Phillips and Company Blog

Small is Big and Big is Insurmountable

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This week I had the pleasure of spending a few private and public moments with our former US Secretary of the Treasury, Hank Paulson. While any private comments will remain just that, some of his public comments were very appropriate for the times we are in. I thought I would share them with the over 3,000 recipients of this blog. 

First, a little background. Hank Paulson took some of the most decisive action while Secretary to save the US and Global economies. He worked hard to pass not one but two critical pieces of legislation: the Housing and Economic Recovery Act of 2008 and the Emergency Economic Stabilization Act of 2008. Just think about that in relation to today's inept, ineffective, do nothing Congress.

Once he left the political class, he launched the Paulson Institute, and focuses his time and resources on China, US economic and environmental policy. He was in Portland discussing his new report, Risky Business, on the environment and the economic costs associated with poor environmental policy. Take a read if you have some time, I found it very fact based versus the normal "flame throwing" garbage you get from the policy crowd.

What I found compelling about his thoughts were a few key comments and how they apply to our current situation.

Hank's Thought #1: Poor public policy is generally the cause of financial crisis, which we tend to bounce off of every 10 or 15 years.

            What will the long-term impact of the Fed's Zero Interest Rate Policy have on corporate profits, retirement savings, job creation and asset bubbles? Certainly we know student loans are at record highs, along with corporate profits.[i, ii]

How much of this is derived from cheap money?

Hank's Thought #2: Warming temperatures will have a dramatic impact on food costs as land becomes more arid.[iii]

Does this mean portfolios (pension and retirement) will have to generate larger returns to support basic needs like food and energy? Most well-run portfolios target a spending rate plus inflation.

We know the government likes to remove this component from their calculations because it is so volatile, but it does represent 15% of our spending.[iv] Where in the world will we find more return without pushing the risk curve even higher than it is now?

Hank's Thought #3: In the middle of the night when he was wide awake thinking about the financial crisis, the small problems he faced seemed big and the big problems seemed insurmountable. In the morning, you get up and start solving them and they become manageable. 

Between:

  • the Ukrainian crisis that is pushing the US to the brink of something with Russia,
  • the 160,000 Syrian's killed by terrorists and the Assad regime, [v]
  • the world's best funded terrorist organization (ISIS) taking over parts of Iraq and Syria,
  • the Israelis rightfully defending their territory with a war on the Palestinians,
  • Iran moving closer to obtaining weapons grade uranium and destabilizing the world,
  • 57,000 unaccompanied children crossing our borders hoping for help,[vi]
  • young adults between the ages of 16-24 unemployed at a rate of 13.3% in our own country,[vii]
  • and a totally inept Congress,

nights can seem pretty dark and the problems appear insurmountable.

Well, here's the morning part that makes this "Wall of Worry" more manageable. Companies are still driving more profits with about 80% of companies reporting last week beating expectations.[viii]

 

Wages are up, albeit not growing fast enough, yet still fueling American consumerism.[ix]

Energy prices are on a secular decline due to innovation and the tapping of natural gas reserves throughout the world.[x]

CEO's are more optimistic about the future than they have been in the past 2 years.[xi]

 

Even though China produces one million engineers a year compared to our 70,000, the greatest innovation in the world still occurs in America because we can wake up and think creatively and not purely in a linear fashion.[xii]

If that doesn't help you digest the apparently insurmountable problems we as investors face and you ponder selling out, think about this. Past stock market reactions to crises have generally been muted at the time of the event, and more importantly, the market had larger gains over the following six months.[xiii]

Somehow I feel better already...Thanks, Mr. Paulson, for your visit to Portland and the sage advice. It's timely. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Jeff Paul, Senior Investment Analyst – Phillips & Company

References

[i] Federal Reserve Bank of New York. (Mar 29, 2013). Student Loan Debt by Age Group.

[ii] Federal Reserve Economic Data. Corporate Profits After Tax.

[iii] Federal Reserve Economic Data. Consumer Price Index for All Urban Consumers: Food.

[iv] US Dept of Agriculture. (2012). Share of U.S. household consumer expenditures by major categories.

[v] Karimi, F. and Abdelaziz, S. (May 20, 2014). Syria civil war deaths top 160,000, opposition group says. CNN.

[vi] Archibold, R. (Jul 20, 2014). Trying to Slow the Illegal Flow of Young Migrants. NY Times.

[vii] Statista.com. (2014). Monthly youth (16-24) unemployment rate in the United States from June 2013 to June 2014.

[viii] Bloomberg LP.

[ix] JP Morgan Asset Management. (July 2014). “3Q 2014 Guide to the Markets”, p. 25.

[x] Nasdaq. (Jul 21, 2014). U.S. National Average Natural Gas Price.

[xi] Vistage. (Dec 2013). CEO Confidence Index.

[xii] Wadhwa, V. (Sep 1, 2011). President Obama, there is no engineer shortage. The Washington Post.

[xiii] Hulbert, M. (May 2, 2014). What an International Crisis Could Mean for Stocks. The Wall Street Journal.

 

Retailers...Just Hit a Pot Hole!

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Coming off of a spectacular jobs report in the previous week, we should be seeing some pretty strong numbers from the US retail sector. It's pretty easy to argue more people working would support more people spending. After all, 70% of the economy is driven by consumption.[i]

 

Shockingly, early data from numerous retailers suggests that the “jobs equals spending” picture is not as clear as one would like. 

Here are some recent retail highlights: 

Bob Evans Restaurants:

  • 2014 Q4 GAAP earnings per share (EPS) were 61.9% lower than in 2013 Q4. Same store sales were down 4.1%.[ii]
  • CFO Mark Hood said, "Consumer confidence continues to be adversely impacted by ongoing macroeconomic headwinds, including health care costs and unemployment, which disproportionately affects lower- and middle- income consumers.”[iii]

The Container Store:

  • 2015 Q1 EPS were negative and missed estimates by 20.7%.[iv]
  • CEO Kip Tindell said, "Consistent with so many of our fellow retailers, we are experiencing a retail 'funk'."[iii]

Lumber Liquidators:

  • 2014 Q1 EPS missed estimates by 20.8%. Demand improvement in mid-March did not carry into May, and June weakened further.[iii,iv]
  • CEO Robert Lynch said, "Our reduced customer traffic has coincided with certain weak macroeconomic trends related to residential remodeling, including existing home sales, which have generally been lower in 2014…"[iii]

Family Dollar Stores

  • 2014 Q3 EPS missed estimates by 4.4%.[iv]
  • CEO Howard Levine said, "Our results continue to reflect the economic challenges facing our core customer and an intense competitive environment."[iii]

The Gap

  • June same-store sales declined 2% year-over-year.[iii]

So how is it that the jobs picture is improving and consumers are not spending with any aggressiveness?[v]

 

Perhaps it's all the part-time workers being absorbed into the workforce?[vi]

Perhaps it's the increased cost of healthcare being absorbed by Americans.[vii]

Regardless of the cause, without a strong consumer in Q2 we might be in for a bit of a surprise.  The good news for Q2 is that earnings expectations are at some of their lowest levels since March. According to Zach's Research analysts are only expecting S&P 500 companies to grow earnings by 2.9% during Q2.[viii] Certainly there is plenty of room to be pleasantly surprised.

In the coming weeks, keep your eye on these consumer-oriented companies (VF Corp, Columbia Sportswear, Mattel, McDonalds, Hasbro) to get a little more clarity on the consumer and be prepared for a bit of a bumpy ride. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Jeff Paul, Senior Investment Analyst – Phillips & Company

 

References

[i] JP Morgan Asset Management. (July 2014). Q3 Guide to the Markets. Economic Growth and the Composition of GDP. p 17.

[ii] GlobeNewswire. (Jul 8, 2014). Bob Evans Reports Fiscal 2014 Fourth-Quarter and Full-Year Results; Updates Fiscal 2015 Outlook. Yahoo Finance.

[iii] Udland, M. (Jul 11, 2014). Retailers Have Given Some Discouraging Commentary About The US Economy To Start Earnings Season. Business Insider.

[iv] Bloomberg LP. Quarterly Earnings Data.

[v] Weisenthal, J. (Jul 3, 2014). CHART OF THE DAY: Here’s the Chart Obamacare Critics Don’t Want You to See. Business Insider.

[vi] Federal Reserve Economic Data. Employed, Usually Work Part-Time.

[vii] Alvarez and Marsal. (Mar 27, 2014). Consumers Passing Threshold of Healthcare Affordability.

[viii] Mian, S. (Jun 26, 2014). Mixed Start to Q2 Earnings Season. Zacks Research.

Fireworks - Do They Matter?

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Entering the Independence Day holiday, we had some pretty good economic news to celebrate. 

The jobs report from the Department of Labor came out on Thursday and crushed economists’ expectations. The report said the US economy added 288,000 jobs in the month of June and the unemployment rate plummeted to 6.1%, its lowest level since 2008.[i] The unemployment rate has fallen 1.4% over the past year, that's the steepest decline in over 3 decades.[ii,iii]

 

Further, the number of consecutive months that the US economy has added jobs reached a record 52 months.[iv]

 

Additionally, the trend for average monthly job growth shows an improving economy.[v] It's hard to argue with the data and the Dow Jones certainly agreed by setting another record, crossing over 17,000 for the first time based upon all of the employment fireworks.

Unfortunately for all of us investors, we can't celebrate too much mostly because we have to live in the future. Capital market participants are constantly absorbing, digesting, discounting and pricing in data (especially current data like the jobs report).

To avoid getting too carried away by all the jobs-related fireworks, I tend to focus on what really drives equity valuation to get a better understanding of where prices could head. 

What really matters is simple: Earnings.

We know historically that the long-run 10% stock market returns have been driven by a combination of dividends (5%) and earnings growth (5%).[vi] With the current S&P 500 dividend yield well below 5%, even higher earnings growth is needed to achieve the historic rate of return.

Unfortunately, current earnings growth expectations for Q2 2014 are much more muted. Both Zacks and FactSet are forecasting a benign Q2. Zacks clearly shows a degrading earnings estimate picture for most of Q2. In March, estimates suggested 5.5% EPS growth and now they sit at just over half that at 2.9%. [vii] This is clearly well below the long-term trend for the S&P 500. 

FactSet shows a slightly higher EPS growth estimate for Q2 at 4.9%.[viii]

 

What is compelling in all of this is the future growth being anticipated. Both FactSet and Zacks are showing considerable growth in EPS for Q3 and Q4. The 10.8% estimated Q4 growth rate is almost 3.75x the 2.9% Q2 rate.[ix]

 

While the employment fireworks were great, what matters is the earnings growth being forecast for Q3 and Q4. It's understandable to be cautious, especially as earnings are coming in well below long term growth averages, however, the expectation is for companies to earn more in the near future.

Perhaps it's the better jobs picture that will fuel more consumption and fulfill expectations. 

That's what really matters in this part of the market cycle. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Jeff Paul, Senior Investment Analyst – Phillips & Company

 

References

[i] Logiurato, B. (Jul 3, 2014). The US Just Broke The Record For The Longest Stretch Of Private Sector Job Growth. Business Insider.

[ii] Ibid.

[iii] Federal Reserve Economic Data.

[iv] Logiurato, B. (Jul 3, 2014). The US Just Broke The Record For The Longest Stretch Of Private Sector Job Growth. Business Insider.

[v] Weisenthal, J. (Jul 3, 2014). CHART OF THE DAY: Here’s the Chart Obamacare Critics Don’t Want You to See. Business Insider.

[vi] Journal of Indexes. (Nov 1, 2005). Bogle’s Corner. ETF.com.

[vii] Mian, S. (Jun 26, 2014). Mixed Start to Q2 Earnings Season. Zacks.

[viii] Butters, J. (Jul 3, 2014). S&P 500 Earnings Insight. FactSet.

[ix] Mian, S. (Jun 26, 2014). Mixed Start to Q2 Earnings Season. Zacks.

 

Your Silent Partner Wants You

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The global equity markets continue to march forward in-spite of valuations.[i]

The cyclically adjusted P/E (CAPE) ratio for the S&P 500, a 10-year average earnings compared to current price, is at historic levels only seen a few times in the last 100 years. Robert Shiller, the creator of this metric, suggests stocks may be in "nose bleed" territory.[ii]

Historical CAPE and Long-Term Interest Rates (1880 to Present)

With a reading of 25.6, the metric has been higher only three times since 1880 - in 1929, 2000 and 2007.[iii]

This would seem to suggest that we are in store for a correction of some sort. However, there are a few data points one should consider before accepting the obvious (although the obvious might be precise).

1)    Spending continues to match income with both rising about 4% year-over-year in May. Personal consumption was up 0.2% in May after no growth in April. This bodes well for a stronger Q2.[iv]

2)    Consumer confidence is showing very positive signs that suggest consumers are willing to spend. Consumer confidence is near a 6-year high.[v]

3)    Individual investors tend to be very predictive of market tops and bottoms in a contrary way.  I mean no offense, but past indicators on individual investor sentiment suggest that they are pretty good at being wrong. According to the American Association of Individual Investors, investors are not getting wildly bullish regardless of what the main stream media suggests. From the data below, they appear to be both concerned and optimistic.[vi]

4)    Further, mutual fund flows suggest some investors have indeed been selling out of their U.S. equity holdings.[vii]

5)    The highest tax bracket investors are faced with the daunting task of paying increased capital gains rates, and those earning over $200,000 may owe a 3.8% Medicare surcharge tax, with no place to go.[viii]

6)    Finally, returns on fixed income continue to be persistently low. Looking at the historical CAPE chart, long-term interest rates were generally much higher at each of the past CAPE peaks: around 3.5% in 1929, 5% in 1966, 6% in 2000, and 5% in 2000.[ix] Today we are at 2.54% on the 10-year Treasury and 3.36% on the 30-year.[x]

While markets appear extended, it wouldn't surprise me if they continued their modest gains under low volatility. Until rates actually rise, there really is nowhere for investors to find returns. They either reallocate assets into other equity asset classes or park funds in zero-return cash. 

While your silent business partner (The US Government) will appreciate you paying your capital gains and Obamacare taxes, all to get near zero returns for investing in safe assets, I'm just not sure how your lifestyle in the future will appreciate that.

It's more critical in the current market cycle to assess your holding time frame in case you need to weather a storm. If you can maintain your lifestyle or institutional needs for a 5-7 year period, deferring the benefits to your silent partner might be worth it. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Jeff Paul, Senior Investment Analyst – Phillips & Company

 

References

[i] Businessweek.com. (Jun 30, 2014). World Stock Markets & Stock Index Performance.

[ii] The Capital Spectator. (Jun 26, 2014). CAPE Crusades.

[iii] Ibid.

[iv] Briefing.com (Jun 26, 2014). Personal Income and Spending.

[v] Short, D. (Jun 29, 2014). Final June 2014 Michigan Consumer Sentiment: A Small Improvement.

[vi] American Association of Individual Investors. (Jun 25, 2014). Sentiment Survey.

[vii] Investment Company Institute. (Jun 25, 2014). Estimated Long-Term Mutual Fund Flows.

[viii] Dzombak, D. (Mar 29, 2014). Capital Gains Tax Rate for 2013 and 2014: 58% Increase for Top Earners.

[ix] The Capital Spectator. (Jun 26, 2014). CAPE Crusades.

[x] U.S. Department of the Treasury. (Jun 30, 2014). Daily Treasury Yield Curve Rates as of June 27, 2014. 

Low Volatility, New Market Highs - Don’t Get Too Complacent

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It seems that no matter what is going on in the world, the stock market has had little reaction and continues to reach new highs. The Federal Reserve recently expressed its concern that investor complacency could “sow the seeds for disruptive market moves that could undermine the economy.”[i] Low volatility may encourage investors to increase borrowing and to take greater investment risk, strategies that could end up being detrimental if the economy does not perform as expected.

This quiet market makes us a little skittish too, as past periods of low volatility have been followed by high volatility episodes.

A 25-year chart of the VIX volatility index shows that we are near longer-term lows.[ii] In two previous instances, volatility increased within a few years.

Looking at a shorter time period, we can also observe spikes in volatility every couple of months.[iii]

We can’t predict what will happen or when, however markets are more predictable given enough time. Using historical data, we can determine the average daily return and standard deviation (SD) for the market, which can help us to understand the risk. SD is a measure of how much something moves up or down from its average.

The chart and table below from the CFA Institute show the number of S&P 500 Sigma (standard deviation) Events over a 62-year period.[iv] 95% of the time, the S&P 500’s daily return was within 1 SD, which is about a range of -1.0% to 1.0%.

About 4% of the time, the index had a more moderate change (2 SDs to 3 SDs), and then the last 1% represents the more significant market moves. Let’s look at a few examples:

  • -20.98 SD event: The Black Monday crash (October 19, 1987 ).[v]
  • -7 SD event: Data shows the US economy slowing, and political and economic uncertainty in Russia (Aug 31, 1998).[vi, vii]
  • -4 SD event: The US losing its AAA credit rating (Aug 8, 2011).[vi, viii]
  • +4 SD event: The US Treasury announced plans to purchase toxic assets (Mar 23, 2009).[vi, ix]

The preceding data and examples apply to the S&P 500, a 100% equity index. A balanced portfolio would have lower SD due to the inclusion of less correlated assets, such as fixed income. Looking at annual returns and SD provides a way to measure your threshold for market declines.

The table below shows the estimated range of returns for different allocation portfolios based on their respective 10-year mean annual return and standard deviation.[x] Higher equity allocation (e.g. 80/20) results in larger return ranges. The table only represents 2 SDs, so keep in mind that about 5% of the time, annual returns exceed these ranges.

Your target return drives the level of risk you take, so unfortunately, risk cannot be avoided. However, if the potential decline makes you lose sleep at night, there are some proactive steps you can take to manage it.

  • Consider spending less of your income and build a reserve fund to help you wait out any periods of volatility.
  • Re-evaluate your target return rate and investment allocations. Make sure you aren’t taking more risk than necessary to achieve your goals.
  • With the market run-up, your portfolio likely has a higher weighting of equities than it did at the start of the year. This may be a good time to review your portfolio allocations and rebalance while the markets are at their high and in this low-volatility mode.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Jeff Paul, Senior Investment Analyst – Phillips & Company

Tim Phillips, CEO – Phillips & Company (Editor)

 

References

[i] Reuters. (May 30, 2014). Low volatility sparks concern at Fed over investor complacency.

[ii] Udland, M. (Jun 16, 2014). Wall Street’s Summer of Doom: Why Everyone is Board and Bleeding Money. Business Insider.

[iii] Ibid.        

[iv] Voss, J. (Aug 27, 2012). Fact File: S&P 500 Sigma Events. CFA Institute.

[v] Ibid.

[vi] Yahoo Finance. S&P 500 Daily Historical Adjusted Closing Prices.

[vii] CNNMoney. (Aug 31, 1998). Historic losses wipe out market’s gains for 1998 as global turmoil mounts.

[viii] Sweet, K. (Aug 8, 2011). Dow plunges after S&P downgrade. CNNMoney.

[ix] Zacks. (Mar 23, 2009). Stock Market News for March 23, 2009.

[x] Morningstar Direct. 10-year statistics for a portfolio consisting of the S&P 500 and Barclays Aggregate Bond Indices in the specified proportions.

 

Lifestyle Change

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Not too many weeks ago the world, and especially Europe, was faced with an energy crisis from Russia and its geopolitical adventures with Ukraine. Russia is responsible for about one fourth of Europe's energy needs.[i] With the European Union being the largest combined economy in the world, that's no small matter for anyone.

Today the world, and especially the United States, is faced with its own potential energy crisis.  Over the last week, a very aggressive and well organized terrorist organization, ISIS (Islamic State of Iraq and Syria), seized control of some very productive energy reserves in Iraq.[ii]

 

Iraq is the 8th largest oil producer in the world (3 billion barrels a day) and has the 5th largest proven oil reserves in the world.[iii] It's no wonder we've seen oil prices rise by 2.65% over the last week.[iv]

This modest increase in oil prices suggests that the major energy traders are not overly concerned about this "rag-tag" group of terrorists. However, I would not underestimate the consequences of the events in Iraq.

This is not simply a group of underfunded terrorists. They now possess US military hardware including anti-aircraft weapons and helicopters. On top of that, they grabbed $429 million in Iraqi dinars, as well as a large quantity of gold bullion, during their raid of Mosul.[v] What's terrifying is that they also control some prime oil fields in both Iraq and Syria and have been selling their oil. They are now one of the best funded terrorist organizations in the world.[vi]

Their goal is pretty clear. They want to rewrite the borders of the Middle East and form an ultra-sectarian state for Sunni Muslims.[vii]

 

If successful, the ISIS would control some of the most productive oil reserves in the world.  Combine this with the Kurdish Iraqi's who want their own state and we could have a destabilizing event in the Middle East, which could lead to higher oil prices. As observed in the chart below, the markets have historically reacted negatively to large oil price increases.[viii]

 

The US currently receives 3.1% of its imported oil needs (9 million barrels per month) from Iraq and that's no small matter.[ix] The good news is that we could potentially begin to increase our imports from a former "Axis of Evil" member state, Iran. That would certainly stabilize energy markets, improve relations with Iran and satisfy our energy needs.

It's clear that US consumers can only bear so much when it comes to increases in oil and gas prices, especially as we enter the heavy summer driving months.

Research by IHS Global Insight found that a 10% increase in the price of gas decreases consumer confidence by 1.4% to 1.5%, which impacts consumer spending beyond the actual gas price increase.[x]

It seems to me that former Defense Secretary Don Rumsfeld was right about one thing when he said, "We either change the way they live, or they’re going to change the way we live" when he was discussing the nexus between our use of force and our need for Middle East oil.[xi]

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Jeff Paul, Senior Investment Analyst – Phillips & Company

 

References

[i] Kennedy, B. (Mar 4, 2014). Ukraine crisis highlights Europe’s dependence on Russian energy. CBS News.

[ii] Fisher, M. (Jun 12, 2014). How ISIS is exploiting the economics of Syria’s civil war. Vox Media.

[iii] U.S. Energy Information Administration. (Apr 2013). Iraq: Country Analysis Brief Overview.

[iv] Investing.com. (Jun 16, 2014). Historical Data: Crude Oil Futures – Aug 14.

[v] MoneyJihad (Jun 12, 2014). ISIS steals $429 million in Mosul. Moneyjihad.wordpress.com.

[vi] Ibid.

[vii] Kates, G. (Jan 16, 2014). Iraq and Syria: Past, Present, and (Hypothetical) Future Maps. Radio Free Europe Radio Liberty.

[viii] Roche, C. (Mar 2, 2011). When Will Oil Prices Hurt Equity Markets?. Pragmatic Capitalism.

[ix] U.S. Energy Information Administration. (May 29, 2014). U.S. Imports by Country of Origin for March 2014.

[x] Steiner, S. When gas prices rise, consumers cut back. Bankrate.com.

[xi] US Embassy. (Aug 7, 2004). Rumsfeld: Free Afghanistan and Iraq Will Mean Terrorist Defeat.

Are You Prepared for Retirement?

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We all look forward to retiring with sufficient funds to enjoy the latter part of our lives, but data from retirement surveys indicate that many Americans may not achieve this goal. The statistics are frightening:

  • 46% of Americans have less than $10,000 saved for retirement. [i]
  • 36% of Americans say that they don’t contribute anything to retirement savings.[ii]
  • 74% of American workers believe they will need to work during retirement.[iii]
  • 37% of middle-income Americans think they will work until they die or become too sick.[iv]

Americans seem aware of this dire situation, as 49% said they were not very or not at all confident about having enough money to live comfortably in retirement.[v] This is up from 27% in 1995.

However, according to a Deloitte retirement survey, 58% do not have a formal retirement savings and income plan in place.[vi] As shown in the chart below, Americans are more likely to have a retirement plan as they get closer to retirement.

While over two-thirds of retirees have a plan, the younger age groups would benefit the most, as they have time on their side both to allow investments to compound and to make adjustments to ensure that their goals are met. For example, investing too conservatively could result in a large difference by retirement. The impact on a $200 per month investment over 40 years is almost $300,000 if it is invested at 6% instead of 8%.

We plan for weddings, home purchases, vacations, and grocery shopping…why not for retirement? Two often cited reasons are other financial priorities get in the way and not having enough money to warrant a financial plan.[vii, viii]. However, even a small amount of money (for example, $100 per month, the cost of a Starbucks per day) can grow over time into a much larger sum through the power of compounding.

The compounding effect doesn’t kick in until the later years, so we must be patient and start early.

A retirement plan also goes beyond the financials by helping to first clarify goals and time frame. How can we decide when to retire without first deciding what we want in retirement and when? From there an advisor can assist with determining your risk tolerance, selecting appropriate investments and estimating returns, and providing a benchmark for gauging progress. The planning process provides a framework that can help you avoid some common retirement pitfalls.

Deloitte found that about 66% of those surveyed did not consult a financial advisor, mainly because they preferred to handle the planning on their own.[ix]

While some may have the financial expertise and experience to manage their own investments, the survey data suggests that for most, having an advisor to guide them through goal setting, a savings plan, and investment options would be beneficial. We don’t know what we don’t know and through omissions and assumptions, mistakes could be made including: not planning for your parents or children, failing to maximize Social Security benefits, not saving enough (or too much), and investing too conservatively or aggressively.[x] For example, the chart below illustrates the wide range of beliefs in terms of the percentage of income workers believe they need to save for a comfortable retirement.  [xi]

Establishing a plan that outlines your goals, current financial state, and the steps to get to your desired retirement removes much of the uncertainty and will provide you with more confidence regarding your future. Research has also demonstrated that those who establish plans are more likely to engage in behaviors that help them achieve their goals.[xii] Periodically reviewing your plan with your advisor will ensure that any deviations, whether due to life changes, new goals, or unexpected market activity, are discussed and that your plan is updated accordingly.

We look forward to helping you prepare for your retirement. Contact an advisor to get more information about retirement planning or to review your current plan.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Jeff Paul, Senior Investment Analyst – Phillips & Company

Tim Phillips, CEO – Phillips & Company (Editor)

 

References

[i] Durden, T. (Jan 11, 2013). So You Want to Retire? Five Disturbing Statistics About Retirement: An Infographic. ZeroHedge.com

[ii] Ibid.

[iii] Peoples Bank POST (Dec 2013). Notable Retirement Statistics.

[iv] Rosenbaum, E. (Oct 22, 2013). Six feet under as a retirement plan?.  CNBC.com.

[v] Helman, R.; Greenwald, M. & Associates; Adams, N.; Copeland, C.; and VanDerhei, J. (Mar 2013). The 2013 Retirement Confidence Survey: Perceived Savings Needs Outpace Reality for Many. Employee Benefit Research Institute.

[vi] Deloitte Center for Financial Services. (2013). Meeting the Retirement Challenge. Deloitte.

[vii] Ibid.

[viii] VALIC Financial Planning. Financial independence is a nearly universal goal, but few achieve it. Data source: HSBC, The Future of Retirement: The power of planning, 2011.

[ix] Deloitte Center for Financial Services. (2013). Meeting the Retirement Challenge. Deloitte.

[x] Nason, D. (May 27, 2014). Avoid these 8 retirement screwups. CNBC.

[xi] Helman, R.; Greenwald, M. & Associates; Adams, N.; Copeland, C.; and VanDerhei, J. (Mar 2013). The 2013 Retirement Confidence Survey: Perceived Savings Needs Outpace Reality for Many. Employee Benefit Research Institute.
[xii] Deloitte Center for Financial Services. (2013). Meeting the Retirement Challenge. Deloitte.

Who Missed Catching the Ball?

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The answer: Most of Wall Street, including to some degree us, when it comes to the short-term direction of interest rates.

While we knew rates would be persistently low for some period of time, we expected a small rise in rates at the beginning of the year. See our posting on Too Soon to Taper (Dec 2013).

It's always hard to be right when forecasting the future and it appears bond bulls were rewarded in the short run. You can see from the chart below, rates actually dropped and bond traders accurately forecasted a pullback in US economic growth.[i]

 

With the 2nd revision of Q1 GDP posting a reduction, a recession is only one more quarter away. The common definition of a recession is a period of two consecutive quarterly declines in real GDP.[ii, iii]

 

So what is the actual risk of recession? There is actually an indicator for risk of recession and it's dropped. The risk of recession is lower now than in prior periods, which flies in the face of the latest print on GDP.[iv]

Clearly a more granular look at the component parts of GDP is needed to see how things look for Q2.[v]

Looking at recent trends, consumption in Q1 remained stable, which is important as it makes up about 70% of GDP. The decline in Q1 GDP was driven by drops in the inventory, fixed nonresidential investment, and net exports segments. Businesses produced less product, invested less in capacity, and sold less internationally. Initial reports for GDP-related data suggest that Q2 GDP is off to a slow start.

  • Retail sales, which account for one third of consumer spending, were up just 0.1% in April, after rising 1.5% in March.[vi] Sales were held back by declines in receipts at furniture, electronic and appliance stores, restaurants and bars, and online retailers. Economists noted that a late Easter may have caused difficulties with smoothing the data for seasonal fluctuations.[vii]

  

  • According to the Commerce Department, orders for durable manufactured goods rose 0.8% in April from the previous month.[viii] This was mainly due to a large jump in defense goods. Excluding defense, orders would have fallen 0.8%.[ix]

 

  • Orders for core capital goods, a proxy for business investment plans, fell 1.2% in April, the weakest showing since January.[x]
     
  • Total exports increased 2.1% in March, after a drop of 1.3% in February and just 0.6% growth in January.[xi] Imports also increased, due in part to a higher volume of petroleum imports and higher oil prices. The US trade deficit improved, but was still higher than Bureau of Economic Analysis estimates. There is also concern that slower growth in China could reduce demand for US exports in the coming months.[xii]
     
  • The Labor Department reported that import prices fell 0.4% in April. Weak import prices are helping to keep inflation low.[xiii]

Will we have another quarter of GDP shrinkage? It’s possible, but slow growth appears more likely based on the indicators. Economists are calling for a significant rebound in Q2, in part due to pent-up demand from consumers who delayed purchases due to the bad weather earlier in the year. We’ll know soon enough if they are correct, or if the ball gets dropped again.

In this type of environment, we are adding some duration to the fixed income portion of our portfolios. With continued low inflation and slow GDP growth, rates are likely to remain low for the near term and higher duration portfolios should benefit in this scenario.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Jeff Paul, Senior Investment Analyst – Phillips & Company

 

[i] Federal Reserve Economic Data.

[ii] Moody’s Analytics. (5/29/2014). United States: GDP (Second Estimates).

[iii] Shenk, M. (10/10/2008). What Exactly Is a Recession – and Are We in One?  The Cleveland Federal Reserve.

[iv] Moody’s Analytics. (5/30/2014). United States: Risk of Recession.

[v] Moody’s Analytics. (5/29/2014). United States: GDP (Second Estimates).

[vi] Moody’s Analytics. (5/13/2014). United States: Retail Sales.

[vii] Mutikani, L. (5/13/2014). Retail sales slow, but growth outlook still upbeat. Reuters.

[viii] Moody’s Analytics. (5/27/2014). United States: Durable Goods (Advance).

[ix] Crutsinger, M. (5/27/2014). US durable goods orders rose 0.8 percent in April, but business investment demand declined. Star Tribune.

[x] Ibid.

[xi] Aleman, E. (5/6/2014). Net Exports Will Still Be a Drag on Q1 GDP. FXstreet.com.

[xii] Crutsinger, M. (5/27/2014). Star Tribune.

[xiii] Mutikani, L. (5/13/2014). Reuters.

Rhetorical Calm Before the Political Storm

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Jobs continue to dominate the headlines since Janet Yellen took control of the Federal Reserve.  She has a legitimate dual mandate to improve the jobs picture by fostering "full-employment", estimated as longer-term unemployment in the range of 5.2% to 6.0%, and maintaining inflation at 2%.[i]

With most state political primary elections now in the rear view mirror, we will see the start of the political silly season. Traditionally, the party that controls the White House tends to lose seats in Congress during this mid-term election cycle. In other words, Democrats are going to be playing defense through November.  

It's clear that one strategy that will be employed to move and motivate voters will be the income inequality issue. It's timely as there are still 1.08 million people unemployed above the median estimated Fed mandate of full employment, and a further 9.625 million underemployed that want full-time work.[ii]

Since our economic power is almost solely based upon consumption, income inequality is a compelling issue to attack. While we are at record levels of household net worth, you can see there continue to be some significant shifts in the distribution of total income in the US.[iii]

   

As it relates to consumption, the following graphs show that the gap in share of personal consumption expenditures between the Top 20% and the Bottom 80% of earners has widened over the last decade.[iv]

 

Those with higher income contributed a larger share of personal consumption in 2012 than in 1992, and those with lower income had a smaller share. You can bet there will be legitimate political debate and some illegitimate political points scored over the data presented above. The data certainly supports the "rich are getting richer" narrative that will be needed to buck the mid-term election trends. 

However, from a different lens, income is not all that bad. Clearly one's perspective can easily be shaped by the data set being used. 

The chart below shows modest and stable growth in average household incomes.[v] All income cohorts have experienced growth and that is good.

It's obvious that there are issues with income equality as it relates to share of total income, but income for all quartiles is growing albeit at different rates. If this weren't the case, we might experience some serious strains on our consumption obsession.

The differences in income growth among the quartiles is due in part to differences in the types of jobs being created and lost, and their wages. Since the Great Recession, the energy, tech, education and leisure/hospitality sectors have added a significant number of jobs, while manufacturing and construction have lost a significant number of jobs.[vi]

The real challenge is in the pay rates of the jobs that have been added and lost.[vii,viii]

For now, you can take a deep breath and enjoy the calm before the political storm erupts in the fall. Certainly, income inequality will be on the docket as a premier political football. Don't be fooled however, it's not as dire or sunny as either side will present. The bottom line is consumption will continue to dominate our economy as it's in our DNA to spend. The data clearly supports our ability to consume at some modest growth rate. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Jeff Paul, Senior Investment Analyst – Phillips & Company

 

[i] Federal Reserve Bank of Chicago. The Federal Reserve’s Dual Mandate.

[ii] Bureau of Labor Statistics. (May 2, 2014). The Employment Situation.

[iii] Clarion Partners (May 16, 2014). Market Outlook & House View. p. 25.

[iv] Waldron, A. (Mar 18, 2014). 6 Cold, Hard Facts about U.S. Economic Inequality. Market Eyewitness.

[v] Invesco. (May 2014). Higher Income Households Lead Income Recovery. p. 32.

[vi] Clarion Partners (May 16, 2014). Market Outlook & House View. p. 8.

[vii] Phillips & Company (May 5, 2014). Life Support. http://phillipsandco.com/blog/2014/5/5/life-support/

[viii] Bureau of Labor Statistics.

Courage, Confidence, and the Housing Market

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In The Wizard of Oz, the Cowardly Lion needed courage to overcome his fears and build some confidence. Based on recent data, the players in the housing market may be in need of some courage, as there appears to be plenty of signs of doubt with respect to the economic recovery, leading Goldman Sachs to cut its forecasts for U.S. housing and GDP growth.[i]

In her recent prepared remarks to Congress, Fed Chair Janet Yellen noted that the recent recovery in housing had flattened out and requires “close observation.”[ii] She also alluded to concerns about the effectiveness of the Fed’s low interest rate policy to stimulate the economy. The Fed doesn’t hold all of the cards when it comes to the recovery. Let’s look at some other players in this market.

Previous blogs have highlighted the high underemployment rate and low wage growth. These trends have impacted household formation, which has leveled off the past two years.[iii]

Among employed 25-to-34 year olds, 25% reported living with their parents even though they had full-time jobs in 2013 versus 22% in 2007.[iv] A similar Gallup survey (24-to-34 year olds) illustrated the relationship between living arrangement and employment status. Those living with parents had a higher underemployment rate, with 50% not fully employed.[v] Concerningly, 50% had full-time jobs, so wages are a factor as well.

Until the economy reaches fuller employment and younger Americans feel more confident about job security and wages, purchasing a home may be challenging.

Adding to the difficulty, mortgage credit availability remains tight relative to pre-2008 levels.[vi]

New homebuyers may not qualify for loans and will need to save up for a down payment. While tighter standards help avoid practices that led to the financial crisis, overly strict standards can limit demand, which brings us to the homebuilders.

In May, homebuilder confidence fell to its lowest level in a year, and investment in single-family residential property relative to GDP remains at historically low levels (blue line in the graph).[vii,viii]

Historically, single-family home investment contributed around 2.25% of GDP, but since 2009, the contribution has been closer to 1%.

With less single-family home construction, supply is down and home prices have increased 22.5% since January 2012, making homes less affordable.[ix]

 

The economic impacts are considerable:

  • If building activity returned to its postwar average proportion of GDP, growth would jump to 4% from its current 2%+ level; each percentage point of GDP equals around $170 billion.[x]
  • This would add 1.5 million jobs and reduce the unemployment rate by one percentage point.[xi]
  • The health of the housing market has been linked to consumer spending. As housing prices increase, homeowners feel more wealthy and increase spending. Consumption accounts for over 70% of GDP.[xii]

We seem to be caught in a cycle, where the lack of confidence leads to behaviors that will not help the housing market to grow at a higher rate. In October 2011, former Treasury Secretary Lawrence Summers wrote:[xiii]

“The central irony of [the] financial crisis is that while it is caused by too much confidence, too much borrowing and lending, and too much spending, it can only be resolved with more confidence, more borrowing and lending, and more spending.”

All eyes will be on the Q2 home building figures. A second quarter of contraction suggests a housing recession, while growth could indicate increasing strength in the economy. If there is a decline or low growth, the housing market will be looking for one or more of its participants to find the courage to take actions that break the cycle, increase confidence, and bring about stronger growth.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Jeff Paul, Senior Investment Analyst – Phillips & Company

Tim Phillips, CEO – Phillips & Company (Editor)

 

References

[i] Ro, S. (May 18, 2014). Goldman Just Hacked Its Forecasts for US Housing and GDP Growth. Business Insider.

[ii] Sanati, C. (May 8, 2014). Janet Yellen reveals concerns for U.S. recovery. CNN Money.

[iii] Number of Households: US (estimate, in thousands). Economagic.com

[iv] Irwin, N. (Apr 24, 2014). Why the Housing Market Is Still Stalling the Economy. The New York Times.

[v] Jones, J. (Feb 13, 2014). In U.S., 14% of Those Aged 24 to 34 Are Living With Parents. Gallup.

[vi] Ro, S. (May 18, 2014). Goldman Just Hacked Its Forecasts for US Housing and GDP Growth. Business Insider.

[vii] Hoover, K. (May 15, 2014). Home builder confidence hits lowest level in a year. Washington Bureau.

[viii] McBride, B. (May 5, 2014). Q1 2014 GDP Details on Residential and Commercial Real Estate. CalculatedRISK.

[ix] Federal Reserve Economic Data.

[x] Ro, S. (May 18, 2014). Goldman Just Hacked Its Forecasts for US Housing and GDP Growth. Business Insider.

[xi] Ibid.

[xii] Federal Reserve Bank of San Francisco. (Jan 2007).

[xiii] Summers, L. (Oct 23, 2011). Why the housing burden stalls America’s economic recovery. Financial Times.

What's the Fed Up To?

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These last few weeks have seen a quieter equity market with lower volumes

and volatility moderating from some recent spikes.[i],[ii]

As earnings season winds down, we have seen better than expected revenue numbers from Corporate America. As observed in the chart below, 57% of Russell 1000 companies that have reported so far have beaten sales estimates.[iii]

The cumulative effect of all this data has pulled investor attention toward the new all-time high reached by the Dow Jones Index on Friday. Interestingly, the Federal Reserve has had their attention on another matter.

One very unnoticed event came from the Fed last week in the form of a new monetary tool announcement. The Fed announced that they will begin to use Reverse Repurchase Agreements as a part of their tool kit. Simply put, a "reverse repurchase agreement”, also called a “reverse repo” or “RRP”, is an open market operation in which the Fed sells a security to an eligible RRP counter-party with an agreement to repurchase that same security at a specified price at a specific time in the future.

Basically the Fed will sell bonds at a discount out of their very large balance sheet to banks and receive cash in return.[iv]

Banks will be allowed to sell those bonds back for full value at a specified time in the future. The difference will represent the interest received.

The bottom line: The Fed has another tool to soak up liquidity from the banks. This is on top of the current Excess Reserve Interest Rate that the Fed pays banks to hold extra cash. 

It's clear that the Fed is concerned about all the cash sloshing around on banks’ balance sheets, especially as the economy might heat up.[v]

 

Runaway inflation is certainly something to be concerned about, especially as we are seeing some continued loosening of bank lending standards. In the most recent Senior Loan Officer Opinion Survey, a net 13.9% of banks reported looser lending standards on commercial and industrial loans to large and medium-size businesses, and a net 9.9% of banks loosened lending standards to small businesses. Lending standards for consumer credit were broadly reduced as well.[vi]

While the Fed creates more policy tools to deal with inflation, we are looking at the following asset classes that can help portfolios hedge against inflation:

  • Floating-rate fixed income
  • Real estate / REITs
  • Dividend growth stocks

If the Fed’s tools are effective, we could see a managed approach to inflation for years to come, especially with all the slack in the labor market that we have written about. If not, we could see some wild swings coming out of a near deflationary cycle.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Jeff Paul, Senior Investment Analyst – Phillips & Company

 

[i] U.S. Stock Exchanges - Historical Market Volume Data. (May 12, 2014). BATStrading.com.
[ii] S&P 500 Volatility Index. (May 12, 2014). Yahoo Finance.
[iii] Bloomberg LP.
[iv] United States: FOMC Minutes (Apr 9, 2014). Fed’s balance sheet. Moody’s Analytics.
[v] Federal Reserve Economic Data (May 12, 2014).
[vi] United States: Senior Loan Officer Opinion Survey (May 5, 2014). Moody’s Analytics.

Life Support

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It appears the economy might be coming off the life support provided to us by the Federal Reserve. Since 2009, the Fed has expanded their balance sheet by about $2 trillion to get to where we are today.

Source: Federal Reserve.

In its April meeting, the Fed continued to trim their purchases of Treasuries and mortgage bonds by $10 billion per month, reducing the purchase level to $45 billion.[i],[ii]

Rightfully so. There has been some confirming data that suggests the US economy is lifting after a very long-term chronic ailment of slow growth.

While GDP growth in Q1 2014 came in at a near contraction level of 0.1%, there were some very positive signs.[iii]

 

Consumption which accounts for 70% of our GDP expanded by 2% which is a very strong sign the consumer continues to prop up the economy. As expected, inventories contracted by -0.57% as businesses needed to sell down their backlog. Net exports and government spending lead to another -0.9 of drag on our economy.[iv]

As a pure headline number, the low Q1 GDP growth should be very troubling. However, when you dig into the details there are some signs of life. 

The economy added 288,000 jobs in April, the strongest jobs report we seen since January 2012.[v]

 

This brought the unemployment rate down to 6.3%. Some of the largest gains came in higher paying sectors such as professional/business services, healthcare, and construction.[vi] Information services and government jobs declined slightly.

Unfortunately, and this is a large misfortune, our labor participation rate fell to a low not seen since 1978.[vii]

The Government reported another 988,000 Americans of working age were moved to "not in the labor force" category, raising the total in this group to 92.02 million.[viii] Combined with the 9.75 unemployed, that brings the total to a whopping 101.77 million working-age Americans without a job.[ix] Viewed another way, 20% of American households do not have a single member that is employed.[x]

So while the headline number on labor looks great, a behind the scenes look paints a grim picture. 

My macro formula for the US economy is very simple: Jobs -> Wages -> Spending -> Corporate Profits -> More Jobs (repeat process for expansion).

 

The keys are jobs and wages. If it's so simple, what's the Fed missing by cutting their "economic stimulus"?  In my opinion, they are realizing that their tools aren't working on a sustainable basis. Perhaps it's time for new tools.

In any case, we continue to advise for caution by allocating to cheaper assets and lower duration (around 5 years), and utilizing diversification as the best approach to mitigate normal market cycle swings (1-2 standard deviation events).

The patient looks like it's on the mend, but what's really going on is hard to tell by just looking at it on the surface. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Jeff Paul, Senior Investment Analyst – Phillips & Company

 

[i] Sharf, S. (Apr 30, 2014). Fed Cuts Monthly Asset Purchases to $45 Billion at April Meeting. Forbes.
[ii] Mangus, P. (Mar 20, 2014). The Fed Chair’s Debut. Wealth Management Insights Center. Wells Fargo.
[iii] Hoyt, S. (Apr 30, 2014). United States: GDP (Advance Estimate). Moody’s Analytics.
[iv] Ibid.
[v] Koropeckyj, S. (May 2, 2014). United States: Employment Situation. Moody’s Analytics.
[vi] Ibid.
[vii] Federal Reserve Economic Data (May 5, 2014).
[viii] Durden, T. (May 4, 2014). The Number of Working Age Americans Without a Job Has Risen by 27 Million Since 2000. ZeroHedge.com.
[ix] Ibid.
[x] Ibid.

2014 Q1 Earnings Season Scoreboard

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In the Phillips & Company 2014 Q2 Look Ahead, I noted that while year-over-year earnings per share (EPS) growth was strong in 2013 Q4, most of it came from margin expansion as opposed to revenue growth.[i] Companies grew profits mainly by controlling expenses.

While efficient operations are important, cost controls can only go so far as a driver of earnings. Future EPS growth will depend on higher revenues. So how are companies doing so far in 2014 Q1? Let’s take a look at the Q1 scoreboard.

According to FactSet, of the 240 S&P 500 companies that have reported earnings, 73% have reported earnings above their mean estimate.[ii] This is in-line with recent averages. Looking beyond the S&P 500, Bespoke Investment Group found that 61.1% of around 700 companies reporting so far have beaten earnings estimates, just slightly below the 62% rate from last quarter.[iii]

At the sector level, the Utilities, Energy, Info Tech, and Industrials sectors had the highest percentage of outperformers, while Telecom and Health Care had the highest percentage of underperformers.[iv]

Investors have rewarded companies that beat earnings expectations a little and punished those that came up short. Interestingly, on average, share prices drifted down during the day regardless of whether the company beat or missed earnings expectations.[v]

 

While earnings have been strong overall, revenues are not faring as well. Of the 240 S&P 500 companies that have reported, 53% have beaten sales estimates, which is below the 1-year average of 54% and the 4-year average of 58%.[vi] The Telecom, Utilities, and Energy sectors had the highest percentage of outperformers, while Materials, Industrials, and Consumer Staples had a higher percentage of revenue misses.[vii]

Two common factors mentioned for the revenue misses were the unusually cold and stormy winter weather during the first quarter and unfavorable foreign currency exchange rates caused by a strengthening US dollar.[viii] While the currency issue could continue into the future, the weather-related impact should be lifted for Q2 and perhaps even contribute a positive bump from delayed purchases.

Without higher sales, corporate earnings growth will eventually slow, as margin expansion through cost cutting can only go so far. Larger companies seem to be factoring this concern into forward guidance. FactSet reported that 36 of 51 (70%) S&P 500 companies have issued negative EPS guidance for Q2 so far, above the 5-year average of 65%.[ix] Analysts are projecting higher double-digit earnings growth in the second half of the year for an annual growth rate of 7.8%.[x]

For this strong second half finish to occur, companies will need to grow their top line sales. We will be on the lookout for signs of improving sales and indications, such as increased wages or consumer credit, that suggest the consumers’ ability to spend more and support the next leg of the economic recovery. The Q2 scoreboard in July will be an important update on the strength of our economy and the ability to grow corporate earnings.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Jeff Paul, Senior Investment Analyst – Phillips & Company

Tim Phillips, CEO – Phillips & Company (Editor)

 

[i] JP Morgan Asset Management (April 2014). Guide to the Markets. p. 9.
[ii] Butters, J. (Apr 25, 2014). Earnings Insight – S&P 500. FactSet. p. 3.
[iii] Bespoke Investment Group. (Apr 25, 2014). The Bespoke Report. p. 11.
[iv] Ibid. p. 14.
[v] Ibid. p. 13.
[vi] Butters, J. (Apr 25, 2014). Earnings Insight – S&P 500. FactSet. p. 3.
[vii] Ibid. p. 9.
[viii] Ibid. p. 5-6.
[ix] Ibid. p. 7.
[x] Ibid. p. 7.

 

Reduce the IRS Tax Bite with Municipal Bonds

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Another tax season is over, making this an excellent time to examine the size of the tax bite that you sustained and to consider strategies to reduce your taxes for coming year. The 2013 tax year included two changes that may have increased your taxes: a 39.6% marginal tax rate for those with adjusted incomes over $400,000 / $450,000 (single/married filing jointly) and a 3.8% surtax (part of the Affordable Care Act) on investment income for those with adjusted income over $200,000 / $250,000 (single/married filing jointly). [i,ii]

Together these changes created an effective top marginal tax rate of 43.4%, which is plenty of reason to consider tax-exempt investments, such as municipal bonds. Municipal bonds (munis) are debt issued by states and municipalities whose income is exempt from federal income taxes. The graph below compares Treasury, Corporate, and Municipal bond yield curves and the dark blue line shows the tax-equivalent yields for the muni’s curve, assuming a 43.4% tax rate.[iii,iv]

 

For those in the highest tax bracket, munis generally offer a higher tax-equivalent yield than similar-grade corporate bonds. In many cases, munis are also exempt from state income taxes, which would increase the tax-equivalent yield. Here in Oregon, this could provide an additional tax savings of around 9%.

With recent headlines about Detroit in bankruptcy and Puerto Rico potentially defaulting on its debt, investors may be concerned about the safety of municipal bonds. Fortunately, these high profile municipalities are not the norm.

As observed in the table below, from 2001-2011 the muni default rate was below 0.25%, except in 2011.[v] Even then, most of the default value was concentrated in 4 issues, so proper diversification can mitigate default risk. By comparison, Moody’s reported a corporate bond default rate of 2.9% in 2013 and projects a 2.2% rate for 2014.[vi]

Furthermore, state finances have improved. Total state tax revenue has nearly recovered to its pre-financial-crisis level.[vii]

  

Insurance provides another level of safety for many munis, though since the financial crisis, insurance on new bonds declined significantly.[viii]

However, most munis have investment-grade credit ratings compared to a wide range of ratings for corporate bonds.[ix] Between the high credit ratings and low default rate, insurance may not be a large concern for muni investors.

As with all bond investments, munis are subject to interest rate risk. Shorter duration bonds will be less sensitive to rising rates, however CNN Money noted that the 3- to 5-year munis are richly priced at the moment.[x] In the graph below, Morgan Stanley recommends considering the 4- to 9-year range, as it captures nearly 63% of the yield curve, providing some cushion against rising short-term rates and the potential for capital gains if short-term rates stay low.[xi]

Based on the data, municipal bonds are worth consideration, particularly for investors in the higher tax brackets. Compared to similar-grade corporate bonds, munis offer potentially higher tax-equivalent yields and safety. Contact your advisor to learn more about municipal bonds and opportunities to reduce next year’s tax bite. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Jeff Paul, Senior Investment Analyst – Phillips & Company

Tim Phillips, CEO – Phillips & Company (Editor)

[i] TaxFoundation.org. US Federal Individual Income Tax Rates History, 1863-2013.
[ii] Saret, L. (Mar 14, 2013). What the New 3.8% Medicare Surtax Means for You and Your Investments. Forbes.
[iii] Yahoo Finance (Apr 19, 2014). Composite Bond Rates.
[iv] US Department of the Treasury (Apr 19, 2014). Daily Treasury Yield Curve Rates.
[v] Deane, J., et. al. (Feb 2012). Credit Counts: The New Municipal Bond Market. PIMCO.
[vi] Monga, V. (Mar 3, 2014). Moody’s Predicts Drop in 2014 Corporate Default Rate. The Wall Street Journal.
[vii] Fried, C. (Apr 2014). Munis on the Rise. Money. p. 81.
[viii] Deane, J., et. al. (Feb 2012). Credit Counts: The New Municipal Bond Market. PIMCO.
[ix] Moody’s Investors Service (Mar 7, 2012). U.S. Municipal Bond Defaults and Recoveries, 1970-2011. Moody’s. p. 3.
[x] Fried, C. (Apr 2014). Munis on the Rise. Money. p. 81.
[xi] Dillon, J. and Gastall, M. (Mar 13, 2014). Municipal Bond Monthly. Morgan Stanley. p. 7.

Disclosures

Bond investing poses special risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yield and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa.

Yield Curve Comparison is based on combined federal income tax rate of 43.4%. This chart is intended for hypothetical illustration only and is not intended to be representative of the past or future performance of any particular investment.

Municipal bond income is generally exempt from Federal and state taxes for residents of the issuing state. While the interest income is tax-exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the Federal Alternative Minimum Tax (AMT).

Insurance pertains to the timely payment of principal and interest by the issuer of the underlying securities, and not to the value of the fund’s shares. Insurance applies to the payment of principal and interest payments. The insurance does not guarantee the original price or current market value of the bonds. 

The First Real Test of the Year: JOLTS and Volatility

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Volatility.

I'm not referring to tremors or seismic events in the title. US and Global equity markets added some significant volatility this week in light of a weaker than expected start to the earnings season.[i]

Volatility is up with only a few companies reporting earnings. Most significantly, Alcoa reported a revenue miss of $97M, but beat adjusted EPS expectations by 4 cents, and JP Morgan Chase missed adjusted EPS estimates by 18 cents.[ii] It's abundantly clear that market participants are extremely jumpy about this earnings season. 

According to FactSet, analysts expect a Q1 S&P 500 earnings per share decline of 1.6% on revenue growth of 2.2%.[iii] Zacks Research estimates an even larger EPS decline of 2.6%.[iv] As shown in the graph below, this estimate has been declining since January, reflecting changing sentiments.[v]

With Q1 earnings growth estimates already negative, anything short on either the earnings or revenue side will lead to continued volatility.

The bottom line on earnings season is: overreactions are to be expected early in the season.

JOLTS

Based on recent statements by our new Federal Reserve Chairwoman, Janet Yellen, we know that she is going to focus on a much different data set to drive interest rate policy than her predecessor. 

“This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.” (Fed Statement, March 2014) [vi]

In the past 5 years, Former Fed Chairman Bernanke gave guidance based upon the unemployment rate. Needless to say that data never really painted a clear picture of what's going on with jobs and employment in our economy. 

Employment participation and underemployment data paint a fuller picture of our economy. The participation rate continues to decline and underemployment remains high at 12.7%.[vii, viii]

  

Now it appears that Janet Yellen might be looking at another set of data to complete her picture and help her fulfill the Fed mandate of full employment. The Job Openings and Labor Turnover Survey (JOLTS) is a data set that measures the number of job openings and the rotation of jobs on a monthly basis. You can see from the charts below that the number of openings is increasing and turnover is dropping.[xi]

The data suggests that the jobs picture is indeed improving and on the rebound. 

The first test of the year for investors is to manage their reflexive behavior and stay committed to their plan, regardless of the volatility. It's one thing to reexamine your personal or organizational financial picture and to make portfolio adjustments accordingly. It's an entirely different, and perhaps destructive, approach to react to normal market volatility, which is needed to generate returns.

Let's hope we all pass this first test of 2014 and don’t get JOLT'ed by the volatility.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Jeff Paul, Senior Investment Analyst – Phillips & Company

 

[i] Federal Reserve Economic Data.
[ii] Bloomberg LP.
[iii] Butters, J. (Apr 11, 2014). Earnings Insight. FactSet. p. 1,4.
[iv] Mian, S. (Apr 3, 2014). Taking Stock of the Q1 Earnings Season. Zacks.
[v] Ibid.
[vi] Rooney, B. (Mar 19, 2014). Fed moves economic goalposts. CNNMoney.
[vii] JP Morgan (Mar 31, 2014). 2Q 2014 Guide to the Markets. p. 25.
[viii] Federal Reserve Economic Data.
[ix] Ibid.

 

Breakeven

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Posted by siteadmin under Market Commentary

The US jobs report on Friday was only exceptional in one regard. It wasn't the 192k jobs added in March to the US economy. It wasn't the paltry 1k manufacturing jobs created.

What was exceptional was the fact that we have now recovered all of the jobs lost during the "Great Recession".[i]

It may seem like a nice time to rejoice and declare victory on the jobs front. Unfortunately, reality gets in the way of the jobs celebration.

One, the time it's taken to recover to this point has been the longest in post-WWII recession history.[ii] That means the economy has underperformed for a very long period of time.

Two, the breakeven point does not reflect the 6 million new entrants that have reached working age since 2008 when the recession began.[iii]

 

Finally, the addition of 192k jobs simply brings us back to a slow growth trend. As observed by the red line in the graph below, the rate of job growth in this recovery remains flat versus more rapid growth prior to 2007.[iv]

While breakeven feels good, especially when we were down 8.8 millions of jobs from the peak, it is not likely to change the Fed's stance on taper reductions.[v] The only thing breakeven confirms is that this economy continues to need extraordinary measures to help it lift beyond its current flat trend.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Jeff Paul, Senior Investment Analyst – Phillips & Company

 

[i] Kurtz, Annalyn. (Apr 4, 2014). “Private sector jobs finally back to 2008 peak, but…”. CNNMoney.com.
[ii] McBride, Bill. (Jan 10, 2014). “December Employment Report: 74,000 Jobs, 6.7% Unemployment Rate”. Calculated RISK.
[iii] Federal Reserve Economic Data.
[iv] Federal Reserve Economic Data.
[v] JP Morgan. (Apr 2014). Guide to the Markets. p. 24.

 

The Dollar Decline

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One of my favorite poets, T.S Elliot, wrote in his seminal poem The Dry Salvages (1941), "We had the experience and missed the meaning."[1] It's quite possible we are about to encounter a global event where we might just miss the meaning.

While much of the world debates the importance of Russia and Crimea, a region with two million people, the GDP 1/7 the size of the state of Vermont and of no real consequence economically; I'm much more focused on a little discussed aspect - the impact on the US dollar.[2][3]

Here are some basic facts to consider:

1)    Almost all oil traded in the world is done in US dollars. This was a byproduct of President Nixon cutting a deal with Saudi Arabia to buy their oil as long as it was in dollars, and they in turn bought US debt with our money, aptly named the Petrodollar. This led to the US dollar becoming the primary currency used for international transactions and foreign countries purchasing US dollars in reserve to support those transactions. With about 85% of the world’s foreign exchange transactions involving US dollars, countries worldwide hold nearly $6 trillion in US debt.[4] The top holders are in the table below.[5]

2)    Russia currently exports about 126B cubic meters of natural gas to Europe, supplying 30% of Europe’s natural gas demand.[6] In 2012, Russia exported over 3M barrels of oil per day to Europe and 777,400 per day to Asia.[7]

3)    This chart on China says it all about China's insatiable demand for fossil energy.[8] 

4)    China surpassed the US as the world’s largest importer of Oil/Natural Gas in September 2013.[9]

5)    Upon his appointment, President Xi Jinping made his first official foreign trip to Russia.

6)    President Xi Jinping was at the Olympics side by side with Putin. Our President was nowhere to be seen.

7)    Vladimir Putin will be visiting Chinese President Xi Jinping in May and you can bet they’re not sharing recipes for Szechuan Chicken.

Here is the missed meaning part of this little global poem being played out over Cremia. 

If Russia and China cut an oil and gas deal, which is highly anticipated, Russia can certainly withstand any European boycott. This transaction, which would likely be one of the world’s largest energy transactions, will most certainly occur in a currency other than the US dollar. Could this become the tipping point for other nations to transact their global trade in something other than the US dollar?

It certainly could be. In fact, dominant currencies have never held the world stage for infinite periods of time.[10]

If so, the US dollar could weaken substantially and here are the consequences of that on investors and our economy.[11]

  • With fewer deals done in dollars, higher interest rates would be an immediate consequence. The cost of funding debt would become more expensive, putting more pressure on government spending and home ownership.
  • A weaker dollar helps US exporters by making US-produced goods cheaper in foreign markets. Stocks and debt of US Large Cap companies with export exposure may benefit.
  • Conversely, goods and resources imported to the US will cost more. US companies may absorb some of the higher input costs initially, but eventually they will have to pass along cost increases, generating higher inflation.
  • US travelers to foreign countries will have less purchasing power, as a US dollar will translate into less local currency.
  • US investors holding Emerging and Foreign market debt may benefit from the weaker currency exchange, as the local currency will be worth more US dollars.

I don't predict a doomsday dollar scenario, as China still needs to export goods to the US to keep domestic peace and a dramatically weaker dollar makes that much more difficult.

I do anticipate some weakness in the dollar and higher rates for US consumers. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Jeff Paul, Senior Investment Analyst – Phillips & Company

 

[1] Eliot, T.S. (1941). Four Quartets. Wikiquote.org.
[2] RT.com. (Mar 15, 2014). Crimea’s economy in numbers and pictures.
[3] USGovernmentSpending.com. (FY 2014). Comparison of State and Local Spending and Debt in the US.
[4] Eichengreen, B. (Mar 2, 2011). Why the Dollar’s Reign Is Near an End. The Wall Street Journal.
[5] US Treasury. (Jan 2014). Major Foreign Holders of Treasury Securities.
[6] Samuelson, R. (Mar 27, 2014). Russia’s natural gas shutoff threat overblown. The Spokesman-Review.
[7] Stratfor Global Intelligence (Jan 22, 2013). Russian Oil Exports to Europe and Asia.
[8] Crude Oil Peak. (Sep 2013). China.
[9] Institute for Energy Research. (Mar 26, 2014). China Exceeds U.S. as Largest Net Importer of Petroleum.
[10] J.P. Morgan. (Jan 1, 2012). Eye on the Market | Outlook 2012. p. 5.
[11] Handley, M. (May 12, 2011). What a Weak Dollar Means for Consumers. US News.

Higher Interest Rates: Are We There Yet?

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With the Federal Reserve taking extraordinary measures since 2008 to lower interest rates, we know that rates will have to go higher eventually; it’s a question of when and how quickly?

The Fed typically offers vague guidance on future interest rate policy, much like parents answering a child’s constant inquiries of “Are we there yet?” on a long road trip. While I used to find such responses frustrating, I now recognize that answers like “Almost” or “We’re getting closer” avoided setting up expectations when uncertainty could change the timeline.

In her first press conference as Fed Chair, Janet Yellen was a little too specific when she commented that interest rates could rise about 6 months after the bond-buying program ends (sometime in 2014 Q4), which means around April 2015.[i] This timeframe was sooner than the market expected, causing intermediate-term yields to jump as seen on the yield curve chart below.

Source: US Treasury. Nominal Treasury Yield Curve.

Overall though, the Fed’s intentions did not change. It dropped the guideline of a 6.5% unemployment rate for considering a rate hike, but we are already near that rate.[ii] The Fed now plans to look at a “wide range of economic indicators” to inform decisions on overnight rates.[iii] Based on the US economy’s tepid growth and low inflation, there’s little reason to raise rates at this time and perhaps not until later in 2015 depending on what happens. The most recent FOMC expected Fed Fund rate estimates continued to show very low rates through 2015, though they inched up since December’s estimate, but more so for 2016.[iv] A rate hike for 2014 appears less likely based on the lower rate projection.

 

But even when rates finally increase, does this spell immediate trouble for the fixed income and equity markets?  Perhaps not, based on research by Kathy Jones, VP/Fixed Income Strategist at Charles Schwab.

Today’s bond-buying policy is similar to the 1940’s, when the Fed absorbed much of the bond supply to keep interest rates near zero. The Fed’s holdings rose to 22% of GDP, comparable to the increase we’ve seen since QE began in 2009.[v]

 

The Fed sold bonds in 1948 and raised short-term rates in the 1950s, but long-term interest rates didn’t exceed 3.5% until the late 1950’s.[vi] For about 20 years, long-term rates were well below 3.5%.

Despite differences in our current situation, Jones noted that history teaches us that:[vii]

  • The Fed’s withdrawal of QE may not impact interest rates as quickly or significantly as we fear.
  • The Fed can be flexible and hold bonds for a long time without causing inflation.
  • Anchoring short-term rates near zero can keep long-term bonds low.

Of course, whether history repeats itself is the million-dollar question. While data suggests that rates may stay low longer than anticipated, sudden interest rate shocks can punish long-duration portfolios in the short term. For example, when the Fed first discussed tapering last spring, 10-year rates increased over 100 basis points from May to September and longer-term Treasuries fell in response.

Source: Yahoo Finance, May 1, 2013 – Aug 30, 2013.

With rate increases apparently at least a year away, adding a modest amount of duration (1 or 2 more years) to a portfolio with a current duration below 5 years may be a reasonable idea, as long as you can withstand the volatility.

Even after the Fed begins to tighten credit, Goldman Sachs found that historically the S&P 500 peaked 18 months later on average, suggesting that the stock market may have more upside.[viii]

Convertible bonds may be a fixed income alternative to consider, as they benefit from a rising stock market. Banks should also benefit from the steepening of the short-end of the yield curve, as long as the very short rates stay near zero.[ix]

With Yellen likely to be vaguer with her future responses to the question of when interest rates will rise, we’ll keep monitoring the economic sign posts as we continue along this long road to economic recovery. We aren’t there yet, but we’re getting closer.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Jeff Paul, Senior Investment Analyst – Phillips & Company

[i] Saphir, A. and Hughes, K. (Mar 19, 2014). Fed may raise rates as soon as next spring, Yellen suggests. Yahoo Finance.
[ii] Ibid.
[iii] Ibid.
[iv] Bespoke Investment Group (Mar 19, 2014). FOMC Recap. p 3.
[v] Jones, K. (Spring 2014). How Long Can Interest Rates Stay This Low?. ONWARD, Schwab. p 12.
[vi] Ibid. p 12.
[vii] Ibid, p 13.
[viii] Investment Strategy Group (Jan 15, 2014). Outlook: Within Sight of the Summit. Goldman Sachs. p 12.
[ix] Bespoke Investment Group (Mar 19, 2014). FOMC Recap. p 4.

Time in a Bubble

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I often try to assess whether we are in an equity bubble (unsustainable price valuations on stocks) to add perspective to the allocation work we do at Phillips & Company. This week in Barron's and during a private investment strategy meeting I attended, one of the more prolific investment firms (GMO) suggested that we may not be in bubble territory yet. 

Jeremy Grantham, co-founder of GMO, said the following in Barron’s.[i]

"We are not even that close to a bubble. With the S&P 500 at around 1860 recently, we are at about a 1.4- to 1.5-sigma event. Another way to say that is that we are between one and two standard deviations outside the normal distribution of stock-valuation levels. A two-sigma event would put the S&P 500 at 2350. So using the standard definition, it has to go up another 30% from here to get to a bubble. But you don't know when an ordinary market move is a bubble; you only know that in hindsight."

Well, here's some hindsight. In 2000, according to our friends at Bespoke, the 10 largest S&P 500 stocks traded at a whopping PE multiple of 62.6x.[ii]

Today, the 10 largest S&P 500 stocks are trading at a PE multiple of 16.1x.[iii]

Clearly in the words of Jeremy Grantham, we are "not even that close to a bubble" at least relative to the levels in 2000.[i]

One reason that equity valuations have been so strong and certainly not bubble worthy is the record profits corporations are posting.[iv]

The question I ask is how long can this cycle last? Interestingly, with wage growth being so muted, tremendous slack in the labor force, and labor’s share of national income falling to levels not seen in 50 years, corporations have costs under control. The elevated profits trend could continue for a while.[v]

While a normal pull back could and should be expected, especially as interest rates creep higher, it's quite conceivable to see equity prices continue to move higher. Goldman Sachs noted the lack of evidence of the “typical factors that have ended past bull markets in the US.”[vi] As illustrated in the table below, current rates for unemployment, interest, and inflation are not near the median levels for 10 historical market peaks (1950-2013).[vii]

At the same time, any expectation for outsized gains in US stocks in the near term should be put aside...quickly. Goldman Sachs is just one of many capital market expectations that we use. You can see from the data below that expecting less is perhaps the best approach. We are certainly building our portfolios based upon these below-trend expected returns.[viii]

Bubble talk may be premature at this stage of the market cycle. However, the one tool that we use to mitigate some of the bubble risk is portfolio rebalancing. With the stock market reaching record highs, it’s likely that your portfolio’s asset allocation has shifted more toward equities. This is an opportune time to review your portfolio with your advisor and discuss rebalancing.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Jeff Paul, Senior Investment Analyst – Phillips & Company

 

[i] Ro, Sam (Mar 15, 2014). GRANTHAM: Stocks Are 65% Overpriced, But They’re Not A Bubble. Business Insider.
[ii] Bespoke Investment Group (Mar 12, 2014). Bubble Talk. p 1.
[iii] Ibid. p 2.
[iv] Investment Strategy Group (Jan 15, 2014). Outlook: Within Sight of the Summit. Goldman Sachs. p 10.
[v] Ibid, p 10.
[vi] Ibid, p 11.
[vii] Ibid, p 13.
[viii] Ibid, p 24.

Is It Time to Reflect?

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Posted by siteadmin

On Thursday, the Fed released its quarterly net worth statistics for American households and nonprofit organizations.[i]

The data suggests that household net worth is now at record levels, over $10 trillion above 2008 levels, thanks to gains from stock, bond, and real estate investments. Further, recent credit card data from the Survey of Consumer Finances indicates that U.S. households have been deleveraging.

Overall, fewer U.S. households have credit card debt, though there was a slight increase among high school dropouts.[ii]

However, the average balance for households with credit card debt decreased 7.8% on average from 2007-2010 for all educational cohorts.[iii] This occurred despite U.S. median household income decreasing by only 2 percent and personal disposable income increasing by around 7 percent during this time period.[iv] Consumers reacted to concerns about the economy and their future income by saving more and spending less, resulting in more assets and less liabilities.

If Americans choose to take advantage of their newfound financial strength, this could bode well for our consumption-driven economy.

From an investment perspective and the nearly 30 years of managing wealth for others, this is the time for investors to look in the mirror. You may have made one or more of the following statements in the past months:

  • "My portfolio was not up that much last year."
  • "My advisor (or portfolio) is too conservative."
  • "I want to take more risk."

We believe that on-going conversations about your changes in circumstance are healthy. Aligning your portfolio with your goals, financial strength, risk tolerance, and time horizon is valuable. However, if you are reacting to the monster year that the S&P 500 had and want to chase returns, such market timing will generally hurt your portfolio’s performance. Heed Warren Buffett’s words of wisdom in his recent letter to shareholders:[v]

  • “…To achieve satisfactory investment results…follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick ‘no’.”
  • “If you instead focus on the prospective price change…you are speculating…Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game.”

If your financial situation is similar to the data presented above, it may be time to reassess your investment objectives with us.

Here are some things to think about:

  • Your household net worth has improved since the Great Recession and you want to add more risk to your holdings. However, you are now 6 years older and may need to draw down your assets in the next few years. How much risk can you reasonably add?
  • Your household net worth is unchanged and you are now 6 years closer to retirement. What's the right level of risk that you can tolerate and to meet your retirement goals?
  • You have generated more liquidity and don't need to access your invested assets for a longer time period. What's the right level of risk?

If you realize that there is no free lunch in investing and that you take various risks to achieve your returns then you will be fine.

Further, time is really the only way to shape most risks. Short-term results from a diversified portfolio can vary widely, both in terms of return and volatility. Over longer time periods, we arrive at a narrower range of returns. The table below shows performance statistics for the S&P 500 for different rolling return periods.[vi]

Simply put, if indeed your household net worth has improved dramatically then it's worth a reexamination of your investment policies and goals. It might not mean adding more risk. Time matters most when adding risk and that should be factored into our discussion.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Jeff Paul, Senior Investment Analyst – Phillips & Company

 

[i] Federal Reserve Economic Data. (Mar 10, 2014). Households and Nonprofit Organizations, Net Worth, Level.
[ii] Sanchez, Juan M. (Feb 24, 2014). The Deleveraging of U.S. Households Since the Financial Crisis. Economic Synopses. Federal Reserve Bank of St. Louis. p.1.
[iii] Ibid.
[iv] Ibid., p.2.
[v] 2013 Shareholder Letter. Berkshire Hathaway. http://www.berkshirehathaway.com/letters/2013ltr.pdf. p.18.
[vi] Sensenig Capital Advisors, Inc. (Sep 16, 2011). Fundamentals in Uncertain Times. Data from Schwab Center for Financial Research / Morningstar.

What’s Up? – WhatsAPP?

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There is so much going on that a very big event, Facebook’s acquisition of WhatsApp, might get obscured by other news.

Russia invaded the Crimean peninsula of Ukraine. Being a noteworthy topic, there should be plenty of punditry to inform all of us on the significance of this event. Here's what I believe:

  • Ukraine has a GDP of about 175 billion dollars just behind Kazakhstan. That's about 1% of our GDP.[i]
  • Putin wants to reacquire more former Soviet Bloc territory and create a bigger buffer between Russia and Europe.
  • Europe wants more buffer between itself and Russia.
  • Ukraine is a geographically critical country for both Russia and Europe.

Beyond this fact, I think something more telling for our economy occurred this week. 

Noteworthy investor Warren Buffett issued his annual letter, which is widely anticipated each year. Buried in the 24-page document there are a few nuggets of gold for any investor.[ii]

  • “You don’t need to be an expert in order to achieve satisfactory investment returns.” However, Buffett noted that non-experts must know their limitations and follow a plan certain to work reasonably well. Keep it simple and “don’t swing for the fences.”
  • “Focus on the future productivity of the asset you are considering.” If you aren’t comfortable estimating its future earnings, move on; you need to understand the actions you are taking. If you are focusing on potential price change, you are speculating. “Games are won by players who focus on the field – not by those whose eyes are glued to the scoreboard.”
  • Buffett advocated for non-professional investors to own a portfolio of businesses that together are bound to do well versus picking “winners”. Index ETFs are a vehicle to achieve this.[iv]
  • He also cautioned against acting irrationally due to the irrational behavior of other investors.

Certainly when a successful long-term CEO/investor and the 4th richest man in the world speaks, people tend to listen.[iii]

Neither Ukraine nor Buffett are as telling an event as Facebook paying 19 billion dollars for a virtually unknown company, WhatsApp.[iv] Some might discount this as a simple act of overpaying for an instant messaging company. That's certainly a reasonable judgment.

After all, WhatsApp was started in 2009 with as little as $250,000 in seed funding. A few years later, they took a cash injection of 8 million dollars. They have about 400 million active users sending 10 billion messages and 400 million photos a day. That's about $48 per user that Facebook was willing to pay.[v]

The fact that Facebook would pay this amount for a company with about 55 employees is indeed astonishing, but for me, it's not really about the valuation.[vi] When Facebook is willing to pay the same value as The Gap, Whole Foods Market, Waste Management, and Sherwin Williams, it's time to look at the world a little differently.

Troubling, this buyout continues to reinforce my belief that the labor market has tact away from significant job creation. WhatsApp has a sum total of 55 employees. Shareholder value has nothing to do with large employers. Take a look at the list below:

Company

Market Cap

#Employees

Valuation per Employee

WhatsApp

$19.0B

                     55

 $       345,454,545

Sherwin Williams

$19.9B

            37,633

 $                528,525

Waste Management

$19.2B

            43,500

 $                440,690

Whole Foods Market

$19.8B

            80,000

 $                247,500

The Gap

$19.2B

          132,000

 $                145,758

 

Sources: Market Caps from Google Finance. Employee counts from Wikipedia corporate profiles and Whole Foods Market web site.

Mostly though, this buyout tells me something about the nature of what's going on in Corporate America. Non-financial companies are sitting on 1.63 trillion dollars in cash and cash equivalents, and it may no longer make any sense to invest heavily in R&D.[vii] After all, WhatsApp invested a pittance compared to most large R&D budgets and walked away with a value based upon their ability to dominate a market space. Mohamed El Erian, the former Co-CEO of PIMCO, calls this a "winner-take-all" economy.[viii] Less convinced that “normal” innovation yields big payoffs, companies invest less in R&D.

If you look at companies like Apple, Google, Microsoft, and Hewlett Packard, one can question the old approach of linking R&D expenditures to improved values. Perhaps this is one of the reasons why companies are sitting on their cash.

Company

 R&D Expenses

Cash and Equivalents

Hewlett-Packard

$3.14B

$21.72B

Microsoft

$10.41B

$87.87B

Apple

$4.48B

$146.76B

Google

$7.95B

$60.69B

 

Source: Yahoo Finance, latest fiscal year income statement and balance sheet.

I believe WhatsApp tells us something about the changing nature of not just employment, but perhaps corporate capital deployment. If it only takes a minuscule investment to build shareholder value, why deploy the 1.63 trillion dollars in corporate cash balances?

WhatsApp is much more than what's up. It might just be what's coming. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Jeff Paul, Senior Investment Analyst – Phillips & Company

 

[i] 2012 Ukraine GDP. http://www.tradingeconomics.com.

[ii] 2013 Shareholder Letter. Berkshire Hathaway. http://www.berkshirehathaway.com/letters/2013ltr.pdf. p 18-20.

[iii] Forbes (2014). The World’s Billionaires.

[iv] O’Brien, Chris. (Mar 3, 2014). Confirmed: Facebook’s $19-billion WhatsApp deal is Jaw-Dropping. The LA Times.

[v] WhatsApp. Wikipedia.org.

[vi] Ibid.

[vii] Federal Reserve Economic Data. Sum of Non-financial Corporate Business: Checkable Deposits, Time and Savings Deposits, Money Market Funds, Treasury securities, and Commercial Paper, using the latest data available for each category.

[viii] Weisenthal, Joe. (Mar 2, 2014). Mohamed El-Erian Has a Fascinating Theory for Why Companies Aren’t Spending More Money. Business Insider.

 

Facing the Ugly Truth- Is the Labor Market Stuck?

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On Thursday of last week, The Federal Reserve released the minutes from their meeting on January 29, 2014. They made an astonishing statement:

"...the Committee continues to see the improvement in economic activity and labor market conditions over that period as consistent with growing underlying strength in the broader economy.[i]

Let's just take a look at some data and see what exactly the Fed is talking about with respect to "improvement in...labor market conditions...".

In the graph below, you can see the last two jobs reports suggest anything but improvement in labor market conditions.

(Source: Moody’s Analytics)

Let’s take a look at wage growth as well. I often remind readers of this data, as the macro US economy is almost solely consumption driven. Over the last five years, average hourly earnings for production and nonsupervisory employees increased at a compound growth rate of just 2.06%.[ii]

You can see that there is a systemic problem with wage growth in the American economy. Not to mention the labor participation rate is at a 35-year low and US consumers are spending down savings. [iii, iv]

What data is the Fed looking at when they see improvement in labor conditions? Can we now conclude stagnant economic growth is structural vs cyclical?

The challenge for investors is to evaluate the outcomes in light of the fact that we have never seen so much monetary intervention in our "free market" economy. The Fed balance sheet now has 23.7% of assets to nominal GDP.[v] As professional investors, we simply have no guide to help us navigate these uncharted waters. 

Investment Implications

            Fixed Income: The Fed seems very concerned with deflation and mentions low inflation on several occasions in their statement. The low duration profile of many fixed income portfolios will lag most benchmarks. We need to determine whether we should add more duration risk despite the Fed withdrawing stimulus from the economy.

            Equity Exposure: Equity positions should continue to do well in a low rate environment with easy capital propelling earnings growth for companies. The challenge comes from more deflation threats. Stocks tend to perform poorly during deflationary periods, as observed by the performance of Japan’s Nikkei Index during an extended deflationary period from mid-2008 to the end of 2012.[vi]

(Source: Google Finance)

The fact that the Fed continues to withdraw monetary stimulus, in the face of overwhelming data that the labor markets are anything but improving, suggests to me that their quantitative easing tool kit is not working. Wage growth, job growth, and labor participation are all slowing. The only thing expanding is the Fed's balance sheet. In light of very low inflation, investors need to keep their heads on a swivel and watch for what no one is talking about...deflation or the threat thereof. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via TwitterFacebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Jeff Paul, Senior Investment Analyst – Phillips & Company

 

[i] Federal Reserve. Jan. 29, 2014.
[ii] Federal Reserve Economic Data. Feb. 24, 2014.
[iii] Ibid.
[iv] Ibid.
[v] United States: FOMC Minutes. Feb. 19, 2014. Moody’s Analytics.
[vi] Japan Inflation Rate (annual change on CPI). Feb. 24, 2014. TradingEconomics.com.

The Handoff

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As we have opined in the past several months, much of the US GDP growth has come from businesses pushing "all in" on the US consumer and building up inventories to meet expected demand. 

(Source: Moody’s Analytics, GDP)

As the impact of inventory on GDP begins to diminish, will consumption take its place? It's a risky bet as we have seen an increase in tax rates, a reduction in unemployment benefits, and brutal weather, all of which impact consumption.

All of that headwind aside, there are some strong currents that can bode very well for the US consumer in the coming years. Perhaps inventory driven GDP can hand off to the next player in the relay....US banks. If we hold consumer savings and wages at current low levels, we can isolate and look at bank lending to allow credit expansion.

First, banks have every incentive to lend more. They are making some of the lowest margins on deposits since 2008, as shown in the graph below.[i]

Second, banks are sitting on historically high amounts of cash (making near zero returns), as observed by the widening gap between the total deposits (blue) and total loans (red) lines on the graph.[ii]

Third, banks are at historically low levels of loans to deposits not seen in over 35 years.[iii]


Finally, if willing, the consumer is in the best shape to lever up their personal balance sheets and consume more.[iv]

What if banks were to simply return to their average loan to deposit ratio of 0.87 from the current ratio of 0.75?[v] That would pump $1.4 trillion dollars back into the economy fueling 6.7% of GDP growth on top of what we are currently growing.[vi]

If US banks can take the handoff from US business, we could see another leg up for corporate profits driven by consumption. The key will be the willingness for the US consumer to lever up. Banks will also need to be willing to make credit more available. In 2014Q1, lending standards for prime residential mortgage borrowers tightened, and demand weakened for the second consecutive quarter. However, other types of consumer credit improved due to looser lending standards and increased demand.[vii]

Watch out - if "animal spirits" return, we could have another surprise to the upside.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via TwitterFacebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Jeff Paul, Senior Investment Analyst – Phillips & Company

 

[i] Federal Reserve Economic Data. Feb 14, 2014.

[ii] Ibid.

[iii] Ibid.

[iv] Ibid.

[v] Ibid. Average calculated from weekly ratios from Jan 1, 1973 to Feb 5, 2014.

[vi] GDP Report. Bureau of Economic Analysis, US Dept of Commerce. Jan 30, 2014.

[vii] Moody’s Analytics. Feb 3, 2014. US: Senior Loan Officer Opinion Survey.

 

Restrictor Plate Racing

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(click here for a definition)

The latest jobs report should confirm a concern we have expressed for many years; the economy continues to need extraordinary action by the Federal Reserve to keep the macro US economy limping along. 

In December, the monthly jobs report showed the US economy only added 75,000 jobs.[i] On Friday, the US Department of Labor released their latest edition of the US jobs picture. Again, the report showed the US economy only added 113,000 jobs in January.[ii] This time the weather can't be blamed as the survey data used the pay period including the 12th of the month [iii], when the weather across the US was fairly benign relative to January 2013.[iv]

You can see from the chart below the jobs picture has taken a turn for the worse. Is it an anomaly or is there something bigger playing out in the real economy?

(Source: Moody’s Analytics)

Perhaps, as we have opined in the past, without the confidence of either massive fiscal reform (congressional actions) or monetary intervention (Federal Reserve activities), the markets and economy will begin to suffer.

(Source: Federal Reserve, Bloomberg LP. Q4 2013 Look Ahead, Phillips & Co.)

What's comforting to the investor class is the fact that companies are crushing their earnings. FactSet reports that of 344 companies that have released earnings to date for 2013Q4, 72% reported earnings above the mean estimate.[v]

Unfortunately, the companies that are really beating estimates are not hiring any more people. Companies including Johnson & Johnson, McDonald’s, Lockheed Martin, and Kimberly-Clark, all of which beat earnings expectations, did not mention any additional hiring in their conference calls. These results are consistent with a Markit survey of 11,000 companies, where 41% of companies expected better activity in 2014, but only 19% planned to expand staff.[vi] In fact, companies that are beating or barely missing earnings estimates are announcing reductions or freezes.  

(Source: EPS data from Bloomberg. Staffing Plans [vii-xi])

It seems like there is a restrictor plate on hiring in-spite of tremendous wealth being created for investors. The investor class is prospering while the working class is not gaining ground.

With 71% of our economy based upon consumption, how long can we grow our GDP with a weak working class and a withdrawal of monetary policy? Can the restrictor plate economy race ahead without help from corporate America or Monetary America?

I don't think so.

It’s a race between corporate earnings driving jobs (which is not happening now), fiscal reform being put in place by an ineffective congress and President, and a business cycle induced recession that cannot be predicted effectively.   

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Jeff Paul, Senior Investment Analyst – Phillips & Company

 

[i] Current Employment Statistics, Bureau of Labor Statistics.
[ii] Ibid.
[iii] CES Overview, Bureau of Labor Statistics.
[iv] “January Hasn’t Been As Cold As You Think”, January 22, 2014, Time.com
[v] FactSet Earnings Insight, February 7, 2014, FactSet.
[vi] “Vital Signs: The World’s Glass Looks Half Empty”, Nov 18, 2013, Kathleen Madigan, Wall St. Journal. 
[vii] “IBM Sales Slump Prompts Top Executives to Forgo Bonuses”, Jan 21, 2014, Alex Barinka, Bloomberg.com.
[viii] “Intel Plans to Cut 5,000 Jobs in 2014”, Jan 17, 2014, Quentin Hardy, The New York Times.
[ix] “Disney Interactive expected to begin layoffs”, Feb 3, 2014, Daniel Miller, LA Times.
[x] “Walmart Will Lay Off 2,300 Sam’s Club Workers”, Jan 24, 2014, Elizabeth Harris, The New York Times.
[xi] AT&T Earnings Call Transcript, Jan 28, 2014, SeekingAlpha.com.

 

Lowering Expectations

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We are now 40% of the way through earnings season.  It's a good time to take a quick look at how the scorecard looks—especially since we have seen much of our recent stock price appreciation driven by multiple expansion rather than earnings growth. [i]

According to our friends at Bespoke, 65.5% of all companies that have reported are beating their Wall Street estimates in Q4.  Not since Q4 2010 have we seen this level of outperformance relative to estimates. [ii]

Further, 63.8% of all companies are beating Revenue targets.  Not since Q2 2011 have we seen companies show such promise relative to estimates. [iii]

What's so positive about this data is that we could see continue stock appreciation driven by the right reasons: EPS growth.  The average EPS growth rate for Q4 2013 is 7.9%. [iv} Expectations for S&P 500 EPS growth rates have been coming down throughout all of 2013.  We may now have an opportunity to exceed those expectations. [v]

Guidance

Unfortunately, corporate officers have gotten wise, in my opinion, to the game of managing expectations.  Long gone (or so I hope) are the financial shenanigans CFO's who were playing games with inventory and revenue recognition.  Now, they can simply look at macro stock market environments and determine if there is any benefit to their stock price for setting higher expectations or being conservative and surprising to the up-side later   Bespoke shows that companies have been lowering guidance, and this looks like the "best worst" quarter for guidance in quite a while. [vi]

While we are only 40% through the quarter it would take some pretty bad data to crush the earnings trend.  I do expect companies to be cautions on forward earnings guidance as there is no real benefit in this macro environment to forecast aggressively.  Lowering expectations now might pay off big in a better valuation (Price to Earnings or Price to Earnings Growth) environment in the coming quarters.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

[i]  “1Q 2014 Guide to the Markets”, JP Morgan Asset Management
[ii]  “The Bespoke Report”, January 31, 2014, Bespoke Investment Group
[iii]  Ibid.
[iv]  “Earnings Insight”, January 31, 2014, FactSet.
[v]  “It is the best of times and worst of times for the S&P 500 Financials sector in Q4”, January 11, 2014, FactSet
[vi]  “The Bespoke Report”, January 31, 2014, Bespoke Investment Group

A Gentle Reminder

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Friday's market action was some of the most severe to the downside we have seen in months.  In fact, the 318 point drop on the Dow was the largest since June 20. [i]

(Source: Bloomberg LP)

The reasons for the sudden drop are really anyone's guess.  Some of the "talking heads" and prognosticators suggested the following:

  •  “There's a lack of buyers supporting the market and incremental sellers who are de-risking on the back of the macro developments.” –Doug Crofton, Bank of America Merrill Lynch [ii]
  • The response I'm getting from people who generally were 'buy on the dip'-type accounts is we're looking at things a little differently now.” –David Seaburg, Cowen & Company [iii]
  • “We’ve got the emerging markets under stress concurrent with a mediocre earnings season and we’re seeing money come out of stocks.” –Walter Hellwig, BB&T Wealth Management [iv]

As for us, the reasons are important to understand, yet more critical is the real takeaway for investors.  Anything can happen in the stock market at any time, and likely will happen at some point.  Even if one of the reasons given was anticipated, like most market selloffs, it’s generally never one thing.

Think about the selloff this way:  Wall Street at the start of the year forecasted an average increase on the S&P 500 of 5.32% for 2014, so the market from last Friday’s close would now have to return 8.74% to meet those forecasts. This would be an increase of 64.27% from the original forecast. [v]

When portfolios are risk managed, we attempt to mitigate the downside relative to a comparable index.  For example, if your portfolio is 60% global equities and 40% bonds, that portfolio averaged 12.16% last year.  While much lower than the 22.80% returns in a 100% global equity portfolio, there was much less risk. [vi]

Friday's market action should serve as a gentle reminder to all of us that markets have unexpected risks.  It seems a little unusual to have to state the obvious; however, there have been several investors that may have forgotten that simple fact, as it's been seven months since we have seen a drop this large.

To get our thoughts on what we see for Q1 2014, take a look at our latest Look Ahead (click here to view).  We used some new technology and we would appreciate any feedback on the ease of use and understanding.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

[i]  “Wall St. slammed; Dow drops more than 300 points”, January 24, 2014, NBC News
[ii]  “Dow Drops Most Since June”, January 24, 2014, Wall Street Journal
[iii]  Ibid.
[iv]  “S&P 500 Falls Most for Week Since ’12 on Emerging Markets”, January 25, 2014, Bloomberg
[v]  Forecast source data: “Here’s what 14 top Wall Street strategists are saying about the Stock Market in 2014”, Business Insider, December 13, 2013. Bloomberg LP. S&P 500 close on Friday was 1790.29 according to Bloomberg LP.
[vi]  Returns and risk statistics from Morningstar Direct based on a 60% MSCI ACWI/40% Barclays US Aggregate Bond Index blend and 100% MSCI ACWI.

Gut Check Time

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As this calendar year unfolds it looks quite apparent market participants are in a bit of a tug-o-war.  Markets have barely budged from the start of the year. [i]

Equity investors are dealing with an interesting equilibrium point as it relates to valuations.  According to Goldman Sachs, there is still some room for US equity valuations to rise.  This chart provided by Goldman Sachs suggests US Equity prices are in the 9th decile of most expensive. [ii]

Yet, the average 5 year annualized return is around 5%.  While that's certainly a nice return, average returns clump together once your cross over the 4th decile and the 9th decile is literally at the edge of the cliff.

By contrast you can see Europe offers much more opportunity from a valuation perspective. [iii]

It's one of the reasons why we are adding more tilts toward international developed markets.  At current valuations 5-year historic annualized returns are around 12% with a cliff coming in the 6th decile.  It's still very possible Europe can fall into a deflationary spiral, especially with Greece at a staggering 27.8% unemployment rate. [iv]

From another perspective, you can see from the data below why US investors are in a classic equilibrium showdown. In my opinion, without substantial corporate earnings growth, P/E ratios are destined to expand, thus pushing them into a much more volatile territory that is not matched with appropriate returns. [v]

The red lines represent current valuations. The left chart shows 1-year returns following certain valuations, and the right chart shows 5-year returns. At current valuations, returns begin to scatter. To the left of the line shows much more clustering in the positive quadrant. To the right of the line reflects much more variability in returns, both positive and negative.  From a 5 year perspective, returns suck toward the zero line.

The bottom line for the path forward in US equity prices will likely be filled with much more volatility, uncertainty and variability all the while returns being muted.  The risk to return tradeoff is under serious debate.  Either earnings will reaccelerate and change the debate or we will continue to inch closer to a cliff.  

Be prepared to check your gut and examine your time frames for US equity investing.  It's no time to be uncertain about what you’re doing, why you’re doing it and for how long.

Gut check time is upon us.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

[i] Bloomberg LP
[ii] “2014 Outlook: Within Sight of the Summit”, p. 8, Goldman Sachs Investment Management Division, January 15, 2014
[iii] Ibid., p. 18
[iv] “Greek unemployment rises slightly in October to new record 27.8 pct”, Reuters, January 9, 2014
[v] “1Q 2014 Guide to the Markets”, JP Morgan, p. 14

Will the Bad Weather Last?

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The US economy added the fewest number of jobs in December (74,000) since January 2011. [i]  Much of the blame for the terrible jobs report was the weather.  I know the weather was horrific in parts of the country.  We have a national clientele and plenty of anecdotal evidence.  According to Phil Izzo and Kathleen Madigan from the Wall Street Journal, some 273,000 people were not at work in December due to weather. [ii]

Unfortunately, there are two problems with this thinking. First, the 273,000 are counted as employed whether or not they had to miss work because of weather. It’s treated in the jobs number the same way as an employee taking a sick day or a vacation day.

Secondly, if you thought that adding the 273,000 number to the 74,000 jobs added would give you more clarity on how many new jobs we’d have without the weather, that would give you 347,000. To give perspective on that number, the average number of jobs added in 2012 was 183,000 per month and 192,000 in 2013 excluding the December report. A growth of 347,000 would be near double the average over the last two years. I just don’t see that as realistic.

The problem with the report

I’m not convinced that weather alone was the cause of the bad jobs report.

When you look at the industries that had a net loss of jobs in December, you do indeed see construction workers—which would be expected if you blame it on the weather.  However, you also see job losses in the fields of computer and electronic products, motion picture, accounting and bookkeeping services, and health care.  I don't associate these jobs tied to weather. [iii]

It's still too early to tell if there is a blemish developing in the economy or it's the same old "slow growth" we are accustomed to in the last 5 years.  One thing is certain, which is that the headline unemployment rate is now rendered useless.  Friday's labor report showed the unemployment rate dropping to 6.7%, just 0.2% above when the Fed said in the past that they would raise rates.  We all know that's not likely to happen.  The sole reason the unemployment rate dropped is associated with Americans dropping out of the job market. [iv]

We are now at the lowest point in American workforce participation in almost four decades.

While we will get a better picture of the jobs situation next month when weather isn't to blame the bad weather will likely persist when it comes to our workforce participation.

We continue to hold lower duration bonds, fundamentally strong equities, and a tilt toward non-US developed and emerging economies.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

[i]  “All Employees: Total nonfarm (PAYEMS)”, Federal Reserve Economic Data
[ii]  “Vital Signs: Mother Nature Keeps Workers at Home”, January 10, 2013, Wall Street Journal
[iii]  “Table B-1. Employees on nonfarm payrolls by industry sector and selected industry detail”, US Bureau of Labor Statistics
[iv]  “Civilian Labor Force Participation Rate”, Federal Reserve Economic Data

The World Didn't Come to an End!

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In recent weeks we have seen some extraordinary data published by the federal government.  It seems like our budget deficit (the amount of money the government has to borrow to meet its spending) has been shrinking at an astonishing pace.

Contrary to what economists predicted as doom if the US Government cut deficit spending, the US economy has grown.  In fact, if a politician ran on the platform of higher taxes, lower spending and more growth, that would be the accurate outcome.  Of course, that wouldn't be a winning message for the American voter.

Take a look at the massive buildup and then reduction in deficit spending. [i]

Now take a look at a chart on total federal spending. [ii]

You can see from these two charts we increased our total spending by 19.79% and increased our deficit spending by a colossal 779.1% from 2007 to 2009 in order to accommodate the financial crisis and reduction in consumer spending.   

One of the biggest concerns by many of the economic elites was any reduction in deficit spending would lead to a contraction in GDP.  They come by this fear honestly.  Keynes one of the foremost thinkers on fiscal policy preached this lesson from the 1920's in his book The General Theory of Employment, Interest, and Money.

In our current case, there is no doubt deficit spending (Keynes) was right to some extent. [iii]

However, what's telling about our current expansion is much of it is happening with declining federal deficits.  Realize for every 169 billion dollar cut to federal spending, we technically lose 1% of GDP growth.

But, look at the same chart when focused in on the years since the financial crisis. You can see that GDP was growing, despite a drop in deficit spending.

Even more astonishing is we have had higher taxes at the same period of time.

  • Expiration of the Bush tax cuts, causing the top tax bracket to rise from 35% to 39.6%
  • 3.8% surtax on investment income and long-term capital gains for taxpayers with income above $250,000
  • Increase in the estate tax from 35% to 40%
  • 2.3% excise tax on medical device manufacturers and importers 

Investors could become hopeful the nasty fiscal debates of the past are just that: in the past.  Is it possible our economy is becoming less dependent on deficit spending?  Will the upcoming debt ceiling debate be a non-event?

Could Europe be next to grow despite less deficit spending? [iv]

It's certainly possible and all of this would be positive for investors. 

The world did not collapse when facing less federal deficits and higher taxes.  While no collapse occurred, certainly we have not seen stellar growth either and I expect Q1 2014 to be a bit more challenging for economic growth.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Alex Cook, Investment Analyst – Phillips & Company

[i]  “Federal Surplus or Deficit [-] (FYFSD)”, Federal Reserve Economic Data
[ii]  “Federal Government: Current Expenditures (FGEXPND)”, Federal Reserve Economic Data
[iii]  “Federal Surplus or Deficit [-] (FYFSD)”, “Gross Domestic Product (GDP)”, Federal Reserve Economic Data
[iv]  “General government deficit/surplus”, “GDP and main components – current prices”, Eurostat

Ambiguity Aversion

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In the next several days you will begin to see a dearth of predictions about 2014.  How much will the S&P 500 go up or down?  How much will the US economy grow in 2014?  Unemployment?  Wall Street firms know one thing about us that we generally don't realize. 

Investors are predisposed to avoid ambiguity.  We will buy investment letters that predict the future and forecast precisely the outcomes for stocks.  We will make asset allocation decisions based upon the latest Wall Street prognostications.  We might even go as far as believing large financial firms like Wells Fargo, JP Morgan and Goldman Sachs must know something we don't. 

Unfortunately, for all of us, no one knows and generally the more precise that their predictions are, the more inaccurate they will be.

Last year in our forecast blog, we listed the predictions for some major Wall Street firms.

You can see the tens of millions of dollars these firms spend on prediction addiction got them precisely wrong.  Wells Fargo predicted the market would drop by 2.54%, when instead we saw a rally of 31.74%. The group on average missed the actual return of the S&P 500 by 24.60%.

Worthless

I could go on and on about the variability of annual predictions but suffice it to say they are worthless.  It's really not the prognosticators' fault.  Fundamentally, they know they are going to be wrong and they still provide systemically bad data.   Investors simply like certainty.

Look below at a chart showing the ranges of the highest and lowest market returns over various timeframes: [i]

With stocks returns deviating up or down by 44% in a one year period, you can only expect predictions to be wrong. 

2014 Precisely Inaccurate Predictions

For those that enjoy the entertainment value in the predictions parlor trick, here are the 2014 predictions from the same firms we listed above for the S&P 500, GDP, unemployment, and interest rates. [ii]

Here are also forecasts for developed markets outside of the US, and for emerging markets. [iii]

Below are GDP predictions for various economies, from central banks, the IMF, and the Organization for Economic Cooperation and Development. [iv]

If you’re investing for a one year period of time, the above data might be remotely relevant.  But, if that is your time horizon, two things are apparent.

1) We have failed to educate our clients and readers on the importance of time arbitrage when it comes to investing.  Targeting short term gains and market timing is a fool’s trap.  Even if you’re successful, you will likely pay 43.4% in federal taxes if you’re in the top bracket—a big erosion of your gains.

2) You certainly don't need to be in an investment environment that will provide you with 44% up or down of annual variability.

Our predictions for 2014 are much broader and give us a small chance at being somewhat accurate.

1) Intermediate and Long-term treasury rates will rise but certainly not as much as the market currently expects.

2) Developed markets will continue to provide lumpy but positive returns by the end of 2014, much of which will be driven by improved balance sheets at banks.

3) Emerging markets will continue their Q4 trends and provide positive returns.

4) Global de-leveraging will continue and be the driver for better foreign returns.

5) Diversification will continue to be rewarded.

6) US corporate earnings will continue to moderate in 2014, which poses a significant threat to this current bull market.

From all of us at Phillips & Company, we wish you a very happy, healthy and prosperous 2014.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

 

[i]  “Historical Returns by Holding Period”, Barry Ritholtz, The Big Picture
[ii]  “Here’s what 14 top Wall Street strategists are saying about the Stock Market in 2014”, Business Insider, December 13, 2013. “Wells Fargo Advisors Releases 2014 Economic and Market Outlook Report”, Wells Fargo, December 4, 2013. Bloomberg LP.
[iii]  Ibid.
[iv]  Bloomberg LP.

Complacency

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It's the holidays and there is no better time to relax with family and friends.  We have had an amazing year in the US equity markets.


Source: Bloomberg

The economy looks like it certainly reached "escape velocity" from the latest Q3 GDP revisions.  GDP was up 4.1%. [i] Consumption even ticked up a touch from prior reports.

Investors appear to be very happy and enjoying opening their statements at month end. This is quite a change since the financial crisis. 

It's also apparent to me that clients are becoming complacent, at minimum, and in some cases forgetful about the risks associated with investing (This conclusion from the thousands of investors we serve).

Complacency is the byproduct of some very nice success.  We have seen portfolios this year far exceed their intended performance targets" [ii]

Just remember what it felt like during this period of time in 2008-2009:

Source: Bloomberg

The world markets looked like they would freeze up, money markets looked insolvent and doubts about the creditworthiness of our banking system were a daily reality. 

Since that time, we have enjoyed many years of investing success.

Source: Bloomberg

It's easy to see how we can all become complacent. 

There is absolutely no free lunch when it comes to the returns you are experiencing with us or any investment advisor/manager.  Make no mistake about it: you are paying for your returns with an associated amount of risk in your portfolio.  Nothing has changed when it comes to that. 

The time to prepare for the next event, whenever that will be, is now. 

Knowing the risks you are taking—or in some cases, the risks your advisor is taking on your behalf—would be the first thing I would do.  Make it a goal to examine those risks with us early in the new year.

Second, take a macro view of your entire portfolio (401k's, IRA's investment accounts, real estate, business valuation) and see how all the component parts can work with each other.  We can help you with this. 

Third, reassess your time frame.  How much time do you have before you need to draw on your assets? How are different parts of your portfolio aligned to your personal and professional time frames? 

Finally, realize the averages can kill you.  A 6 foot person can drown in 5 feet of water on average.  You need to also look at surviving the worst.

The headlines on the economy look great.  However, below the surface there are indeed a couple of currents that are concerning.  Inventory buildup accounted for 40% of GDP in Q3. [iii] That will likely not be the case in Q4.  Corporate earnings growth has remained stagnant from 1.9% growth from Q1 to Q2, and 1.7% from Q2 to Q3 [iv]. Analysts are also revising down year-over-year earnings growth estimates for Q4: [v]

I know you might be thinking this is certainly not the cheerful email you want to read before the holiday.  While I acknowledge I could be much more Pollyanna, I think it's more prudent I encourage introspection.  Let's all take a hard look at how things are working with your holdings.

Helping you fight complacency could be the best gift we can give you for the New Year. 

We are grateful for your partnership with us and feel blessed you allow us to serve you and your family. All of us at Phillips & Company wish you and your family Happy Holidays and Merry Christmas.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Alex Cook, Investment Analyst – Phillips & Company

[i]  “United States: GDP (Third Estimate), Moody’s Analytics
[ii]  Investor Advantage Year to Date model returns calculated by Morningstar Direct. Returns are based on model portfolios and may not reflect actual account performance and the impact of management fees. Phillips & Company composite capital market expectations based on data from JP Morgan Asset Management "Long-term Capital Market Assumptions: 2013 Edition", Neuberger Berman "Asset Allocation Committee: Market View & Capital Market Assumptions Methodology", Cambridge Associates "Equilibrium Asset Class Assumptions”, and AllianceBernstein “Capital Market Projections.” Cambridge Associates figures were originally presented in real terms and have been adjusted to nominal terms based on Cambridge Associates 'inflation expectations. Capital market expectations are merely projections and are not guarantees or promissory of future returns. There is no guarantee that events will occur as planned. 
[iii]  “United States: GDP (Third Estimate), Moody’s Analytics
[iv]  “Earnings Insight”, FactSet, December 20, 2013
[v]  “Fed in Focus as Q4 Earnings Reports Trickle In”, Zachs Investment Research, December 13, 2013

Too Soon to Taper

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The week before Christmas will certainly be anything but quiet for global equity markets.  With the recent strong jobs report, stronger than anticipated Q3 GDP, and consumer confidence improving, some market prognosticators are now suggesting the Fed might begin to cut back on their bond purchases as early as this week. [i]

While I don't believe the Federal Reserve quantitative easing program has created strong growth for much of the economy, there is certainly no question asset prices have improved.  Since QE3 began on September 13, 2012, the stock market is up 24.97% and housing prices are up 13.29%. [ii]

Why they should wait

In spite of my personal opinion, the last time the Fed pulled their QE program, the stock market dropped sharply and the economy stalled. [iii]

Second, the economy is still dangerously close to flat-lining when it comes to inflation. [iv]

After spending over $2 trillion on bond purchases since QE 1 [v], it would fly in the face of the Fed's past experience to prematurely pull one of their last tools. Additionally, deflation is far more harmful to the economy than inflation.

Finally, the Fed does have one new tool to attempt to use.  As I have written on several occasions, most inflation hawks don't appreciate the Interest Rate Paid on Excess Reserves. Basically, the Fed is paying banks interest to hold excess reserves above the mandatory requirements—creating an incentive for banks not to lend.

In the current case, the Fed is paying 25bp to banks for not taking on any lending risk. [vi] If the Fed wanted to stimulate more money velocity in our economy they could move that rate to zero, pushing banks to take more risks and actually lend, rather than collecting free money.

Specific predictions are almost always wrong, but if I were to predict a course of action the Fed might take this week, it would be some kind of adjustment to the Interest Rate Paid on Excess Reserves.

I would also suggest that both the very short and very long ends of the yield curve are most likely to face selling pressure associated with any tapering.  That's why we are targeting durations around 4 years. [vii]

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Alex Cook, Investment Analyst – Phillips & Company

[i]  “Economists split on start of Fed pullback”, Wall Street Journal, December 13, 2013
[ii]  Bloomberg LP. Stock prices are represented by the S&P 500. Housing prices are represented by the S&P/Case-Shiller Composite-20 Home Price Index. Note that the most recent housing price data are as of September 30, 2013.
[iii]  Federal Reserve, Bloomberg LP. “Federal Reserve: Unconventional Monetary Policy Options”, Congressional Research Service, February 19, 2013.
[iv]  “Consumer Price Index for All Urban Consumers: All Items (CPIAUCSL)”, Federal Reserve Economic Data
[v]  “Federal Reserve prolongs stimulus”, CNN Money
[vi]  “Interest Rate Paid on Excess Reserve Balances”, Federal Reserve Economic Data
[vii]  “Daily Treasury Yield Curve Rates”, US Department of the Treasury

Bad News was Good News, Good News was Bad News...Now What ?

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Something happened last week in capital markets that might suggest a significant shift with investors thinking.

The market sold off despite some very strong economic news all week—until Friday.

Consumer credit expanded by 18.2 billion in October, which was the largest increase in 5 months.  Revolving credit expanded by 4.3 billion, which was the largest increase since May. [ii] The US consumer is certainly feeling confident enough to take on more debt on their credit cards.

The US economy expanded at a much faster pace in the 3rd quarter than originally anticipated.  Q3 GDP grew at a 3.6% annualized pace.  Businesses certainly are anticipating a strong consumer as they added inventory to the tune of 1.7 percentage points or almost half of GDP growth. [iii]

New home sales recovered from a precipitous drop this summer, adding 444,000 homes in October. [iv]

Consumption grew at a reasonable pace and the consumer was willing to spend down their savings to make purchases.  Again, this is showing us that the consumer is gaining confidence in the recovery. [v]

The tepid movement in the market prior to Friday, despite the good economic news, might have been because of concern that good news would mean that the Fed starts tapering their bond purchases—which have fueled much of the recovery.

Yet, something happened on Friday.  The jobs report was released adding to all the positive releases throughout the week.  The US economy added 203,000 jobs, almost all coming from the private sector. [vi] The market reaction was quite the opposite with a very strong rally of 198.69 points on the Dow. [vii]

My take is participants might be growing comfortable with the eventual Fed taper not leading to an immediate spike in rates. Or, investors may now believe that the economic recovery is strong enough to sustain itself without the stimulus that the Fed has been providing.  If you look at 10 year Treasury rates, they barely budged all week.  They rose by 10bps during the week and were at a standstill on Friday. [viii]

 

If my assessment proves correct, the equity markets could launch much higher and not pose a significant threat to bond holdings for now.  Be aware that bonds could drop in price as actual rates begin to rise and that might be some time in the distant future.

The real test of economic resilience should be reflected in wages.  Wages are simply not growing and it's hard for an economy that is roughly 70% dependent on consumption to sustain itself without real wage growth.  You can see over the past five years that growth in real compensation per hour has moved a little around the edges, but the trend is basically flat. [ix]

Slight sifts in allocation may be necessary, but it's difficult to find things that are undervalued at this time within the US. We continue to find opportunities overseas in developed and emerging international markets.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Alex Cook, Investment Analyst – Phillips & Company

[i]  Google Finance
[ii]  “United States: Consumer Credit (G19)”, Moody’s Analytics
[iii]  “United States: GDP (Second Estimate)”, Moody’s Analytics
[iv]  Federal Reserve Economic Data
[v]  Ibid.
[vi]  “Economic Calendar”, Bloomberg
[vii]  Bloomberg
[viii]  MarketWatch
[ix]  Federal Reserve Economic Data

Chasing

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At this stage of a bull market cycle we start to see investor behavior trump reason and logic.  One of the most common behaviors/mistakes investors make is to chase valuations.  They start to buy when in fact they should err on the side of caution.

As I wrote last week, market cycles where price/earnings multiple expansions, can last a lot longer than expected.

The expansion of multiples over long periods of time makes it difficult for investors that like to market time (move in and out of the markets) to know when to move back it and at what multiple.

If you look at current valuation multiples you could get the picture that the equity markets are fairly valued.  Two common measures are the price-to-earnings multiple on a trailing twelve month earnings basis  The other is a PE on a next twelve month period based upon forward-looking earnings estimates. [i]

If an investor were to use just these metrics as determinants on when and what to buy you might come to the conclusion the coast is clear on buying.

The problem I have with these two measures is the limited amount of time with the earnings part of the equation.  Simply put, 12 months of trailing earnings is a very short period of time and can't quite capture the natural cycles business go through over a longer period of time.  Further, it's almost impossible to accurately forecast future earnings beyond 12 months.

I tend to use a modified PE multiple called the Shiller PE named after the Nobel Prize winning economist Robert Shiller.

Shiller intuitively knows businesses run "hot and cold" over much longer periods of time than 12 months and so he modified the traditional PE methodology to incorporate a 10 year rolling average of earnings adjusted for inflation.  Adjusting out inflation is critical over long periods of time as it has a tremendous impact on earnings growth if not adjusted. [ii]

Comparing the two methodologies gives two distinct pictures.  With traditional PE's the S&P 500 is over its 10 year average by 4.4%, which for our purposes is essentially in line.

With the Shiller P/E, the S&P 500 is overvalued by 8.8% from its 10 year average, and overvalued by 51.9% from its average since its earliest available date in January 1881.

If you took this model and applied it to various markets and sectors you get the following valuations above and below averages. [iii]

Practicum

So what should investors do with sideline cash in the face of these two competing notions and the realization that markets can overshoot averages for long periods of time?

  1. Get "crystal clear" on your equity investment time frame.  If it is shorter than a few years, then don't chase.  Wait.
  2. If you have a longer time frame (5+ years), phase in the resources over a period of 12 months. Try to dollar-cost average into this market
  3. If you have a perpetual time frame (foundations, endowments or pension plans), you should avoid market timing altogether.  However, if you are sitting on cash use a 4-6 calendar quarters to phase cash in.
  4. Make sure that your portfolio is properly diversified with assets that are not correlated to each other. Use this time to consider buying assets that are not correlated to overvalued sectors.
  5. Develop a target rate of return you need to meet your liability needs.  When I say liability I'm not just talking about debt obligations but also spending requirements, inflation, fees and perhaps taxes.

a)  A target rate of return will help you avoid timing traps and keep you focused on your long term objectives.

b) A target rate of return will provide you with a benchmark to measure your performance against that is not theoretical but significant to you or your organization

While many of our competitors might boast high returns this year, I can assure you of one thing: you are paying for those returns with the risk they are taking on your behalf.  Whether or not you are made aware of those risks tends not to be of great concern in the wealth management industry.

If we have not worked with you on developing a return target, it's time we have that conversation.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

[i]  Bloomberg LP
[ii]  “Stock market data”, Home Page of Robert J. Shiller, Yale University
[iii]  Bloomberg LP, Federal Reserve Economic Data

Risk Is Not Relative

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This week marked another week in which the major market indexes hit all-time highs.  It’s clear that investors are feeling very good and continue to pour more money into equities. Since the start of October, investors have added $34.2 billion into equity funds, and have withdrawn $26.9 billion from bond funds, according to Investment Company Institute data. [i]

The one surprise for me which I would have never predicted is the amount of aggressive behavior that I am witnessing. For example, an article in Forbes in September said that at Tesla’s current price, the company would have to be selling cars at a price of $1.1 million each, whereas the actual price of a Tesla Model S is between $80-110,000. [ii]

I'm shocked at how quick greed has come back to the US investor.  I thought it would be a generation before we saw speculative behavior return.

Intrinsic Value

Just by first principles, finding out how much a company should be worth is easy.  In fact, the recent Nobel Prize winning economist, Robert Shiller pondered a simple question.  If companies can be valued based upon their cash flows (dividend growth), stock prices should be fairly stable. In the chart below, the dotted line represents the present value of the dividends of a stock—fairly consistent. [iii]

The problem comes in to play with the solid line, which represents the actual price of the stock.  Shiller suggested something else was going on with prices—namely, investor behavior.  He went on to spend his career understanding that exact behavior.

Let's walk his Nobel Prize-winning question forward through today. We have seen dividend growth rates start to peak out. Below is the dividend growth rate chart on S&P 500 stocks: [iv]

Also, earnings growth rates have been declining and are presently close to flat. Below is a chart on earnings growth rates on S&P 500 stocks: [v]

Shiller’s study was written in 1981. Nowadays, more companies sometimes choose to reinvest earnings into their own business activities, so earnings growth rates are one of the major drivers for the true intrinsic value of a stock—as we have written before.

Yet, we are seeing multiples expand and prices rise in spite of a drop in earnings growth rates. Below is a graph of the S&P 500 PE ratio since the start of the year. Just look at how it keeps pushing higher: [vi]

So, how is it that stock prices are going up when drivers of intrinsic value are not?

Answer: Investor’s behavior toward risk is changing.  In the past 5 years, investors have gone from evaluating risk on an absolute basis to a relative basis.  Before, investors were asking how long will my assets last and how will the markets impact me if I see a drop a few years before retirement?

Now they are asking, how I can get 24% returns like the S&P 500 is posting this year?

Risk isn’t relative

It's a little like driving your car on a highway going 90 mph when everyone else is going 90 mph.  It may feel like you are going with the flow...until you hit something. Whenever price diverges from intrinsic value (which is what we are seeing right now), risk in the market goes up.

Risk perception is not a relative exercise. Risk is an absolute based upon your individual circumstances. 

So how long can investors drive valuations higher before they hit something?  Let's take a look. Below is a chart on the PE ratio of the S&P 500 over the last 30 years:

PE ratios expand over several years and then consolidate. Right now, we are just over two years into a multiple expansion cycle. As you can see below, those cycles can run for a long time.

The undisputed truth in any investment is you are going to pay for whatever returns you generate in the form of risk.  There is no way around that simple truth.  You simply need to decide how much risk is really appropriate for your long-term financial plan.  Remember, your landlord doesn't care how many shares of Tesla you own.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

[i]  “Summary: Estimated Long-Term Mutual Fund Flows Data”, Investment Company Institute
[ii]  “Tesla is Overvalued: Let me count the ways”, Forbes
[iii]  “Do stock prices move too much to be justified by subsequent changes in dividends?”, Robert Shiller
[iv]  “S&P 500 Dividend Growth”, multipl.com
[v]  “S&P 500 Earnings Growth Rate”, multipl.com
[vi]  Bloomberg LP
[vii]  Bloomberg LP

Obamacare by the Numbers

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With so much discussion, debate and concern being expressed by the rollout of the Affordable Care Act, also known as Obamacare, I think it's critical to look at the program and its economic impact in the simplest terms.

Here’s Obamacare made easy:

  • It provides a basic set of coverage that must be included in all plans.
  • All Americans are required to have coverage by March 31st, 2014 or face a fine of sorts. The fine is as follows: [i]

There are some variables to these fines if you get into the details. The short explanation is that the fines are minimal in the first few years, and they grow to get closer to what you would pay for insurance coverage in 2016 from the exchange. Also, there are really no teeth in the ACA to allow for collection of the fines other than on tax returns.

According to the Federal Government, the average plan will cost $328 per month without any subsidies. [ii] But, keep in mind that the various “Bronze” or “Silver” plans may not have the same coverage as individual plans previously, so individuals may need to pay more to buy a higher-tier plan to get the same coverage as in the past.

Another factor is two new taxes: first, the top income-tax bracket will pay an additional 3.8% tax on income and capital gains in 2013 and due in 2014, and secondly, high-income taxpayers will pay 0.9% more on the Medicare portion of their payroll tax.  In total, the Joint Committee on Taxation estimated this to be $20.5 billion for tax year 2013 (paid in 2014). [iii]

The last major issue that needs to be considered is the rating system Obamacare places on insurance carriers administering Medicare Advantage products.  The system rates carriers on a 5 star rating system based upon services covered, responsiveness to customer needs, and other metrics. Carriers could get different reimbursements from Medicare depending on where they rank on the system, and this could create uncertainty for current Medicare Advantage users.

Critical Path

Like any insurance risk pool, Obamacare needs more healthy participants than sick participants.  Without the correct blend, the risk pool costs rise rapidly and insurance firms can withdraw out of concern for accumulating losses. Here’s what could happen:

1) Based upon the premium costs in 2014 for the individual versus the penalty, it's clearly worth waiting until you’re sick to sign up—especially if you’re making low income and don’t pay taxes (i.e.: the only way the ACA fine can be enforced). The healthy can defer until at least the third year when the penalties grow closer to equilibrium with the premiums.

2) People on individual plans are estimated around 19 million [iv], and these plan holders are facing some termination risks. The most recent proposal being floated in Washington allows insurance firms to extend previous policies. The outcome from this is pretty obvious; if you’re an insurance company that can now pick winners and losers for a year, you’re going to re-sign your healthy policy holders and dump the sick ones.  They can shop on the exchange.

3) Obamacare has two key subsidies: one for premiums, and one called a “cost-sharing subsidy” for deductibles and co-pays. The premium subsidy is exempt from sequestration, but the cost-sharing subsidy could theoretically be sequesterered. [v] This could become another battleground in January 2014, when the continuing resolution that re-opened the government is set to expire.

Consequences, Economic and Otherwise

First, the risk pool looks like it will be tilted toward the sick, creating tremendous pricing problems in 2015.

Secondly, If 50% of the 19 million individual plan holders lose their policy, that's a loss of $2.04 billion in premiums (average individual premium nationally is $215 according to the Kaiser Family Foundation). [vi]

Finally, the Obamacare tax will take $20.5 billion next year and redistribute it to insurance companies and health care providers.

Based on these numbers, the immediate impact of Obamacare will be $22.9 billion, or 0.13% of GDP.

To itself, the immediate impact of 0.13% of GDP isn’t much. The bigger concern is the uncertainty that these new regulations can have on long-term health care costs, which currently totals to 17.7% of GDP. [vii] If Obamacare disrupts the risk pool for insurance, this could have a more serious impact on the economy than just the immediate impact of the taxes and potentially dropped premiums.

That’s the real issue that we need to watch out for.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

[i]  “Uninsured next year? Here’s your Obamacare penalty”, CNN Money. August 13, 2013.
[ii]  “Obamacare’s average monthly cost across U.S.: $328”, Reuters. September 25, 2013.
[iii]  “Estimated revenue effects of the Amendment in the nature of a substitute to H.R. 4872…”, Joint Committee on Taxation. March 20, 2010.
[iv]  “Individual Market Health Insurance”, America’s Health Insurance Plans.
[v]  “Budget Sequestration’s Impact on Obamacare Subsidies”, Heritage Foundation. October 24, 2013.
[vi]  “Average Per Person Monthly Premiums in the Individual Market”, Kaiser Family Foundation.
[vii]  “OECD Health Data 2013: How Does the United States Compare”, OECD

Is Rome Still Burning?

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The US economy had some reasonably good news last week. US GDP was up 2.85% in the 3rd quarter. It's the fourth consecutive quarter of growth. [i]

Further, the monthly employment situation took a surprising turn for the better. The US economy added over 204,000 jobs in October. The private sector added 212,000 jobs with the government shedding 8,000 jobs.

(Image source: Calculated Risk)

Additionally, consumer credit expanded by 13.7 billion in September, above expectations. [ii]

On the face of this data, the US is looking pretty strong. One might even want to consider adding more risk to their portfolios as the US looks like it's healing.

In fact, if you look at the typical (if there ever was a typical) credit induced financial crisis, we are making some steady progress in working our way out of it as time passes. As we’ve written before, economists Carmen Reinhart and Kenneth Rogoff compiled research on the historical impact of a financial crisis. You can see that compared to both the historic levels as well as our worst levels, we have made progress. [iii]

We’re just a little more suspect and erring on the side of some caution. First, while GDP grew, the largest component of GDP is still consumption, which has seen continued weak growth of less than 2%. Additionally, Q3 was the third consecutive quarter with slower growth than the prior quarter. [i]

Second, consumer credit in total did indeed increase in September; however, for the 4th consecutive month revolving credit shrank. Remember revolving credit is generally used for items that consumers put on credit cards. Clearly they remain skittish and cautious. [ii]

One possible reason for this is that the jobs we are adding to our economy are just not adding too much to spending power. While we did add 204,000 jobs in October, 53,000 of those jobs were in leisure and hospitality, and 44,000 were in retail trade. [iv] If you look at the average salaries of these sectors you will see it's not adding much in terms of wages compared to what we were accustomed to before the crisis: manufacturing and construction. [v]

Essentially, we’re adding jobs, but in lower paying occupations.

Further the participation rate (the number of people actively working and looking for work) has now dropped to the lowest level since 1978. [vi]

One might think this is driven by retirees, but unfortunately that's wishful thinking. According to economist David Stockman, in 2000, there were 75 million unemployed. There are now 102 million, and only 6 million Americans went into retirement over this time frame. [vii]

So what's the solution?  Well, we know what's not working: Monetary policy or the actions that the Federal Reserve is taking. Said another way, monetary policy might be working to the extent it can but it's not solving our jobs and confidence problem.

What could work are fiscal policies (the items that Congress and the President should do) that are stable and can be relied upon by consumers and businesses alike. Unfortunately, we've seen how these institutions act. In fact, I think they might need Rome to burn before they can muster the courage to act. 

In my opinion, the key to investing in this environment is to not miss the big moves up and also to build plenty of caution into your equity exposures. As it relates to fixed income, shorten durations and tilt more to active management vs. passive vehicles. Rising rates will be our enemy in this slice of the pie.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

 

[i]  “United States: GDP (Advance Estimate)”, Moody’s Analytics
[ii]  “United States: Consumer Credit (G19)”, Moody’s Analytics
[iii]  “This Time is Different, An Update”, Josh Lerner, Oregon Office of Economic Analysis. Federal Reserve Economic Data.
[iv]  “Economic Calendar”, Bloomberg
[v]  “Table B-3. Average hourly and weekly earnings of all employees on private nonfarm payrolls by industry sector, seasonally adjusted”, US Bureau of Labor Statistics
[vi]  “Whopping 932,000 Americans drop out of labor force in October; participation rate drops to fresh 35 year low”, Zero Hedge
[vii]  “The Born Again Jobs Scam and the Fed’s Terminal Incompetence”, David Stockman, Zero Hedge

Defying Gravity

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Defying Gravity

The S&P 500 rallied 4.59% over the last month.This rally continues to mystify conventional thinking— that is, for those that believe market reactions should be conventional. [i]

Conventional thinking goes something like this: Earnings continue to come in at weaker levels than expected by Wall Street analysts, and revenue expectations continue to disappoint. [ii]

Conventional thinking would suggest that the market would pull back, yet the market continued to rally in the face of such headwinds.

However, like most things investing, the non-conventional and counterintuitive generally prevails (at least it has for the 28 years of my professional investing career).

Try this on for counterintuitive.  The trillions of dollars in pension funds, endowments, foundations and insurance companies must achieve a fairly high bogey for a return. In all likelihood, they will simply not meet their payout mandates with 4% returns.  Couple this with the pressure to meet performance benchmarks and the career risk these "professionals" face if they slip too far behind their peers.  This will certainly drive more dollars to chase equity performance regardless of the facts.

Pan y agua

Seniors in this country cannot live off bread and water alone.  On average, savings accounts are yielding 0.06%. [iii] On a $100,000 account, that will give a whopping...60 dollars per year in interest.  With over $563.2 billion in personal savings, there may be a continued push toward risk. [iv] 

The Fed’s zero interest rate policy and the on-going incompetence of policy makers are punishing retirees who have worked hard to build their savings.  While we manage risk in our allocated accounts, so many others simply do not.  Blind speculation in hopes of a return seems to be an investment strategy being used by so many. 

Total Retirement Assets in Trillions

Further, the sheer numbers of retirees compounds the investment challenge. The number of retirees is 40.3 million according to the Social Security Administration: [v]

Make no mistake about it: speculation can last a lot longer than most anticipate.  Certainly trying to time the markets is an absolute fool’s game.  Just look at the data below.  If you miss just a few key days in the market, you miss all the advantage. [vi]

I can probably list another 6 reasons to expect this market to continue its rally.  The real lesson is the futility in trying to time the market.  The only investment strategy I have relied on is to use time to shape the risk in a portfolio.  When risk management is done properly, short term swings matter so much less.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

[i]  Bloomberg LP
[ii]  “The Bespoke Report”, Bespoke Investment Group, November 1, 2013
[iii]  “Savings accounts with the highest yields”, CNN Money, October 1, 2013
[iv]  “Savings Deposits—Total (SAVINGSL)”, Federal Reserve Economic Data
[v]  “Benefits paid by type of beneficiary”, Social Security Administration
[vi]  “The pros’ guide to weathering volatility”, Fidelity, February 19, 2013

Sugar in the Gas Tank is Better than Water

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The unemployment figures came out last week and they were certainly less than anticipated—an increase of 148,000 in nonfarm payrolls in September compared to the expectation of 185,000. [i] This is troubling and reflects a continuing deterioration of job growth.

Take a look at the table below.  You can see the rolling 3-month average of jobs added to our economy is 143,000 per month, down from 233,000 in February 2013.  That's a 39% drop. [ii]

Further, more people are dropping out of the work force in the same time period.  The number of Americans not in the labor force increased by 1.3 million from February to September. [iii]

All of this deterioration in employment growth happened despite the Federal Reserve buying $85 billion in bonds per month as part of their third round of quantitative easing (QE). The Fed’s balance sheet now sits at $3.88 trillion, a record high. [iv]

In fact, we do know the only thing that has expanded during the series of QE's has been the stock market and GDP. [v]

You can also note that during periods when the Fed allows the economy to function without such extraordinary measures both the economy and stock market drift lower.  The “Wealth Effect” did boost household wealth but did not translate to jobs. 

While it's clear the Federal Reserve will continue with its bond purchases for a while out of despair and a lack of credible tools, at some point they will have to pop their own balance sheet bubble.  At some point the sugar they put into the tank will mix with gas and gum up the fuel injectors.  Thus we should be preparing investors and portfolios for a post-federal reserve world.

Here are my guesses as to what could happen.  If and when they happen is anyone’s guess.

1) Long interest rates could rise to between 4-5%.  Long duration bond portfolios will get slammed.

2) We could experience a reasonable slowdown in housing.  After all, it has had a nice run up in prices since early 2012. [vi]

3) Spending could remain around current levels.  US household revolving debt is not inflated by any measure (still below pre-recession levels) and should not be impacted by higher rates.  Non-revolving debt levels have had some growth in recent years. Perhaps consumers will not react too sharply to an increase in rates. [vii]

4)  Jobs and income may not be impacted on higher rates as they really were not positively impacted by all the low rates.

5)  US stocks could hold their ground based upon corporate margins holding above 9% and modest revenue growth in companies. [viii]

6)  Emerging market debt issuance and prices could collapse as investors buy US issued debt at better rates once they stabilize at higher yields. 

Sugar in the gas tank really makes a car run poorly and can damage the engine; however, it is better than water. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

 

[i]  “Employment Situation”, Bloomberg
[ii]  “United States: Employment Situation”, Moody’s Analytics
[iii]  “Not in Labor Force (LNS15000000)”, Federal Reserve Economic Data
[iv]  “4Q 2013 Guide to the Markets”, JP Morgan Asset Management, p. 34
[v]  “Q4 2013 Look Ahead”, Phillips & Company. Data from Federal Reserve and Bloomberg LP.
[vi]  “S&P Case-Shiller 20-City Home Price Index (SPCS20RSA)”, Federal Reserve Economic Data
[vii]  “Total Revolving Credit Owned and Securitized, Outstanding  (REVOLSL)”, “Total Nonrevolving Credit Owned and Securitized, Outstanding (NONREVNS)
[viii]  “Earnings Insight—S&P 500”, FactSet

Multiple Expansion?

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Multiple Expansion?
Weekly Market Commentary 10-21-2013
Tim Phillips, CEO—Phillips & Company

As markets return to "normal" and participants attempt to discount and anticipate future events, it’s worth taking a look at what fundamentally drives value.  Earnings growth is the one undisputed value driver for companies.

So far earnings are coming in weaker than anticipated.  While it is still very early into earnings season, only 60% of companies have beaten estimates compared to the average of 63%.[i]

What's more concerning is revenue is coming in weaker than anticipated.  Again our friends at Bespoke Investment Group provide the following data: [ii]

Much of these estimates are from Wall Street expert guessers that can be notoriously wrong.  It's not surprising how off-based a 27 year old MBA with zero operating experience can be when working at a Wall Street firm and trying to guess at the future.

On the other hand, corporate CFO's and executives, whom have a much better feel for how their companies are doing have been painting a dreary picture: [iii]

Out of the 110 companies that have issued earnings guidance for Q3, 89 of them (or 82%) issued negative guidance. This is a record percentage since this figure was first tracked by FactSet in 2006. You can see in the chart above that negative guidance has been trending higher.

A few things can happen in the very near future.  Earnings can grow albeit at a very slow pace and multiples can expand creating a continued uptrend in stocks (upper left).  Earnings can grow at slower rates and multiples can contract (upper right) creating an offset in pricing action.

You could draw the conclusion that we are due for a correction, and that would be completely intuitive.  Unfortunately, investing is far from intuitive.  You can see from the chart below multiples can expand for a very long time while market timing investors tend to miss critical moves in the market:[iv]

Multiples have expanded from the trough of the market on March 9th 2009 by 38.83% to 14.3 where they sit now.

In my opinion, what drives investors to expand multiples is their belief that companies can sustain earnings growth at a reasonable rate.  That was clearly the case in 2000 when new technology was driving investors to near euphoric levels.

It's clear we are not at that level yet but almost anything can happen when it comes to investing and it usually does.

I would anticipate a wider trading range in the next several weeks up or down 5% as we digest earnings and a possible slowing in growth rates. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

[i]  “Third Quarter Earnings and Revenue Beat Rates”, Bespoke Investment Group, October 18, 2013
[ii]  Ibid.
[iii]  “Guidance—S&P 500”, FactSet, September 30, 2013
[iv]  “4Q 2013 Guide to the Markets”, JP Morgan Asset Management, p. 6

Life Goes On!

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Life Goes On!
Weekly Market Commentary 10-14-2013
Tim Phillips, CEO—Phillips & Company

We are in full circus mode with Congress doing exactly what we hoped they wouldn't: take the "full faith and credit" of the United States to the brink of its capacity.

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It's Running Out!

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1.jpg

Weekly Market Commentary 10-7-2013

Tim Phillips, CEO—Phillips & Company

As we discussed in last week’s blog, most government shutdowns don't come with extreme long-term consequences.  Just take a look at market action for last week.



[i] Source: Google Finance

marketchart.jpg

The S&P 500 was down only 0.48 percent—well within the range of possibilities for any ordinary week in the market.

On the face of things, there would appear to be not enough pain to push the political class to work for an immediate resolution, in spite of the fact that Americans confidence in the economy dropped precipitously.  

2.jpg

With the debt ceiling fast approaching and congressional action needed to avert a default on some of our obligations, it might be worth a closer look at what's causing the gridlock.  The mainstream media suggests this is simply a matter of partisan politics.  Unfortunately, my political view is a little more detailed. 

Why the President won't compromise?

Many polls suggest Americans overwhelmingly oppose tying a delay or repeal of Obamacare (ACA) to budget negotiations and blame Republicans for attempting this:[i]



3.jpg

As we have commented in the past, President Obama may have been put in "lame duck" status very early in his second term post Syria.  Clearly, pressuring Republicans and winning the house in 2014 could give him the legislative make-up needed to become effective in his final two years.

 

Why Republicans won't compromise?

Many blame the Tea-Party members for the Republican gridlock. 

The Tea-Party caucus, which is made up of 66 members of the Republican Party, has some very interesting economics driving them.  I took a sampling of the 66 members, and I found that some of them have never had opponents—either in the primary or in the general election, as they come from very conservative districts. Also, on data from campaign information website Open Secrets, the average spending by a Tea Party member is about $867,000 per cycle.  The average spending by all house candidates in an open seat election is about $1.5 million.  This means that it costs 42% less for a Tea Party Member to run and win a congressional seat.  Clearly, they might be in a position to hold out and risk very little from their constituents both from a cost and a primary challenger perspective. 

 

What to expect?

I suspect we are going to have to experience some pain to get our political class to come to terms with the risks they are making the investor class face.  While we have never defaulted on our debt, we have experienced a debt downgrade by Standard and Poor’s (a US credit rating agency).  Oddly enough, after the downgrade on August 5, 2011, interest rates actually dropped from 2.58% to 1.98% one month later.[i]



10yeartreas.png

We would expect rates to increase if we do default.  However, there really is no other country for investors to run too with any significant size.  Think about the alternatives:

  • Russia: too much political instability, as well as too much concentration in energy production
  • Argentina: serial defaulter
  • France, United Kingdom, or other EU countries: too much uncertainty on final resolution of the European debt crisis
  • Canada, Australia, or Switzerland: solid AAA-rated countries, but simply not enough public debt outstanding to satisfy investor demands

It appears we are really the only choice for safe dollars even as our country is being drained of its last penny.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Alex Cook, Investment Analyst – Phillips & Company

 


[i] “HUFFPOLLSTER: Reviewing The Polling On A Government Shutdown”, Huffington Post, Sept. 30, 2013

[i] Source: Federal Reserve Economic Data

 

Wake Up - It's the Economy

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Wake Up-It's the Economy
Weekly Market Commentary 9-30-2013
Tim Phillips, CEO—Phillips & Company

By the time you get this we will likely be hours away from another government shutdown.  Although we humans suffer from "present bias" (events that happen now seem more important than those in the distant past), government shutdowns have been more common than we may think:

Take a look at the last 17 shutdowns and the market reaction [i]:

The average decline in the S&P 500 index during a shutdown lasting 10 days or more is about 2.5 percent. For shutdowns lasting five days or fewer, the average decline is 1.4 percent.[ii]

As we have written in a past post, what dictates market reaction is the broader economy and earnings, rather than a temporary action or crisis from the government.  Make no mistake: a prolonged shutdown could have a dramatic impact on our economy.  Moody’s economist Mark Zandi estimates a shutdown of more than a few weeks would cut GDP by 1.4 points off of a 2.5% growth rate in Q4 (over 50%).  But, if it’s a few days to a week, he forecasts almost no impact.[iii]

To give some perspective to the wider picture, the US consumer is in as strong a shape as they have been since the Great Recession began.  Savings rates have stabilized at 4.6% [iv], and US wealth is now back to peak levels. [v]

While total wealth has recovered, when you factor in inflation and population growth it's not all that impressive.  That being said, we are in pretty good shape relative to where we were in 2009. 

 

The timing of all the policy uncertainty with a recovering economy and consumer would be comical if it weren't so serious.  That's why I believe we might avoid a shutdown entirely or have a very limited shutdown.  The new normal might just be policy uncertainty.  As you can see, we are not experiencing as high a measure of uncertainty as we have in the past as it relates to government shutdowns.  (This index measure news articles from 4300 sources that mention policy related uncertainty items).[vi]

It would appear a limited shutdown might provide for an excellent buying opportunity.  Unfortunately, what's next for policy uncertainty rests in on a debt ceiling extension. This matter is far more serious, and any default or credit downgrade associated with our debt would be devastating.

We continue to tilt toward some caution and quality while we try to find a bottom in policy uncertainty and await indications of earnings for Q3.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


[i] "Government Shutdowns—Not much to worry about”, SentimenTrader, April 7, 2011, 

[ii] “Why investors shouldn’t fear a government shutdown”, Associated Press, September 28, 2013, http://bigstory.ap.org/article/stocks-dont-melt-down-when-government-shuts-down

[iii] “Shutdown would shave US Growth as much as 1.4 pctg. points in Q4”, Bloomberg, September 27, 2013, http://www.bloomberg.com/news/2013-09-27/shutdown-would-shave-fourth-quarter-u-s-growth-as-much-as-1-4-.html

[iv] “Personal Savings Rate”, Federal Reserve Economic Data

[v] “US Household Wealth Rises Rapidly”, Moody’s Analytics, September 26, 2013

[vi] “Economic Policy Uncertainty Index for United States”, Federal Reserve Economic data

Slow Economy 3 Fed 0

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373038_249119018463416_1552291967_n.jpg

Slow Economy 3 Fed 0

 Weekly CEO Commentary 9-23-2013

 Tim Phillips, CEO—Phillips & Company

 

This week the Fed blinked and decided to continue their purchase of 85 billion in mortgage and treasury bonds as part of their non-traditional monetary policy (QE3). 

The Fed's statement accompanying their decision was one that I did not consider that negative.  You can see the full statement here.

Here is the essence of their decision:

            "Taking into account the extent of federal fiscal retrenchment, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy. However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases." [i]

The bottom line is that the Fed sees the economy functioning just fine except for the Federal Government’s spending cuts. 

The immediate reaction from many investors was one of relief.  However, upon further reflection the news may not be all that good.

One piece of data did get widely ignored by the main stream media when the Fed made their announcement.   The Fed also released their quarterly economic growth outlook and, once again, they guided down economic growth for the US. 

The Fed is now projecting a change in 2013 real GDP between 1.8% and 2.4%, down from 2.0% to 2.6% in June. For 2014, the Fed is now predicting GDP growth of 2.2% to 3.3%, down from 2.2% to 3.6% in June. [ii] 

The Fed is notoriously overoptimistic at predicting economic growth, notwithstanding the over 500 economists (employed or on contract) that work for the Fed.  Just take a look at the table below to see how positively biased the Fed can be.  You can see they continuously revise downward their economic expectations. [iii]  

New Fed Revisions.jpg

What can be more troubling is the simple fact that since 2011 the Fed's belief in their ability to stimulate the economy continues to disappoint their own projections.  It's been nothing but a downward spiral of disappointment for the minds working at the Fed. [iv]

four.jpg

While some might be rejoicing at continued lower rates, what should worry them is the underlying fundamentals of a sustainable economy do not rest in near zero interest rate policy. 

At some point the economy is going to have to expand at a much higher growth rate while facing higher interest rates.

As for our allocations, we continue to tilt toward a slower growth economy: Shorter duration bonds, fundamentally solid companies with lower debt ratios, emerging markets, and some small tilts toward technology and industrials. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via TwitterFacebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company
______________________________________________________________________

[i] “Press Release”, Federal Reserve, http://federalreserve.gov/newsevents/press/monetary/20130918a.htm.  

[ii] “Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, September 2013”, Federal Reserve,  http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130918.pdf.

[iii] “Fed’s Economic Projections – Myth Vs. Reality (Sep 2013)”, STA Wealth Management, http://stawealth.com/daily-x-change/1823-fed-s-economic-projections-myth-vs-reality-sep-2013.html.

[iv] “The Fed’s About-Face”, Guggenheim Partners, http://guggenheimpartners.com/perspectives/macroview/the-fed%E2%80%99s-about-face

 

One Year Early: Lame Duck?

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One Year Early: Lame Duck?
Weekly CEO Commentary 9-16-2013
Tim Phillips, CEO—Phillips & Company

American politics had a very strange week.  The President went from a go-it-alone war President, to a collaborator with Congress, and ended with our country being lectured by Russian President Putin. The traditional Congressional support paradigm was thrown into disarray several times this week. 

The President’s approval rating is now hovering near his all-time lows and at levels similar to President Bush during his dark days of Iraq.  Of course, Congress is the only body that is worse. Below are the approval rating charts from Real Clear Politics[i]:

Not surprisingly a recent poll by Gallup suggests "Fewer Americans Than Ever" trust their government.[i]

I don't want you to think this is a partisan blog.  We have professionals at our firm that reflect personal and political beliefs across the political spectrum. 

I do want to advance one thought: could this President have just put himself into a lame duck situation 8 months into his 2nd 4 year term?

Most typically, the last two years of a Presidents final term are generally "lame duck," where there is too much political maneuvering and political silliness to get anything real done—not withstanding a crisis of some sort. We Americans are amazingly focused during crises.  

In my opinion, that leaves us with only two must-act issues Congress and the President will need to address: budgets and debt ceilings.

As it relates to the upcoming budget battle, let's accept some basic facts.  Congress and the President have not approved a full budget process since 2009. [iii]  That's right: it's been 4 years since a budget has been presented by a President and approved by Congress.  Your government has been run for the last few years by measures called "continuing resolutions," normally used as a temporary interim stop-gap until Congress can approve a budget.

The charts below show the number of continuing resolutions and the days between the continuing resolutions. [iv]  Let's face it, budget battles are Kabuki theater, so don’t get fooled by the drama and pageantry of it all...it's still theater.

The other issue is the debt ceiling.  As much as everyone wants to play chicken with the debt limit of our country, no one party want's to be responsible for the actual default of our debt.  Republicans especially know this based upon the last debt episode.  You only have to look at the Senate election outcomes of 2012 to appreciate the lessons Republicans have learned [v]:

  • Out of the 33 Senate seats that were up for election in 2012, Republicans only won 8.
  • Democrats gained a net two seats.
  • The vast majority of Democratic senators who were up for re-election in 2012 ended up winning.

My belief is Congress will pass a temporary debt extension and kick the can until they can get to 2014 when they can deal with sequestration or they will extend beyond 2014.  Either way it's going to be dramatic but dealt with.

Once we hit 2014 Congressional races will take over and nothing looks like it will get done:

  • Immigration reform
  • Tax reform
  • Continued Obamacare debate

All of these issues could then become partisan posturing issues for the 2014 election cycle.

Post-2014, the President historically enters a lame duck period

All of this is to say, the President could have just entered his "lame duck" cycle early.  Again none of this is a partisan attack on the President.  It's simply an analysis of the political environment.

The incredibly good news is Lame Duck Presidents/Congress benefit our stock markets.  While we don't have data on lame duck Presidents as early as in year 1 or 2 as I think we are in, we do know lame duck sessions are very positive for US markets.  Years 3 and 4 of Presidential terms are generally good for stocks. [vi]

While no one knows why definitively, one can suggest Washington policy gridlock is good for stocks.  Let's hope that's the case in this cycle.

It would be nice to have an effective government doing our business.  If that can't happen at least we have a chance at some decent returns.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


[i] “President Obama Job Approval”, Real Clear Politics, http://www.realclearpolitics.com/epolls/other/president_obama_job_approval-1044.html. “Congressional Job Approval”, Real Clear Politics, http://www.realclearpolitics.com/epolls/other/congressional_job_approval-903.html.

[ii] “Fewer Americans Than Ever Trust Gov’t to Handle Problems”, Gallup, http://www.gallup.com/poll/164393/fewer-americans-ever-trust-gov-handle-problems.aspx

[iii] “A budget, you say?”, Chris Stirewalt, Fox News http://www.foxnews.com/politics/2013/01/08/budget-say/

[iv] “Congress’s use of continuing resolutions is a common practice”, National Journal, http://www.nationaljournal.com/congress/congress-s-use-of-continuing-resolutions-is-a-common-practice-20120911

[v] “2012 Election Senate”, Real Clear Politics, http://www.realclearpolitics.com/elections/live_results/senate/

[vi] “The Economic Sweet Spot of Presidential Terms”, New York Times, http://www.nytimes.com/2010/12/11/business/economy/11charts.html

Can higher rates lead to more jobs?

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Can higher rates lead to more jobs?
Weekly CEO Commentary 9-10-2013
Tim Phillips, CEO—Phillips & Company

The trend in jobs continues to disappoint and suggest a very sluggish economy in the months to come.  The US economy added only 169,000 jobs in August, and the current 3 month average is 148,000 jobs per month.[i] At this rate, all else being equal, it will take us until November 2015—26 months—before we get to 6.5% unemployment.[ii]

What's worse is another 312,000 people dropped out of the labor force last month[iii] bringing the participation rate to a low not seen since August 1978.


At the same time, we have seen a steady rise in interest rates since May.[iv]


 

There has not been a tremendous amount written about the correlation between interest rates and job growth.  Some speculate that low rates encourage more spending and leisure.  If you can't make money with you savings, you might just consume it now as the thinking suggests.  Certainly low rates have correlated to the participation rate, as you can see below.[v]

What is well documented is the correlation between capital and labor.  To put this in simple terms, when the cost of capital (plant and equipment) is cheaper than labor, more money is allocated to capital expenditures as opposed to adding labor.  Companies would prefer to spend on technology, manufacturing lines, robotics or other capital equipment to avoid adding expensive labor.  Low interest rates certainly encourage this.

When rates rise, at some point adding labor becomes cheaper than the cost of adding capital equipment and facilities. 

The Fed’s zero interest rate policy might have propped up consumption over the last several years.[vi]

At the same time, it might be keeping a lid on job growth if capital is cheaper to invest in.  At some point, if theory holds true, higher rates might lead to acceleration in spending on labor, higher wages and more consumption. The question then becomes how high is too high. 

Certainly a tilt toward more growth oriented stocks that are less dependent on debt financing could benefit from the continued rise in interest rates. Further, as rates rise the dollar should strengthen, which makes foreign goods cheaper. Emerging market stocks and bonds would certainly benefit from a stronger US dollar relative to their currency.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


[i] “United States: Employment Situation”, Moody’s Analytics

[ii] “Jobs Calculator”, Center for Human Capital Studies, Federal Reserve Bank of Atlanta

[iii] “United States: Employment Situation”, Moody’s Analytics

[iv] “10-Year Treasury Constant Maturity Rate (DGS10)”, Federal Reserve Economic Data

[v] “Low Interest Rates Have Yet to Spur Job Growth”, Federal Reserve Bank of St. Louis, William T. Gavin

[vi] “Real Personal Consumption Expenditures (PCEC96)”, Federal Reserve Economic Data

Turmoil Part ___?

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Turmoil Part ___?
Weekly CEO Commentary 9-3-2013
Tim Phillips, CEO—Phillips & Company

We had a spate of economic data released last week some suggesting continued growth: 

  • Auto sales are expected to rise broadly in August, and are estimated to be an increase of 13% from a year earlier[i]
  • The investment component of GDP increased by 4.4% in the second quarter[ii]
  • Exports increased by 8.6% in the second quarter[iii]

 Some suggest continued sluggishness:

  • Consumption, the largest component of GDP, only increased by 1.8% in the second quarter[iv]
  • Jobless claims last week were slightly higher than expected, and consensus for Friday’s employment situation report is no change and remaining at 7.4% unemployment[v]
  • Personal income growth is still anemic[vi]

What prevailed in last week’s light volume on Wall Street were Syria and our potential military involvement in that country. 100,000 people dead and chemical weapons use is a serious matter.

Notwithstanding the very grave nature of the killings, Syria’s impact as an economic power is very limited to America.  The country has about $107.6 billion in GDP (about 6/10th of 1% of our GDP) and only 22 million people (similar to the New York City metropolitan area). The country also has a staggering 18% unemployment rate and 37% inflation rate.  They export virtually nothing to the US and we export virtually nothing to them. Most of their business happens with other Middle Eastern countries, such as Saudi Arabia, the UAE, and Iraq[vii].

Addressing the humanitarian issues is certainly a legitimate discussion; however, as it relates to any economic impact, there is little to be concerned with.  Even if you consider the larger issues with Iran, which is already under sanctions, there are limited economic effects.

As far as any stock market reaction, consider recent conflicts. You can see on the chart below that there is really no consistent pattern to market performance either before, during, or after the military action[viii]:

Markets during the 1998 Iraq bombing campaign and the Kosovo War continued to rise, largely due to the tech boom, and markets after the Georgia-Russia War fell due to the US financial crisis.

Some leading economists, including Larry Summers, conducted a comprehensive study of non-economic events, such as Pearl Harbor and Kennedy’s assassination:

“They came up with little evidence that non-economics events had a big effect on the stock market. On average, across all 49 events on their list, the S&P 500 moved just 1.46%, less than one percentage point more than the 0.56% that prevailed on all other days. Because of this small difference, the professors concluded that there’s “a surprisingly small effect of non-economic news” on the stock market.” [ix]

Link to article

Link to study

The bottom line is we have much more relevant issues to worry about when it comes to market reactions than the Syrian crisis, such as the upcoming debt ceiling debate, fiscal budgets and continued sequestration cuts. 

In fact, any temporary pullback derived from a Syrian conflict might bring US equity valuations back to a strong buy level.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via TwitterFacebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company



[i] “Week Ahead: Jobs Report on Friday; Auto, Retail sales”, Wall Street Journal, August 30, 2013

[ii] “News Release: Gross Domestic Product”, Bureau of Economic Analysis, August 29, 2013

[iii] Ibid.

[iv] Ibid.

[v] “Jobless Claims”, Econoday, August 29, 2013. “Employment Situation”, Econoday, September 3, 2013.

[vi] “Personal Income and Outlays”,  Econoday, August 30, 2013

[vii] “Syria”, CIA World Factbook

[viii] Performance source: Bloomberg LP

[ix] "What US intervention in Syria would mean", MarketWatch, August 28, 2013

Can't Live With It, Can't Live Without It

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Can't Live With It, Can't Live Without It
Weekly Market Commentary 8-26-2013
Tim Phillips, CEO—Phillips & Company

Fixed income was once an easy asset class to allocate to. You could by US Treasuries or municipal bonds, collect good income, hedge against deflation and mitigate the risk of having equity exposure in the other part of your portfolio.

In fact, over the course of a longer period of time a 100% fixed income portfolio produced some of the best risk adjusted returns over other generic allocations.

Click for larger image

Prior to this last mega bull market in fixed income (pre-2002) the average returns you could expect from the asset was impressive [i]:

Unfortunately, today it's an entirely different time and the asset class has entirely different risks.  Rising rates and Federal Reserve activity have created tremendous uncertainty and risk to fixed income.  So many investors are either ignoring the risks or abandoning the asset class only to face another set of risks associated with too much equity exposure.

On the one hand fixed income is providing "return free risk".  Yet on the other hand it does provide an excellent defense against equity risk.  The chart below shows from top to bottom a 100% stock portfolio could drop 54% [ii].

We have all seen this in the not too distant past.  It also suggests mixing bonds into an allocation can mitigate the drop substantially.

How to manage in today’s environment

In our current environment it's just not enough to have "bonds" in your allocation.  In today's fixed income reality, you need to define your goals much more clearly with your advisor. 

Let's assume almost all bonds will provide a hedge against deflation.  That leaves us with 3 other basic goals for fixed income allocations:  hedging against volatility in equity holdings, low risk liquidity, and of course maximizing income.

Again, in the past you could almost get all three objectives in a core bond portfolio, but today it's more complicated. 

If your goal is to maximize income, you’re going to need more high yield bonds—potentially both corporate and municipal.  The good news about high yield is they tend to hold up better in a rising rate environment.  The tradeoff is in credit risk and some call risk.

If your goal is to maintain liquidity with low risk, you’re going to have to choose to trade off income.  You can buy money markets, CD's and very short term bonds as well as some investment grade floating securities. 

Finally if you goal is to hedge against your equity exposure in the other part of your allocation you might consider all of the above as well as more intermediate term bonds, long/short fixed income alternatives, industry specific bonds and mortgage backed securities. 

The bottom line is you can't lock it and leave it anymore.  Much better definition of your goals and time frame as well as better matching your goals to the fixed income mix will be necessary for the time being.

The good news is we could return to a more normal environment in the coming years.  Once rates normalize you could see better normalized yields [iii]:

Until then, be prepared to adjust quickly according to your objectives.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


[i] Data table source: Morningstar Direct

[ii] “Bonds: Using the Full Toolkit”, AllianceBernstein, page 3

[iii] Data table source: Federal Reserve

Are we overextended?

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Are we overextended?
Weekly Market Commentary 8-19-2013
Tim Phillips, CEO—Phillips & Company

The number one question that I get asked is if the markets are overextended. Invariably, most people already have formed their own opinion, but my answer is no—based upon several metrics.

Look at the chart below of current PE ratios versus their 10-year average historic levels.[i]

As you can see, US market valuations are close to their long term averages, and emerging markets are below their averages. We have written before that market valuations have mean reverted closer to their average, but there is a big difference between moving up to the average level and being overvalued.

However, to keep moving upward from the average, you need a confident consumer and investor.

Consumer confidence has certainly improved from the lowest part of the recession, but the most recent report showed a slight decline.[ii]

Moody’s analyst on the consumer confidence report summarized the situation:

“Consumers are sending mixed signals. Despite feeling decidedly better about their current financial circumstances, shoppers are showing less faith that the economy recovery will stay its course over the latter half of the year.” [iii]

Investor confidence is tepid and slightly below average, as you can see below.[vi]

What really matters

That all being said, the market timing question of whether or not the market is overextended doesn't really amount to much when it comes to real returns. We have written multiple times (here and here) about what really drives stock returns: earnings and dividends. That's the value that a company can give to shareholders.

Any return above earnings growth and dividends is the result of stocks moving on speculation. Historically, this speculative return has been minimal. In a 2007 paper [v], John Bogle from Vanguard quantified this amount of speculative return as being only 0.1% per year over the past 100 years:


Is the market overextended? The data doesn’t really suggest this, and in fact says markets are closer to average valuation levels. Regardless though, the real thing that investors should pay attention to is earnings and dividends, and not speculation on which way the market will move in the short term.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


[i] Source: Bloomberg LP

[ii] “United States: Consumer Board Consumer Confidence”, Moody’s Analytics, July 30, 2013

[iii] Ibid.

[iv] “Sentiment Survey”, American Association of Individual Investors, Aug. 14, 2013

[v] “Stocks in the coming decade”, John C. Bogle, Forbes, Oct. 25, 2007

Fiscal Trifecta

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Fiscal Trifecta
Weekly CEO Commentary 8-12-13
Tim Phillips, CEO—Phillips & Company

As earnings season winds down, it appears we had an excellent outcome.

(Image source: Bespoke Investment Group)

Roughly 63% of companies beat their earnings estimates, and earnings grew by 2.1% in the quarter.[i]  These were some of the best numbers we have seen since 2010.  It also appears there is continued rotation into stocks from bonds as we are seeing the price to earnings multiple on the S&P 500 expand from 12.70 on January 2012 to 16.30 today. [ii]

(Image source: Bloomberg LP)

With the good news of earnings behind us, the next big hurdle markets participants will focus on is the upcoming political circus around our fiscal house.

Three things in Congress are colliding around the same time: 

1)  The debt ceiling will need to be extended by October or November, according to the CBO [iii], or we will be in risk of default—not very good for our credit rating.

2) The 2014 Federal Budget needs to be completed by October 1st. Congress comes back on September 9th, giving them only 3 weeks to avoid a government shutdown[iv].

3)  The next round of sequestration cuts will take place 15 days after Congress adjourns at the end of the year, impacting fiscal year 2014.  The cuts amount to another $76 billion, or about 1/3rd of 1% of GDP.[v]  Almost everyone in the political class agrees the sequestration process is damaging critical functions and there needs to be a better budget cutting process.

The last time we experienced these three events was:

(Data source: Bloomberg LP)

We should expect similar volatility as we approach the upcoming fiscal trifecta.  My guess is Congress will likely use the Continuing Resolution process to push all three of these issues until the first of the year and align them all around the sequestration cuts.  This will put the political class in a box with a massive fiscal crisis looming and the hopes that a compromise will occur. 

The average PE during those prior four fiscal events was 14.65. With expanded PE's now, our markets are trading on 13.5% more speculation than in prior crises, only adding to the drama.  Add to this the notion that the Fed could begin to withdraw, or at least slow the rate of their bond purchases as early as September, and you can begin to see the excitement building (sarcasm).

I hope we can all enjoy a quiet next couple of weeks of summer. The fall circus is about to begin, and it might not be peaceful.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


[i] “Earnings Insight”, FactSet, August 9, 2013. “The Bespoke Report”, Bespoke Investment Group, August 9, 2013.

[ii] Bloomberg LP

[iii] “Federal Debt and the Statutory Limit”, Congressional Budget Office, June 2013

[iv] “US Senate Budget Chief: Need FY 2014 Deal Soon to Avert Crisis”, MNI Deutsche Borse Group, July 16, 2013

 [v] “Here comes Sequester: Part 2”, The Hill, May 22, 2013

Part Time America

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Part Time America
Weekly Market Commentary 8-5-2013
Tim Phillips, CEO—Phillips & Company

I have written on many occasions about the possibility of a structural change in the American workforce. 

Work is the bedrock of our economy.  With over 71% of GDP generated by consumption, how we get our money matters.  There is much more than a casual linkage between work, wages and consumption. 

First, wages as a percent of GDP use to be over 51% of GDP.  It now sits at roughly 43%, which is near an all-time low.

(Image source: Federal Reserve)

Second, the percent of people participating in the workforce is also at a low not seen in decades.[i]

(Image source: Federal Reserve)

 

Finally, and most troubling, is the boom in part-time employment for economic reasons.  In the current jobs report, part-time workers increased to 8.25 million.[ii]  Part-time work accounted for more than 65 percent of the positions employers added in July[iii].

(Image source: Federal Reserve)

While there is a slight improvement since the financial crisis, it's disturbingly high. Low-paying retailers, restaurants and bars supplied more than 40 percent of July's job gains.[iv]

Over the long-run (5 years or more) it's difficult to make the case for growing consumption without more people being put to work full time. 

One cause of the boom in part-time employment is the concern over Obamacare.  Employers with fewer than 50 employees have a direct incentive to not cross that threshold due to penalties associated with not-providing health care or being forced to provide coverage. 

Since the Census Bureau does not specifically list companies with 50 employees or fewer, we can estimate that number to be 5.6 million, out of 5.9 million total employer firms.[v]

That's 26.31% of all employees and 93.73% of all firms.  This is no small matter.

Another likely cause is companies want to maintain profit margins, and hiring full-time workers without a clear pick-up in demand does not fulfill that mandate. 

A flexible workforce (code for part-time workers) is a much better proposition for those that own companies versus those that don't.  You can simply look at union membership to see how expensive labor is doing in our country.[vi]

In any case, part-time employment is a trend worth watching and reacting to accordingly.  As an investor, in the short-run, profit margins should continue to prosper.  This is good news. 

The problem is the fuel that runs the profit engine is income and wages.  If we don't see an improvement in this area, portfolios will need significant adjustments.

Part-Time America is not a pretty picture.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

 


[i] “Civilian Labor Force Participation Rate”, Federal Reserve, July 2013
[ii] “Employment Level—Part time for economic reasons, all industries”, Federal Reserve. July 2013
[iii] “July jobs report: Disproportionate number of jobs added were part-time, low-paying, or both”, New York Daily News, Aug 3, 2013
[iv] “Employment Situation Summary” , US Bureau of Labor Statistics, Aug 2, 2013
[v] “Employment Size of Firms”, US Census Bureau
[vi] “Vital Signs Chart: Union Membership Hits Postwar Low”, Wall Street Journal, Jan 24, 2013

The Sidelines: It's the Investor’s turn to sit on cash

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The Sidelines: It's the Investor’s turn to sit on cash
Weekly CEO Commentary 7-29-2013
Tim Phillips, CEO—Phillips & Company

Fixed income investments have become increasingly difficult to implement, manage and maintain.  Since Fed Chair Bernanke began his "thinking out loud" on May 22 about the end of QE3, we have seen a wild ride for fixed income investments.[i]

You can see we have seen some pretty nervous times in an asset class most expect to be safe, stable and anything but risky (volatile). 

Investors, including many professionals, have been caught by surprise by how much actual risk is exhibited in a host of fixed income assets—so much so, that they have been withdrawing their money from the investments.

In fact, outflows in June from fixed income mutual funds are the largest amount on record with $43 billion coming out of taxable bond funds.[ii]

But, if you look at our earlier chart, you can see that fixed income started to recover in July. Once again, the emotional investor likely withdrew at the exact wrong time and didn't participate in the small recovery. 

While some money has flowed into equities, even more has simply moved into cash.[iii]

One highly likely outcome is this money might just sit on the sidelines for a period of time.  It's hard for investors to switch fixed income assets to equity assets based upon the risks associated with equity investing.  It's also not that easy to adjust investment policies that quickly for institutions and well run allocations. Asset allocations will likely embrace more cash while waiting for a return to historic fixed income yields.[iv]

My guess is this money might just sit on the sidelines.  We know corporations, both here and in Japan (see last week’s article), as well as banks have been sitting on cash. Now it's the investor’s turn to do the same.  It will be important to watch what happens, as the $2.62 trillion[v] of investor assets currently in money market funds is no small matter.

To see our full Q3 Look Ahead, please click here for the PDF.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


[i] Chart data source: Morningstar Direct.

[ii] Source: “Bond Investors Turn to Cash”, Wall Street Journal, July 25, 2013

[iii] Chart data source: “Weekly Estimated Long-Term Mutual Fund Flows”, “Weekly Money Market Fund Assets”, Investment Company Institute. Bond fund statistics include both taxable and non-taxable bond funds.

[iv] Chart data source: Federal Reserve.

[v] Source: “Money Market Mutual Fund Assets”, Investment Company Institute

 

Inflation Urgency

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Inflation Urgency
Weekly Market Commentary 7-22-2013
Tim Phillips, CEO—Phillips & Company

Over the weekend Japan, the world’s 3rd largest economy and 2nd largest developed economy, held a historic vote. Their Prime Minister, Shinzo Abe, basically won control of both parliamentary houses and now has a mandate to continue to push his economic reforms.[i]

He has pushed for fiscal, monetary and policy reforms that promote job growth, corporate spending and personal consumption.

All of this is good for our global economy. Japan represents almost 10% of global GDP and having them become more consumption-oriented can only help us.

Unfortunately, Japan suffers from a symptom that is becoming quite familiar to us Americans. Corporations in Japan are hoarding cash. 

Japanese companies are sitting on $2.4 trillion in cash and American companies are sitting on $1.78 trillion.[ii]

We have written on many occasions about the massive amount of cash US Corporations are sitting on.[iii]

If Japanese companies spend something as little as 10% of their cash they would add 4.0% to their GDP, and if US companies did the same, we would add 1.1% to our GDP[iv]. It is clearly a big issue.

Generally companies hold excessive levels of cash for a few very specific reasons:

  • Cash is cheaper as a financing mechanism than safe debt, risky debt, and equity.
  • Excessive levels of cash allow corporate managers to have more flexibility and control on what their personal preferences are, versus their boards or shareholders.
  • Excessive cash is a reflection of an investment opportunity set corporate managers might want to take advantage of, either from buyouts or capital expenditures.

We know capital expenditures are not booming. Both US and Japanese capital expenditures have yet to reach pre-2008 recession levels, as you can see in the graphs below.[v]

Abe's and Obama's Problem

There could be one critical additional reason companies are holding cash. Things are getting cheaper while they wait.

Look at Japan's inflation trends You can see that over the past decade, inflation has been hovering around zero and often dips into deflation.[vi]

Now look at our inflation trends. We don’t have deflation on Japan’s level, but inflation in recent months has been very low.[vii]

If capital expenditure items are getting cheaper—or at least, not getting more expensive— corporate managers don’t have urgency to spend today. That thesis can probably be made for workers as well. As you can see below, wage growth adjusted for inflation has been stagnant, and in some months, it has actually shrunk.[viii]

Inflation is a call to action.  It forces our hand to make decisions to spend today versus waiting until tomorrow when things get more expensive.

Japan has acknowledged this problem by trying to persuade companies to spend. Abe said in May on the campaign trail that he is seeking to increase Japanese capital spending by 10% in three years through a number of measures:[ix]

  • Government backstop insurance on large corporate leases to reduce the risk in corporate spending
  • Establishing “special economic zones” to encourage foreign investment
  • Broad tax and regulatory reforms

What we need to get the economy moving is inflation to create the urgency to spend down the large cash reserves, and the current (low) inflation rate isn’t enough.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


[i] “Japan election: Abe ‘wins key upper house vote’”, July 21, 2013, BBC

[ii] “Flow of Funds Accounts of the United States”, June 6, 2013, Federal Reserve. “Japan Inc. Holds Italy-Sized Cash Pile as Abe Urges Spending”, June 19, 2013, Bloomberg.

[iii] Ibid.

[iv] Source for GDP information: Bloomberg LP. Percent added to GDP if cash is deployed is calculated as 10% of corporate cash divided by the most recent GDP figures.

[v] Federal Reserve

[vi] “Consumer Price Index of All Items in Japan”, Federal Reserve

[vii] “Consumer Price Index for All Urban Consumers: All Items”, Federal Reserve

[viii] “Real Earnings—June 2013”, July 16, 2013, Bureau of Labor Statistics

[ix] “Abe Seeks to Get Japanese Businesses to Spend”, May 17, 2013, Wall Street Journal. “Japan Plans Abenomics Zones to Boost Economy”, June 3, 2013. Wall Street Journal.

Earnings Outlook

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Earnings Outlook
Weekly Market Commentary 7-15-2013
Tim Phillips, CEO—Phillips & Company

Earnings season is starting, and as we have written about in the past, earnings are what really drive stock prices.

Expectations for this earnings season are somewhat cautious. According to Thomson Reuters:

“So far, S&P 500 companies have issued 97 negative earnings preannouncements and only 15 positive ones, for a negative to positive ratio of 6.5.”[i]

Businesses are indeed cautious. The Institute for Supply Management (ISM) puts together an indicator called the Purchasing Managers Index, which tracks inventory levels, new orders, and other indicators of health in the manufacturing sector.

Whenever the index is below 50, it is a sign of contraction. In May, the index was at 49.0, showing a slowdown in manufacturing. The most recent report released a few weeks ago showed the index rebounded to 50.9 in June, but this is still a borderline reading.[ii] You can see in the chart below that the index has been hovering around 50 for some time.[iii]

In aggregate, quarterly earnings per share expectations on S&P 500 stock are for new highs of 26.51, and growth of 2.55% from Q2 of last year.[iv]

Sector breakdown

Analysts have revised down earnings estimates for nearly every sector, as you can see below.[v]

The sectors with the greatest amount of downward revisions are energy and materials. This could be a sign of a contracting global economy, if businesses slow down and use fewer raw materials in their manufacturing. I say global economy instead of just saying a contracting US economy, since much of the demand in recent years for energy and materials has been driven by China.

On the good side, consumer discretionary was interestingly one sector that stood out as actually having positive net revisions. We have indeed seen consumers start to spend, as we wrote about last week, and as we have seen in economic data. Real spending (inflation-adjusted) on retail and food services have reached pre-recession levels, as you can see below.[vi]

Some key earnings releases to monitor are Exxon Mobil on August 1, Freeport-McMoRan on July 23, and Nordstrom on August 15. Beyond just the actual earnings numbers, the management commentary and forward outlook will help give us insight into whether or not energy and materials are slowing, and also insight into how strong the consumer is really.

Conclusion

The last time that we saw this level of negative to positive earnings revisions was December 2012.[vii] Since then, the S&P 500 has rallied 19.18%.[viii] While negative preannouncements and negative estimate revisions could be a sign of caution, it could also be a chance for the market to rally if companies end up beating the (low) expectations.

Expect continued volatility ahead, and we continue to recommend splitting the fence between growth and quality. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


[i] Earnings Roundup: Negative revenue guidance foreshadows weak top-line growth”, Thomson Reuters Alpha Now, July 1, 2013

[ii] “June 2013 Manufacturing ISM Report On Business”, Institute for Supply Management, July 1, 2013

[iii] “ISM Manufacturing: PMI Composite Index”, Federal Reserve Economic Data

[iv] “Earnings Insight”, FactSet, July 12, 2013

[v] “Earnings Revisions”, Bespoke Investment Group, July 12, 2013

[vi] “Real Retail and Food Service Sales”, Federal Reserve Economic Data

[vii] “Earnings Preview: Q2 earnings season gets into high gear”, Zacks, July 12, 2013

[viii] Bloomberg LP

It's Not Working

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It's Not Working
Weekly Market Commentary 7-8-2013
Tim Phillips, CEO—Phillips & Company

What if the Fed is not talking about tapering their purchases of bonds because the economy is getting better.  There is no doubt parts of the economy are improving over the past year: 

  • Housing starts are up
  • Auto sales have risen
  • Durable goods orders have risen

What if the Fed is talking about ending their purchases of bonds (QE3) because it's simply not working? 

First, let's define what "working" means to the Fed. According to the Federal Reserve Act amended in 1977: 

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."

What this means in English is that the Fed has a “dual mandate” to promote employment and prevent out of control inflation.[1] Ben Bernanke has taken this to mean that the Fed will continue their asset purchases until unemployment is below 6.5%.

So, how has employment been looking since they began QE3? When the program started in September 2012, unemployment was at 7.8%, and it is currently at…7.6%.[2]

(Source: Federal Reserve)

The employment picture isn’t improving. Even with last week’s great employment report, the averages suggest the Fed’s program is simply not putting enough fuel in the tank for jobs.

In fact, participation rates (the percentage of people looking for work out of the total working-age population) have dropped, as you can see in the chart below. Remember that the government only counts people as unemployed if they are actively looking for work, so discouraged workers aren’t included.

(Source: Federal Reserve)

Inflation is not a problem, and in fact we have slipped a little closer to deflation since QE3 began. In March and April, the consumer price index actually dropped. 

(Source: Bureau of Labor Statistics)

What we do know that we have gotten from QE3 is asset price inflation in our stock market and housing prices, which you can see below[3]:

All of the Fed's bond purchases were designed to do exactly what has happened: inflate wealth in our personal economies in hopes that we would spend the money—which we have done to an extent. Consumer spending is up 1.4% since the start of QE3, and up 16.9% since the market bottom in March 2009.

(Source: Federal Reserve)

Unfortunately housing prices, stock prices and spending are not the Fed's mandate.  Full employment is. 

It's clear all of this wealth creation is not creating jobs.  Where is it going?  Corporate cash balances. Rather than hiring people, corporate cash has risen by $45.8 billion to reach $1.78 trillion, since QE3 began.[4]

The Fed might know one thing: it's dangerous to continue to inflate asset prices and not achieve their goal of improving employment. They might just want to stop. 

The Amazon Effect

What if our employment picture is structural rather than cyclical?  Perhaps all of these "new economy companies" and "old economy companies" can meet consumer demand with fewer employees. 

Amazon employs 91,300 people. Think of all the employees that Borders, Tower Records, Hollywood Video, and Blockbuster used to have—and now they are all gone. It simply takes fewer workers to do the same thing.  

Action Item

Although your fixed income portfolios likely, took hits this last quarter, some fixed income sectors performed better than others. Junk bonds held up better than long-term Treasuries, for example.

Duration and fixed income sectors should be managed, but don’t give up on your fixed income allocations altogether. Fixed income helps hedge against stock pullbacks and deflation, and it helps provide your portfolio with a predictable level of income.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


[1] Federal Reserve

[2] Ibid.

[3] Source: Bloomberg and S&P Dow Jones Indices LLC. S&P 500 data from Sept. 13, 2012 to July 5, 2013. Case-Shiller data from September 2012 to April 2013, as April 2013 is the most recent month available.

[4] “Flow of Funds Accounts of the United States—Nonfinancial corporate business; total financial assets”, June 6, 2013, Federal Reserve

Learning how to see…things that aren't really there!

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Learning how to see…things that aren't really there!
Weekly Market Commentary 7-1-2013
Tim Phillips, CEO—Phillips & Company

After spending a considerable amount of time traveling to one of the financial "hot zones" in the world, Italy, I can make an important observation.

Italians, like most investors, are having trouble seeing around the corner. I have had the opportunity to meet with the owners and employees of a few businesses, both small and large, during my time abroad. 

It's clear they are not optimistic about the future of Italy.  Regulations are increasing, taxes are significant, confidence in politicians is low, manufacturing is being outsourced to Eastern Europe and Asia, and jobs are far too few. Sounds a little familiar.

In fact, European unemployment looks awful.

Italians have made some fiscal and monetary changes similar to our response to our own financial crisis:[1]

  • Tax relief measures for enterprises
  • Central bank bond purchases
  • A temporary car-scrapping program (similar to “Cash for Clunkers” in the United States)

What's fascinating is the business-oriented Italians that I spoke to don't believe these changes will work.  I think I heard much the same thing in 2009 within the US.

It's clear they worked for us, and it could work for the Italians as well.

Knowing how to see

Perhaps it's human nature but people tend to overstate their current circumstances to an extreme.  This is called Peak End Bias, which we have written about before. Take a look at some predictions from smart, well-regarded investors a few years ago:

“There’s not a doubt in my mind that you will see a spate of municipal bond defaults…You could see 50 sizeable defaults. 50 to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars worth of defaults.” –Meredith Whitney in December 2010.[2]

“I am 100 percent sure that the US will go into hyperinflation.” –Marc Faber, in May 2009.[3]

Both ultimately were wrong, and investing with those forecasts would have been painful.

Saper Vadere: US Style

The current volatility in the US markets is a precise outcome in the difficulty of seeing around corners. 

Let's take a stab at what's around the corner and see if we can develop a little clearer vision.

Fiscal cuts: Spending cuts enacted by sequestration will most likely take 1.5% of GDP growth and much of that impact has not been felt at this point.  However, I believe that is soon to come.

Monetary changes: Rates are anticipated to rise when unemployment drops below 6.5%, according to statements from the Federal Reserve.[4]  At the current rate of hiring, that could be as far out as August of 2015.[5]

Housing: the housing market has been improving with tight inventory, rising prices and more permits for new construction being issued (see chart below). Housing comprises 15.1% of GDP.[6]

(Source: Econoday)

Credit: Consumer credit is expanding at a slow pace but expanding.

(Source: Federal Reserve)

Jobs: This chart speaks for itself.

(Source: Calculated Risk)

Savings: savings rates have been dropping from their peak in 2008, which takes dry powder away from the consumer. On the other hand, it's a sign of consumer confidence about their incomes.[7]

Spending: Consumers have been opening their wallets. For example, spending on retail and food services (restaurants) is back at pre-recession levels, even after being adjusted for inflation.


(Source: Federal Reserve)

The bottom line is I see selective growth in the US for the next 6 months, and I guess that means I think the Fed might have been too optimistic.

As for the Italians, if they continue down the path they are following, they too can enjoy a little bounce in their economic step.  If only they could see that.  Perhaps it's me and I am just seeing things that aren't really there.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


[1] “The reaction of fiscal policy to the crisis in Italy and Germany: Are they really polar cases in the European context?”, Deutche Bundesbank and Bank of Italy, January 14, 2012

[2] “What are the chances of a muni doomsday?”, Reuters, December 22, 2010

[3] “US inflation to approach Zimbabwe level, Faber says”, Bloomberg, May 27, 2009

[4] “Fed ties interest rate to 6.5% unemployment”, USA Today, December 12, 2012

[5] “Jobs Calculator”, Federal Reserve Bank of Atlanta Center for Human Capital Studies

[6] Housing percent of GDP from the National Association of Homebuilders. Housing breaks down as 2.83% residential fixed investment and 12.24% housing services expenditures.

[7] “Personal savings rate”, Federal Reserve

Returning to Rational

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Returning to Rational
Weekly Market Commentary 6-24-2013
Tim Phillips, CEO—Phillips & Company

If there was any question about what direction monetary policy (interest rates) are trending toward the Fed clearly laid those to rest:

Going forward, the economic outcomes that the Committee sees as most likely involve continuing gains in labor markets, supported by moderate growth that picks up over the next several quarters…If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year; and if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear.

-Fed chairman Ben Bernanke, from press conference on June 19, 2013 [1]

Going forward we can expect a return to rationality when it comes to both fiscal (government spending) and monetary policy.  It's clear that fiscal policy will be a drag on the overall economy; however, expansionary tail winds look strong enough to overcome those challenges. We can see three strong economic signs:

1)      In housing, existing home sales beat expectations for the month of May.[2]

2)      Motor vehicle sales beat expectations in May, and have been steadily trending higher since the market bottom in March 2009.[3]

3)      Debt service payments of both households and corporations are at multiyear lows, as we have written about previously. Corporations also continue to sit on large sums of cash, which can be deployed into the economy.

The Federal Reserve looks likely to want to raise rates as the economy expands through a slow withdrawal of bond purchases.  Over the last 50 years, interest rates have averaged 6.68%, with a wide range of dispersion.[4]

Source: Federal Reserve

In periods of time where interest rates have been below the 6.68% average (1991-1993 and 1995-1997), we have seen very strong annual growth in real GDP and in equity returns.

Source: Bloomberg LP

We have seen a steady increase in volatility in the last four weeks since monetary policy has been in doubt, as you can see below on a chart of the volatility index (also known as the “VIX”).

We have also seen a pullback in most sectors and asset classes.

We have a long way to go to return to the mean, and plenty of opportunity to capture positive annualized returns.

One of two things are happening:

1)      Capital market participants know something about the economy the Fed does not, and the economy’s underlying strength cannot withstand even slightly higher rates.

2)      Participants are reacting out of short-run fear to the unusual abnormal monetary (zero interest rates) and fiscal ($1 trillion+ annual government deficit spending) policy. 

Either way, if the economy cools, the likelihood of Fed tightening diminishes, so stocks and bonds could react and potentially return to their highs.  If the Fed does in fact tighten, it's now been anticipated by market participants, and stocks could rise on the outlook for a more normal functioning economy with a strong consumer, as well as corporate earnings growth recovering. 

It would make sense to use these windows of opportunity to rebalance equity, adjust bond holdings, and prepare for a return to normal. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


[1] Source: “Transcript of Chairman Bernanke’s Press Conference”, Federal Reserve, June 19, 2013
[2] Source: Econoday
[3] Ibid.
[4] Source: Federal Reserve Bank of St. Louis Economic Research

Testing Your Nerves

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Testing Your Nerves
Weekly Market Commentary 6-17-13
Tim Phillips, CEO—Phillips & Company

Since the world misinterpreted the Federal Reserve Chairman's comments, we have seen a massive increase in volatility (also known as worry, anguish and second guessing by investors).

Volatility index

Prior to Bernanke’s comments, the Dow Jones moved 100+ points in a single day only 4 times since the beginning of the year[1].  Since his testimony, the Dow Jones has moved 100+ points 10 times—more than double the entire first part of 2013.[2]

I'm starting to see the worry within our clients and think it might be time to reaffirm some key concepts we have learned over many decades of collective experience at Phillips and Company. 

1) Your overall allocation, which is the amount you allocate to stocks and bonds, in addition to sector allocation (small cap, mid cap, etc.), determine most of your returns.[3]

2)  To suggest anyone can predict exactly what will happen in markets, let alone individual securities, is a "trap for fools", to borrow from my favorite poet Rudyard Kipling. 

Phillips & Company did a case study on timing.  If you were to time perfectly the buying and selling of asset classes over the last decade, you could take a small investment of $10,000 and turn it into $168,997. You can see below[1] that these returns are simply not realistic.

Seriously, do any of us believe someone would share with us their hidden gem of a tool to make money out of benevolence or a small fee, compared to what they can hoard for themselves?  I especially love the online brokerage firms touting their special trading tools that can make you money. Really?

3)  You can only shape the risks you take by using time. The longer time horizon you have for your investments, the less theoretical risk you take, as volatility can be smoothed out over time.  Take a look at the chart below.[5]

The challenge is to adjust those allocations as you get close to drawing down your investments. 

Why wealthy people get wealthier is in large part a matter of the time they allow their investments to work. They just don't need the money to maintain their daily living expenses or retirement.  The reason good foundations and endowments grow is that they have structural controls on their spending and allow multiple generations to grow the assets, looking past volatility.

4) Investors need to overcome the Sleep Well, Live Well Paradox. Your spending rate, inflation, fees and the time you have in the market will determine most of your allocation.

You can see from the table above[6] if you spend about 5% of your assets a year like most foundations, you will need to generate at least 8.20% returns to keep up with inflation and fees. A 70-30 allocation has historically produced these returns over the past 20 years, although a one-standard deviation event could cause returns to swing up or down by 10.70% in a given year.

Now, you’re talking about living with more volatility or losing some sleep. If you don't like the volatility, you will have to spend less.

I hope these rules of thumb can help as they guide us daily.  We have many more but perhaps these will calm nerves, stir a debate on your investment committee or dinner table about your timeframe, return requirements or simple ability to hold on. We certainly hope that we can engage you in this conversation with your financial advisor in the near future.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


[1] “Recent Swings…”, Wall Street Journal, June 17, 2013

[2] Ibid.

[3] “Determinants of Portfolio Performance II: an Update” by B.G.P. Brinson, B.D. Singer and G.L. Beebower.Financial Analysts Journal, May-June, 1991. Results are based on the 10-year performance record of 91 pension funds.

[4] Historic returns from Bloomberg and JP Morgan Asset Management.

[5] Image source: “4Q 2012 Guide to the Markets”, JP Morgan

[6] Data source: Morningstar Direct. Return and volatility data are historic 20 year figures as of May 31, 2013. Maximum spending rate is calculated as historic returns, minus fees and inflation. Fees and inflation figures are for illustrative purposes only and may not be reflective of actual account fees or actual levels of inflation. The S&P 500 is used as a proxy for stocks, and the Barclays Aggregate Bond Index is used as a proxy for bonds.


 


There Is No Free Lunch: Correlations Abound

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There Is No Free Lunch: Correlations Abound
Weekly Market Commentary 6-10-13
Tim Phillips, CEO—Phillips & Company

Since the beginning of the year, the S&P 500 is up 16.2%, the Dow up 17.7% and the NASDAQ up 15.6%.[i]

Over the last several weeks, Wall Street has been having a capital debate with your wealth.  On one side, there were those that feared the end of Federal Reserve’s bond buying and intervention in our capital markets.  That side was selling. On the other side, there were those that felt the economy was too weak for the Fed to withdraw their stimulative efforts, and hence they were buying. 

With Friday's jobs report, the latter side won.  Last month, the economy added 175,000 jobs, but it’s important to note that 26,000 of those jobs were temporary help jobs. While it is good that those 26,000 people are now working, it is clearly a sign that employers do not have enough confidence yet to offer non-temporary positions.[ii]

On average, the US economy has added about 155,000 jobs per month for the last 3 months.  This is about the average when the Fed began their buying programs.  The economy needed help then as it does now.[iii]

What is worse is that corporate earnings growth is expected to be down substantially. Growth in Q2 2013 earnings over Q2 2012 is expected to be 2.59%, compared to 8.29% growth from Q2 2012 over Q2 2011—almost two-thirds less. Also, at the end of March, analysts expected 4.5% earnings growth from Q1 to Q2 2013 on S&P 500 companies—but now, that estimate has been revised down to 1.3%.[iv]

Source: FactSet Earnings Insight—June 7, 2013

Finally you can see continued weakness in commodity prices.  These tend to be predictive of future growth; if commodities are strong, it could be a sign that businesses and manufacturing are expanding, and hence need more raw materials like aluminum, copper, and so forth. The reverse is also true if the economy is shrinking. You can see from the chart below that commodity prices have been pulling back:

Source: Bloomberg LP

So, it seems bad news in our economy is good news for the market.  On Friday, when we received the modest news about jobs, the markets rallied over 200 points.  Bad news in the economy keeps the Fed pushing their agenda, and our capital markets moved up.  Before the jobs report, we saw many asset classes correlate: stocks, bonds, commodities—and this isn’t normal. Usually, US stocks and bonds have a negative correlation, meaning they move in opposite directions, but you can see below that last week (excluding Friday with the report), stocks and bond actually showed positive correlations:


Source: Bloomberg LP

I normally suggest the only free lunch in the long run is diversification.  Unfortunately, without our friends at the Fed, it seems like that free lunch is being challenged.  Remember, under extreme events, everything correlates, similar to what we experienced over the last few weeks.

Stay focused for the long run.  My expectation is for significant volatility in the short run, challenging most portfolios and investors.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


[i] Bloomberg LP

[ii] “Employment Situation Summary” US Bureau of Labor Statistics, June 7, 2013

[iii] “May Employment: Not Too Hot, Not Too Cold”, Moody’s Analytics, June 7, 2013

[iv] “FactSet Earnings Insight”, June 7, 2013


The Onion Has More Than One Layer: Crying or smiling will depend on your sensitivity

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The Onion Has More Than One Layer: Crying or smiling will depend on your sensitivity
Weekly Market Commentary 6-3-13
Tim Phillips, CEO—Phillips & Company

As discussed in last week’s blog, policy errors are all around us.  The US equity markets have pulled back 1.44% since May 22, when the Federal Reserve Chairman suggested they might ease off on buying bonds in the open market if the economy improves.[i]

So why would equity prices drop if the economy improves?  It would seem logical if the economy improves, companies and consumers are doing much better and that should drive stock values higher not lower. 

While this is all true, what is also true is interest rates would have to rise to reflect the strength of our economy and act as a brake to inflation.  Generally this is done through monetary policy set by the Federal Reserve Bank.  As efficient as our capital markets are, participants (bond traders, mutual funds, pension plans, etc.) all anticipate changes well before the Fed can take action.  In this case, rates rise before monetary policy can be enacted.

Take a look at the 10 year Treasury market that measures real interest rates (TIPS).  It is important to note that what matters is real rates (those that adjust for inflation, as inflation erodes our buying power).

(Source: Federal Reserve)

You can see that quite a spike recently occurred.

So back to the question, why would equities drop when the economy improves and real interest rates rise?

The simple answer is higher interest rates lead to the following, in theory:

Note that I said all this could happen, in theory.  In practicality, stocks tend to rise during rising rate environments up until a point:

(Source: JP Morgan 2Q 2013 Guide to the Markets)

As you can see from the chart, stocks have historically risen with rates up until around a 5% rate on the 10 year Treasury.

Why? This is the speculative part.

  • Rising rates don't always impact consumers immediately at lower rate levels. Take housing for example; if your house price rises faster than inflation, you might feel good and spend more in spite of a rise in interest rates.  By the way, housing prices have risen by 8.74% in the last two years.[iii]
  • If you are collecting more interest income, you might spend more of it.
  • If you are not paying that much in interest expense, a rise in interest rates might not impact you as much at lower rate levels. As you can see below, household debt service payments as a percent of disposable personal income are at multiyear lows:
  • If companies can buy things with cash vs. borrow, or borrow at very low long term rates, a rise in interest rates might not impact them at lower rate levels. You can see below that corporate cash levels are at generational highs, and real interest rates for corporations are at generational lows.

(Source: Federal Reserve. Real interest rates for AAA corporations based on AAA bond yields deflated against the year over year change in CPI).

  • US Government borrowing needs are dropping with a rise in taxes and a cut in spending, which reduces our debt services going forward—almost not worth mentioning but theoretically true. According to a Wall Street Journal article on May 15, the Congressional Budget Office is expecting the deficit to shrink to $642 billion, which is substantially smaller than the $1.087 trillion deficit last year.

My guess is market participants are once again only looking at the outer peel of the onion and reacting (selling) when it comes to stocks.  While this time could be different, we might just have some time to go before rising rates impact our consumer and economy.

Special note on bonds

None of this diminishes the notion that bond durations should be lowered in portfolios and that requires some active management on your part as well as ours.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


[i] Bloomberg LP

[ii] National debt figure and interest expense figure from TreasuryDirect.gov “Debt to the Penny” and “Interest Expense on the Debt Outstanding.” Interest expense as a percent of the budget is calculated as the 2012 interest expense divided by total actual FY 2012 federal outlays from the CBO.gov publication “CBO—The Budget and Economic Outlook: Fiscal Years 2013 to 2023.”

[iii] “S&P/Case Shiller US National Index Levels Q1 2013 Not Seasonally Adjusted”, S&P Dow Jones Indices

Words are Worth 380 Billion Dollars: The Era of Policy Errors Begins

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On Wednesday, the Chairman of the Federal Reserve gave a very slight indication the Fed would consider adjusting the amount of bonds they buy on a monthly basis from $85 billion.(source: Bespoke, 5/24/13)  In that moment, the US Equity markets tanked.  We lost approximately $380 billion dollars in stock market valuation or 2.5% of GDP. (www.tradingandeconomics.com: United States GDP 5/28/13)

Bespoke, 5/24/13

 

Global markets also reacted negatively.

International Market Reactions

The Telegraph 5/24/2013

(The Telegraph 5/24/13)

While we can all prognosticate how and when the Fed will begin to cut back on their purchases of bonds (which are driving down fixed income yields and forcing investors into stocks); it should now be obvious investors don't trust the economy to function at any meaningful level without policy intervention.

The question prior to Wednesday was how much policy reliance were investors counting on versus a properly functioning economy and capital markets?  Answer:  Quite a bit.

Volatility jumped to its highs in the last 30 days as measured by the VIX.

www.marketwatch.com: VIX Index Chart 5/28/13

While Bernanke said nothing he has not said in the past and his formal comments reiterated the Fed stance to maintain the buying of bonds for a prolonged period of time, there are some very nervous investors. 

It does no good to speculate on investor jitters and concerns over a pull back.  Much of this thinking I put in the "market timing" category.  What is productive, is for you to again evaluate the time horizon as to when you begin needing your capital. 

If it's less than 5 years, start having a serious conversation with your advisor.  I use 5 years as a market cycle and you should be willing to withstand almost any volatility if you have time. 

If it's more than 5 years, take a hard look at your fixed income allocations.  Duration and where your fixed income falls on the yield curve will start to matter a whole lot.

We can now officially kick off the “Era of Policy Errors.”  It won't come on all at once but the "new normal" will require a deft hand with politicians and the Federal Reserve.  That's why I expect this period to be very volatile, nerve wracking and in the short run maddening.  Whether you are a pension account, a foundation or endowment, family or individual, it's critical to reassess your time horizon.  The only free lunch I can ever give you is the ability to shape risk with time when it comes to broad based public market equities. 

 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via TwitterFacebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO - Phillips & Company

 


Client Education - Planning for Health Care in Retirement

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Client Education
Planning For Health Care in Retirement
May 22, 2013

As part of our ongoing mission to help our clients make educated financial decisions, we are now releasing our latest client education presentation. This issue focuses on a topic that many of our clients brought to us as a concern, which is planning for health care expenses in retirement.

Click here to download presentation: "Planning for Health Care in Retirement"

You can also view our earlier client education presentations here:

With the uncertainty about rising health care costs and uncertainty over what may happen with health care benefits and insurance, planning for health care expenses should be a key component to any broad financial plan. I hope that you will find this presentation informative and that it will give you some issues to discuss with your financial advisor. You can also email me directly at tphillips@phillipsandco.com.

Tim Phillips, CEO—Phillips & Company

The Most Undervalued Asset Class? Can Cheap get Cheaper?

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The Most Undervalued Asset Class? Can Cheap get Cheaper?
Weekly Market Commentary 5-20-13
Tim Phillips, CEO—Phillips & Company

It seems like nothing will stop the US equity markets from rallying.  I'm convinced Federal Reserve activity is creating distortions in market participant’s valuation perspective.  Equities in the US are getting more expensive.

PE Ratios as a Percent of 10 Year Average [1]

When you look at asset classes across the globe, you can see they are trading near their mean valuations.  It seems like coordinated central bank intervention has distorted global asset valuations.

PE Ratios as a Percent of 10 Year Average [2]

One asset class that appears to be below its mean by multiple measures is emerging market equities.

MSCI Emerging Markets Index [3]

In fact, emerging market equities are at a valuation similar to US equities back during the financial crisis.  The PE ratio on the MSCI Emerging Markets index is 12.65 currently, while the PE ratio on the S&P 500 on the market bottom of March 2009 was 10.29. [4]

It's to nobody’s surprise that the S&P 500’s PE ratio has expanded by 58.9% since the market bottom in March 2009 through today, leading to a total return on the index of 167.5% over that time. [5]

I think a similar opportunity presents itself in EM equities, but I am concerned about the Middle East/North Africa (MENA) countries. You can see below that Arabian Markets are trading at PE ratios significantly below their averages, much more so than just broad emerging markets:

Valuation Levels as a Percent of 5 Year Average [6]

In this case, it could be a situation where a cheap valuation gets even cheaper. MENA countries generally have one thing in common; they are large exporters of oil.  It seems like market participants have already priced in some significant economic disruption in these countries as domestic natural gas is discovered throughout the world. The current turmoil in Syria, ongoing concern in Egypt, and the risk of spillover is also a concern for the market.

While in general emerging market assets are cheap and I expect valuations to rise, in some regions “cheap” could be a true reflection of a shift in value, so cheap could get cheaper. Simply think of the 30 component stocks of the Dow Jones Industrial Average (DJIA) 50 years ago and realize that there are only 14 left in existence, and of that only 4 are still in the DJIA. [7] Investments that appear to be reliable can and sometimes do fall off of the map forever.

For example, 50 years ago, Bethlehem Steel was part of the DJIA. The world has changed, and in part due to inexpensive foreign competition, the company went bankrupt in 2001[8]. My concern is that the world is changing when it comes to energy production, and MENA countries are at risk.

I like emerging markets with growing middle classes, but I don't like declining markets that are in a fight for their survival. In those cases, cheap is never cheap enough.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


 

[1] Bloomberg LP. 10 year average is trailing from May 2013.

[2] Ibid.

[3] Ibid.

[4] Ibid.

[5] Ibid.

[6] Bloomberg LP. 5 year average is trailing from May 2013. Arabian Markets is represented by the MSCI Arabian Market Index, Kuwait is represented by the MSCI Kuwait Index, Saudi Arabia is represented by the MSCI Saudi Arabia Index, and  the UAE is represented by the Dubai Financial Markets General Index.

[7] “Dow Jones Industrial Average Historical Components”, Dow Jones Indexes

[8] “Bethlehem Steel in Chapter 11”, CNN Money, Oct. 15 2011

A Chink in the Armor

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A Chink in the Armor
Weekly Market Commentary 5-13-13
Tim Phillips, CEO—Phillips & Company

Amidst all the euphoria of a record stock market and plethora of earnings reports, it's easy to lose sight of how weak and cautious the consumer really is.  We have written in the past about the lack of wage growth in middle income families.

What's new this week is that we are seeing signs of the consumer beginning to perhaps pull in the reins on spending.  Consumer credit increased by only $8 billion in the month of March, compared to an $18.6 billion increase in the prior month.[1]

Image source: “United States: Consumer Credit”, Moody’s

Moody’s reported that consumers reduced the use of revolving credit (credit cards) by $1.7 billion.[2]  Credit cards, as we all know, have much higher interest rates than other sources of financing.

Revolving vs. non-revolving credit

What's particularly astonishing is that 97% of the total increase in consumer credit over the last 12 months has come from non-revolving items. Much of this is being spent on automobiles and student loans.[3]  You can see from the chart below by Quartz, student loan growth looks very similar to the recent run up in the stock market.

From the perspective of someone who sits on the board of a major US university, the trickle-down effect of money spent on a college education has a significant lag effect on our economy.  There is no question in the long-run a college degree leads to higher earnings and higher spending (while that notion is certainly debatable in our current economy).

Unfortunately for our current economy, the money consumers are borrowing at low interest rates is being locked into the educational establishment, and that is a very narrow aspect of our economy. Spending on higher education was only about half of one percent of GDP in 2010.[4]

When consumers spend on things like cars, the flow of capital into our economy is much quicker and much more impactful.  A study by the Center for Automotive Research showed that automobiles represent about 3-3.5% of overall GDP.[5]

Consumers are less likely to tap into sources of credit with high interest rates because of increases in taxes and no growth in wages.  They are, however, willing to load up on low interest rate financing activities—especially on education.  While the long-term benefits will be tremendous, the short term payoffs are limited.

With limited immediate benefits from educational spending on our overall economy, revolving credit becomes even more important.  Clearly, the data suggests there is a chink in the consumer’s armor. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


[1] Source: “United States: Consumer Credit”, May 7, 2013 update, Moody’s

[2] Ibid.

[3] Ibid.

[4] Source: “Share of budget for higher ed shrinks”, October 2011, Minnesota’s Private Colleges

[5] “Contribution of the Automotive Industry to the Economies of all Fifty State and the United States”, Center for Automotive Research

The Dividend Trump Card

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The Dividend Trump Card
Weekly CEO Commentary 5-6-2013
Tim Phillips, CEO—Phillips & Company

The most frequent question I'm being asked right now is, "Can this market continue to move higher?"  The short answer, in my opinion, is yes.  One basic rule of thumb on investing is anything can happen in the stock market and usually does.

As it relates to our current rally, the best answer is vested in good data.  For over a year now, we have seen stock valuations move much closer to their 10-year mean. Keep in mind that for something to have a mean, it must trade below and above that average for a period of time.

Source: Bloomberg LP

Historically, according to data compiled by Yale Economics Prof. Robert Shiller, earnings per share on US stocks grew at a 4.01% annualized rate between 1874 and 2012, and dividends per share grew at 3.46% over the same period.

Image source: Yale University website for Robert Schiller

Currently, the S&P 500 is posting a growth rate of 3.2% for companies that have reported Q1 2013 earnings so far, according to FactSet (May 3, 2013 article “Despite high negative EPS guidance, estimate cuts for Q2 on pace with recent averages”).

Image source: Yardeni Research article “Earnings, Revenues & Valuation: S&P 500 Sectors”, May 6, 2013

Clearly, companies are growing at a rate below mean averages.  However, a close look at dividends can help round out the picture from a fundamental perspective.  From a simple math standpoint if a company is growing its earnings at a certain rate and also growing its dividends at a certain rate, its value should grow (based upon a discounted cash flow model). 

According to the FactSet Dividend Quarterly (March 28, 2013), aggregate dividends per share (“DPS”) on the S&P 500 grew by 15.9% year-over-year at the end of Q4, and the number of companies  paying  a  dividend  over  the  trailing  twelve-month  period  (“TTM”)  hit  a  new,  thirteen-year high  of  405 companies (81%).

So while EPS growth is moderating, dividends per share growth is exploding. From an increasing valuation perspective, companies are doing very well once you factor in dividends.

What matters more, dividends per share or earnings per share growth?  Recent data might surprise you.

Image source: FactSet Dividend Quarterly, March 28, 2013

You can see from the data dividend growth rates were capable of overcoming some slow earnings growth rates. 

While current EPS growth rates look troubling, dividend growth rates look exceptionally strong and perhaps prove to be the trump card when determining stock market sustainability.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via TwitterFacebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

The Consumer Did Its Job

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The Consumer Did Its Job
Weekly CEO Commentary 4-29-13
Tim Phillips, CEO—Phillips & Company

The much anticipated report card on the US economy was released last week and I would grade it a C overall.  The US economy grew at an annualized pace of 2.5%.

The consumer represented almost 90% of the growth in GDP. They deserve an A+.  Business did its share, making up much of the rest of the growth through expanding inventories. Not surprising, government and net exports continued to represent a drag on the overall economy.

Source: Bureau of Economic Analysis

What We Know

Unfortunately, we know the consumer can't continue to represent this much a share of our national output.  Some kind of reversion to the mean is in store.  Much of consumer spending came from savings.  The US Savings rate dropped to 2.6%, which is the lowest level since 2007. 

Source: Bureau of Economic Analysis

We also know from earlier posts that businesses will find it harder to add to inventories as they are already at relatively high levels.

We certainly know there is significant fiscal drag in our economy.  Driven by tax increases and sequestration induced government spending cuts, we can see a drag of as much of 1.8% on GDP in the coming quarters.

So, what's left to keep the economy and markets going in the coming quarters before we get released from much of the fiscal drag in 2014?

Consumer credit is showing some signs of strength.  If the consumer can't spend their savings it looks like they are still willing to go to the credit card.

They are also making a little more money as personal disposable income recovered from a large drop in January.

The markets will soon start to anticipate better times ahead in 2014.  From my experience it could be as early as 6 months ahead or as late as several months.  It appears that investors have significantly more "present bias" and that could mean a sluggish summer before market participants look forward to 2014.  I also give my usual caution on accuracy and specificity on forecasts.

The summary of all this data looks as follows:

  • Companies will want to shrink inventory before they rebuild delaying any significant movement in employment.
  • Consumers will need to reload savings but can certainly continue to sustain a slightly elevated level of spending from a slight rebound in incomes, access to credit and a recovery in housing.
  • Fiscal headwinds will continue throughout the rest of 2013.
  • Market participants will look for sunnier times in 2014 so pull backs can be viewed as a normal reaction to an almost normal business cycle.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


The Fed: Do we trust them?

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The Fed: Do we trust them?
Weekly CEO Commentary 4-22-13
Tim Phillips, CEO—Phillips & Company

“Inflation, not if, when"- A noted Wall Street firm

Like you, all of us at Phillips and Company are very sad at the events that occurred this week in Boston.  Our hearts are broken for all the victims.

It made traveling to New York City a little more interesting than usual this week.  I had an opportunity to spend a couple days in the city meeting some of the finest minds on Wall Street.  (I say that with a healthy dose of skepticism in some cases). 

One firm that I admire posited, "Inflation, not if, when".  Good question.  Getting a feel for this answer can guide investors immensely when it comes to their overall allocation.

Here's the problem: I'm not sure it's a "when" question as much as it's an "if" question at this point in our cycle.  No question when you look at food prices, taxes,  health care, higher education—and don't forget grades—you see some serious inflation.

Source: gradeinflation.com

But, for the last 30 years, we have seen the rate of inflation trend downward.  Granted there are issues within the measurement.  Nonetheless, all things being equal, inflation has been an "if" question and not a "when” question.

Granted, there are issues within the measurement.  Nonetheless, all things being equal, inflation has been an "if" question and not a "when” question.

What are we facing now?

Noted professionals have been pounding the "When vs. If" paradigm for decades:

“Among the biggest worries have been higher import prices generated by the decline in the dollar’s value over the past year and increased wage demands from the nation’s workers. Even the trade bill pending in Congress and the new immigration law could add to the upward pressure on inflation, some economists said.” –Associated Press article from August 8, 1987

“Once inflation starts in the US, it usually is not interrupted until a recession.” –Allen Sinai, chief economist for Boston Co. Economic Advisers, quoted in January 20, 1988

Inflation, loosely defined, is a function of too many buyers vs. sellers, more dollars vs. more goods and services, and more demand than supply.

The challenge we face in our economy is from the demand side. 

First, look at wages as a percent of the economy (44 percent currently). Wages are not rising and in fact have been steadily falling. You can see this on the chart below:

Secondly, there are fewer workers who spend that 44 percent. The total rate of unemployed and underemployed Americans is 13.8 percent. Also, the labor force participation rate has been dropping since 2000, as you can see below:

Third, you can see a trend if you look at American demographics and aging.  Assuming older Americans 65 years and older consume less (eat less, go out less, need smaller homes, fewer cars), inflation gets a little harder to see.

Source: US Census Bureau

The one noted exception is health care.  While it might be inflationary for the government, because health care is a social cost, the government passes the cost increases along to producers in the form of higher taxes.  This is deflationary when it comes to producers having money to consume other goods and services.  

Changing paradigm

Structurally, we also face technological changes.  In the book "Nothing Like it in the World...." by Stephen Ambrose he noted the systemic economic shift brought on by the completion of the Transcontinental Railroad.  Travel costs dropped from $1,000 a person to $150.

More recently, we saw the same thing with the internet and telecommunications. In 1956, an international phone call on the original trans-Atlantic cable cost $12 for three minutes. Compare that to services now like Skype that let you call people or video conference globally for free using your existing internet connection.

No inflation there, because of new technology that lowered costs.

What this all means

While I know this time is no different than other times, I would not expect inflation to rear its ugly head in the coming couple of years.  Perhaps in 2015, which is how far out the Fed says it will maintain “exceptionally low levels” for interest rates.

Banks are still not lending and with the excess reserve interest rate and inflated FICO requirements, it looks like it could be a while before they pump the economy with their excess cash.

What I would do is trim duration risk, be patient with cash and work to squeeze more risk out of the portfolio through correlation diversification.

"If, not when" seems to be answered for us by the Fed for now at least.  The real question is: do we trust them?

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

2011, 2012, Now 2013?

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2011, 2012, Now 2013?
Weekly CEO Commentary 4-15-13
Tim Phillips, CEO—Phillips & Company

Earnings season kicked off a quite start last week.  We had 33 of the S&P 500 companies report earnings so far, with 69.7% of them beating expectations (source: Bloomberg). So far, this looks good; however, things really get started in earnest this week with some key companies reporting: 

  • Tuesday, April 16: Intel, Coca-Cola, Johnson & Johnson
  • Wednesday, April 17: Bank of America, American Express
  • Thursday, April 18: IBM, Microsoft, Verizon
  • Friday: April 19: General Electric, McDonald’s

Unfortunately for the economy, we continue to see deterioration in economic reports.  As you can see from the following table, we are experiencing a rapid decline in economic indicators.

One important indicator is the Retail Sales report released last Friday.  Expectations were for retail sales to be flat month over month, but actual results showed that retail sales shrunk by 0.4% from February to March. Consumers appear to be cautious.

While I expect Q1 GDP to bounce back from near recessionary levels experienced in Q4 2012, I don't expect Q2 and Q3 this year to be strong for the US economy.  Much of my caution stems from the headwinds caused by the increase in payroll taxes and sequestration.  One impacts the consumer (70.7% of our GDP), and the other impacts Government Spending (22.3% of our GDP).

Another reason for my caution is in the large inventory buildup during Q1 2013.

While the inventory build was additive to GDP in Q1, it may not be helpful in Q2 and Q3 as consumers might be more cautious.  This will cause companies to replace inventories slower, adding to more economic headwinds.

I do believe our foundational economy is stronger in 2013 than the past two years, but I also believe that we might see a repeat of market activity post Q1:

The reason I would not bet too heavy against this market is the Federal Reserve’s vigilance in propping up this economy.  Perhaps a cautionary pull back will be short lived and viewed as an opportunity for investors to put cash to work.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

The Waiting Is Over

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The Waiting Is Over
Weekly CEO Commentary 4-8-13
Tim Phillips, CEO—Phillips & Company

It's finally upon us: earnings season. To me this season is one of the most anticipated in many years.  Between the tax increases taking effect on January 1, and the sequestration cuts in government spending, the consequences are highly anticipated. 

  • Is this recovery stalling? 
  • Does the consumer have the financial strength to power through in light of tax increases? 
  • What is the impact on spending cuts from the US Government?
  • Ultimately, will companies hire more people?

We have for the first time in over a year ended an earnings period that is expected to be quite pessimistic. Between Q3 2011 and Q4 2011, the last period where we saw a significant earnings drop, the S&P 500 dropped -3.67 percent (source: Bloomberg). FactSet shows that analysts expect earnings to shrink slightly this quarter from Q4 2012.

Source: FactSet Earnings Insight

Guidance from companies, a much more reliable source, is also showing signs of extreme caution.  You can see from the chart below that negative guidance has been rising from December through now.

Source: FactSet Guidance

Guidance is particularly pessimistic in the consumer discretionary and health care sectors, as you can see below. Some sectors like energy and financials do not have enough companies issuing guidance yet to get a read on the sector.

Source: FactSet Guidance

The mood amongst professional investors is growing worrisome:

“On a scale of 1-10 measuring asset price ‘irrationality’, we are probably at a 6 and moving in an upward direction.” –Bill Gross, co-CIO of PIMCO from the PIMCO March 2013 Investment Outlook

“In the short-term, if the data are weakening - and I think investor expectations haven't really adjusted to that - there's a chance for the market to consolidate in the short-term.” –Thomas Lee, chief US equity strategist at JP Morgan

A drop in the markets is part of the consensus view in the short term. As we wrote last week, investor sentiment has remained cautious.

At the same time, we are seeing investors grow quite worried about their bond holdings.  The talking heads on TV are pitching the "bond bubble" notion (there is some truth to this).  Yet, bonds are the general safe haven for a falling equity market.

What do we do?

My strategy is to keep our foot on the brakes and the gas at the same time:  focusing on quality fundamentals in equity asset classes and shrinking the duration risk in bonds (click for a definition on duration).  While we will certainly miss some of the party on equities, we should reduce our risk on the downside.  I emphasize reduce risk—not eliminate it.  

I might regret saying this, but I'm glad the waiting is over and we can get on with it.  I want some answers to the questions I have.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

Contrarian Viewpoint

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Contrarian Viewpoint
Weekly CEO Commentary 4-1-13
Tim Phillips, CEO—Phillips & Company

It's quite common when markets achieve new highs to see lots of headlines, and typically the individual investor plows money into the market.  When the individual investor chases market returns, they typically get burned.  Contrarian investors and value investors are constantly on the watch for the emotional investor to buy things that are overvalued and sell things that are undervalued.  Greed and fear can take over for rational thinking. 

I know this seems counterintuitive and if investors were truly rational, you wouldn't see such mispricing in asset classes.

The question today, as we are at all-time highs on the S&P 500 and Dow Jones, is how much irrationality is in the market?  There are a few things you can look at besides pure valuations to get a sense of irrationality.

Contrarian indicators

The Investors Intelligence Bull and Bear indexes are surveys of investment newsletters, and if their recommendations are bullish or bearish.

Image source: “Stock Market Indicators: Fundamental, Sentiment & Technical” Yardeni Research

Investors Intelligence noted that in times of heavy bullish or heavy bearish recommendations, markets tend to do the opposite.

As another example, below is a chart by Avondale Asset Management of historic investor sentiment from the American Association of Institutional Investors (lots of people using discount brokerages), and how actual market performance has been during bullish and bearish levels of sentiment.

Image source: Avondale Asset Management

You can see from the chart that the individual investor is typically wrong.  When the individual investor is very bullish (right portion of chart), there is historically a 70% chance they will lose money.  Conversely, when they are extremely bearish, they historically have had only about a 15% chance of losing money, and in fact the average return was a positive 9.96%.

Just to prove how reliably wrong the individual investor tends to be, take a look at where sentiment stood during the last market bottom and also where it stood at the prior peak:

If you look at the table below, you can see we are nowhere near an extreme bullish sentiment by the individual investor.  

Perhaps because the last negative experience was so traumatic, investors are being cautious.  This bodes well for continued positive trends in the market, if you follow the contrarian models.

None of this is to say that it’s easy sailing ahead.  In my opinion, there are real world worries to consider:

  • Stagnant European Union growth
  • Flattening in US Corporate earnings growth
  • A soft landing in China
  • Federal Reserve monetary withdrawals
  • Rising US interest rates
  • US Government spending cuts

Perhaps that's why the individual investor is so cautious, and perhaps that's why valuations are in the fair range and not extremely overpriced.  Perhaps that's also why the market might move higher because the individual investor has not been in full chase mode. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company


Can it happen to us?

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Can it happen to us?
Weekly CEO Commentary 3-25-13
Tim Phillips, CEO—Phillips & Company

One of the nice things about managing money professionally is if you’re intellectually curious, it provides for ample opportunity to learn new things all the time.  Case in point: Cyprus.  I have heard the name of the country before, and that's about it.  I do enjoy seeing the Cypriotic (my term) experts roll forth with their infinite knowledge on something they probably knew nothing about.  That's an illness in our industry and a topic for later.

The real question for me and likely you as a saver with money in a bank is:  Could what happened in Cyprus happen to us?

What happened

The roots of the problem in Cyprus came down to some key points:

1) The financial sector is a large portion of the Cypriot economy, and a significant portion of the deposits aren’t domestic savers, but rather foreigners who sought to park cash overseas. CNN reports that “Nearly a third of the money in Cyprus' banks is Russian, and the country's 10% corporate tax -- half that of Russia's -- meant Russian firms had been using it as a tax haven since the early 1990s.”

Source: Central Bank of Cyprus

2) Cyprus was also damaged by the crisis in Greece. Cypriot banks held large positions in Greek debt, which ultimately turned out to be toxic assets.

3) Cyprus also has a great deal of political uncertainty. The country still suffers from the after-effects of a civil war in the 1970s, which has left an active UN Peacekeeping Force on the island to this day.

So in all likelihood what happened in Cyprus can't happen to us...exactly.

With the bailout agreed to, it looks like large savers will lose some of their deposits in the form of a tax, in exchange for continued EU support for the country. Originally, the terms were set to be a 6.75% levy on depositors under 100,000 Euros and 9.9% above that amount, but now the Cypriot government can adjust those figures (to try to spare small depositors) as long as they raise 5.8 billion Euros in total.

Larry Elliot, the economics editor at European newspaper The Guardian, also reports that, “The shakiest of the Cypriot banks – Laiki – will be closed. Deposits of more than €100,000 – amounting to €4.2bn in all – will be placed in a ‘bad bank’. That means savers will only get a fraction of their savings back and the deposits could, in theory, be lost entirely.”

Implications for US savers

Unfortunately, US savers have also lost money on cash savings during the 2008 financial crisis—something that was thought to be unthinkable before then.  Little known to the investing public was the “breaking of the buck” of the Reserve Primary Fund, a money market fund that in theory should stay at a value of $1 per share, but actually lost money for investors during the 2008 crisis—something that is not supposed to ever happen.

On another side of things, US savers are getting punished right now by extremely low interest rates. Over a 5 year period of time, who is better off: a Cypriot saver with a small haircut, or a US saver with near zero interest rates?

BankRate.com shows an average annual rate on a US 5-year CD is 1.34 percent. The European Central Bank does not keep data on 5-year fixed deposits (the European equivalent of a CD), but shows that a 1-year fixed deposit in Cyprus has a rate of 4.53 percent.

If a Cypriot saver loses 10 percent up front due to the tax, and assuming that they can roll their 1-year fixed deposit over at the 4.53 percent rate for five years, they would still break even with their capital loss and eventually outpace an American saver.

The government isn’t putting a tax on US deposits, but savers have been hurt nonetheless by minimal returns.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

After the Fall: The Rocky Road Upward

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After the Fall: The Rocky Road Upward
Weekly CEO Commentary 3-18-13
Tim Phillips, CEO—Phillips & Company

It's great to see equity markets at all-time highs.  It doesn't feel that long ago when we were working with clients to not jump off the cliff and give up on their equity strategy.  It feels good for markets to prove to us that they can and do revert to their mean, and in this case move from a crash low PE on the S&P 500 of 10.21 on March 6, 2009 (the market bottom), to where it stands now at 15.33—closer to long-term averages (source: Bloomberg).

So, what happens now becomes the paramount question.  When you look at the data from Rogoff and Reinhart in their seminal study of financial crises, you can see the economy is working its way through much of the traditional trouble. Below are measures from their report, which we have updated to current figures:

(source: Bloomberg, Calculated Risk, Federal Reserve)

The data shows major progress, more or less consistent with the time it takes to recover from past financial crises. 

One item that is getting tremendous amount of attention is housing, as it has a major impact on our overall economy by creating jobs and increasing household wealth. Total residential construction spending is on the rise, as you can see from the chart below.

From this chart, you can see we have added $74.8 billion in residential construction spending since spending bottomed in June 2009. You can also see improvements in private housing building permits.

All of this improvement in housing has improved our personal balance sheets. The chart below shows our balance sheets are $1.98 trillion better from housing alone, from its bottom in 2009 to the most recent quarter.

If you look at overall Net Worth things look even better, as it is reaching pre-recessionary highs.

All of this shows a picture that bodes well for jobs and the economy over the long run.

If we show you the same chart on total net worth on a percent change from a year ago, you would get a more cautious picture. 

You can see that growth in total net worth has been stalling from the prior year.  Add to this view the fiscal cuts that are well detailed by Mark Zandi at Moody's:

"Sequestration adds to the already-considerable fiscal drag on the economy, which will reach full force this spring and summer. The fiscal cliff deal that resulted in the American Taxpayer Relief Act, reached at the start of the year, raised taxes by almost $200 billion for calendar 2013, and will cut 0.8 percentage points from 2013 real GDP growth. Other congressional spending decisions, including the caps agreed to in the 2011 debt-ceiling agreement and appropriations for reconstruction after Hurricane Sandy, net a further 0.2 percentage point cut in real GDP this year. All told, federal fiscal policy will reduce real GDP in 2013 by almost 1.5 percentage points".

While we are working our way through the long and arduous process of recovery from a typical financial crisis (I emphasize financial as they are the worst type), we might have a hiccup or two along the way.

By no means do I suggest trying to time the market.  I have never seen the individual investor consistently do it profitably in my 27 years of investing.


Conclusion

I want to relate this to a personal experience. While traveling through the Himalayas of India last year in search of a rare fish, I was confronted with a terrifying series of rocky roads upward.  This economy and market feel about the same.  While upward is indeed the destination it will likely be very rocky going forward. 

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

Where Do We Go From Here?

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Where Do We Go From Here?
Weekly CEO Commentary 3-11-13
Tim Phillips, CEO—Phillips & Company

The Dow hit an all-time high of 14,397.07 on Friday. Bloomberg shows that since the market bottom on March 9, 2009, when the Dow was at 6,547.05, the market has rallied 146.33 percent. Year to date, the Dow is up 10.8 percent. On one hand, it’s comforting that we have come a long way since the depths of the financial crisis. On the other hand, hitting an all-time high is sometimes a cue to take a step back and make sure that the market has not gotten over-extended.

One of the tools that we use to value stocks and markets as a whole is called mean reversion. The idea is that performance of stocks and markets tend to converge to a long-term average, or a “mean.” If you flip a coin and get heads, it doesn’t necessarily mean that you will get tails on the next flip, but over the long run, you will probably get close to 50 percent heads and 50 percent tails. It’s a similar idea with markets; over enough time, high valuations will probably come down to average levels, and likewise low valuations will probably come back up to historic averages.

Where we are at now

Here is a table showing how much over or under P/E ratios from various markets are from their historic levels:

Compared to long-term averages, markets are still undervalued, with the most extreme example being Japan. What this all means is that some profit taking or a correction is possible, as markets have been rallying, but markets are still trading at valuation levels below historic averages.

We also looked at fixed income, by looking at the 10-Year Treasury data from the Federal Reserve, and seeing how its yield compares to historic averages.

It is clear that Treasury bonds yields are far below historic average levels, which is why we have been positioning out of long-term Treasuries and have been exploring other options in fixed income.

Important caveat

It’s worth noting a quote from Benjamin Graham: “It is absurd to think that the general public can ever make money out of market forecasts.” We do have to remember that mean reversion is simply a tool to help value markets, and it is not a crystal ball. This is why we have written previously that we look at forecasts, but we take them with a grain of salt. Using mean reversion and P/E ratios can be helpful for positioning or making tilts, but we do not make all in bets either in or out of the market.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

What's Next?

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What's Next?
Weekly CEO Commentary 3-4-13
Tim Phillips, CEO—Phillips & Company

The world did not come to an end. As I traveled through security lines at airports this weekend, I saw absolutely no signs of long lines caused by cuts to government budgets, nor did the air traffic controllers have to leave their posts.

What I did see was people shopping, eating out and spending money.  From the looks of things, the Great American Ponzi Scheme, consumerism, is alive and well.  I have written several times that the essence of growth in our economy is largely driven by the US Consumer.  The formula is simple:

It's clear our current consumer is a little more cautious and consumes a little less, with the final outcome being fewer jobs created and not much support for wage inflation.

Fortunately for all of us, consumers can get their hands on money to spend through their savings.  That's exactly what we saw recently.

The Federal Reserve reported that the US Savings Rate dropped from 6.4% in December to 2.4% in January. This means that consumers deployed $513.5 billion from savings. This more than compensates for the $85 billion that is being cut from the federal budget.

It's also encouraging to see the US equity markets greeted the news with some support. Bloomberg shows that the S&P 500 is up 8.40% over the last three months.

 

  • Is it possible global investors want a more responsible US fiscal policy?
  • Perhaps the investor class cheered the fact that further tax increases might not be as easy to capture?
  • It could also be a welcome indicator that the political class can focus on tax reform to help companies unlock the nearly $1.7 trillion in cash[1] sitting on their balance sheets.

I am comforted that there is plenty of dry powder in our system (corporate cash and personal savings/credit).  It's also comforting to see the Federal Reserve’s Flow of Funds showing that US homeowner’s equity improved by $387 billion from Q2 to Q3 2012 (most recent quarter available), largely due to a recovery in real estate prices.

On the other hand, I am also cautioned that there is a continued concern over slow growth that may be a precursor to a mild recession.

What I am working on with our investment staff is how to continue to optimize our equity allocations, and at the same time realign fixed income to reflect the transition phase we may be entering when it comes to interest rates.

Some specific fixed income issues we are also working on:

  • Lower duration risk (how your bond portfolio reacts to rising rates)
  • Yield curve opportunities
  • Geographic credit dislocations that are improving
  • Industry specific debt
  • How fast to run away from Treasuries and TIPS on the longer end—and actually, you should have already run from the longer maturities
  • Equity risk substitutions for fixed income

As long as the consumer has dry powder and housing prices improve, it's critical we start thinking about what's next for valuations in all asset classes.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company



[1] Source: Federal Reserve

Spending For Spending

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Spending For Spending
Weekly CEO Commentary 2-25-13
Tim Phillips, CEO—Phillips & Company

It's apparent we are facing $85 billion in cuts to government spending.  As I mentioned in last week’s blog, there appears to be too wide of a gap for an immediate political solution.

So, can our economy sustain and grow without as much government?  If you listen to the President we are facing dire consequences if these cuts come to fruition:

 “Once these cuts take effect, thousands of teachers and educators will be laid off, and tens of thousands of parents will have to scramble to find child care for their kids. Air traffic controllers and airport security will see cutbacks, causing delays across the country.” –President Obama, weekly radio address, according to Real Clear Politics on February 23.

There is no question that many people who work in government or within its food chain will certainly feel some pain.

Putting the cuts in perspective

However dire the cuts might sound, these cuts are immensely survivable by our economy.  In fact, if we look at the period following WW2 when the government was withdrawing massive amounts of spending we see an entirely different picture. 

A September 2012 paper by Cecil Bohanon from Ball State University found that in 1944, the US Government was about 55% of GDP, and by 1947, government shrank to a more normal 16% of GDP.  This was a reduction of government spending by 75%. On the other hand, consumption rose by 22%, private investment rose by 223%, and housing exploded by 600%.

Similar to today's rhetoric, some very smart people predicted some doom and gloom. According to Bohanon’s paper, Gunnar Myrdal, who later became a Nobel Prize winner, forecasted an “epidemic of violence" by the amount of spending being withdrawn by the government after the war.  Oops!

Needless to say, we are not facing a human consumption explosion similar to that in 1947.  However, we really don't need one either.  We are talking about $85 billion in cuts, which is only 0.53% of today’s GDP of $15,829 billion.

Cash pile

When you look at consumer savings, they are sitting on massive amounts of cash—and have been adding to it.

The Federal Reserve reports that personal savings as of December was $805.2 billion, which is an increase of $412.3 billion since September. FactSet also reports that non-financial S&P 500 companies are holding on to $1.23 trillion of cash. Suffice to say, between households and corporations, there is a very large amount of cash on hand that can be spent.

While it might be time to brace for the impact of a policy induced recession, it might also be necessary to continue to keep our tilts toward growth.  Consumers might just surprise expectations and make up for what policy makers can’t: spending.

Will the cuts be hurtful? Sure. Is it as apocalyptic as the headlines suggest? Far from it.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

Handicapping Sequestration

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Handicapping Sequestration
Weekly CEO Commentary 2-19-13
Tim Phillips, CEO—Phillips & Company

It simply amazes me how much we have to talk about government fiscal policy and the market moving forces it creates.  Just as a recap, the list of the times the US Government has been in a fiscal debate during these last two years is astonishing:

-December 2010: The Simpson-Bowles Deficit Reduction Committee report is released; the report is ultimately largely ignored
-May 2011: Bipartisan “Gang of Six” talks to raise debt ceiling begin to break down
-July 2011: The House passes a plan to raise the debt ceiling and reduce deficit; plan is immediately tabled in the Senate
-August 2011: A compromise debt ceiling plan is ultimately passed, and as part of this plan, Congress must pass a deficit reduction bill or $1.2 trillion in automatic cuts will take place—which came to be known as the “Fiscal cliff”
-December 2012: Congress attempts to pass a resolution to the “Fiscal cliff”, and ultimately postpones the issue until March

It’s no wonder why corporations are sitting on cash. Here are some stats on cash positions at major companies:

What's ironic is the President is asking Congress for $1 billion dollars for innovation programs recently. That figure is just 8/10ths of 1 percent of General Electric’s cash and short term investments.

How about this: the political class should create some stability in governmental fiscal and tax policy, and then perhaps GE and others will spend some of their massive cash stockpiles on innovation.  The best part is corporations need no congressional silliness to do this. 

The 120 billion dollar outcome

The sequestration in its current form will require cuts of $1.2 trillion over 10 years, split evenly between domestic discretionary spending and defense, according to CNN’s article “CNN Explains Sequestration” on February 19. This would be $120 billion per year. To put this number in perspective, US GDP from the Q4 Bureau of Economic Analysis report on January 30 was $15.8 billion.

A cut of $120 billion would cut US GDP by 0.75%, which is significant when we already had negative GDP growth for last quarter (discussed in our blog two weeks ago).

More Spending, Higher Taxes

I regrettably am handicapping sequestration as a 60% reality. Here's why based upon some basic facts:

Fact 1:  Most Republicans are sitting on very safe seats.  Nate Silver, the noted handicapper of political races, wrote a December 27 article in the New York Times titled, “As Swing Districts Dwindle, Can a Divided House Stand?” In it, he wrote that there are only 35 swing seats—down from 103 in 1992.

Fact 2:  Gerrymandering has created a very Republican bias in the House, and that is driven by the rural nature of their constituents.  While there were more votes for Democratic congressmen, they were mostly wasted votes in urban population centers.  Essentially, Democrats had lots of turnout in their fewer congressional seats vs. Republicans that had less turnout but in more seats.

The table below from the Washington Post shows this trend in actual bias with and without incumbency.    

Fact 3:  The most recent proposed solution to the sequestration cuts suggest a split between cutting spending by $55 billion and raising taxes by $55 billion, according to a recent plan titled the “American Family Economic Protection Act.”

Deduction 1:  Republicans in safe seats cannot vote for more spending and higher taxes.  It's not in their DNA, and they are certainly afraid of a primary challenge to their seat.  Basically, it's not in their incentive to do so.

Deduction 2:  If Republican's give on taxes now, they will not have anything to negotiate with on tax rate reform later in the year.  The President will have gotten more taxes and a little less spending, leaving Republicans scratching for something to negotiate a flatter tax system with.

Deduction 3:  There is little time to negotiate a major tax rate overhaul in this round leaving them with only two choices; sequestration cuts go through or they kick the can again.

My handicapping suggests a 60% likelihood of sequestration, and a 40% likelihood of kicking the can.

So what to do with your money 

The first thing is to realize the anticipated impact on GDP from the cuts will be -0.75%.  Second, and this is critical, GDP and stock market performance are not highly correlated, which we wrote about previously.  Finally, these cuts will have very little impact on emerging markets and developed economies outside the US.

I would suggest keeping a well-diversified portfolio with a decent exposure to global markets.  I would not run for the exit on most fixed income, with the exception of longer-term TIPS and US Treasuries.  In either sequestration scenario detailed above, a mild recession could be in the offering. 

Most importantly, continue to examine your need for funds from a timing perspective and be clear about the volatility you would face in your allocation during that time.  From there you can make some very educated decisions.  We would welcome the opportunity to run this analysis for you and I think it's the most important data point you can have.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

Beating (Low) Expectations

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Beating (Low) Expectations
Weekly Market Commentary 2-11-13
Tim Phillips, CEO—Phillips & Company

As we have written about previously, beyond the noise of headlines, what really drives stock prices is earnings. The S&P 500 has been approaching all-time highs, and as of last Friday, according to FactSet, 72% of S&P 500 companies reported better earnings than analyst estimates for Q4. Also, 67% of those companies had better sales than estimated.

Part of this, however, is because expectations for earnings and sales were set low to begin with. Since last summer, there have been more earnings estimates by analysts revised downward than upward.

Image source: Bespoke

Companies seem to be keeping investor expectations cautious for this quarter as well. FactSet reported that “63 companies have issued negative EPS guidance for Q1 2013, while 17 companies have issued positive EPS guidance.”

Image source: Bespoke

Cautious expectations are not without merit, as we did see negative GDP growth last quarter, and policy concerns remain.

Then again, continuing to have a low bar for expectations could set us up for another round of beating estimates for next quarter. It’s worth noticing that institutional investors don’t seem to be spooked by the low expectations; in fact, according to Thomson Reuters, money has been moving into equity funds at rates not seen since the year 2000. If the bar continues to be set low and if companies continue to leap over it, the market could continue to rally.

We remain with the view that the best approach is setting a long-term asset allocation, sticking with it, and tuning out some of the noise.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company
Alex Cook, Investment Analyst – Phillips & Company

Policy Errors, Part II

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Policy Errors, Part II
Weekly CEO Commentary 2-4-13
Tim Phillips, CEO—Phillips & Company

It's official: the threat of massive cuts in spending with the fiscal cliff created a contraction in our economy.  According to the Financial Times, GDP as reported this last week contracted by 0.1%,  which is a drop from positive growth of 3.1% in Q3 to a drop in Q4.

Much of the drop resulted from a contraction in defense spending, which dropped by 22% or 1.3% of GDP, according to reports in the Financial Times and the Washington Post.  The Defense Department foretold steps they would have to take in preparation for sequestration, even if it were delayed. As early as February 2012, Defense Secretary Leon Panetta asked Congress to undo sequestration, saying, “There is very little margin for error in this budget.” Defense contractor Lockheed Martin announced layoffs in September, citing declining military spending as one of the reasons.

More recently, Ashton Carter, the Deputy Secretary of Defense, stated in a memo to the Department of Defense on January 10, 2013:

“The possibility of sequestration occurring as late as the beginning of the sixth month of the fiscal year creates significant additional uncertainty for the management of the Departments…I therefore authorize all Defense Components to begin implementing measures that will help mitigate our budget execution risks.”

The memo went on to outline hiring freezes, cuts in the Defense Department’s civilian workforce, and other measures.

What this means

It's critical to realize nothing actually happened from a policy standpoint. There were no mandatory cuts or congressional action–just simply the threat of massive cuts, which caused the Defense Department to scale back in preparation.

Generally when we wind down from a war, we collect on a "peace dividend", or cuts in defense spending, similar to the end of the Cold War. In the 1990's, the economy was growing at an average of 3.3% according to Bloomberg, so any cuts in defense spending after the Cold War were easily offset.

Today, it's an entirely different story.  While consumer spending expanded by 1.52% of GDP, it's not enough to help offset such a major impact on Defense.  We simply didn’t grow our economy fast enough to take massive cut's in any one component of GDP.

Source data: Bureau of Economic Analysis

Consider Q4 2012 to be Policy Error I.  Regrettably, we still face Policy Error II.  The "Political Class" kicked the can on sequestration until March 1. If we have a repeat of Q4 2012, that would be two quarters of contraction.  That would be the official definition of a recession. 

Market participants are clearly forecasting a resolution to this problem, as the S&P 500 is trading near all-time highs.  Let's hope they are right.  A 2% GDP growth economy is not enough to offset massive immediate cuts in consumption, government spending or business investment.  I would keep your foot on the gas and the brakes at the same time with your portfolio.  Don't give up on your fixed income allocations.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

Measuring Sleepless Nights

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Measuring Sleepless Nights
Weekly CEO Commentary 1-28-13
Tim Phillips, CEO—Phillips & Company

I was recently asked by a client to explain what standard deviation is as it relates to investments and what's a good number.  Two things struck me about the questions.  One, it's a great question that merits an answer, and the other is a reminder to all professionals in my field, including me, to speak English and not complicate matters.

Most of you reading this will likely care very little about the standard deviation of your portfolio.  You outsource those issues to us and depend upon our background, experience and analytical ability to deal with such technical issues.

What I have learned though over the many years is that standard deviation impacts every investor in a very personal way.  Allow me to explain.

Standard deviation (which we will abbreviate as SD), when it relates to your portfolio, is a measure of how much your portfolio moves up and down from its average return. Basically, it is a measure of volatility.

As you can see from the table above, a sample 60% Equity/40% Fixed Income portfolio over a 10 year period has an average return of 6.62% with an annualized SD of 9.03%.  That means in any one year period given a 1 SD event, this portfolio could move up or down from its average by 9.03%, to -2.41% or 15.65%.

Unfortunately, this is not very real world.

What constitutes a 1 SD event?  That's a really hard question to answer as almost everything falls within a 1 SD event: earnings reports, economic releases, government interventions (tax policy and budget problems) interest rate movements—the list can go on.  You can see from the table below that 95.5% of the issues that impact a portfolio are within a 1 SD event.

Table: Percentage of standard deviation events by time period 

Source: CFA Institute

To add a bit more real world to this example, let's take a look at pretty big standard deviation periods.  According to the CFA Institute, "the largest positive [SD] event of all time occurred on 13 October 2008, when the S&P 500 surged upward 11% registering as an 11.82 [SD] event.” This was due to central banks coordinating easing policies to calm credit markets.  Meanwhile, the largest negative SD event was the famous 19 October 1987 crash, which was a whopping 20.98 SD event! (I have experienced both as a professional advisor as I am sure many of you have as an investor).

Table: Actual number of standard deviation events.

Source: CFA Institute.

Conclusion

In real world terms, standard deviation is a measurement tool that should be used by you to measure your threshold for pain, ability to withstand that pain, and time needed to survive it.  If you think you might lose sleep at night when your 60/40 portfolio drops by 1 SD or 9.03%, you might have to get used to sleeping less.  It's a fairly regular occurrence—but it also happens on the upside as well.

Of course, we spend considerable time trying to reduce the SD in a portfolio while minimizing the impact on the returns you could experience.  Pragmatically, it's really your ability to deal with the standard deviation/volatility that allows us to generate the returns you need.

That's why I always remind investors that sometimes going overly conservative and sleeping well today may not lead to living well tomorrow.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company


American Consumerism

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American Consumerism
Weekly CEO Commentary 1-22-13
Tim Phillips, CEO—Phillips & Company

If the S&P 500 is any guide, the American Economy is back on track.  Reuters reported that we hit a five-year high on the index last week, and it also appears we will not have a nasty showdown over the debt limit in the coming weeks—all good news indeed.

The question that still looms large in my mind is will the American Consumer return to his or her normal ways?  When I mean normal, I am referring to borrowing and shopping.

So far, this post-recession recovery has been exceedingly muted.  According to Bloomberg, we are averaging about 2.25% in real GDP growth since the economy bottomed out in Q3 2009.  While that does not seem so bad, it actually is low when it comes to recession recoveries, which historically have been 3.0% in real terms, and 6.3% in nominal terms.


With 70.4% of our GDP driven by consumption, it's important to ask, has consumer behavior changed—and if so, when will it change back to normal?

Much of what drives consumerism in America is expectations.  Consumers that have positive expectations tend to spend more and save less.  The best indicator of consumer expectations is from The Conference Board that measures consumer confidence.  Unfortunately, consumer confidence dropped last month, and has yet to reach pre-recession levels, according to Bloomberg.

Even more troubling is consumers attitudes towards a return to normal. According to the latest COUNTRY Financial Security Index survey, just 27 percent think the old, pre-recession economy will return. Half of these Americans don’t expect to see it return until 2015 or later.

The survey went on to suggest that 35% of Americans are dealing with the "new normal" by cutting spending or downsizing—not exactly the news you want to hear if you’re betting on a quick recovery in consumption. 

According to the Senior Loan Officer Survey from the Federal Reserve, demand for consumer credit weakened a bit in the fourth quarter. A net 8.5% of banks reported stronger demand for credit card loans, compared with 11.1% last quarter. A net 16.9% of banks reported stronger demand for auto loans, compared with 33.3% in the third quarter. And, a net 4.8% of banks reported stronger demand for consumer loans excluding cards and autos, compared with 10% in the third quarter. While we do not want to go back to the extreme levels of debt that got us into the crisis, it is clear that consumer’s appetite to take on credit has weakened to some extent.

Housing

Before we write off American Consumerism as dead, we should test all of this negativity against the largest purchase a consumer makes: their home.  It appears home ownership, in spite of the trillions lost and millions of foreclosures, still appeals financially to the vast majority of Americans.

Attitudes and fear appear to be immovable objects when it comes to a return of the American Consumer.  I would not bet in the short run on the type of consumption habits that we saw in 2006 or 2007.  However, I would also not bet against the long range return of the consumer.  I would adjust my holdings to reflect those beliefs as we have done in many of our allocations. 

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

Diversification Finally!

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Diversification Finally!
Weekly CEO Commentary 1-14-13
Tim Phillips, CEO—Phillips & Company 

For the last couple of years, investors that followed the easiest thing in finance, diversification, were not properly rewarded.  In fact, a heavy emphasis on US Large Cap stocks was a fairly rewarding experience.  From January 2009 to December 2011, the S&P 500 had an annualized return of 14.12 percent, according to Bloomberg.

For many wealth management firms and "Too Big To Fail" banks, this was a particularly rewarding experience.  Most of these institutions have a bias toward US Large Cap because it's easy to research and clients generally don't question what they know: large, familiar US companies.  Behavioral scientists call this a “home bias”.

Unfortunately, my concern is investors have become complacent with the previous wonderful US Large Cap returns.

This past week might have marked a return to rewarding diversification, where we saw the largest flow of funds into long-only equity funds since March 2000, according to Business Insider.  Bloomberg also reported that last week was the 18th-consecutive week that emerging market stock funds showed inflows, showing that investors have been moving into asset classes aside from just US Large Cap.

Why diversification works

What makes diversification work is something called correlation: the way in which asset classes move in the same direction and to what degree. The highest possible correlation is 1, meaning the asset classes are moving in the exact same manner.  As investors, we want to see low correlations, meaning our portfolio isn’t as affected by a swing in one of our holdings.

In 2008, we saw correlations come together.  It's what you would expect when markets are under so much distress; investors sell everything and move to cash, so correlations tend to get closer to 1. Below is a table of correlations in 2008 from Bloomberg:

Now, here is another correlation table from Bloomberg for the second half of 2012.  When you compare the two, you can see asset classes are starting to decouple—hopefully rewarding diversification.

It's important to remember that in any given year, there will always be at least one asset class that outperforms a diverse portfolio.  For example, if you rolled the dice and invested heavily into real estate investment trusts in 2006, your portfolio would have easily beaten a diverse portfolio. REITs returned 35.1%, whereas a sample diverse portfolio only returned 15.2%, according to JP Morgan. Unfortunately, in the following year, REITs were the worst performing asset class with a drop of -15.7%, whereas diversifying across asset classes gave positive returns. Below is a table from JP Morgan illustrating this:

The "Free Lunch" of diversification comes in the form of reduced risk and smoother returns in the long run. Investors may have piled into US Large Cap equities because they are familiar—and because they have indeed performed well in the last few years—but our expectation is diversification will be rewarded over concentration going forward.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company


Precisely Inaccurate

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Precisely Inaccurate
Weekly CEO Commentary 1-7-13
Tim Phillips, CEO—Phillips & Company

This is the time of year when firms roll out their predictions for 2013.  Honestly, if they were so accurate they wouldn't need clients, nor would they share their information.  It would be too valuable.

However, firms understand one thing about investors; they love predictions.  I call it the "Prediction Addiction".  There is plenty of behavioral science research that supports this phenomenon, and mostly it comes down to our preference for certainty—even when it means inaccuracy.

Just take a look at the last year's market forecasts of top firms.  Remember that the S&P 500 closed at 1426.19 at the end of December 31, 2012, and GDP growth through Q3 2012 (the most recent set of data available) was 3.1%.  How accurate were these forecasters?

Perhaps the collective wisdom of all the firms, by looking at the average predictions among them, is the best relevant tool.  Regrettably though, when you look at last year’s average prediction among those eight firms, it was also inaccurate. The average among those firms was 1341—off by 85 points, or 6 percent. That may not seem like much, but keep in mind that the S&P 500 was up by 13.42 percent last year, according to Bloomberg. A miss of 6 percent is a miss of almost half of the S&P 500’s returns.

In light of this repetitively inaccurate exercise in forecasting, we thought we would simply publish others attempts at guessing where the market would end and how much GDP would grow this year.

The bottom line is very few of us will profit from these parlor tricks.  Making a very precise prediction may sound good; however, the more precise a prediction is, the less likely it is to be accurate.

Our predictions:

  • Diversification will be rewarded this year as correlations among equity asset classes decouple.
  • Emerging Markets finally have a recovery and outpace US equities, especially China and Russia.
  • International Developed and Emerging Small Cap stocks will have the biggest risk to reward opportunities, especially Japan.
  • Emerging Market Debt and International Developed Debt will offer better upside than US High Yield.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

All The Times I Thought I Should Sell: Panic

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All The Times I Thought I Should Sell: Panic
Weekly CEO Commentary 12-31-12
Tim Phillips, CEO—Phillips & Company 

As of this writing (Sunday Night) the Political Class in this country has failed to come to terms with over 500 billion in tax increases and spending cuts that will take place throughout 2013. This chart below from Goldman Sachs shows the projected impact of these measures on GDP next year.

According to Bloomberg, most Wall Street firms are forecasting GDP growth of 2.0 percent for next year, or approximately $316 billion based on the current GDP number of $15,811 billion.

As we wrote previously, Credit Suisse estimates a most-likely case drop in GDP growth by 1.5 percent from the fiscal cliff. It’s just simple math: if our baseline growth is only 2 percent, and if the impact from the fiscal cliff is 1.5 percent, that takes our economic growth down to almost zero.

So, one might think we would fall into a mild recession or a near zero growth economic environment.

As I have said in the past, I am hopeful something permanent will be resolved and allow the US economy to continue to slowly recover.  However, there is always a little part of me that thinks, sell.  It's only through 27 years of experience that has me fight that bias and reflect on all the times in the past I thought I should sell.

Here’s a table with some of the troubles I have seen in the past, and how much the market has risen since then:

As you can see, after each event, a recovery was forthcoming and those that would have sold and panicked would have paid dearly. In fact, some of the best performance came immediately after the market bottoms.

The rational things to do in times such as this are to assess your time horizon and reconfirm your targeted rate of return.  Be certain you know what you’re trying to achieve with your investments and if you are not clear, gain clarity and alignment with your advisor. 

Unfortunately, of all the times I thought I should sell, this one seems like the silliest.  The political class in this country has become tone deaf and has lost perspective on how much pain and suffering comes from their inaction.

As for specific actions, we continue to favor assets that pay a return while we wait.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company


Really?

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Really?
Weekly CEO Commentary 12-24-12
Tim Phillips, CEO—Phillips & Company

While I was traveling through India in April I snapped the photo you see on the header of this blog.  I've looked at it several times over the course of this year and I finally figured out what his expression suggests: Really?!

I can only imagine that same look on his face if he considered what the political class is incapable of doing in our country: Solving our fiscal issues.

Consider the following numbers. The difference between the President and the Speaker on spending and revenue is only $200 billion. That's $200 billion over 10 years, or $20 billion a year.

Now consider that last week, we saw a spike in the Volatility Index—a measure of fear in the market—and we also saw consumer confidence fall to a five-month low. On the other hand, we also saw GDP growth revised up to 3.1 percent—not bad at all—and we saw a better than expected report on durable goods orders. There may be fear in the market, but the economy is showing signs of resilience.

If the political class cannot come to terms on a solution, we will face significant uncertainty, and that's not good for our economy. Let’s not ruin things over $20 billion per year.

If you consider a 1% drop in equity markets, as measured by the S&P Composite 1500 broad market index, that would be equal to $145.2 billion in equity stripped out of our asset base and economy.

A 5% drop would be $707.98 billion in equity.  When we are only talking about $20 billion in revenue and spending per year, the only thing one can say is, really?

Now consider how much we spent on stimulus ($819 billion) and how much Federal Reserve intervention was taken (over $2 trillion) to save our economy from ruins.  Again, reflect on the small difference that separates the two Parties and what their indifference can do to our economy.  Really?

This type of decision making process is what makes a third-world country risky to invest in.  Political risk should be left for others—not America.  Really?

I'm still hopeful we will see a resolution and continue to see our economy work its way back to a more prosperous growth footing.  Perhaps that's just hope.

After all, this is the season of hope.

Wishing you a very Merry Christmas and the Happiest of Holidays.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

Don't Look Down: The GDP Growth Clfif

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Don't Look Down: The GDP Growth Cliff
Weekly CEO Commentary 12-17-12
Tim Phillips, CEO—Phillips & Company

This week the Federal Reserve took another step in encouraging risk taking by shifting their communication policy.  They effectively went to a rules-based approach to managing interest rates.  In short they said as long as unemployment was above 6.5% and inflation was below 2.5%, we could expect near zero interest rates:

“…The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

-Federal Reserve press release on December 12, 2012

Couple this with their prior statement in September when they committed to keeping rates very low until 2015, and it's easy to conclude we are in for a slow growth economy.

Fortunately, we can now almost build a matrix or grid to calibrate interest rate expectations.  While the Fed gave themselves plenty of room to maneuver in their statements by suggesting other factors would be taken into consideration, it's quite clear we now have some specific rules of thumb to rely upon.

For example, if we added 150,000 jobs per month and keep the labor force participation at 63.6% of the population it would take roughly 3 ¼ years around 2016 to get us to the 6.5%.  In fact, I have included a link from the Federal Reserve Bank of Atlanta that will let you run your own scenarios.  

What happens if we change the participation rate?  After all, when the economy heats up more people will likely jump back into the labor market.  Take the 150,000 jobs per month and simply increase the participation rate to 65% and we are talking about 9 years to see interest rates rise and unemployment drop below 6.5%.

Behaviorally, you might think it's time to run for the exit on your equity investments—but once again, the counter-intuitive point might be better with finance. Historically, according to Goldman Sachs, there is little correlation between GDP growth and equity returns, Also, interestingly enough, the Goldman study suggests that the relationship between equity returns and GDP growth actually shows better returns during slower GDP growth. Here is a chart below from their study:

Further, when you look historically at different inflation and interest rate environments, we can see that with low and rising inflation, all asset classes showed positive returns, according to JP Morgan’s chart below:

While the Fed through their actions signaled we are actually well over the GDP Growth Cliff, it certainly does not suggest we should sell and hide.  Quite to the contrary, it might just suggest that we don't look down. 

Newtown

All of this seems trivial in the face of such a horrific event in the Sandy Hook village of Newtown, Connecticut.  Every one of us at Phillips & Company extend our deepest sympathy and heartfelt thoughts and prayers to all those suffering and grieving, especially our clients and colleagues in Connecticut.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

It's Never Quite What You Expect

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It's Never Quite What You Expect
Weekly CEO Commentary 12-10-12
Tim Phillips, CEO—Phillips & Company 

If you followed your instincts and sold out of your equity positions 3 weeks ago, you would have missed a 2.25% return.  Certainly you would have been reacting to your instincts that tell you the political class in this country will not resolve our fiscal issues without a messy fight.

Your instincts would have also told you the last time we saw such a fight—the summer of 2011 with the debt ceiling—our markets dropped precipitously. We saw a drop of 16.5% from May 18, when negotiations started to break down, to August 8, the Monday after the US credit rating got downgraded.


Your next thought might be to simply sell out and avoid a possible drop.  The problem is that now you’re in the slippery slope of market timing, and we all know where that leads.

The political class has been playing chicken with a very fragile economy, destroying the confidence of business and consumers, and the media has been painting a doom and gloom scenario. But, the reaction of market participants has been quite the opposite from what you would expect.  They have been buying.

Could it be the underlying economic data suggests something else is occurring?  When you look at the recent jobs report, you see a fairly stable picture of employment.  While the participation rate in the labor force is indeed down, companies are still hiring—albeit at a very slow and steady rate.  According to Dismal Scientist, US companies added 147,000 jobs in November, just enough to keep up with new entrants to the workforce.

Consumers are certainly willing to take on more credit to express their desire to spend.  Our recent report on Consumer Credit contained some interesting data.  

According to Dismal Scientist, Consumers borrowed 14.2 billion dollars in October with 3.4 coming from revolving credit (basically things you buy on your credit cards).  Overall this reflects a 6.2% increase on a YOY basis.  What is really impressive is the consumer is willing to make non-revolving purchases on things like homes and autos.  On a non-revolving basis, consumer credit expanded 7.1% on a YOY basis.

While this data reflects on behavior from two months ago, and I certainly expect a slowdown to some degree, it's not likely the consumer will shut down like we saw in the last recession.  Between a decent jobs report and consumers feeling confident enough to borrow, the de-leveraging trend we have seen in household balance sheets might be easing and allow for some economic tailwinds.  

Perhaps that is what market participants are seeing as they bid up stocks despite the incredible uncertainty surrounding the circus in Washington DC.

My recipe for working through the next several weeks is quite simple:  look past volatility, be ready to deploy any dry powder during a significant pull back in valuations, and don’t anchor your investment timeframe on political noise.

Of course, you could continue to buy in defensive sectors like consumer staples or healthcare, as well as income paying assets.  However, nothing is really safe from the circus in the short run.  It only takes one clown nowadays to make a circus and we have a wide variety of actors to choose from.

Panic and emotional reactions are not an investment strategy, and besides, we have all been fooled plenty of times as the markets never react quite the way we expect them to.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

Weekly Market Commentary 12-3-12

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Stock Buybacks: Headline Investing or Looking Under the Hood?
Weekly CEO Commentary 12-3-12
Tim Phillips, CEO – Phillips & Company

Stock buybacks are expected to be on the rise, according to a report in the New York Times. We have already seen Starbucks, Procter & Gamble, and Chipotle announce buybacks, and ADT has announced both a buyback and a dividend. In the past, buybacks were generally viewed as a bullish sign, but there is more to the story. Here is what investors need to look out for to stay prudent.

Why do companies buy back stock?

As investors, the whole reason why we buy a piece of a company is to get a return on our investment. We can do this by either having the value of the stock increase in value, or we can get a return by the company paying a dividend. From a longer term perspective, if the economy is strong and there are lots of growth opportunities for the company, a way to increase value could be for the company to invest back into its own operations and grow the business further.

Clearly, we’re not in an economy where growth opportunities are abundant. But, corporations are sitting on record amounts of cash, so what do companies do to satisfy their investors?

When there aren’t many opportunities to re-invest into their own business, companies have two options. One of them we already discussed which is paying a dividend, but another option is for a company to buy back its own stock from the open market. Like any stock purchase, this puts an upward pressure on stock prices, which is good for investors.

But, there are some things that investors need to watch out for when it comes to stock buybacks.

The earnings management game

“Facts are stubborn, but statistics are more pliable.” –Mark Twain

Stock buybacks can create the illusion of growth when there really isn’t any. Let’s take an example of a fictitious company that has 10 shares of its stock outstanding, and the company makes $50 per year. This means the company has earnings per share of $5. Now, let’s say that one year later the company bought back two of its shares on the open market, and earnings stayed the same at $50. The company would now have earnings per share of $6.25.

That would make earnings per share look like it grew 25% in a year—seems pretty good in this economy!

But, let’s take a step back. Earnings didn’t really change at all; it was flat at $50 in both years. The only thing that changed was the number of shares on the market went from 10 to 8.

Earnings per share growth is one of the more common ways investors use to evaluate companies, but investors need to take this number in its appropriate context. If revenue growth or growth in operating cash flow is flat, but earnings per share growth is high, that might be a red flag that investors need to do some more research.

Real world data: Do buybacks actually work?

Some companies have had better success than others in giving shareholders value through stock buybacks. Fortuna Advisors and Institutional Investor magazine put together a study, where they ranked “the biggest spenders on buybacks among the members of the S&P 500 based on the two-year returns their repurchased generated.” Of the 253 companies they examined, the data shows quite a bit of disparity.

Here’s the return on investment over the last two years on the 10 best and 10 worst buybacks.

The real world data shows that buybacks have the potential to return value to shareholders, but they are by no means a cure-all if there is a more serious economic problem with the business.

The tax management game

We’re still waiting on the details of what will happen in the fiscal cliff negotiations. As we wrote about previously, one thing we do know for sure is that if nothing changes, the tax rates on dividends are set to go up significantly. The worst case on a dividend tax rate would be a maximum rate of 43.4%, and the worst case on a long-term capital gains rate would be 23.8%.

If this happens, investors may pressure companies to buy back stock rather than pay dividends, as the capital gains would be taxed at a lower rate.

Conclusion

With corporations sitting on large amounts of cash but not many opportunities for growth, expectations are that shareholder buybacks are going to be on the rise, and an increase in the tax rate on dividends could fuel this.

Even though the earnings per share growth would be manufactured from a buyback, I wouldn’t bet against irrational exuberance and investors chasing the headlines. When investors see 15% or 20% earnings per share growth rates, regardless of what the true cause was, we could see a round of speculative buying.

Investors need to be careful though. Buying back stock can, in theory, boost stock prices, but the actual results show there is a significant amount of variance in performance after buybacks.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

Weekly Market Commentary 11-26-12

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The All Consuming Fiscal Cliff
Weekly CEO Commentary 11-26-12
Tim Phillips, CEO – Phillips & Company

It's clear that Thanksgiving dinner could barely wrap up as the shopping began.  Stores opened as early as 8 PM on Thursday to get a jump on the most important tradition Americans share: consumption!

CNN reported that shopping was up 9 percent on Black Friday alone and up 13 percent over the whole four-day weekend compared to last year. Also, they reported that Internet sales were up 26 percent over last year and set a new record by breaking above $1 billion. Clearly, the US consumer doesn’t seem swayed by the uncertainty around the threat of higher taxes. 

I had a fulsome discussion with Jon Talisman, a leading expert on tax policy from the Washington DC based Capitol Tax Partners. It might be helpful to consider the impact on consumption from some of his thoughts. After all, 70%+ of our economy is based upon our willingness to shop. 

As you can see from his bio, he has clearly spent time with those that are in control of the outcomes on taxes in the coming years.  Here is a link to our first in a series of 4 conversations that will take place over the next several weeks, in MP3 format.

The good news

People at specific income levels consume a certain percentage of their income. As you can see in the chart below, those in the lowest levels consume more than 1.6 times their income, generally through government transfer payments to them. Those at the very highest income level consume about 9% of their income.

For our purposes, it's not necessary to calculate which quintile consumes the most in aggregate dollars, but rather to examine the income impact for those in each quintile based upon some proposed tax scenarios.

First, let's look on the chart below at the income impact from an idea to cap overall deductions to $50,000.


For those in the lowest quintiles, the tax impact is negligible.  For those earning, $100,000 the impact is still negligible.  While the impact on the top quintile is more pronounced at almost a 1% drop in after tax income (that's about $21,000 in additional taxes that won't go to their consumption), this is also a group that only consumes about 54% of their incomes—not a small amount, but not enough to drop us off a consumption cliff either.

Those earning over $7 million would see a drop in after tax income of 2.4%, or $194,000 on average. What decision would a person making over $7 million make regarding their consumption? Probably nothing different.

Here is a chart giving a look at the projected impact of a tighter cap of $25,000 on itemized deductions.  Again, there is nothing that suggests a shut down the great American tradition on spending and consumption.

Given the fear in the market, if the ultimate solution is a cap on deductions, we could see an upside surprise to low expectations on consumption.  The hard data suggests we just wouldn't see the impacts being talked about under that scenario.  Don't get me wrong: no one wants to pay higher taxes and I'm not supporting that as a position.  I'm simply trying to determine if we will fall off a consumption cliff if certain tax measures are implemented.

Based upon income levels associated with consumption and tax increases, it doesn't appear to pose a threat to our American tradition.

The bad news

However, if we do not have a definitive agreement and we were to fall off the fiscal slope, consumption would indeed take a hit.  When you consider all that is going to expire—the Social Security payroll tax cut, the lower income tax rates from the Bush tax cuts, the lower tax rates on dividends, the “patch” on the Alternative Minimum Tax—you can see how consumption would be impacted across the board.

Below is a graph showing the percentage change in federal tax rates if everything in the fiscal cliff hits.

Conclusion

It's clear that policy makers know what is at stake.  If they implement a cap on deductions or something similar, we wouldn’t get a major negative shock on consumption.  If we get no agreement and taxes go up on everyone, then there will be pain felt across the spectrum. The problem with playing chicken on policy is the small chance of something big and bad happening. 

What investors can do:

  • Look past volatility in the short run.
  • Recalibrate your time horizon in the markets. Don't have assets that you will need in the short term exposed to excess volatility.
  • Calculate your future liabilities and determine if your current portfolio is meeting those or taking too much risk.
  • Email your representatives in Congress and demand that they solve this game of policy chicken.

While the fiscal cliff seems scary enough, it's really the consumption cliff that we need to avoid.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

Fear or Rationality

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Fear or Rationality
Weekly CEO Commentary 11-19-12
Tim Phillips, CEO – Phillips & Company

With the markets down 3.7% in the last three weeks, it's easy to think investors are fearful.  Or, they could also be rationally pricing in some legitimate issues.

Let's take the fear side first.  It's easy to be fearful of the fiscal cliff, as it has significant economic importance to future growth.  According to Credit Suisse, the most likely case after negotiations are finished is a -1.5% drag on GDP growth.

It's also important to consider these cuts not as a cliff, but perhaps something much more gradual.  As you can see from the graph from Goldman Sachs below, the economic impact is expected to come over the course of the year. As for reasons to sell assets immediately, that would fall on the massive increase in capital gains taxes as well as increased tax on dividend and interest.

However, both parties agree that one critical component of any deal cannot be policies that hurt growth in our economy.  According to MarketWatch, President Obama has been in conversations with business leaders to try to mitigate the impact of the fiscal cliff, including names such as Jamie Dimon (JP Morgan), Tim Cook (Apple), and Jim McNerney (Boeing).

Representative Tom Price, the chairman of the Republican Policy Committee, also spoke on CNN’s State of the Union on November 18, saying “We want a real solution, which means increasing tax revenue through pro-growth policies.”

Certainly it is plausible that investors are selling from fear of the unknown.  But, for investors that are collecting some very large yields from investments bought cheaply, selling is much harder to do.   For example, if you bought GE at its price of $7.60 on March 2, 2009 you would be receiving an annual dividend yield of 8.9% with today’s quarterly dividend of 17 cents per share. To put that 8.9% in perspective, buying GE today has a current dividend yield of only 3.3%.  It’s hard to sell something that gets you generous cash flows, when you would have to re-invest in much lower yields today.

Rationally, there could be more to this pullback than fear of the unknown.  As we mentioned in a past blog, earnings matter most when it comes to driving stock performance.

With earnings season wrapping up soon, we now have a clear picture of what's going on.

According to Bespoke, more analysts are now revising earnings expectations downward and more companies are lowering guidance than this time last year. More troubling, however, is that 58% of S&P 500 companies missed expectations on sales last quarter. 

You can see from this data that overall, earnings and revenue growth are showing some deterioration.  But, there is a bright spot in retail. As we wrote about in a previous blog, the American consumer has been surprisingly resilient.  According to FactSet, estimated Q4 earnings growth is expected to be high in apparel retail, stemming from “Black Friday” and holiday shopping.

I believe this might be a small earnings recession that you would see in any business cycle. 

It might just be magnified as we are in a slow growing economy—but one that could erupt with growth if we could eliminate the fear that is plaguing investors and consumers.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Alex Cook, Associate – Phillips & Company

Weekly CEO Commentary 11-12-12

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The Emotional Cliff: Jumping is not a Strategy
Weekly CEO Commentary 11-12-12
Tim Phillips, CEO – Phillips & Company

Before I get into my market commentary, I want to take a minute to extend a thank you to all of our veterans and active duty military personnel for all of the grueling hard work and sacrifices that they make for our country. We hope everyone deployed overseas comes home safe and can enjoy a little down time for the holidays.

Investing after the election

It seems that the investor class is taking the election results very hard.  As Phillips and Company serves literally thousands of business owners and employees with defined contribution accounts, we have a decent view on attitudes. It's clear that investors are worried and perhaps fearful.

The election results could have a significant impact on personal income taxes, as well as taxes on dividends and interest.  After all, it was perfectly clear that taxes were going to change for upper income earners no matter who won.

Tax rates[1]


Before we all jump off the emotional cliff, let's just step back for a moment and evaluate a few of issues.

What's in your control - Expectations

First, when you invest, you should be looking to meet an overall objective.  In my opinion, the number one objective is to meet some kind of expected rate of return.  That target rate should be set by your future needs or liabilities, and your target rate should not change with election results. However, if you want to lower your expected rate of return, you could spend less today to have more tomorrow.  If you want to spend more tomorrow, you can take more risk and increase your expected rate of return.

You can see nothing political drives your expected rate of return, and whether or not you meet that expectation is another matter.

How serious are we about debt?

Second, while the consensus opinion might suggest tax rates are going up, I want to advance another perspective.  It's possible rates might not change at all.  In fact, we might see rates lowered.

“Let's extend middle class tax cuts right now. Let's do that right now. That one step would give millions of families, 98% of Americans, 97% of small businesses, the certainty that they need going into the new year.” –President Barack Obama on November 10.[2]

“It’s clear that there are a lot of special-interest loopholes in the tax code, both corporate and personal. It’s also clear that there are all kinds of deductions, some of which make sense; others don’t. And by lowering rates and cleaning up the tax code, we know that we’re going to get a lot more economic growth.” –House Speaker John Boehner, November 9.[3]

You can see both party leaders are thinking along the same lines. Perhaps deductions might be trimmed, but actual rates could be lower. Or, perhaps spending cuts might not happen as fast in order to keep tax rates on dividends low.  We will see how serious politicians are about cutting spending in the face of certain higher taxes. 

No one questions the fact that for our country to resolve our fiscal issues, it's not income or debt alone that will do it.  Growth is really the only big solution. Clinton era tax rates worked in the face of a massive technology boom not seen since the transcontinental railroad, with an average GDP growth rate of 3.8% from 1993 to 2000.[4]

It's also clear we are not facing the growth rates Clinton era economies experienced.  I would not be surprised to see much less rhetoric about spending cuts, in exchange for some compromise on tax rates and deduction caps. 

Don't bet against stability

Third, I often site John Maynard Keynes when he says: “It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain.” Keynes wrote in his book The General Theory of Employment, Interest and Money about the importance of investors having certainty of what kind of fiscal policy to expect.

If we get some answers from Washington about policy—regardless of the answer, but as long as it clears up uncertainty and confusion—I think a couple of things happen:

            A)  US corporations that are sitting on historic levels of corporate cash would begin to invest in expansion.  Corporations are currently sitting on $392 billion in cash, and the average over the last 20 years is only $193 billion. If that extra $199 billion gets deployed, that could add 1.3% to GDP.

            B)  Banks are sitting on $1.4 trillion in funds above and beyond their reserve requirements. Normally, banks keep as little excess reserves as possible, as banks want to make money by lending.

Clearly, the supply of loanable funds is ample. The problem at the moment is a lack of demand, and lack of banks willing to take risk.

Keep in mind that banks can lend at 10x the amount of reserves, so a $1.4 trillion reserve amount could lead to $14 trillion in lending over the years to come.  I would not want to bet too much against the American Consumer to tap into this source of "consumption cash" when they get the urge.  Just take a simple formula of as little as $500 billion in additional loans for consumption or capital investment.  With current US GDP at $15.1 trillion, an extra $500 billion would add 3.3% in GDP growth.

A special note on inflation control:

One common concern I hear is all of this liquidity can cause inflation.  On its own, there is no question it can.  However, a little known piece of the Emergency Economic Stabilization Act of 2008 (the TARP “bank bailout” law) now allows the Federal Reserve to pay interest on bank deposits held at the Fed.

What this means is that the Fed can get another measure of control over the flow of this capital. For example, if the Fed wants to hit the brakes on inflation, they could raise the interest rates on deposits held at the Fed, and banks will be more likely to park their cash, rather than making loans. With a natural productive capacity of 3% growth a year without too much inflation, we now have a standard. The boom years of the 1990s gave us 3.8% annual GDP growth with an average inflation of only 2.6%--in line with historical averages.[5]

Conclusion

While I have been warning against some massive volatility in weeks to come, there are just too many strong factors that suggest a run to cover approach.  Unless you can lower your lifestyle in the future and change your expected rate of return you need, allocation will matter the most in meeting your lifestyle and planning needs.  Jumping off the cliff is not a strategy.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Alex Cook, Associate – Phillips & Company



[1] Source: “Top small business tax-saving moves for remainder of 2012”, Thompson Reuters, Nov. 12

[2] Source: “Obama demands fast action on fiscal cliff, including tax hike on wealthy”, CNN.com, Nov. 10

[3] Source: “Boehner, Obama start to agree: Limiting tax breaks”, The Wall Street Journal, Nov. 9

[4] Source: Bloomberg LP and Federal Reserve Economic Data.

[5] Source: Bloomberg LP


Weekly CEO Commentary 11-5-12

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Does It Matter
Weekly CEO Commentary 11-5-2012
Tim Phillips, CEO – Phillips and Company

Of all the times to not be political, now is one of the best.  In what looks like a very close election and polls suggesting an evenly divided country, I am sure emotions are running very high.  Out of respect for our equally divided and diverse client base, I think its best I focus on what we all are:  The Investor Class.

If you have a 401(k) with your company and we provide advice, you’re part of the Investor Class.  If you’re a CEO and we manage your wealth, you’re part of the Investor Class.  If you sit on one of the many committees for the foundations or endowments we advise, you’re part of the Investor Class.

The most important thing to the Investor Class is the macro environment in which we operate.  The overall economy is slowly improving.  We added 184,000 private sector jobs in October which was spread across several sectors according to the BLS:

  • Construction
  • Manufacturing
  • Retail
  • Professional and Business Services
  • Leisure and Hospitality

Especially helpful were those jobs added in construction and manufacturing, 17,000 and 13,000 respectively.

US GDP grew at an annualized rate of 2% in the last quarter according to the BEA. By all measures, this will not create enough jobs to dramatically reduce the 7.9% unemployment rate; however, it will keep us from slipping into a recession.  

In fact, at the current rate of new jobs (184,000) it will take almost 4 years to see the unemployment rate drop to 5.5%.  Don't take my word for it; the Federal Reserve has a pretty nice calculator to help figure it out. 

Unfortunately, trying to forecast the future based on historical data is a bit like driving while looking in the rear view mirror.  As we have discussed in past posts, earnings are what really drive equity performance and in our current case, earnings are coming in very weak. 

According to FactSet, the S&P 500 blended earnings growth for the third quarter this year is -0.5%. If this number remains negative it will mark the end of the eleven-quarter streak of earnings growth for the index.

There’s plenty to drive the retail investor crazy with concern.  In fact, it's just the thing short-term money does: go crazy and run for the exits.  You can see from the chart below, institutional investors have been adding equities while the retail investor has been selling.  No wonder the S&P 500 is up over 125% since the March 2009 lows, when you saw the retail investor run for the exit.  

Below is a chart of the S&P 500 after Presidential Elections provided by Calculated Risk and as you can see, it would be futile to make a prediction using this type of short-term data. If you even look at slightly longer data than one or two days – perhaps something as long as 3 months – you can see elections matter, but how much?

As part of the Investor Class, we might face some short term pain.  We might face the median outcome of all elections which is 3.6% until the end of the year.   We might face even more upside through the end of the year.  It's especially important to keep one simple fact in mind.  For as long as business and government co-existed in our country, business and government have both thrived. I believe businesses will continue to innovate and find ways to grow earnings and benefit the Investor Class. The one thing the Investor Class could really benefit from is a stable tax policy from whoever lives in the White House.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

Weekly CEO Commentary 10-29-12

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Managing Earnings and Expectations
Weekly CEO Commentary 10-29-12
Tim Phillips CEO, Phillips and Company

We are over two weeks into earnings season, and it looks like companies are doing two things: managing their earnings well, and also managing expectations well.

Through the end of last week, 245 companies of the S&P 500 have reported earnings, and 71% have beaten earnings estimates. According to FactSet, over the past 4 quarters, 70% of the S&P 500 companies have beaten earnings estimates, making this quarter fairly in line with prior earnings seasons.

You can see from the chart below from FactSet, when it comes to setting investor expectations, only 64 companies in the S&P 500 have issued guidance for the next quarter and 48 of them have been below EPS estimates. It's clear that corporate offices are feeling nervous as they give guidance about future earnings that are much lower than expected.

When you review a few earnings releases from some of the largest companies, they are consistently citing global growth in emerging and developed economies as a major concern.

 

“You know, clearly we have – we saw a softening in the consumer segments. We talked about that when we did the pre-announcement about a month ago, and the surprise there was that China, which had been very strong, turned weak on us…” –Intel (Oct. 16, FactSet)

 

“Service orders of $2 billion were down 1%, also driven by Europe, down 12%...” – GE (Oct. 19,  FactSet)

“Sales in China remained weak in the third quarter and below the third quarter of 2011…While we have reduced production in China substantially, we have not seen an improvement in sales yet, and, as a result, the inventory reduction in China is slower than we had expected.”  Caterpillar (Oct. 22, FactSet)

There still appears to be a lot of uncertainty in this final quarter of the year which could lead to some turbulence in the markets:

  • Uncertainty about earnings
  • Uncertainty about Presidential election outcomes
  • Uncertainty about Fiscal Cliff issues

However, we have seen uncertain and turbulence times in the past.  At the turn of the century you could have seen a list of worries like this:

  • Bombing at the BBC Television Centre March – 2001
  • Collapse of the dot-com bubble – March 2001
  • Early 2000s recession – March 2001 – November 2001
  • September 11 Attacks – September of 2001
  • Anthrax Attacks – September 2001
  • The Enron Scandal – October 2001
  • Argentina Default – December 2001
  • Passover Massacre in Netanya, Israel – March 2002
  • WorldCom Accounting Scandal – July of 2002

When you look at what the markets have done since then, you can see our economic engine continues to run.  

I suspect companies are just being prudent in managing expectations for earnings, and I suspect we should be prudent in managing your expectations for returns in the short term.  On the other hand, low expectations can lead to large outperformance.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

Weekly CEO Commentary 10-22-12

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The Stealth Consumer
Weekly CEO Commentary 10-22-12
Tim Phillips, CEO – Phillips and Company

For the third month in a row, retail sales numbers were stronger than expected according to the US Census Bureau. Perhaps the consumer is doing better than most give credit. This week I want to dive a little deeper into the consumer, because 70% of our economy is consumption, which drives corporate earnings.

Every category was up for the month with the exception of “Miscellaneous” (this category includes stores with unique characteristics like florists, used merchandise stores and pet supply stores).

 

To be fair, food and gas inflation has led to some of the gain. However, when you look at savings, revolving credit and personal income – factors that drive spending – they appear to confirm this positive trend.

First, consumers are willing to spend down their savings as the personal savings rate has dropped from 4.4% earlier this year to 3.7% in August. Either they are getting more confident in the economy or they are desperate and have no choice.  

\

Second, revolving credit has been increasing. This year alone consumers have added almost 10 billion in revolving credit.  That's enough to add almost 1/10th of 1% to GDP growth.  Not bad for all the fear we hear about the American Consumer.

Lastly, personal incomes have been stagnant for at least 20 years, and all the while consumers have found ways to continue to spend.  While there is much debate over how to lift personal incomes, the data suggests we continue to consume in-spite of our slow growing wages.

It seems like we’re at a critical juncture in our forecast.  If you simply look at all the good news about the consumer you could put more growth into your portfolio, meaning commodities, growth stocks versus value stocks, and technology stocks over dividend payers.

On the other hand consumer spending is closely tied to confidence in the economy:

  • Consumers will spend savings down only to a minimal level based upon their confidence in the economy
  • Consumers will only spend so much on credit based upon their confidence in the economy
  • Consumers personal income will only increase based upon businesses confidence in the consumer

As you can see, this can be a bit of a vicious trap.  In the case of a marginally confident consumer, a continued defensive approach might be warranted. 

In either case, it appears the consumer is quietly spending and perhaps will continue to do so.  This would be a big surprise to the consensus thinkers and could put a floor in for any market pull back we might be seeing right now.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:
Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

Weekly CEO Commentary 10-15-12

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Q4 2012 Look Ahead: Look Beyond 66 Days
Weekly CEO Commentary 10-15-12
Tim Phillips, CEO – Phillips and Company

Every quarter for the last several years, I have presented a “Look Ahead” for the coming quarter during my committee meetings with institutional clients. I have summarized the presentation below, and provided a link to follow along with the full presentation.

Click here to access full Phillips & Company Q4 Look Ahead

Many have called this a “jobless recovery” because it has been almost five years since it began, and we have only recovered half of the 9.8 million jobs lost. However, when you compare the loss of employment to other financial crises, it’s not that unusual. In fact, it’s actually been one of the smallest losses of employment during a financial crisis.

It’s clear the Federal Reserve’s use of unconventional monetary tools has helped in lifting asset prices. With the Federal Reserve’s latest round of quantitative easing having an unlimited time horizon there is no reason to believe it will end anytime soon.  The question is now, “Will it ever lead to job creation?”

The Federal Reserve can use all the monetary tools it wants, but at the end of the day, earnings drive prices. Despite the day-to-day volatility you see in the news, earnings are what matter over the long run when you are investing in equities.

This is concerning because corporate earnings for the S&P 500 are expected to shrink by 2.7% this quarter. It would mark the end of an 11 quarter streak of earnings growth for the S&P 500. Further, expectations for next quarter might be too optimistic with a growth rate near double digits.

If we go over the fiscal cliff in 2013, the economy is expected to contract by 2.9% in the first half of the year according the CBO. We don’t see that as the most likely outcome, and based on the performance of defense stocks (mentioned last week), the market doesn’t either.

Overall the outlook for 2013 is similar to this year: low growth, low inflation, and continued high unemployment.

Now before you consider selling everything you own, buying gold and burying it in your back yard, it's important to consider how and when returns are generated. It’s not from timing the market and it’s not always when the coast is clear according to a study by Michael Cembalest at JP Morgan. To summarize his study, if you invested $100 and only stayed invested when times were good as defined by:

  • Attractive Valuations: Market P/E of 17 or less
  • Not in a Recession: Unemployment below 6% and manufacturing expanding
  • Stable Inflation: Inflation below 4% 

You would generate an annualized return of about 5.67% since 1980 and 5.36% since 1948. However, if you stayed invested no matter what, you would generate an annualized return of 7.50% since 1980 and 7.01% since 1948. Almost 200bps of additional annualized return by simply staying invested.

 

There are signs of stress as we look ahead this quarter, but it’s important for you to put this in the context of the time horizon of your portfolio. If you’re a foundation, endowment, or pension then you can probably look past short term volatility as you have a perpetual investment mandate. If you’re an individual or family then you need to consistently be recalibrating your portfolio to account for the changes in your investment time horizon and liquidity needs. Generating returns involves taking risks and time is a key component in shaping those risks.

Of course, if you think the world will end in 66 days with the Mayan Calendar on December 21, 2012 then you might want to sell everything anyway and have fun with the money.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via TwitterFacebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company

Alex Cook, Associate – Phillips & Company

Weekly CEO Commentary 10-8-12

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Part Time Confusion
Weekly CEO Commentary 10-8-12
Tim Phillips, CEO – Phillips and Company

In September, the unemployment dropped to 7.8% from 8.1%, according the Bureau of Labor Statistics report last Friday. With such a dramatic drop in the unemployment rate, you would assume more Americans are getting back to work at a much faster pace than anticipated.

The reality is we only added 114,000 jobs last month. Most economists suggest we need to add at least 200,000 per month just to keep up with new entrants into the workforce. The disparity between the net new jobs number and the dramatic drop in the unemployment rate has led a number of people, including famed former CEO of GE Jack Welch, to suggest some kind of conspiracy theory about the government manipulating the numbers.

Breaking down the BLS Report

While it would be easy to leave it to the conspiracy theorists, I’m not buying their stories. Instead, let’s take a deeper look at the report from the BLS to see if we can determine what is really going on.

First, we need to realize the report is comprised of two separate surveys. One is a survey of households, and results from this survey said we added 873,000 jobs. This is the data used for the unemployment percentage calculation. The other is a survey of establishments (business), and the results from this survey said we added only 114,000 jobs. This is the data used for the net new jobs numbers. These two surveys usually give us close to the same number, however right now they are clearly suggesting two different economies.

Second, this is not the first time the two surveys have shown such a divergence. In the graph below you can see the new jobs added based on each survey (household survey in green, and establishment survey in brown) going back to the beginning of the millennium. In the recovery from the early 2000s recession we saw similar spikes in the household survey suggesting a stronger recovery than the establishment survey.

So what drove this divergence in the household survey this time? It appears to have come from people getting part time employment due to economic reasons. In other words, they got part time work but really wanted full time work. Looking back at the data during the recovery from the early 2000s recession, you can also see a rise in the number of people claiming “Part Time Employment for Economic Reasons”   

This is better than Americans not working at all, but it's not necessarily the outcome we want for sustainable economic growth.

Digging deeper into the establishment survey, we did see other troubling signs. Manufacturers and Good’s Producers shed 16,000 and 10,000 jobs respectively. Some might consider the fact that government added 10,000 jobs as a positive sign, but if we are facing deep cuts to government, I don’t believe this segment can be counted on for much more.

Some concluded from this report that the coast is getting clearer, some see more clouds on the horizons and a few are still fitting it into their most recent conspiracy theory. The bottom line is we still have a tough fiscal debate coming up at the end of the year –and the last time Congress failed to act, equities sold off, volatility spiked and the United States’ credit was downgraded. 

Based upon the 50 billion dollar cuts to defense spending in 2013 if Congress fails to act and the fact that defense stocks have hardly dropped…

...one should be wary of gaining any comfort from the part time confusion in the employment numbers.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via TwitterFacebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

Weekly CEO Commentary 10-1-12

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The Real Meaning of Retail
Weekly CEO Commentary 10-1-12
Tim Phillips, CEO – Phillips and Company

If you look at the chart below from the Federal Reserve, the dramatic peaks in the non-seasonally adjusted retail sales (green line) paint a clear picture, ‘tis the season for retail. This week we will preview how the numbers are looking.


As we’ve discussed before, consumption represents approximately 70% of our GDP. A crucial component of this number is retail sales.

According to the US Census, retail sales were up 0.6% in July and 0.9% in August, and if you just look at the financial headlines from the last two months, the trend seems favorable. But, once you get past the headlines, some troubling trends emerge:

Looking at the big picture, retail sales are still up compared to last year. However, the rate of increase has slowed down since last July. We have seen similar slowdowns before, and unfortunately they came before the last two recessions.

Lastly, real final sales have stalled out at 2.0%, a rate associated with prior recessions when you look at the graph below from the Federal Reserve.

Turning to the consumer, they continue to spend down their savings leaving a little less “dry powder” to spending this retail season.

Combining this slow down with the uncertainty of an election year and a fiscal cliff, where the typical middle-income household would face a tax increase of about $2,000 according the Tax Policy Center, you can start to get a strained view of this retail season.

The very word ‘retail’ comes to us from the art of tailoring, where apparel is “cut off, clipped, or pared down.”  What’s troubling me is that based on the data above, this year’s retail season could be more “cut off, clipped, or pared down” than we want.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via TwitterFacebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

Weekly CEO Commentary 9-24-12

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Wealth Does Not Equal Consumption: How Long Can This Last?
Weekly CEO Commentary 9-24-12
Tim Phillips, CEO – Phillips and Company

It's abundantly clear that Chairman Bernanke has been hard at work, and his actions have now had a positive impact on investors.

As we have written in the past, the only thing monetary intervention might be creating is a bit of the wealth effect. Based upon the chart above, those that have investments should be feeling wealthier since the Federal Reserve began quantitative easing.

Further, those with homes might be feeling less poor with a recent upturn in housing prices according to the Case-Shiller Composite Indices.

Unfortunately, the end goal of all of this monetary intervention is to stimulate end demand (consumption) and create job growth, not increase asset prices. The consequences of all of this market distortion will be felt most likely in some outlying years, 2016 and beyond.

As for creating job growth today, unemployment appears to remain stubbornly above 8% and weekly initial unemployment claims have been moving sideways most of the year according to the Bureau of Labor Statistics.

In order to create job growth, we need to focus on addressing real concerns that affect businesses. A recent NFIB (National Federation of Independent Businesses) survey clearly shows small business wants more demand (Poor Sales-20) much more than they want lower interest rates (Fin. & Interest Rates-3). 

In addition, a recent survey by Duke University showed 43% of CEOs are most concerned about consumer demand while only 15% are worried about interest rates.

What you might notice, besides the disparity between consumer demand and interest rates, is how much concern there is over high government regulations, red tape and federal government policies.

Unfortunately, no matter how good it feels to investors today, no matter how misguided recent Fed policy might appear, and no matter what CEO's say, we might be in for a long haul.

Carmen Reinhart and Kenneth Rogoff wrote one of the best history books on financial crises called This Time Is Different. In a recent paper titled, Public Debt Overhangs: Advanced-Economy Episodes Since 1800, they looked at countries since 1800 with 90% public debt to GDP for 5 years or longer, which now includes the United States.  Their study concluded:

  • The average duration of the debt overhang is 23 years.
  • The debt slows down economic growth and losing even 1 percentage point per year from the growth rate will produced a substantial decline in output.
  • The average annual growth rate is 1.2 percentage points lower in periods of high debt (90% debt/GDP ratio).

It's not clear what causes high debt countries to find themselves in their high debt situation.  The reasons include war, excessive borrowing for social programs, and simulative efforts to avoid depressions, to name a few.  It is clear, however, that the time it takes to resolve these behaviors massively distorts markets.

The good news in all of this is that stock markets are not entirely correlated to US or World GDP in the short run. So, perhaps we can grow our wealth at the same time people consume less.  I have a funny feeling this can't last long though.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via TwitterFacebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

Weekly CEO Commentary 9-17-12

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The Kitchen Sink
Weekly CEO Commentary 9-17-12
Tim Phillips, CEO – Phillips and Company

Last week the Federal Reserve announced additional steps to try to support a stronger economic recovery according to their press release on September 13, 2012. Here's what they are going to do: 

  • Purchase $40 billion of mortgage debt every month (Quantitative Easing 3)
  • Continue to extend the average maturity of its holdings (Operation Twist)
  • Extend forward guidance from late-2014 to mid-2015

The Federal Reserve is throwing everything but and the kitchen sink at this economy.  In addition to extending their forward guidance the Federal Reserve tied these actions to the labor market:

"If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability"

What was a bit more concerning in the statement was their comment regarding inflation:

"The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective."

Running so dangerously close to the red line of deflation for a prolonged period in the future is certainly a risk to investors and savers.  From the data below we have been in a prolonged period of declining inflation.

While too much inflation is a bad thing, deflation is the worst possible outcome for savers and investors because it can lead to a vicious spiral. Lower prices lead to lower production, which leads to lower wages, which leads to lower consumption (GDP), which then leads to further decreases in prices.

Now that the Fed has pushed most of us to take more risk to generate limited returns, we should see inflation in asset prices—specifically in homes and more immediately in stocks. I think Howard Marks said it best in his latest letter to his investors:

Today’s low interest rates, engineered by the central banks, mean that investors are consigned to doing business in a low-return world. Interest rates near zero on T-bills, and yields of 1-3% on Treasury notes and bonds, set the base from which the prospective returns on investments entailing risk are established. And because that floor is so low today, even with healthy risk premiums added, the absolute prospective return on many investments isn’t nearly what it is was in the past.

Unfortunately we still have a fiscal policy to contend with in the form of a Fiscal Cliff

I am reading Bob Woodward's new book, "The Price of Politics".  It's a revealing narrative on how our political leaders were negotiating fiscal policy.  I ran across a statement that caused some lost sleep.  This was a quote from the President during his negotiations on that last extension of the Bush Era tax package:

"I’m drawing a line in the sand after this,” Obama promised, trying to rally the group. This was his final compromise on taxes. “Let’s protect the fragile economy. Come the next round when these things expire, I’m holding. Not happening again.”

It's clear that the Fiscal Cliff will not be an easy negotiation and compromise looks less likely based upon what was reported in this book.

The Federal Reserve is throwing the kitchen sink at the economy making investors take on additional risk in order to achieve a similar level of returns; however, the uncertainty surrounding the upcoming elections and fiscal policy could still hold returns back despite taking on additional risk.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via TwitterFacebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

Weekly CEO Commentary 9-10-12

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A Housing Head Fake?
Weekly CEO Commentary 9-10-12
Tim Phillips, Phillips and Company

Last Friday's jobs report almost guaranteed additional monetary intervention by the Federal Reserve to come this week at the end of their meeting on the 13th. As I mentioned in last week’s blog, that could be a catalyst for a sell off. After all, we are still staring down a weak economy, right?

Well, not so fast. Besides the data we presented last week on the underlying strength in our economy, the housing market has been showing signs of life as well. Let's run through the numbers:

  • In July, private residential construction spending decreased 1.6% from June, but it’s 19% higher than a year ago according to the US Department of Commerce.
  • In July, existing home sales increased by 2.3%, and it’s 10.4% higher than a year ago according to the National Association of Realtors.

  • In July, housing inventory decreased 23% from a year ago. This is the 17th consecutive month for a year-over-year decrease according to the National Association of Realtors.
  • In August, homebuilder confidence climbed to the highest level in more than five years according to the National Association of Home Builders/Wells Fargo Builder Confidence Index.

Finally, looking at publicly traded home builders certainly suggest things have improved. The S&P Homebuilder Index, a basket of home building companies, is up 44.15% for the year.

Where’s the Beef?

Unfortunately, we are still missing the economic growth and job creation normally associated with a housing recovery.

In 2005, housing represented 6.1% of GDP when you factor in the construction as well as the associated spending that comes when we buy homes. It now only represents 2.7% of GDP According to the National Association of Home Builders. Clearly, an improvement in housing and its associated components would be very beneficial to our economy.

If the housing industry reached its historical average, it could add almost 3 million jobs and economic growth could double. (Remember more jobs = higher wages = higher consumption = higher GDP = more jobs) according to the Bipartisan Policy Center.

Will this trickle into the rest of the economy or is the recent data just an industry head fake fooling new homeowners?

I can’t be certain either way, but I am seeing more underlying positive trends in the US economy than last year as the US is beginning to lead the world out of this global recession. Certainly a recovery in the housing market would continue to benefit the United States by creating more jobs, higher wages, and drive more consumption.

That’s why our portfolios are overweight US equities, but we still maintain a global asset allocation. Housing head fake? We will soon find out.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via TwitterFacebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company

Weekly CEO Commentary 9-4-12

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Posted by siteadmin under Market Commentary

"Snatching Defeat from the Jaws of Victory"
Weekly CEO Commentary 9-4-12
Tim Phillips, CEO – Phillips and Company

Leave it to Lincoln to come up with another great quip that is very fitting to our current monetary agenda.  Allegedly, Lincoln used this phrase when he was referring to the ill-fated General Ambrose Burnside, shortly after a military defeat and subsequent sacking of said general by Lincoln.

Before we get to the Defeat Snatching component of my assessment, let's review the Jaws of Victory side of the equation.

Jaws of Victory

There are some fairly positive signs bubbling up in our economy.  It's almost hard to imagine saying that in the wake of so much uncertainty.

In fact, a host of economic indicators are pointing in a positive direction.  If you take a look at the chart below you can see key economic factors, like employment, are improving.  What's ironic is this is a chart from our friends at the ECRI (Economic Cycle Research Institute), the guys that are calling for a recession.  While they may still be right, the current data is not trending their way.

Secondly, earnings estimates have seen some improvement in the last several weeks.  I turn to our source at Bespoke to help make the point.  While estimates are still negative, analysts are getting more constructive on their outlook. In fact, they are getting more constructive in almost all sectors.

Snatching Defeat

Last Friday, The Federal Reserve concluded their seminal "Jackson Hole" meeting with Chairman Bernanke delivering his much anticipated closing remarks.  He strongly suggested non-traditional monetary tools were effective and would be strongly considered in the future.

“the costs of nontraditional policies, when considered carefully, appear manageable, implying that we should not rule out the further use of such policies if economic conditions”

One interesting and perhaps overlooked event during the meeting was a presentation by noted Stanford economist Edward P. Lazear.  He wrote a paper that suggested our current unemployment issues were not structural but cyclical. He went on to suggest much of our high unemployment might be strongly explained by "mismatch" in the labor force both within industries and between industries.  Basically, people need time to get retrained and relocated from shrinking skill sets and industries to those growing and needed.  One compelling point he made was: 

"First, the unemployment rate was 4.4% in the spring of 2007 and rose to

10.0% by October of 2009.  Thus, in a little over two years, unemployment rates went up by over5 ½ percentage points.  Most structural changes do not occur so rapidly."

The bottom line is the Federal Reserve is not mandated to handle structural employment problems but cyclical ones. So, Lazear essentially provided the rationalization for further monetary intervention.

The bad news is that most market participants are expecting intervention to occur—which may actually create a sell off when it happens with traders taking profits on “buying the rumor.”  Conversely, if the economy heats up and there is no intervention, market participants could be disappointed–also leading to a sell off.  That's what happens when government intervention distortions a market based economy.

Ultimately though: if the fundamental economic data improves and we get a Federal Reserve induced sell off, then snatching defeat from the jaws of victory could be a great buying opportunity.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via TwitterFacebook, or you can Email me directly.

Tim Phillips, CEO – Phillips & Company

Research supported by:

Adam Gulledge, Associate – Phillips & Company
Alex Cook, Associate – Phillips & Company