $50 billion company.  Mr. Musk apologized during the recent second quarter (three months later).

In July, Mr. Musk referred to one of the British drivers rescuing the trapped soccer team in Thailand as a “pedo” – a shortened term for pedophile.  Vern Unsworth, the driver, had previously described Elon Musk’s offer of a mini submarine as a “PR stunt”.  Mr. Musk deleted the tweet a short time after posting but, by that time, there were many re-tweets and word quickly and widely spread.  Mr. Musk apologized a few days later in an indirect manner as he responded to another post on Twitter.

Last week, in what might be the pinnacle (or nadir depending on your view), Elon Musk posted the “Tweet of the Year” (so far).  Last Tuesday, Musk tweeted “Am considering taking Tesla private at $420.  Funding secured.”  No further details, no press release, no 8-K filing (an S.E.C. filing of material events and news releases), nothing but a tweet.  At $420 per share the deal would exceed $80 billion.

Trading in Tesla’s stock was halted after the tweet.  When trading resumed a couple hours later, the stock jumped to $380 per share.  Then the fireworks really started. Given Elon Musk’s unusual behavior, was this another prank?  Or was this his way of making a factual announcement?  Did the $420 price have drug significance (the number 420 being associated with marijuana)?

As soon as the tweet was posted there was widespread doubt on the claim that financing was secured.  Yes, the bond market has been a 35 year bull market (despite several predictions of its end) and money has been plentiful in the corporate debt markets.  But given Tesla’s challenged operating performance, this was far from a slam dunk.  Secondly, a deal of this size and complexity was not getting thrown together over a weekend.  The required due diligence would take considerable time.  Lastly, a deal of this magnitude, potentially the largest corporate takeover in history, would have generated a constant stream of rumors and leaks.

In addition to these issues, there was outrage over Musk’s tweet given that he is the largest shareholder of Tesla.  Wall Street has a history of stock promotion and things like the internet and financial news networks can be a means to that end.  Many questioned if this was Musk’s way of attacking the large short interest in the stock at same time enriching his net worth.  It is hard to believe that someone would so blatantly and obviously manipulate the stock price.  But given Mr. Musk’s history, nothing is out of the question.  While law suits began over the past weekend, there’s been no enforcement by the S.E.C. (so far).

If listening to earnings conference calls while scanning Twitter wasn’t enough, Wall Street had another meltdown to cope with last week.  The Turkish lira plunged to its lowest level ever over worries about the country’s economic stability.  While no one confuses Turkey with an economic powerhouse, in a financially intertwined global system, everyone matters.

The lira’s decline seriously weaken international confidence and will make it harder for the country to refinance debt.  Also, Turkey’s issues cast a shadow across all emerging markets as well as fragile developed countries such as Italy and Spain.  Also, European banks have exposure to the Turkish economy.

Uncertainty over international stability caused the U.S. stock markets to fall on Friday.  It snapped a string of 5 consecutive weeks of gains for the Dow Jones Industrial Average and the S&P 500.  The S&P 500 had recently broken out of a trading range and had been trending toward a new all-time record level.  It got to within 1% of a new high before Friday’s retreat.

A backdrop of an expanding economy and growing earnings is supportive of higher stock prices.  The employment picture is the strongest since disco was popular and business confidence is at record levels.  Corporate balance sheets are generally strong and business investment is slowly moving forward.

The bearish side of the trade has many intersecting clues.  First global central banks led by the Federal Reserve are talking about or are in a tightening cycle.  This means higher interest rates and less systemic liquidity.  These could turn into significant economic headwinds.

Also, the narrow market leadership is a concern.  As mentioned the FANG + have accounted for such a large portion of the 2018’s stock market gains.  Sustainable market trends typically have a broader participation.

Next sentiment might be overly optimistic.  Some investor surveys are indicating excessive bullishness including an above average level of hedge fund longs in the e-mini S&P 500 futures.  Remember that these indicators are normally viewed as contrarian because investors who are bullish have already done their buying and may not have much dry powder left.

Other risks, of course, include trade wars, geopolitical tensions, and, as mentioned above, emerging market turmoil.  To be sure, these have been potential market obstacles throughout the year but have not had any lasting impact.

Navigating the markets is tricky.  The news flow can have wide reaching effects with unclear connections to other developments.  Something that appears to be pretty straightforward can turn into a tangled mess.  On balance the markets are absorbing the bad news and trading well.  And in an attempt to fill in the blanks and complete the puzzle, perhaps the best mindset for investors is a 19 letter 3 word answer – “optimistic but cautious”.

 

 

 

[i] Ian Anderson, 1979

[ii] The Bespoke Report, August 3, 2018

[iii] www.theice.com

 

 

 

2018 1st. Qtr. Kildare Asset Mgt.-Kerr Financial Group client review letter

 

The following is a copy of the 1st quarter letter sent to clients. It reviews the markets and the client account’s activity and performance for the 1st quarter of 2018.

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

 

Fads and popular trends are common in many parts of our lives such as fashion, food, and pop culture.   They become widely and intensely followed and just as they seem to have established a permanent part of our lives, they often completely disappear.  For those who lived through them, who can forget (as hard we try) leisure suits, mullet haircuts, and pet rocks.

This same human emotion that plays a role in fads is also an important part of the markets.  As a result, there is a long history of popular investing approaches that assembled cult followings.  The Dutch Tulip mania took place in 1630’s and the South Sea Bubble followed in the 1700’s.  Some recent examples include the Nifty Fifty in the late 1960’s, portfolio insurance in the 1980’s, the Dot.Com bubble in the late 1990’s, and house flipping in the 2000’s.  To be sure, all were profitable strategies for a time.  But, as their popularity grew, there were fewer and fewer buyers to push the trade higher and ultimately they ended in tears.

In hindsight it’s easy to distinguish between a successful strategy and a fleeting fad.  However, in the midst of a bull market, nothing looks like a fad that is about to end.  Instead, investors convince themselves that the popular trend is a successful new investment approach and explain away any appearance of shortcomings.

During the past couple of years, passive investing has assembled a following that rivals the historic stock market bubbles.  While passive investing can be an appropriate and reasonable approach, its popularity has grown so much that it is causing distortions in the markets.

First, a review of the passive investing or indexing.  Repeating the description used in last year’s 4th quarter letter, passive investing involves buying exchange traded funds (ETFs) or mutual funds that track an index.     Investors buy various asset classes via these funds.  For example, the SPDR S&P 500 Trust (symbol SPY) tracks the S&P 500 index. The SPY or its equivalent mutual fund is widely viewed as the equity asset class of a portfolio.  The iShares Barclays Aggregate Bond Fund (symbol AGG) tracks the Barclays Aggregate Bond Index which is a broad bond market index.

The goal of passive investing is to achieve market returns over the long term at the lowest possible cost.  As a result, this approach has the advantage of being much simpler as there is minimal upfront research – you are just investing in the chosen index.  Further, there is limited monitoring after investing the money as you looking for market returns, positive as well as negative.

Passive investing’s appeal and popularity is reflected in the capital flows into the investment products that follow the strategy. The two leading providers of passive investing products (Vanguard and Blackrock) have had inflows of over $1 trillion during the past two years.  And there are many other companies that have seen spikes in the inflows into their passive products.

As indexing and passive investing grew in popularity the stock market experienced record low levels of volatility.  This was especially evident in 2017 as the year passed without experiencing a 5% correction and stocks had a smooth gradual journey higher.

Perhaps 2018’s 1st quarter witnessed a peak in this steady move from lower left to upper right.  One of the 1st quarter’s noteworthy developments was a return volatility across the markets something that hasn’t been seen in years.

The stock market started the year by continuing 2017’s rally.  The major indexes climbed into late January setting daily record highs along the way.  However, stocks reversed direction and quickly lost 10% in two week.  Equities recovered a portion of the losses but then retreated in March and retested the February lows as the quarter ended.

As stocks were dealing with their turmoil, bonds were also struggling.  The yield on the 10-year Treasury note rose in January and February climbing from 2.46% to 2.95%.  Its yield ended the quarter at 2.74%.  As a reminder, bond prices move inversely to interest rates which meant that as rates rose, bond prices fell.

Importantly, 2017’s 1st quarter marked the first time in years that stocks and bonds both declined.  The recent pattern has been that if one asset drops the other rose.  This was helped by the passive/indexing strategy as institutional investors constructed portfolios with a mix of stocks and bonds that performed well.  Once again this has become somewhat crowded trade which may explain the increased volatility as there was some unwinding in February.

At the end of the quarter, most of the averages were lower.  The Nasdaq had a positive quarter but there was narrow leadership as a small number of large companies drove the index.  Here is how the major averages performed in the 1st quarter.

2018
Dow Jones Industrial Average -2.5%
S&P 500 -1.2%
Nasdaq Composite 2.3%
Russell 2000 -0.4%

 

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.

Kerr Financial Group – Kildare Asset Management

6.28%

 

Despite the market challenges, your account performed well.  We had several positions that were immune to the tumult together with the use of hedges to reduce exposure and overall market risk.

First, we had another takeover.  Layne Christensen (symbol is LAYN) becomes our third position to be bought out in the last year.  Fortress Investment Group and Parkway Properties were both acquired in 2017.  This demonstrates that the effort to buy the stocks of undervalued and out of favor companies can be a successful approach.

LAYN will be bought by Granite Construction (symbol GVA).  Granite is a $3 billion construction company.  They have divisions that focus on water projects and will try to blend Layne’s expertise with these efforts.

I’m somewhat disappointed at the price of the deal.  LAYN had been making significant strides toward profitability and their mining and energy divisions appeared ready for strong growth.  If they were successful in producing strong profitable growth, the stock could have risen into the $20’s (Granite’s offer was a stock deal that valued Layne around $18 per share.  Granite’s stock has declined since the announcement so Layne’s price is trading lower).

There was some criticism of the deal.  Cetus Capital filed a letter with the SEC that questioned the negotiation process as well as the valuation and suggested that Layne’s board did not fulfill its duties.  Nevertheless, the deal likely gets shareholder approval.  In full disclosure, I voted client shares against the deal.

Another reason for the good 1st quarter’s performance was a Seacor Marine Holdings (SMHI).  As you may recall, Seacor Marine was a big reason for 2017’s disappointing 4th quarter performance.  SMHI was a spinoff from Seacor Holdings.  They provide global marine and support transportation services to offshore oil and gas exploration and production wells.

SMHI’s stock price began the year at $12.15 and rallied to $19.00 by the end of March.  I had suggested in the 4th quarter letter that SMHI’s weak stock price could be a function of tax loss selling in late 2017.  This may have been the case as the stock moved higher through 2018 despite the overall market’s weakness.

Of course, higher crude oil prices obviously help Seacor Marine’s business.  Higher prices should result in increased exploration (both onshore and offshore) which will increase the demand for SMHI’s services.  The industry was devastated during the past few years as crude prices collapsed.  Some competitors filed bankruptcy.  Seacor Marine is well positioned for a return of offshore exploration if crude prices remain firm.

Dick’s Sporting Goods’ stock price had a strong 1st quarter.  DKS began the year below $30 per share and closed the quarter above $35 per share.  As everyone knows, online shopping is a headwind for a business with physical stores.  Despite this, DKS financial performance remained stable.  Dick’s Sporting Goods’ revenues exceed $8 billion (and are growing), they remain profitable, they have a strong balance sheet, and they had a dividend yield over 3%.  In hindsight, investors overlooked the positives and got too pessimistic during 2017.

During the first quarter, I used various hedging strategies to manage risk.  Specifically, I used inverse mutual funds and options (for those clients who have that capability).  These positions move in the opposite direction of the market and provided a way to reduce risk as the market fell.  The timing of these approaches is challenging but it I executed it well and it contributed to performance in the 1st quarter.

The 1st quarter marked the return of volatility in the capital markets.  It’s possible that it was a temporary situation and that the markets return to the calm environment we saw in 2017.  I am not expecting this.

I think there are several changes in capital markets that will shift traders and institutional investor’s viewpoints.  First, the Federal Reserve will continue to raise interest rates.  This hasn’t happened in almost 10 years.  I think there will be an adjustment process for businesses and the markets.

Secondly, the U.S. dollar has strengthened in 2018.  This could have far reaching impacts on emerging markets and international trade.  The emerging markets need dollars to conduct trade and, if the dollar is higher in foreign exchange trading, it is a higher cost to those economies.  Also, a higher dollar make U.S. companies goods and services more expensive for foreign customers.

I think 2018 will be a challenging year for the markets.  Higher interest rates and a stronger U.S. dollar are changes to the international markets that will require adjustments.  I don’t expect these changes to be priced into the markets in a smooth seamless process. I’m not sure that we will have a repeat of the 1st quarter’s turmoil, but I think that the markets could have some additional indigestion.  Of course, if this happens, there will be opportunities.  I hope to be able to recognize these opportunities and take advantage of them.

Please call with any questions.  Thank you for your business.

Jeffrey J. Kerr, CFA

Kerr Financial Group

Kildare Asset Mgt.

45 Lewis Street – Lackawanna RR Station

Binghamton, NY 13901

“I’m Happy When Life is Good and When It’s Bad I Cry. I Got Values But I Don’t How Or Why”

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

 

June 25, 2018 – DJIA = 24,580 – S&P 500 = 2,754 – Nasdaq = 7,692

“I’m Happy When Life is Good and When It’s Bad I Cry.  I Got Values But I Don’t How Or Why”[i]

 

In a world where every statement, email, social media post, wink, nod and gesture causes rage, insult, and protest, the recent news flow has turned up the heat on everybody.  This is no small task given the already intense state of opposing emotions and opinions.

Recent headlines include historic international developments, astounding political announcements, changing financial conditions, corporate developments, stock market peculiarities, and exciting outcomes in sports.

Starting with the least controversial (sports), Justify became the 13th horse to win the Triple Crown of thoroughbred racing.  The Washington Capitals hockey team won the sport’s Stanley Cup after years of frustration at being the regular season’s best team yet losing in the playoffs.  In golf, Justin Thomas won the U.S open for the second straight year something that hasn’t happened since Ronald Regan’s second term.  And of course, soccer’s World Cup has the world’s attention with thrilling wins and upsets.

The Summit with President Trump and Kim Jong Un could be 2018’s biggest story.  Clearly, there is a long path to denuclearizing the Korean Peninsula completely and many challenges remain.  But it’s remarkable that the two leaders met face to face and signed an agreement.

The Department of Justice’s inspector general report on the FBI’s handling of the investigation of Hillary Clinton’s emails was released.  The report concluded that there was no clear evidence that the Clinton probe was tainted by politics.  However, the report was critical of the FBI and President Obama’s Justice Department for “departing so clearly and dramatically from FBI and Department norms”.[ii]  The report strongly implied a culture of bias and corruption with both organizations.

Current FBI Director Christopher Wray, as expected, defended the FBI and responded that changes would include further training for senior executives and rank and file agents.  This training would be focused on the policies that were not followed in this investigation (but have been in place for years).  These types of “do overs” at taxpayer expense, can’t help Washington’s reputation (which is ok as it helps Wall Street move up the public opinion totem pole, although likely still trailing lawyers).

Tariffs are the next important item recently hitting the news wires.  President Trump proposed additional tariffs on Chinese imports two weeks ago. This was countered by increased tariffs on U.S. goods imported into China.  And again, the U.S. responded with additional tariffs.  Trade inequities need to be resolved but tariffs are not the optimum path and how this continues could be an economic headwind.

Ideally the Federal Reserve would be an afterthought.  And given the important developments, it’s easy to overlook that they raised interest rates at their latest meeting.  Importantly, they indicated that two additional increases could occur in 2018. This announcement wasn’t a huge market shock.

There had been chatter over four possible 2018 hikes, but it wasn’t given a high level of probability.  That changed with this recent announcement as a September interest rate increase is very likely with another to follow before the end of the year.

The capital markets are still adjusting to Fed Chairman Jerome Powell whose communication methods differ from his predecessors.  Mr. Powell hasn’t been using the cryptic language that Alan Greenspan, Ben Bernanke, and Janet Yellin employed to reassure traders and investors.  (Alan Greenspan actually said that he worried “terribly that I might end up being too clear”!)  The markets got spoiled from the constant coddling from prior Fed heads during the past 30 years.  But the bigger change is that interest rates are not moving lower.  They are moving up.  And probably for the long term.  This is a big change for the economy and markets.

The stock markets’ have had a very unique reaction to these developments.  Like the polarized society, the markets have separated.  Until last Friday, the Dow Jones Industrial Average was down 8 days in a row.  Blue chips bounced on Friday otherwise the Dow would have tied its longest losing streak since 1978.

As the Dow has been falling, technology and small cap stocks climbed higher.  The Nasdaq and Russell 2000 both closed at record levels last week.  Also, the Russell has closed higher for the past 8 weeks.  The theme behind the Russell’s move is that this index is made up of smaller companies that are domestically focused and, therefore, won’t be impacted by trade wars. We’ll see how that plays out.  Here is where the major averages closed last week.

2018
Dow Jones Industrial Average -0.6%
S&P 500 +3.0%
Nasdaq Composite +11.4%
Russell 2000 +9.8%

 

At the beginning of June, the S&P 500 pushed above a short term trading range that it had been in for weeks.  Not surprisingly the top of the range was widely known (S&P 500 2,740).  Once the S&P 500 traded above that level, many anticipated the run to continue back to all-time highs at 2,872.

Unfortunately, there was very little momentum after the breakout and stocks floundered. Maybe the rally to a new S&P 500 record is forthcoming – nothing has happened that precludes it.  However, this could be a sign of underlying weakness and, if we fall back into the trading range, it might signal some summer weakness.

Another intriguing development is the flattening yield curve.  As short term interest rates have risen, longer maturities have not proportionally climbed.  This is shown in the spread between the yield of the 2-year Treasury note and the yield of the 10-year note.  The 2-year note closed last week at 2.54% while the 10-year ended at 2.89%.  This 35 basis point spread is down from around 80 basis points a year ago.

Below is a graph that illustrates the changes in the U.S. Treasury yield curve during the past year and since March (courtesy of Grant’s Interest Rate Observer).[iii]  It shows the yield for various maturities.  Clearly, the Treasury curve was much steeper in June 2017 as compared to today.  The 3-month Treasury bill has almost doubled its interest rate while the 10-year and 30-year rates have moved much less.

This narrowing of this spread (or flattening of the yield curve) can be a signal of a slowing economy.  Currently, that doesn’t seem to be the case as GDP is expanding.  Alternatively, perhaps it is a sign that the markets doubt that the Federal Reserve will continue to hike short term rates.  Maybe the geopolitical news flow or the upcoming mid-term elections will result in the Fed delaying some future increases.  Or perhaps the market believes that the tightening that has already taken place will be enough to impact the economy and nothing further will be needed.  This will be an important area to watch in the second half of 2018.

There is no clear relationship between cultural division and unrest and the capital markets.  However, it’s easy to think that social turmoil is probably not the best economic backdrop.  On the other hand, that this bickering has polarized Washington could be a positive as a hamstrung legislative branch can’t inflect further economic damage.

The stock markets’ lack of follow through after the mid-June breakout and the flattening of the yield curve are disconcerting signs.  On the positive side of things, the job market is historically strong, the economy is growing, and expectations for corporate earnings remain upbeat.  This conflict within the capital markets combined with national unrest will make for an exciting summer.

 

 

[i] Pete Townshend, 1970

[ii] The Wall Street Journal, July 15, 2018

[iii] Grant’s Interest Rate Observer, June 15, 2018

 

 

 

Extra, Extra Read All About It

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

April 30, 2018 – DJIA = 24,311 – S&P 500 = 2,669 – Nasdaq = 7,119

“Extra, Extra, Read All About It”

 

To borrow a phrase from Ron Burgundy, last week was kind of a big deal.  In the financial markets, we saw 42% of the S&P 500 releasing quarterly results including notable market leaders Amazon, Boeing, ExxonMobil, Facebook, Google (Alphabet), Intel, and Microsoft.  Outside of Wall Street, the heads of North Korea and South Korea shook hands and stepped on each other’s soil for the first time. England’s royal family welcomed a new prince.  And, rivaling all headlines, the Jets drafted a quarterback.  It was truly a remarkable week.

Starting with earnings, they have been very good.  As reported by Bespoke Investment Group (The Bespoke Report, April 27, 2018), over 700 companies have reported earnings and an amazing 73% have beaten analyst estimates.  This is the best beat rate since 2006.  Additionally, 71% of the reports have exceeded revenue estimates which some view as a more important number as it is harder to manipulate.

Of course, a reasonable person would expect these strong results to produce a powerful stock market surge.  It has not.  In fact we’ve gotten the exact opposite as there has been noticeable selling following good earnings reports.  For example, after the markets closed last Thursday, Amazon, Intel and Microsoft reported above expected earnings.  All three jumped in the after-hours trading session with Amazon trading $100 higher (6.5%).  In Friday’s regular trading Amazon share price was higher but closed near the lows of the daily range.  Microsoft closed slightly higher while Intel gave up all of the gains and actually closed lower than Thursday’s level.

Furthermore, this has not been happenstance.  It has been a consistent pattern since 1st quarter earnings reports started as good results have met with strong selling.  Last week’s earnings should have driven prices higher but instead the Dow Jones Industrial Average closed down 0.62% for the week while the Nasdaq dropped 0.37% (the S&P 500 was flat).  While these are not catastrophic losses, they are not a normal reaction positive news.

Including last week’s small dip, here is where the major averages are year-to-date.

2018
Dow Jones Industrial Average -1.7%
S&P 500 -0.1%
Nasdaq Composite 3.1%
Russell 2000 1.3%

Explaining the markets under normal conditions is a futile endeavor.  Explaining this recent paradox is a series of guesses at best.  Nevertheless, investors need to attempt to understand what is going on.  First, markets look forward not backward.  So with these earnings reports being the results of the past three months, they are not as important as what lies ahead.  Perhaps the markets are worried that the future won’t be as strong.

And it doesn’t help that one of the corporate messengers was a little too forthright as was the case in last week’s Caterpillar conference call.  Typical earnings calls are prepared remarks followed by a question and answer session.  It’s common that management puts in best spin on all topics.  That’s not to say it is a complete charade but it is close to Hans Christian Andersen’s crowd showering complements on the naked emperor’s “new clothes”.

During last week’s call, Caterpillar’s CFO referred to company’s first quarter as the “high water mark” for the year.  While the candor is admired, those are not the words that result in a higher stock price.  Cat is an iconic company with wide reaching operations so this statement can reflect many parts of the economy.  And to suggest that 2018 won’t get any better than the first quarter is a glass of water thrown in the face of the bulls.  Cat’s stock dropped 6.5% after the conference call.

Of course, Caterpillar and the rest of corporate America began projecting the benefits of lower taxes last December.  In the market’s view, this is ancient history and now it’s a case of what have you done for me lately.  Unless there is another tax cut coming, it’s no surprise that this is not supporting prices in April.

Higher interest rates are another headwind and this was a popular (or unpopular) trader topic last week.  The 10-year Treasury note’s yield topped 3% which caused much wailing and gnashing of teeth resulting in some selling.  While there is nothing magical about the 3% level, the importance was that the yield traded above 2.95% which was reached amidst February’s turmoil.  Reaching the 3% threshold naturally brought predictions of a continued move higher in interest rates.

Higher interest rates can be a problem for any economy.  The impact on the current landscape with its swollen debt levels could be dramatic.  So the stock and bond markets’ angst could be related to this.  Also, it’s important to remember that interest rates have been declining since the years when disco was popular.  And over 35 years of declining interest rates likely means that investors might not understand how markets operate in these conditions.

Stocks and bonds have provided good diversification during the past several years.  In other words, in those times when stocks went down, bonds prices moved up (interest rates went down).  And vice versa – stocks went up when bonds prices went down.  It became a popular and successful strategy to position in these two asset classes and then apply leverage to achieve good returns.

This has changed.  For the first time in many years, both stocks and bonds declined in 2018’s first quarter.  Global central banks are reducing and reversing quantitative easing.  Add to this a noticeable pick-up in inflation.  In other words, the markets are undergoing important shifts and, as this takes place, risk is increasing.

Stocks and bonds will adjust and stabilize but getting through this process could be painful and investors need to be careful.  If the markets can’t rally on strong earnings (last week for example) or removal of geopolitical risks (South and North Korea), it’s not a good sign.

This apparent illogical trading action probably doesn’t progress into a bear market.  But might result in a nasty correction.  And given the low volatility, steady rally that we’ve gotten used to, a 10% correction will feel like the apocalypse.

Of course, from adversity comes resolve and, if we suffer a setback, there will be opportunities.   They won’t be as easy as selecting a name for a Prince or using your 1st draft pick to select Sam Darnold but lower prices usually means better values.  Unfortunately, the trip from here to there might get messy with elevated pain and frustration.  However, it’s at that point that the markets usually bottom which might be kind of a big deal.

2017 4th Qtr. Kildare Asset Mgt.-Kerr Financial Group client review letter

The following is a copy of the 4th quarter and year end letter sent to clients.  It reviews the markets and the client account’s activity and performance for the 4th quarter of 2017 and year-to-date.

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

 

In a year full of extraordinary events, the financial markets were among the top stories of 2017.  This is no small statement.  In a typical year, something like the Trump administration on its own is a topic that contains enough developments to characterize a year as historic.  Yet in addition to the fury and controversy surrounding President Trump, 2017 will also be remembered for the following things – North Korea, revelations of sexual harassment, Hurricanes Harvey, Irma, and Maria, the national anthem at NFL games, Fake news, and Bitcoin.

 

Staying within the markets, stocks had their best year since 2013 while bond yields remained calm for long maturities but rose on short dated issues.  The U.S. dollar had its worst year in a decade.  Both crude oil and gold prices rose in 2017.  But the biggest story of the 2017 markets was the growth and prevalence of passive investing.

 

Passive investing has been an enormous market influence for the past several years as the growth of investor capital devoted to the approach has been historic.  The two leading providers of passive investing products (Vanguard and Blackrock) have had inflows of over $1 trillion during the past two years.

 

Passive investing involves buying exchange traded funds (ETFs) or mutual funds that track an index.     Investors seek to invest in various asset classes via these funds.  For example, the SPDR S&P 500 Trust (symbol SPY) tracks the S&P 500 index. The SPY or its equivalent mutual fund is widely viewed as the equity asset class of a portfolio.  The iShares Barclays Aggregate Bond Fund (symbol AGG) tracks the Barclays Aggregate Bond Index which is a broad bond market index.

 

One example of a passive approach (also referred to as indexing) would be a portfolio of 70% stocks and 30% bonds using the SPY for stocks and AGG for bonds.  Once set, the investor may periodically rebalance the portfolio to keep the desired balance.

 

The goal of passive investing is to achieve market returns over the long term at the lowest possible cost.  As a result, this approach has the advantage of being much simpler as there is minimal upfront research – you are just investing in the chosen index.  Further, there is limited monitoring after investing the money.

 

While there are many appealing parts to this strategy, especially when the markets are moving up, it still exposes the investor to market risk.  This part of the passive investing equation is overlooked.  If the stock market corrects 15%, your portfolio is declining 15%.  This has not happened in a while so it’s easy to forget this possibility.

 

Another important risk is a function of the popularity of passive investing.  With all of the growth in the indexing approach, there are enormous amounts of capital doing the same thing.  This involves owning the same stocks, bonds, and other assets in the same amounts. If, for some reason, there is move to unwind some positions or raise cash, it could cause a wave of selling.  Depending on the circumstances, this could feed on itself and increase system wide risk.

 

There was very limited selling in 2017.  It was one of the calmest and smoothest years ever for the stock market.  There were no 5% corrections and buyers viewed every small dip as an opportunity.  The Dow Jones Industrial Average closed at a record 71 times last year which is the most ever.  Large cap stocks outperformed mid and small caps and growth stocks outperformed value stocks.  Here are 2017’s and the 4th quarter returns for the major averages.

 

4th Qtr. 2017

Dow Jones Industrial Average

10.3%

25.1%

S&P 500

6.1%

19.4%

Nasdaq Composite

6.3%

28.2%

Russell 2000

2.9%

13.1%

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.

 

Kerr Financial Group

-0.56%

12.82%

The 4th quarter was a challenging one.  Several of our holdings traded flat during the period and a couple even traded lower.  This was especially frustrating because the broad markets were so strong.  Fortunately, this turned out to be a temporary situation as these lagging positions rallied strongly in January.  Nevertheless, 2017’s 4th quarter was disappointing.

 

There was no common reason for this poor performance.  Instead there several distinct developments in the quarter that concurrently pressured different positions to trade lower.  Seacor Marine Holdings is a good example.  The stock (symbol SMHI) began the quarter trading in the mid-$15 per share.  It fell to under $12 in late December.

 

Seacor Marine provides global marine and support transportation services to offshore oil and gas exploration and production wells.  The company offers services that include crew transportation, platform supply, offshore accommodations, maintenance support, standby safety services, anchor handling and mooring capabilities, and liftboats.  The company operates in the Gulf of Mexico, Latin America, the North Sea, West Africa, Southeast Asia, and the Middle East.

 

Seacor Marine was spun off from Seacor Holdings in the second quarter of 2017.  Spinoffs happen for many reasons and often lead to opportunities as well as problems for the newly issued stock.

 

When a division is divested from a corporate owner, its stock often becomes an orphan in the eyes of institutional investors.  Depending on the reason for the separation, Wall Street may have little interest in the standalone company.  This is because there are often undesirable characteristics surrounding the division being let go by the corporate parent.  For example, the spun off company might be in a competitive, low growth industry with shrinking margins.

 

The spinoff of Seacor Marine Holdings was driven by covenants in a debt deal with the Carlyle Group.  Specifically, Seacor Holdings would have had to re-pay $175 million of convertible notes if Seacor Marine was not divested by December 31, 2017.

 

This is not to say that Seacor Marine was an invaluable gem to keep at all costs.  The industry is a mess.  With the growth of on shore drilling that takes advantage of fracking technology, offshore exploration became uncompetitive.  Consequently, companies servicing offshore drilling have been under severe pressure as business has declined.  Chapter 11 filings have been regular developments.

 

From an operational standpoint, Seacor Marine has weathered the storm – so far.  They have a strong balance sheet and have managed the downturn reasonably well.  Further, they have viewed the current industry landscape as an opportunity to buy some competitors’ assets out of bankruptcy.  Management believes that these transactions represent excellent long term value.  Also, there are signs of improvement as off shore drilling has reduced the cost of exploration and activity has increased as crude oil has rebounded to over $60 per barrel.  If offshore exploration continues to rebound, Seacor Marine could be in a position to make a lot of money.

 

Returning to the 4th quarter’s stock price decline, it appears that SMHI was a victim of tax-loss selling.  This involves investors looking to realize losses toward the end of the year as these losses reduce taxes as a deduction or to offset gains.  Seacor Marines stock was valued at $23 per share at the time of the spinoff.  As the stock price declined throughout the year, it became a strong candidate for selling in December to use the losses to reduce taxes.

 

I suspected that this was the reason for the weak stock price.  While the industry challenges remained, there were no new developments involving the company.  Unfortunately, it is never clear that tax strategies are behind a falling stock price.  I did use this opportunity to add to some positions but these were minor adjustments.  There was no way of being certain that the selling would subside when the calendar turned to 2018.  However, the stock has recovered in January 2018 which increases the probability that the 4th quarter’s price drop was tax related.

 

Reviewing other holdings during the 4th quarter, Dick’s Sporting Goods (symbol DKS and covered in the 3rd quarter letter) closed the year strongly.  Given the company’s financials, the stock price plunge that happened in 2017 might have been overdone.

 

Layne Christensen and Hurco both closed flat for the quarter.  Layne reported quarterly results in the beginning of December which showed continued progress in returning the company to profitability and growth.  However, initially the stock price dropped to the $11 per share area before finishing the year above $12.50.

 

2018 has started out with broad gains and we have participated.  While the 4th quarter was disappointing, client accounts have rebounded and outperformed in January.

 

I think this year will be much different from 2017.  The economy is growing but the Federal Reserve is signaling further monetary tightening.  This will provide some headwinds to the capital markets.  In addition, the markets will be adjusting to tax reform and possibly an infrastructure initiative.  It is possible that last year’s leaders are replaced by new sectors.  And of course, the influence of passive investing might be a greater market risk.  As always, this changing investment background will provide new opportunities.  I will continue to seek out those situations.

 

Please call or email with any questions.  Thank you for your continued confidence and trust.

 

“And now for something completely different….” – Monty Python’s Flying Circus

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

April 2, 2018 – DJIA = 24,103 – S&P 500 = 2,640 – Nasdaq = 7,063

In the 1970’s the British comedy group Monty Python’s Flying Circus produced a half hour long show that was broadcast in England and eventually made it on to U.S. television.  This was the stone age of television when viewers’ only choices were ABC, CBS, NBC and the public stations.  No cable, no ESPN, no CNN, and no FOX.  (How in the world did we know what to think??)  With such small distribution options it was remarkable that it got picked up.  Just the same, putting it on Sunday night at 11:00 on public TV (its show time and channel) was the equivalent of not getting air time.

Despite this obstacle, the troupe developed a cult following with their sketches that included topics such as dead parrots, Spam, and lumberjacks.  Many early episodes began with John Cleese in a black suit seated behind a desk which was in an outlandish place – zoo cage, in shallow water at the edge of the ocean, or suspended in air.  He would open the show by saying, “And now for something completely different”.

The reason behind this nostalgic tangent is that the capital markets, like Mothy Python, are acting “completely different”.  And it’s important that investors recognize this change, try to understand the causes, and make necessary adjustments.

To review where we’ve been, during the past several years, the markets were heavily supported by the Federal Reserve asset purchases (bond buying) and suppressed interest rates.  As traders came to understand this landscape and gained confidence in the fed, the result was a steep decline in volatility and steady increases in assets prices.

This is especially true since the bottom of the February 2016 correction and resulted in record calm during 2017.  Unfortunately, all good things come to an end and 2017’s tranquility has been replaced by its arch enemy – volatility.  This began when U.S. stocks hit an air pocket in the beginning of February and the Dow Jones Industrial Average and the S&P 500 both fell over 10% in ten trading days.   Indexes bounced in back during the second half of February but the sellers returned and stocks lost over 5% two weeks ago and closed near the February lows.

Equities bounced last week but are still around 8% below the records reached in late January.  Looking at the first quarter, the Dow and S&P 500 posted their first losing quarter in two years while the Nasdaq was up.  Here is the 1st quarter performance for the major averages.

2018
Dow Jones Industrial Average -2.5%
S&P 500 -1.2%
Nasdaq Composite +2.3%
Russell 2000 -0.4%

Nobody expects the Spanish Inquisition and few expected the stock markets’ tumultuous 1st quarter.  It’s unclear whether there was a specific cause behind the fall or whether stocks were simply overdue for a correction.   Of course, it’s likely a combination of both.  Some of reasons offered for the selling include rising federal deficits, chaos in Washington, trade wars, geo-political tensions, and central bank tightening.

At a minimum, there are some important changes in the financial landscape and this could have had a large influence on the markets.  First, interest rates have risen.  Last month the Fed raised the overnight interest rate to 1.75%.  It was the 5th rate hike since President Trump was elected.  More importantly, investors are pricing in several more rate increases in 2018.

Other interest rates have moved higher too.  LIBOR (London Inter-Bank Offered Rate), which is another short-term rate, is at the highest level since 2006.  Below is a chart of 3-month Libor (the Libor interest rate for 3 month borrowings) which covers the past 10 years and shows the recent jump.

 

There is no honor among thieves and, as the chart shows, apparently very little among bankers in times of financial stress.  3-month LIBOR spiked almost 100% amidst the failures of Lehman Brothers and Bear Stearns as it was every man and woman for themselves.  After the dust settled and the Fed got done fiddling as Rome burned, counterparty risk collapsed as central banks flooded the markets with money.

As can be seen, 3-month LIBOR scrapped along a floor of 20 to 40 basis points for 6 ½ years.  It rose above 50 basis points in 2015 and jumped from 1.2% to 2.2% during 2017.  This may appear to be a somewhat insignificant move but to economies that have become hooked on low rates and monetary easing, this is a big deal.  One of the ripples in this interest rate pond is that adjustable rate loans become more expensive for borrowers some of which probably can’t afford higher expenses.  Given that the Security Industry and Financial Markets Association reports that corporate debt is at all-time highs ($8.83 trillion), rising interest rates are a problem.

As noted, interest rates have been moving higher for over a year.  A more recent change is a new Federal Reserve chairman as Jerome Powell replaced Janet Yellen.  The new sheriff in town comes with a new view.  According to recent congressional testimony, Fed Chairman Jerome Powell said the stock market isn’t the Fed’s focus.  According to The Wall Street Journal, Mr. Powell told the House of Representatives that “We don’t manage the stock market” and “I think the general thing is that the stock market is not the economy”.  He admitted that the markets are important but not central to the organization’s decisions.  (The Wall Street Journal, February 27, 2018).

While the markets are aware of the Federal Reserve’s “dual mandate” (price stability and employment growth), traders have long believed that they also kept close watch on the financial markets especially the stock market.  If stocks approached any level of panic, Wall Street expected the Fed to step in any way possible to support prices.  This has some history as it dates back to Alan Greenspan (the Greenspan Put) and continued with Ben Bernanke and Janet Yellen.  If Jerome Powell views the stock market as less important than prior Fed heads, this represents a material change and might be contributing to the recent declines.

In addition to higher interest rates and less Fed coddling, inflation could be a third head on the market’s adversarial monster.  After years of deflation and falling prices, there are signs that the U.S. economy could be facing a pick-up in inflation.  This will be a tectonic shift in the markets’ landscape and something that many investors have never faced.

Some of the obvious impacts of inflation include higher interest rates and reduced profit growth due to higher costs.  It could lead to a situation of nowhere to hide in the financial markets.  Low or no profit growth would compress valuations and stocks would fall.  At the same time, higher interest rates would result on losses in the bond market.  The 60/40 or 70/30 mix of stocks and bonds strategy that became popular in the past several years of would suffer.  Add some leverage to this equation, as is the case with many hedge funds, and the pain could become intolerable.

Of course, these developments are not certain to happen.  The capital markets have several reasons for confidence.  Lower corporate taxes should drive earnings growth, the Trump administration has rolled back a great number of President Obama’s regulations, and business and consumer optimism is high.  On this final point, there is much expectation on corporate investment as a result of reduced taxes and repatriation of offshore capital.  This could be a powerful economic wave if it happens.

The volatility of February and March has been a surprise.  The important question is whether it is part of “normal” correction and a great buying opportunity or a function of a changing backdrop to the markets and the start of a larger decline.  This latter option would qualify as something “completely different” and would suggest further downside risk.

It would seem that investors are well aware of the bullish argument and that much of the positives are priced in.  The damages from higher rates and increased inflation are less know and could cause further disruptions as the markets adjust to their likelihood.  Caution might be the best investment approach until the answer becomes clear.

 

 

“Popular! You’re going to be Popular!” – Galinda – “Wicked”

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

February 23, 2018 – DJIA = 25,309 – S&P 500 = 2,747 – Nasdaq = 7,337

Popularity is hard to achieve.  The competition for the audience’s attention and affection is fierce despite the fact there are so many more ways to reach them.  For example, putting out a YouTube video is as easy as focusing your smartphone.  And the plentiful options for distribution include Facebook, Twitter, LinkedIn, Snapchat, and Instagram.  However, breaking above the endless and constant flow of information that bombards our normal daily activities and becoming noticed is the challenge on the path to popularity.

Of course once popularity is attained, it is difficult to maintain. And those who have the knack of sustaining their fame have a special talent.  Applying these thoughts to the capital markets, the quintessence of human emotion, we find a situation that rivals the stoutest high school clique.  In the equity markets, the FANG stocks are the equivalent to being on the cover of People Magazine every week.

Popular stock market leadership is nothing new.  Radio and car makers (new technologies at the time) were darlings in the 1920’s, the Nifty Fifty dominated trading in the late 1960’s and 20 years ago there a Dot Com bubble with a handful of stocks leading the charge.  Today FANG (or FANG +) is comprised by Facebook, Apple, Amazon, Netflix, Nvidia, and Google.  Some expanded versions include Microsoft and Cisco Systems despite “M” and “C” not fitting into the acronym (traders aren’t very picky on the grammar as long as the stock is going up!).

FANG’s February muscle flex was historic.  As the stock markets have recovered from their plunge, these favorites have been responsible for much of the bounce. To review, after making fresh all-time highs in late January, stocks plunged over 10% in 2 weeks.  During this air pocket, the major averages sliced through their 50-day moving average and approached their 200-day moving average as the intraday lows were made.  Stocks bounced on February 9th and rallied since then.  The S&P 500 has recovered around 50% of the decline but the Nasdaq Composite’s rebound was much stronger and brought this index back to within 1.6% of its January record.

While a recovery from the intense selling was welcome, this was far from a broad bounce.  At the risk of sounding picky, the speed and narrowness of the rally might be a concern.  To this point, as of the end of last week, the FANG gang accounted for 70% of the Nasdaq 100’s year-to-date performance (the Nasdaq 100 is the 100 largest companies of the Nasdaq Composite).  Amazon’s stock is responsible for 28% of the of the index’s 2018 gain while Microsoft is 12%, Netflix is 7%, Google 7%, Apple 6%, Nvidia 5.5%, and Cisco 5%.  That’s 7 out of 100 stocks contributing 70% of the index’s 2018 move.  That’s a remarkable development.

According to Thomas Thornton at Hedge Fund Telemetry (who is the source of this data) the normal attribution for these stocks range between 40% – 55%.  Given this 70% reading, it makes one wonder how poorly the other 93 stocks are doing.   For those keeping score at home, the Nasdaq 100 has a nice 7.8% YTD gain at the end of last week. While we on the topic, here are the major averages 2018 returns as of last week’s closing.

2018
Dow Jones Industrial Average +2.40%
S&P 500 +2.80%
Nasdaq Composite +6.30%
Russell 2000 +0.90%

The Nasdaq 100 is not the only place where we see over weighted concentration.  Within the S&P 500, the technology sector has moved to represent around 25% of the index.  Throughout the last decade it ranged around 15% and since the financial crisis it has been around 20%.  The last time tech was this much of the S&P 500 was during the Dot Com bubble when its weighting topped out around 35%.

Just because technology has become oversized does not mean that the stock market will decline.  However, narrow market leadership is not typically associated with strong upward trends.  Still, the economy is strong, earnings are growing, and optimism is high.

Looking closer at corporate earnings, they have been strong.  69% of companies have beat their earnings estimates for their quarterly and year-end reports and this is the highest reading since 2006’s 3rd quarter.  Analysts increased their earnings estimates going into the reporting season which makes this ‘beat’ rate more impressive.  On top of these strong bottom lines, 73% of the companies exceeded revenue estimates.

Please note that this is looking in the rearview mirror.  Casting our eyes forward, there are a couple items of concern – rising interest rates and inflation.  Interest rates have been moving higher for some time but the recent move up across the yield curve has investors worried.  There is a lot of system wide debt and a sizable portion is adjustable rate.  The translation is that increased interest payments will hurt margins.

Also, there are some signs that inflation could be lurching higher.  January’s employment report showed increased wage pressures and some commodities prices are moving higher.  Lumber is trading at all-time record levels and crude oil has rebounded above $60 per barrel.  Higher prices could force the Fed to raise interest rates at a faster rate.  These could be issues contributing to the capital markets’ volatility.

The popularity of the FANG stocks have helped the markets recover from February’s drop.  As attractive as their shares are, Wall Street needs to see their charm spread beyond that small group.  If the S&P and Dow can close the gap with the Nasdaq, it would be a strong sign that the February’s drop is probably over.  If stocks continue to rely on FANG’s popularity, the rally would likely fail and lead to a revisiting of February’s unpopular levels.  Indeed, popularity is a heavy burden.

 

Slow Down, You Move Too Fast; You Got to Make the Morning Last.

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

February 12, 2018 – DJIA = 24,190 – S&P 500 = 2,619 – Nasdaq = 6,874

The pace of life in today’s culture is fast.  This we know.  A few years ago, we only got our mail once a day and it was delivered by the U.S. Postal Service.  Now we read freshly delivered emails on a cell phone while standing in line to buy a $5 coffee made from beans grown in Sumatra.

And we know that this swifter pace has changed the financial markets.  We have instant access to quotes, corporate and economic news, and all sorts of financial data.  Unfortunately, during the last couple of weeks this speed showed up in the form of a sudden price plunge.  It has traders wishing for a return to getting their quotes from a ticker tape.

On January 26th (two trading weeks ago) stocks closed the week at record levels.  It was an incredibly strong month to start 2018.  The market then, without much warning, reversed direction and fell hard and fast.  Below is a chart of the S&P 500 for 2017 through the selloff..  As you can see, December and January’s impressive gains were wiped out in a handful of days.  The blue line is the 50-day moving average.  Notice how prices moved so smoothly throughout last year but when the drop happened is was sudden and swift.  The S&P 500 sliced through its 50-day moving average and continued falling.

 

 

Another indicator that demonstrates how dramatic this fall was is the RSI or relative strength indicator.  The RSI is a momentum measurement that tries to quantify the speed and change of prices.  It oscillates between 0 and 100 with readings above 70 considered overbought and under 30 oversold.  Below is a chart of the RSI for the past year.  We have taken this from Jason Goepfert’s Sentiment Trader blog.  It shows the astonishing plunge in momentum.  Mr. Goepfert points out that this move from overbought to oversold is the fastest ever.  He concludes, “that raises concern that we’re now in a different market environment”.

In the understatement of 2018 (so far), a lot of money was taken out of the stock market as prices fell.  According to Trim Tabs Research, a company that tracks money flows in and out of various asset classes, over $50 billion came out of equities, equity mutual funds, and equity ETFs during the first 2 weeks of February.  The previous record for monthly outflows was $46.5 billion which occurred in July 2002.  This graph shows the weekly flows.  Notice the incredibly steady inflows into stocks during the past couple of years together with the amazing flush in February.

Some other painful points of February’s drop include the first ever daily 1,000 point drop for the Dow Jones Industrial Average.  On February 5th the Dow plunged 1,087 which was a 4.26% move.  The next two largest daily declines were in the midst of the financial crisis.  The Dow fell 777 points (6.98%) on September 29, 2008 and 733 points (7.87%) on October 15, 2008.  The 4th largest point drop took place the day that the financial markets re-opened after the September 11, 2001 terrorist attacks (September 17, 2001) – 685 points or 7.13%.  Concerning this month’s 1,000 point daily drop, it is interesting that the prior trading day (February 2nd), the Dow was down 665 points or 2.54%.  Combing these two days, the Dow lost 6.8% in consecutive trading days which, outside of the crashes of 1929 and 1987, ranks among the highest percentage daily losses.

Now that we’ve described the carnage, let’s explore some potential reasons behind it.  January’s employment data was released on February 2nd.  As part of the report, the Labor Department estimated that average hourly earnings for private sector workers jumped 2.9% in January as compared to the year before.  This number raised Wall Street’s fears of inflation and stocks fell while the 10-year Treasury yield climbed to 2.85% which is its highest level since January 2014 (this yield has since moved higher but closed last week at 2.83%).

Inflation, despite the Federal Reserve’s desire for it, would hurt the fixed income market as bond interest payments would have less inflation adjusted value (the real yield).  As a consequence, interest rates would move higher.    Further, corporate earnings might suffer if companies can’t pass along increased costs.  And, if inflation gets too high, the Fed might quicken the pace of interest rate increases which could be an economic headwind.

That Wall Street has inflation worries is an noteworthy change.  Previously, the financial markets’ concerns were more about deflation, but there was confidence that the Fed could prevent it.  Now the markets acknowledge that inflation could be a problem and apparently there is some doubt that the Fed can handle it without upsetting the economy and the markets.

Another contributor to the stock market mayhem involves volatility products.  The VIX index (the CBOE Volatility Index) shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options.  The VIX is widely used in judging stock market risk and the index has a 27 year average of around 19.

The VIX was launched in 1993 and quickly grew in popularity as a gauge for stock market risk.  A separate index was developed for the Nasdaq – symbol VXN.  VIX futures began trading in 2004 and VIX options were introduced in 2006.  Since the financial crisis, exchange traded funds (ETFs) and exchange traded notes (ETNs) began trading.  These securities are tied to the VIX futures market.

As we’ve pointed out in previous newsletters, 2017 was the calmest ever for the capital markets and the VIX averaged 11 during the year.  This tranquility resulted in the strategy of selling volatility through the various VIX derivatives.  This evolved into a virtual flock of geese laying golden eggs as volatility drifted lower and those short sales decreased in price (profits for those who sold).  Further, traders were emboldened as it appeared that the the Fed was determined not to let the stock market fall (and volatility increase).

As the popularity of this trade grew, it included both retail investors as well as institutional players.  An extension of this trade was to increase or decrease equity exposure depending on the direction of your VIX trade.  In other words, increase stock positions as the VIX fell and sell equities if the VIX climbed.  This became a somewhat self fulfilling trade.  For those old enough to remember the markets in the 1980’s, this is similar to the portfolio insurance strategy that contributed to the 1987 crash.

To be sure, this trade was not so common that it was the dominate happy hour topic with everyone bragging about how much they were making by selling “vol”.  However, it was a widespread approach among hedge funds especially those involved in risk parity strategies.  And if hedge funds are doing it, leverage is applied.

Once the VIX panic started, it spread fast.  And interestingly, its largest impact was the U.S. stock market.  Yes, international bourses were affected, but they didn’t encounter the selling that the U.S. market underwent.  Further, the emerging market indexes, usually a victim of global panics, weathered the storm pretty well.  And there was no rush to traditional safety plays such as Treasuries (yield didn’t plunge) and gold (it actually traded lower).

By the end of the week there were some encouraging signs.  U.S. stocks stabilized and recovered a little.  The VIX retreated from the 50’s and looked like it would return to the low 20’s.  Investor sentiment had collapsed which is a good sign as pessimists usually have sizable cash positions which could come back into the market.

On the negative side of the ledger, the depths of the damage are unknowable at this point.  Even if the markets return to their calm ways, we could still see some players taken out in body bags.  There are struggling hedge funds that could have been over leveraged and unable to adjust to the turmoil.  Or an extended “vol” trader who is pressed his bets and is going under.

In addition, the emotional damage to investor psyche could require more time to heal.  With all of the money that has flowed into the stock market over the past year and one-half, this sudden drop could begin to cause investors to second guess their confidence.  And if inflation indicators keep popping up, it’s a good bet that we have not seen the lows for the year.

Of course, recalling that everything happens faster these days, it’s possible that all of the negatives were quickly resolved and the markets will resume their move from lower left to upper right.  However, it would be wise to keep in mind the speed of this month’s decline and develop a plan if we begin to trade lower again.  Indeed, the markets are making us stay nimble as well as fast.

 

 

 

 

Yesterday All My Troubles Seemed So Far Away. Now It Looks as They Are Here To Stay. Oh I Believe in Yesterday.

 

 

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

January 22, 2018 – DJIA = 26,071 – S&P 500 = 2,810 – Nasdaq = 7,336

 

Somethings aren’t what they used to be.  This comment isn’t a nostalgic yearn for the ‘good ole days’ but, instead, an observation that virtually nothing is protected from the ever present upheaval impacting our lives.

Take the National Football League for example.  NFL football games used to be around three hours in length.  Now due to a combination of constant reviews of officials’ rulings and endless player celebrations over the most routine play, the games are a tedious bore and have become unwatchable.

Another example of how times have changed involve federal government shutdowns.  They used to have much more meaning.  Previous shutdowns came with intense angst and fear over their unknown length.  Further they used to be accompanied by threats of credit rating downgrades, a falling U.S. dollar, and widespread fallout.  Sadly, government shutdowns have turned into an exercise in name calling and casting of blame with everyone knowing it won’t last long.  They’ve become routine.

And of course, the stock market is not immune to perception change.  For example, bold headlines used to announce when the Dow Jones Industrial Average crossed a 1,000 point threshold.  The business television stations would break out the party hats and it would be the topic of the day.  Last week the Dow crossed 26,000 for the first time and, if you weren’t paying attention, you could have easily missed it.

Perhaps this has become too common.  Last week’s 26,000 mark is the eighth 1,000 point level gained since Election Day in November 2016.  Furthermore, this latest threshold only took 13 calendar days from when the Dow crossed 25,000 – hardly enough time to get the Dow 26,000 hats made.  This is the shortest number of days for the Dow to move from one 1,000 mark to the next.  Obviously, 1,000 is a much smaller percentage and therefore an easier accomplishment at 26,000 than at the lower numbers.  Nevertheless, this has been a historic move for the Dow.

Not only has the stock market been moving up, it has been a remarkably steady, smooth journey.  Last week the S&P 500 set a new record for the longest time without a 5% correction.  At 395 days, this new stretch beat the 394 days in the 1990’s and 386 days in the 1960’s.  To further point out how rare this is, the S&P 500 has averaged four 5% corrections annually dating back to 1927.  In other words, there are normally four 5% corrections every year but we have’t seen anything close to that since the beginning of 2016.  Investors should consider the possibility that we might have some catching up to do.  Below is a graph showing the previous streaks. (Financial Time, January 19, 2018)

 

Looking at this month’s trading, the rally continues.  The S&P 500 started the year with 9 consecutive days of closing higher than it opened.  Further, it closed at a new record high 11 out of the first 14 trading days.  While this does not set a record for the best start to a year, it is among the top.  Here are the gains for the major averages through last Friday.

2018
Dow Jones Industrial Average    +5.5%
S&P 500    +5.1%
Nasdaq Composite    +6.3%
Russell 2000    +4.0% 

 

Another noteworthy financial market development of 2018 involves a spike in interest rates.  We know that the Federal Reserve raised rates in December and that the shorter maturities of the yield curve had been moving higher for several months.  However, the rates on the longer end of the curve (10-year and 30-year bonds) had not moved much.  In 2018, the longer dated rates have moved up.  Last week the 10-year Treasury note closed around 2.66% which is up from 2.41% at the end of 2017.  The 10-year note was last above 2.5% in March 2017.

On the surface, these higher interest rates might seem insignificant.  But in a leveraged financial system and in an economy that has gotten used to low rates with little volatility, this is a change.  Of course, if rates are moving up due to strong loan demand and that capital is being used to fund investments that will result in further economic growth, that is good.  However, if other factors are pushing rates (inflation, deficit concerns, etc), this could lead to wider spread problems.  Higher interest payments will lead to higher interest expenses for the federal, state, and local governments.  This will lead to larger deficits if tax receipts don’t grow.

Another worry involves individual and corporate debt.  For loans with variable or adjustable interest rates, this move will increase the cost of borrowing.  Whether it’s an adjustable rate mortgage or a bank loan tied to LIBOR, these higher yields will change the landscape.

System wide debt levels are high.  According to the Federal Reserve Bank of St. Louis, non-financial corporate business debt exceeded $6 trillion at the end of the 3rd quarter 2017.  This is up from $3 trillion in the mid 2000’s.  On top of this, individual mortgage debt exceeds $1,300 trillion.  And these totals do not include such things as credit card balances, automobile financing, and student loans.  Clearly there is a lot of debt in the system and this leverage could be stressed if interest rates continue to rise.

Foreign exchange is another market with some important developments.  Actually, this story dates back over a year but has been getting more attention in the New Year.  The value of the U.S. dollar has noticeably fallen against other major currencies.  The dollar index is an index that measures the U.S. dollar against a basket of major global currencies (euro, yen, pound, etc.). It has steadily declined since December 2016 and closed last week at the lowest level since late 2014.  This has gone against the widespread belief that a Trump Administration, with the ‘Make America Great Again’ initiative, would result in a strong dollar.  That turned out to be a bad bet.  Below is a chart for the DXY (dollar index) provided by Bespoke Investment Group.

The U.S. dollar is critical to the international financial markets and global trade.  Virtually all international trade, including crude oil, is transacted in the U.S. dollar.  For example, if Japan imports liquefied natural gas from Australia, it is done through the greenback – the yen and Australian dollar are both converted to U.S. dollars to complete the transaction.  The same flow would occur when China imports commodities from Brazil and Sweden exports to Canada.

The value of the dollar also influences the competitiveness of U.S. companies.  With a weak U.S. dollar, the products sold by U.S. based companies are cheaper in terms of other currencies – the euro or yen buy more dollars.  This means that domestic companies with international markets should be more competitive from a price standpoint and those businesses should see increased sales.

While this improved competitive position is obviously good, a weaker currency has its drawbacks.  A falling currency is usually associated with countries experiencing trouble or instability.  Further, a weak currency can be the result of capital outflows which could turn into a strong economic headwind.

So far, there hasn’t been any noticeable deterioration or impact from the U.S. dollar’s retreat.  This can change but the current landscape is unaffected.  Perhaps the main force behind the fall is the relative position of central bank policy.  The Federal Reserve has been raising rates for a couple of years while the European Central Bank has only begun reducing their monetary easing.  It could be that the markets have already discounted the Fed’s anticipated rate increases while recognizing a strong European economy and higher continental interest rates later this year.

It’s been an exciting new year for the capital markets including a strong rally for stocks.  And while a repeat of 2017 would be welcome for equities, a pick up in volatility is expected.  Given that we typically get four 5% corrections in a year and we haven’t had one in two years, it shouldn’t be a surprise for the markets to be a little choppy in 2018.  Of course, maybe like the NFL and all of the other things in our lives that are going through subtle change, perhaps the markets have transformed into a smooth path of always going up.  That presumes the four most dangerous words in investing – “It’s different this time”!  Yes, somethings in our lives aren’t what they used to be but risk isn’t one of them.

Jeffrey J. Kerr, CFA

Kerr Financial Group

Kildare Asset Mgt.

45 Lewis Street – Lackawanna RR Station

Binghamton, NY 13901

 

 

 

 

I Just Want to Celebrate Another Day of Livin’

 

Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

January 8, 2018 – DJIA = 25,295 – S&P 500 = 2,743 – Nasdaq = 7,136

As we look back at the holiday season, there was some joyful reflection and celebration including relaxing time spent with family and friends.   Unfortunately, for some, the holidays are a time of overwhelming stress and frustration.  Sadly, there appears to be a thin line between these two emotional states and, hopefully, more people enjoyed much of the former and little of the latter.

This range of holiday emotions is comparable, on a certain level, to those that result from dealing with the financial markets. Sometimes there’s a great deal of cheer and jubilation and while other times are filled with lament and despair.  Looking back at 2017, joy and celebration dominated the capital markets.

In most years there are sectors of the capital markets that don’t perform well and even decline.  For example, sometimes an asset class such as commodities, real estate, or fixed income fall due to currency and interest rate movements or economic developments.  It is the natural ebb and flow of the markets.  In 2017, however, all asset classes advanced during the year.

Below is a chart reviewing various asset class returns for 2017.  It shows the steady move from lower left to upper right for stocks (both U.S. and international).  Equities were followed by U.S. real estate and bonds.  Commodities and managed futures (likely related to commodities) both recovered losses in the first half of the year and posted gains.  Hedge funds, as a group, provided mid single digit returns and continued to under perform stocks which provides more ammunition to the passive investing supporters.

The table below shows annual returns of various asset classes dating back to 1998.  The sectors are ranked each year from best (on top) to worst.  The asset classes are basically stock and bond indexes.  It has two major U.S. stock indexes with the S&P 500 (dark green) and Russell 2000 (dark brown) .  International stocks are tracked via the MSCI World ex U.S. (gray), and MSCI Emerging Markets (orange).  Two fixed income indexes are included – the Bloomberg Barclays U.S, Aggregate Bond index (light green) and the Bloomberg Barclays U.S. Aggregate High Yield index (teal).  For more detail, the S&P 500 and Russell 2000 are broken down into growth and value – S&P 500 growth is light brown, S&P 500 value is dark blue, Russell 2000 growth is yellow, and the Russell 2000 value is light blue. (Apologies that size constraints make the text difficult to read).

Some noteworthy nuggets include the fact that for the past two years every sector has show positive returns.  While there are examples of this happening, three year streaks are not common.  This would suggest heightened risks for 2018.

Another important point is the rotation of the leading and trailing sectors.  In other words, last year’s winners could become this year’s laggards.  This rotation gives the table a quilt type appearance as leading sectors change and the colors move around (The exception to this is that emerging markets were the best performing sector 5 consecutive years – 2003 through 2007.  The move was very impressive with yearly gains of 55%, 25%, 34%, 32%, and 39%.  However, the emerging markets plunged 53% in 2008.)

More recently there has been the classic rotation.  In 2016, the Russell 2000 Value provided the best returns with an almost 32% increase.  2017 was a much different story as it was third to last and only up 8% (S&P 500 was up 22%).  It was the worst of the stock indexes and only beat the two bond indexes.  Another example involves the emerging markets index again.  For the 5 year stretch from 2011 to 2015, the emerging markets were the worst performer 3 years and the second to worst performer for 1 year.  They showed losses in each of those 4 years.  But from these depths it returned to be the top dog in 2017 (up 37%).

The table highlights the folly of blindly chasing yesterday’s winners while overlooking opportunities that have fallen from grace.  To be sure, sectors of the market can remain leaders for extended periods of time, but following an  investment strategy that is equal to a popularity contest will likely result in disappointment.

 

In hindsight, it’s easy to see that 2017 was a good year for the markets.  The Dow Jones Industrial Average closed at a record 71 times during the year.  This is the most in history exceeding 69 in 1995, 62 in 1962, and 52 in 2013.  Moreover, it was a steady and smooth trip.  In 95% of the trading days, the Dow traded in less than a 1% range as measured by the day’s high and low.  This bring up the questions – Why can’t they all be this easy?

It’s not hard to forget that the tranquil markets were in sharp contrast to news flow.  There was plenty of news that could have potentially derailed the markets.  The antagonistic political setting including open talk of impeachment of President Trump.  Terrorist attacks in New York, London and Spain.  High levels of social division leading widespread protests (Charlottesville) and massacres (Los Vegas, California, Texas).  High geopolitical tensions including North Korea’s effort toward a nuclear weapon.  Natural disasters with hurricanes hitting Houston, Florida, and Puerto Rico.  With this kind of backdrop, it is remarkable the market were not lower and a lot more volatile.  Here are the final 2017 numbers for the major averages.

2017

DOW JONES INDUSTRIAL AVERAGE                                                                              +25.1%

S&P 500                                                                                                                                      +19.4%

NASDAQ COMPOSTIE                                                                                                            +28.2%

RUSSELL 2000                                                                                                                         +13.1%

Enough of the rear view mirror – inquiring minds want to know what’s going to happen in 2018?  It’s easy to think that the market is poised to pull back given the strength of 2017.  After all it’s second longest stretch in history for the S&P 500 trading above its 200-day moving average and markets don’t normally act this way.  On the other hand, if the capital markets have not only survived but prospered given the events of 2017, it might be another strong year ahead.

Looking at history, Bespoke Investment Group provides some data.  The table below gives the annual performance for the S&P 500 in years following a year with a 20% or greater gain.  As shown, the year after a 20%+ move is positive 68% of the time with an average gain of 10.46%.  Further, there are several examples of back-to-back years of 20% or greater returns.

While the markets absorbed 2017’s body blows, the bears are not extinct (yet).  Some of the remaining ammunition is in the form of potentially higher interest rates and high valuations.  The Fed has been raising the fed funds rate and is projecting further interest rate hikes in 2018.  Rate increases during the past couple of years have been absorbed  by the economy.  But the impact of future raises could be more disruptive.

Corporate earnings growth accelerated in 2017.  However, stock prices climbed faster leaving valuations elevated.  Some of the stock market jump was in anticipation of tax reform and the lowering of corporate tax rates.  How much of this bottom line benefit has been priced in is a critical question facing stocks in 2018.  Another important question is beyond the bump from lowered rates, how much more will earnings grow on a comparative basis.

As hard as it was to predict a smooth and historic year for the financial markets back in January 2017, it is equally difficult to forecast 2018.  There are some expected developments (interest rate hikes) in 2018.  However, it’s the unexpected stuff that could move markets.  Investors should remain flexible and, as much as possible, on top of things.  But before we get too far into the year, there are some New Years resolutions to break.

Jeffrey J. Kerr, CFA

Kerr Financial Group

Kildare Asset Mgt.

45 Lewis Street – Lackawanna RR Station

Binghamton, NY 13901