Phillips and Company Blog

Backward to Forward - China

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Chinese buildings

On my recent visit to China, my goal was to learn much more about an economy we are invested in. It's impossible to summarize China in any one post. It's a country that is complex and so different than the United States, not just culturally but economically. 

I'm going to give it my best shot and summarize my findings.

First, China followed a similar path that most emerging economies followed as they migrated to developed economies. This would include Germany, France, and in some ways the United States and England. 

According to the famed economist on emerging markets, Alexander Gerschenkron, a successful emerging economy needs to exhibit some basic qualities:[i]

1)    The country needs a strong State sponsor to prioritize capital allocations (building projects that can improve infrastructure) which have a significant impact on growth. Think converting a single dirt path for walking into a wide dirt road for horse and cart.

2)    The State needs to organize the capital needed for the projects either through building domestic banking capabilities or encouraging foreign capital investments. Financing needs to be long-term in nature versus the very short-term financing that typifies failed states. Consider Greece and its short-term financing needs right now. 

3)    The State needs to encourage/force the very poor agrarian workers to leave their sustenance jobs and work on the projects, shifting from an agrarian economy to an industrial economy. This in turn increases wages, which the State should incentivize the earners to save. The more coercive and comprehensive the measures required to reduce domestic consumption and allow national saving, the better. 

4)    State sponsored banks need to lend that savings for more capital improvements, which drives even more growth. For example, the State would support manufacturing that builds the tractors that make the dirt roads, as well as finance the mines, sand and gravel companies, or lumber mills.   

5)    The State needs to ensure the capital improvements are done with the latest technology that can be procured from other countries. There is absolutely no point in making capital improvements with old technology.

6)    The country needs to exhibit a few entrepreneurial standouts that want to take over the State's role in organizing capital and labor. 

China has followed this playbook almost perfectly. It has emerged from an agrarian economy to become an industrial economy. According to Alexander Gerschenkron, China has overcome its backwardness.

The result is an economy that looks like this:[ii]

China GDP Components

Compare that to how the US economy looks and you can see China's challenge as they move forward.[iii]

US GDP Components

About 70% of the US economy comes from household final consumption and 19% from capital formation (planned investments like roads, bridges, factories, equipment houses).[iii]

About 37% of China’s economy is from household final consumption and 49% capital formation. This is a byproduct of working out of backwardness and a focus on capital improvements versus consumer demand.[ii]

Based upon my recent visit, I am convinced China is abundantly aware of its need to make a conversion to a less capital intensive economy. After all, how many cities can you build that look like Shanghai (photo taken from my hotel room)?[iv]

Shanghai View

In fact as long ago as 2007, China's then Premier Wen Jiabao said the PRC economy was increasingly, “unbalanced, unstable, uncoordinated, and unsustainable.”[v] This conversion won't be easy, but unlike many economists, I think China has the right ingredients to succeed. 

First, China’s citizens have one of the highest savings rate in the world.[vi]

Savings as a % of GDP

There are many reasons for this, and I can write an entire separate post on this topic, let's simply consider this part of the emergence from backwardness. Needless to say, the Chinese government is working on ways to have its citizens spend down their savings. It’s considering ideas like more predictable state-sponsored health care, pension reform, and liberalized investment choices. 

Second, China still has a massive agrarian economy it can continue to migrate to a more consumer-focused economy. Take a look at some data on this sector.[vii]

  • Almost 300 million people still work in agriculture, earning less than one-third of what their urban brethren make or about $1,000/year.
  • The average Chinese farm is about one acre. That's not a typo, it's about one acre.
  • The Chinese government is buying up these farmers with payments, trying to industrialize agriculture (it's needed to feed 1.3 billion people), and providing cash to sustenance farmers to find higher paying jobs.

Third, Chinese citizens are just now growing accustomed to using credit to fuel their consumption. While they still pay down their balances, those balances are growing.[viii,ix]

Chinese consumers' credit card debt repayment habits

China consumer credit 

Fourth, the Chinese government runs the world’s largest investment fund (CIC) based upon its massive trade imbalance (exports far exceeding imports) that sits at over $600 billion in assets.[x]  It can use this fund to fuel a domestic growth agenda, such as buying stock in service and technology oriented companies. In fact, it recently purchased a minority stake in Alibaba, the Amazon of China.[xi]

While these ideas are going help the success of China in its conversion, the process is going to cost the Chinese some of their growth.

You can already see the slowdown in GDP, much of this driven by a slowing in capital expenditures.[xii]

China GDP Annual Growth Rate

At what level will the Chinese need to consume to sustain the current level of GDP while the economy grows less dependent on cap ex?

If we look at a 7-year period, we can see the Chinese will need to increase household consumption by 13.4% per year and hold capital expenditures steady to achieve a 7% GDP growth rate. At that point, consumption as a percentage of GDP will look more similar to the United States.[xiii]

China Estimated GDP by Component 7-Year

China will need a consumer expenditure growth rate more like the 11% rate in 2011.[xiv]

Household Final Consumption Expenditures China Annual Growth Rate

Emerging from backwardness was hard, now converting to a US-style economy requires a deft touch that only a command-and-control governance structure like China’s can pull off. That's why we maintain some exposure to China. 

As an insurance policy of sorts, exports are poised to grow again with the strong dollar. This could be a 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 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


Post Script

I am fully aware that China is froth with risks:

  • Continued misallocation of capital to projects that cannot meet their debt service.
  • Consumers that simply will not trust the government to meet their social needs (medical and pension), forcing higher savings.
  • Financial repression that does not stimulate consumption and punishes savings.
  • Corruption at the highest levels of government that only looks after the ruling class.


[i] Gerschenkron, A. (Jan 31, 1962). Economic Backwardness in Historical Perspectives. Frederick A. Prager, Publishers. p 5-30.

[ii] (Dec 2013 data). GDP Decomposition by sector – China.

[iii] (Dec 2013 data). GDP Decomposition by sector – United States.

[iv] Tim Phillips. (Mar 2015). Shanghai.

[v] ecr research. (Mar 2015). Reforming China’s Economy.

[vi] Nielsen. (Oct 2010). Savings as a % of GDP.

[vii] Carter, C. (May/Jun 2011). China’s Agriculture: Achievements and Challenges. p 6.

[viii] Accenture. (2013). China Consumer Insights: Financial Services. p 8.

[ix] (Mar 2015). China Consumer Credit.

[x] Wikipedia. (Mar 2015). China Investment Corporation.

[xi] Bloomberg News. (Sep 2012). CIC-Led Group Said to Pay $2 Billion for Alibaba Holding.

[xii] (Mar 2015). China GDP Annual Growth Rate.

[xiii] Projections based on China’s 2013 GDP component data from, and assume no increase in capital expenditures and 7% annual growth in other non-household consumption components (government spending / trade balance).

[xiv] (Mar 2015). Household final consumption expenditure (annual % growth) in China.



One Step Forward, Two Steps Back

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one step forward, two steps back

As expected last Wednesday, the Fed removed the word “patient” from its interest rate policy statement, moving us one step closer to potential interest rate increases, perhaps as soon as the Fed’s June meeting. However, the Fed will still be cautious and consider the merits of a rate increase on a meeting-by-meeting basis. While speaking about normalizing interest rates, Fed Chair Janet Yellen stated,

“Just because we removed the word ‘patient’ doesn’t mean we are going to be impatient.[i]

The Fed effectively took two (or more?) steps back as it highlighted several concerns about the U.S. economy and lowered its estimates for annual GDP and the year-end interest rate level. This led the market to rally, as it interpreted these cautions as a sign that a rate hike may not materialize until at least September and would be smaller than previously expected.[ii]

S&P 500 Index Chart

The Fed’s economic concerns included topics we’ve discussed previously: employment, the strong dollar, and declining inflation.

In addition, economic growth in 2015 Q1 has slowed to about half the pace of the 3.75% annualized growth rate reported in the second half of 2014.[iii] One cause is a decline in U.S. exports due in part to the strong dollar, which makes U.S. goods more expensive in foreign markets.[iv]

US Exports

Here at home, the Fed noted weaker than expected consumer spending despite the benefits of low energy prices, low interest rates, and improved employment. The growth rate for personal consumption has been falling since last August.[v]

Personal Consumption Expenditures

The sharp decline in Q1 earnings growth estimates reflect the slowdown in the economy and the impact of the strong dollar. Even excluding the Energy sector, whose earnings have been negatively impacted by low oil prices, the Q1 earnings growth estimate for the rest of the S&P 500 is at just 2.6%.[vi]

2015 Q1 Zacks Earnings Estimates

Based on the weak data, the Fed reduced its 2015 GDP growth expectations by 30 basis points to a range of 2.3% to 2.7%.[vii] In addition, the median year-end 2015 interest rate projection from the Fed Board Members declined from around 1% to 0.5%.[viii] The Fed Funds Rate is currently at 0.12%.[ix]

Fed Funds Target Projection

While the Fed removed the last technical hurdle to an interest rate increase by changing the language of its policy statement, it does not want to risk stalling the economy by raising rates too soon. Until there’s a change in the current economic growth and inflation trends, a significant change in interest rates is doubtful. The upshot for investors is that interest rates appear likely to stay low longer than expected.

Even when the Fed Funds Rate is eventually increased, JP Morgan noted that longer-term rates are less sensitive to Fed tightening than short-term rates.[x]

US Interest Rates

The negative rates in Europe will also drive demand for U.S. Treasuries from foreign investors and help to keep U.S. interest rates down.

Based on the current economic data and the Fed’s positioning, we are:

  • Targeting duration of around 5 years for fixed income, perhaps moving a little higher if economic data continues to show weakness.
  • Overweight countries that benefit from the stronger U.S. dollar through exports.
  • Tilting to U.S. small-cap stocks that are more domestically oriented versus U.S. large-cap’s that are dependent on exports.
  • Keeping an eye on large multinationals for the impacts of currency and consumer spending on corporate earnings as the Q1 reporting season begins in April.
  • Monitoring for a weakening dollar that could push us back into a stronger tilt to U.S. large-caps.
  • Watching for signs of stronger consumer spending and GDP 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)


[i] Lee, D. (Mar 18, 2015). Fed moves toward raising interest rates – but the when is unclear. LA Times.

[ii] Google Finance. (Mar 20, 2015). S&P 500.

[iii] Lee, D. (Mar 18, 2015).

[iv] (Mar 20, 2015). United States Exports.

[v] Federal Reserve Economic Data. (Mar 20, 2015). Personal Consumption Expenditures.

[vi] Mian, S. (Mar 19, 2015). Zacks Earnings Trends: 3 Things to Know About Q1 Earnings Season. Zacks.

[vii] Lee, D. (Mar 18, 2015).

[viii] Goldman Sachs. (Mar 23, 2015). Market Monitor.

[ix] Federal Reserve Bank of New York. (Mar 20, 2015). Federal Funds Data.

[x] Kelly, D. (Mar 18, 2015). The Investment Implications of Fed Tightening. JPMorgan Asset Management.

Will They Zig When They Should Zag?

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On Wednesday, the Fed will meet to discuss the future of interest rates in the United States. Most commentators don't anticipate a rate increase at the March meeting, yet they do expect more certainty around rate hikes in the near future.

With the removal of one word ("patient") from its official statement around rate hikes, we will be led to believe the Fed’s meeting in June will contain a 25 basis point hike in the Fed Funds rate.[i,ii]

Certainly the Fed could be pushed toward more immediate rate hikes by the employment situation. The average number of jobs added to the US economy over the last six months is 303,000.[iii] This is a strong indicator of a sustainable recovery.

US Non Farm Payrolls

However, there are a couple of trends we have discussed in recent posts that are becoming amplified as the year progresses.

The strong dollar we discussed in a post on March 2, 2015, suggested the strength of the US dollar relative to the Euro and Yen will have a major impact on large US exporters including companies like Johnson and Johnson, Procter & Gamble, and Abbott Labs.

While the United States is not as export dependent as other countries, there is still significant consequence from the strong dollar.[iv]

In fact, foreign-generated revenues account for 46% of sales by S&P 500 companies.[v] CNBC noted a fairly consistent narrative from recent company guidance that currency impact is reducing 2015 earnings and/or revenues by 1% to 4%.[vi]

What's slightly alarming is the dollar has gotten even stronger since our last post on this topic.[vii]

US Dollar vs Euro and Yen

Another troubling trend is earnings per share growth. When you strip all the macro economic, political, national security, and email noise out of the system, we are left with the one element that matters most - cash flows!!! We can value cash flows and estimate a future value of an asset pretty easily. In the case of public equities, cash flows mean earnings per share growth and dividends. 

You can see from the data below, these elements are not looking very strong. 

  • Henderson Global Investors estimates global dividends of $1.24 trillion in 2015, a 4% increase over 2014.[viii]
  • 2015 Q1 and Q2 earnings estimates continue to decline.[ix]

2015 Q1 and Q2 Estimates

We've written about the trouble with earnings in several posts (Do Nothing…Recently?, That Was Ugly), so this should be nothing new to our many thousand readers. 

In fact, we are in the "quiet period" of earnings and indeed volatility has increased as anticipated.[x]

VIX Chart

The Dow Jones Index has also had 7 triple-digit moves since our February 23rd blog on the “quiet period”.[xi]

Finally, inflation is inconspicuous and the latest data suggests as much.[xii]

US Producer Price Change

US Inflation Rate

In light of this narrative of a stronger US dollar, slower EPS growth, declining inflation, and the unknown consequences on the US economy, the Fed's direction on Wednesday will be telling.

Unfortunately based upon the Fed Board Members’ latest indications, the increase in interest rates looks almost inevitable sometime in the middle of 2015.[xiii]

Fed Board Interest Rate Prediction

The time frame of your plan will become much more critical as we flounder our way through this next period of uncertainty. “Will they Zig when they should Zag?” seems to be the question of the week.

I'm off to China in the hopes of learning first hand what's going on in a region where we are invested and will report back soon.

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] Schneider, H. (Mar 2, 2015). Near Fed majority backs June liftoff Yellen hasn’t yet endorsed. Reuters.

[ii] Shover, L. (Mar 2, 2015). What are Fed Funds Futures Telling Us About Rate-Hike Timing? FOX Business.

[iii] (Mar 16, 2015). United States Non Farm Payrolls.

[iv] The World Bank. (Mar 2015). Exports of goods and services (% of GDP). Data from 2013.

[v] Sagami, T. (Feb 3, 2015). Procter & Gamble, the Strong Dollar, and Pepto Bismol. Mauldin Economics.

[vi] Pisani, B. (Mar 11, 2015). Stocks dead in the water due to dollar?. CNBC.

[vii] Google Finance. (Mar 16, 2015). US Dollar vs Yen and Euro.

[viii] Cosgrave, J. (Nov 17, 2014). Don’t expect a dividend bonanza in 2015: Report. CNBC.

[ix] Mian, S. (Mar 5, 2015). Closing the Books on Q4 Earnings Season. Zacks.

[x] Yahoo Finance. (Mar 16, 2015). Volatility S&P 500 Chart.

[xi] Yahoo Finance. (Mar 16, 2015). Dow Jones Industrial Average Historical Prices.

[xii] (Mar 16, 2015). US Producer Prices Change and US Inflation Rate.

[xiii] Federal Reserve Board of Governors.

Interest Rate Hand-Wringing

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hand wringing

US equity markets sold off sharply on Friday driven principally by a very strong jobs report showing the US economy added 295,000 jobs in February.[i]

US Non farm payrolls

This very strong news spooked equity investors as they awakened to the reality of higher US interest rates from the Federal Reserve Board. Higher interest rates impact stocks because companies might have to pay more to borrow which hurts profits, and consumers might have to pay more to borrow for their homes, cars, and consumables. 

US companies in the S&P 500 have $7.4 trillion in debt and the US consumer borrows over $13 trillion, so it's no small matter when rates go up.[ii,iii]

US consumer borrowing

Notice I used the word "might". Traditionally when the Federal Reserve raises the Fed Funds Rate (the rate charged to banks when they borrow from the Fed), this causes banks to raise their rates to companies and consumers. 

However, something else might be going on that we have never seen before. Currently 16% of all world debt issued by countries is at a negative interest rate.[iv,v]

Countries with Negative Interest Rates

We are not talking about real interest rates being negative (interest - inflation), but actual negative interest rates.

According to Vox:[v]

  • In early February, Nestlé (which is headquartered in Switzerland) saw its four-year euro-denominated bonds trading at a negative interest rate.
  • Countries like the Netherlands, Sweden, Denmark, Switzerland, and Austria all saw bonds trade at negative rates.
  • In early February, Finland became the first European government to see negative rates on the initial sale of bonds.
  • On February 28, Germany sold five-year bonds at negative rates.

Why would anyone want to loan their money to a country and not get paid interest? In fact, why would anyone want to loan their money to a country and actually pay interest to that country for taking their money?

It's counterintuitive to understand, as the history of negative rates is limited and typically used to discourage deposits.[vi]

  • Many decades ago and again this year, Switzerland discouraged incoming Swiss-franc deposits by imposing negative interest rates.
  • During the financial crisis in the US, the Bank of New York imposed negative interest rates on deposits over $50 million, effectively telling customers to remove their money.

Some reasons investors would pay to lend their money could be:[iv,v]

  • Fear of keeping their money in the banks, as bank accounts are only government-guaranteed up to a certain extent (100,000 Euros in most European countries).
  • Cash is hard to keep safe, so investors are willing to pay banks or the government to hold their cash in the form of a negative interest rate.
  • European investors seem very pessimistic about the overall economic outlook in Europe, creating high demand for government debt in well-run countries. However, supply of new debt in many of the countries listed above is limited, which is pushing rates into negative territory as investors buy up their debt.

  • Investors who fear or expect deflation tend to find nominal bonds attractive, even with negative yields, as long as expected deflation makes real yields positive.

  • Investors may be buying Swiss or Danish government bonds to speculate on Swiss or Danish currency appreciation.

The implications of all this might play out in our economy. While the Fed tries to tick rates up, perhaps foreign buyers of our debt could keep it at historically low levels. When compared to paying countries to hold their money, why wouldn't they simply buy our debt? Especially since we continue to run budget deficits.

Global bond yields

Further, we continue to have foreign buyers of US debt dominate our Treasury market. Approximately 34% of the $18.1 trillion US debt is held by foreign investors, mostly by China and Japan.[vii,viii] 

Major foreign holders of US treasuries

All of this hand-wringing about higher rates may be for naught. The world is exporting some serious deflation and we might just be importing it in the form of lower rates much longer than the Fed can control.

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] (Mar 9, 2015). United States Non Farm Payrolls.

[ii] Bloomberg LP. (Mar 9, 2015). Short and Long Term debt for S&P 500 companies.

[iii] Federal Reserve Economic Data. (Mar 9, 2015).

[iv] Durden, T. (Jan 31, 2015). 16% of Global Government Bonds Now Have A Negative Yield: Here Is Who’s Buying It.

[v] Yglesias, M. (Feb 26, 2015). Something economists thought was impossible is happening in Europe.

[vi] Kotok, D. (May 30, 2013). Negative Interest Rates. Cumberland Advisors.

[vii] (Mar 9, 2015). National Debt (as of January 8, 2015).

[viii] US Treasury. (Mar 9, 2015). Major Holders of Foreign Treasury Securities (as of Dec 2014)

Inflection and Diversification (A Case for International Investing)

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chart of inflection point 

We seem to be at another inflection point in the US economy and perhaps US equities. The US stock market has rallied for the last 72 months since the financial crisis and is up over 187%.[i]

S&P Standard and Poor 500 after crisis

Valuations are moving to the upper end of their range compared to where they were in March of 2009.[ii,iii]

Forward PE ratio and Shiller CAPE ratio in 2009 and 2015

While most investors get aggressive during this time in an investment cycle, it's incumbent on us fiduciaries to step back reexamine the bigger picture.

Last week we saw one of the biggest drops in the Chicago PMI in its history and the largest since October 2008.[iv] It dropped from an expansionary reading of 59.40 to a contractionary reading of 45.80.[v] Note that the Purchasing Managers Index (PMI) measures the health of the manufacturing sector of our economy.

Chicago Purchasing Managers Index PMI drops in 2015

It's no small thing as manufacturing represents 12% of US GDP and supports 17.6 million jobs in the United States according to the National Association of Manufacturers.[vi] Certainly some of this can be explained by bad weather or port closures on the West Coast. However, that would be a matter of blind faith. 

One large factor is certainly the strength of the US Dollar relative to almost every other currency.[vii]

US Dollar strong in foreign exchange forex market

Just remember a strong dollar means our goods and services are more expensive versus imports. You can see this in the latest trade data with a continued widening of the trade gap between our exports and imports creating a significant drag on continued US GDP growth.[viii]

United States Balance of Trade in 2014 and 2015

We got confirmation of this on Friday with US GDP in Q4 that showed net exports (exports minus imports) reduced growth by 1.15 percentage points in Q4.[ix]

United States net exports contribution to real GDP change

We can continue to expect this trend to persist as long as the dollar remains strong relative to other major currencies. 

It's certainly never a good time to abandon sound investing principals like:

  • Clearly understand your time frames for your assets and use of funds.
  • Know exactly what rate of return your plan requires.
  • Build sound allocations at the lowest possible risk to meet the return target.
  • Rebalance and minimize taxes.

However when it comes to investing, it's also never a good time to base anything on blind faith. 

Were cautiously optimistic about 2015 for US equity investing, while allocating to international markets to perhaps take advantage of a recovery in these economies and companies, especially when you consider the expanding credit growth and strong dollar in some of these countries.[x]

Financial cycle graph based on credit growth

country codes key

I predict the coming months will test all of our nerves, and resolve to stick to sound principals versus being shaken by normal market discounting with a shift in growth rates and constituents. 

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] Google Finance. (Mar 2, 2015). S&P 500 Chart.

[ii] Melin, M. (Feb. 22, 2015). S&P 500 Forward PE Ratio at Highest Level Since 2004. ValueWalk.

[iii] (Mar 2, 2015). S&P 500 PE Ratio by Month and Shiller PE Ratio by Month.

[iv] (Mar 2, 2015). United States Chicago PMI (1967-2015).

[v] (Mar 2, 2015). United States Chicago PMI (2012-2015).

[vi] National Association of Manufacturers. Facts About Manufacturing. Data from Bureau of Economic Analysis (2014) and Bureau of Labor Statistics (2014,2014).

[vii] Google Finance. (Mar 2, 2015). Chart of US Dollar vs Yen, Yuan, and Euro for last 12 months.

[viii] (Mar 2, 2015). United States Balance of Trade. 2014-2015.

[ix] Bureau of Economic Analysis (Feb 27, 2015). Gross Domestic Product: Fourth Quarter and Annual 2014 (Second Estimate).

[x] Bank for International Securities. (Jun 29, 2014). 84th Annual Report. p 70.

The Quiet Period

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gentlemen in suits shush and hush eachother

Now that we have mostly concluded earnings season (over 85% of S&P 500 companies have reported earnings), we enter a quiet period of data and investors shift their focus back to macro events.[i] Before I address the "quiet period", let's quickly review a summary of Q4 earnings.

Q4 2014 growth rates and earnings beat ratios

As you can see we exceeded on both earnings per share and revenue, albeit much lower expectations than historical growth averages (7.0% for EPS and 3.1% for revenue).[ii]

It's not surprising these "quiet" periods of time often meet with more volatility than we see during earnings season. It appears earnings provide investors an anchor to windward.[iii]

1 year VIX volatility index chart

So what macro events and data are likely going to consume our attention before we start Q1 earnings season on April 13th?[iv]

Geopolitically we know we can expect more bad news from ISIS and Middle East volatility.  While that region only represents about 3% of global GDP, the horrific terrorism campaign haunts us more than the economics.[v,vi]

air strikes on ISIS and ISIL in Iraq and Syria

We can also expect continuing troubling news from Russia and Ukraine. It's always been clear to us that Russia wants a much bigger geographic buffer from Europe than simply the old border of Ukraine. In a prior posting, we examined the issue much more closely. A country like Ukraine that would become a NATO and EU member cannot sit only 354 miles from Moscow.[vii] It's their version of the Cuban Missile Crisis without the missiles. 

Ukraine and Crimea separatist map

The current map shows an effective buffer being built by Russia.[viii] Let's hope that's all they want and not a resurrection of the former Soviet Union as many pundits suspect. 

Of course any news on declining oil prices, strengthening dollar, jobs and inflation will adjust investors’ perspective on interest rates.[ix]

upcoming economic reports dates 2015

Right now investors are not expecting the Fed to raise rates until October of this year.[x]

Fed funds futures implied rate increase October

So while we enter a normally volatile cycle in the markets, don't let the variance spook you. Remember your portfolio is likely built on the averages, but the variances can always be painful.

Enjoy the "quiet" period.

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] Mian, S. (Feb 19, 2015). Zacks Earning Trends. Zacks Research. p 2.

[ii] Ibid.

[iii] Google Finance. (Feb 23, 2015). VIX Chart.

[iv] Yahoo Finance. Earnings Calendar.

[v] (Feb 23, 2015). GDP in US Dollars. Data from IMF World Economic Outlook, Oct 2014, for World GDP and Iraq, Iran, Turkey, Syria, Jordan, and Saudi Arabia).

[vi] (Feb 20, 2015). Battle for Iraq and Syria in maps.

[vii] (Feb 23, 2015). Distance from Moscow to Ukraine – Sumy.

[viii] Tharoor, I. (Sep 5, 2014). MAP: Russia’s expanding empire in Ukraine and elsewhere. The Washington Post.

[ix] Bespoke Investment Group. (2015). The Bespoke Market Calendar 2014/2015.

[x] (Feb, 22, 2015). Market expectations of the first Fed rate hike seem unrealistic.

Greece Again - Volatility and the Benefits of Diversification

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Return vs Volatility graph GB5 World Equity

On the face of it, most investors don't really care about what happens to Greece. Foreign conflicts and domestic issues were the top concerns in a recent survey of what concerns US high net worth investors.[i]

top investor concerns and undesirable places to invest

However, most of our allocated portfolios contain some form of global equity diversification. You most likely have some money invested in US stocks, International Developed stocks, and Emerging Markets stocks. 

Conventional investment and allocation wisdom suggests a diversified basket of equity holdings can reduce risk (volatility) without reducing expected returns.[ii]

You can see from the table below a traditional 60% equity/40% fixed income portfolio that is solely focused on US equities had a 10-year annualized return of 8.11% with 10.44% risk (standard deviation).[iii]

Risk and return for different portfolios

You can see from the data above, the returns are enhanced at a comparable risk level through the addition of actively managed International Developed and Emerging Market funds.

This is why you see us work to diversify across the globe. 

Now back to Greece. While there may be only a very small sliver of Greek equity exposure in the hypothetical portfolios above and 0% actual exposure in our current portfolios, the Greeks may have something to say about your International Developed returns.[iv]

Some definitions may be in order:[v]

  • International Developed equities are stocks from countries in Western Europe, as well as Canada, Australia, Japan, Israel, South Korea, Singapore, and Hong Kong.
  • International Emerging equities are stocks from countries in Central and South America, Asia, Africa, the Middle East, and Eastern Europe. This includes countries such as Brazil, Russia, India, China, Mexico, Thailand, Turkey, and Egypt.

I'll focus on the Developed countries and specifically Greece for this post, which was downgraded from Developed to Emerging Market status in 2013.[vi]

The European Union has integrated European countries together financially in a manner unlike any other in Europe’s history. Regrettably, Greece is a member of this union. 

Greece is a serial defaulter on debt. It has defaulted on external sovereign debt obligations five times in the modern era (1826, 1843, 1860, 1894, and 1932).[vii]

Unlike other countries in the EU, Greece has some issues: [viii,ix,x]

  • High unemployment
  • High budget deficits
  • High debt level, nearly double the Eurozone average
  • High levels of tax evasion, up to 30 billion Euros per year in uncollected taxes
  • Social services (health care, pension) equal 31.9% of all state expenses (2012).

Greek debt in comparison to Eurozone average

On top of those fiscal issues, Greece is running a total debt to GDP ratio of 174.9%. Compare that to the United States’ ratio of 101.5% and you get the picture.[xi]

Oh, one more small detail. That debt is due any month now and the lenders want to get paid. July looks particularly painful as Greece will owe its EU brethren lots of money as opposed to the IMF, which is located a few blocks from the White House. 

redemption profile of Greek government debt

As there is no method to exit the EU for member countries, the rules are being made up on the fly. 

  • Perhaps the Greeks will default and exit, converting their EU debt and currency back to their old drachmas?
  • Perhaps they will renegotiate the interest rates they are paying now (about 3% to 4% average for the IMF loans and 11% on Greek government bonds).[xii,xiii]
  • Perhaps they will simply extend the debt out buying themselves more time to address their fiscal challenges at home. 

No one knows what to make of Greece’s negotiating stance, but certainly we can expect some pretty rocky times ahead for developed market equities unless the Greeks come to terms with their reality. 

The last time the Greeks faced such dire consequences (2011), we saw developed market equities drop by 25% only to rally by 60% in the subsequent 32 months after they negotiated terms.[xiv,xv]

Greek equities market drop in 2011

I suspect we can expect the same this time. That's why we have been considering lowering our Developed Markets exposure and preparing to hold through the volatility. The long-term diversification benefits outweigh the risks in the short run.

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] Morgan Stanley. (Jan 26, 2015). High Net Worth Investors Optimistic About 2015.

[ii] Saletta, C. (Aug 13, 2014). Why Portfolio Diversification Is Vital to Investing Success. Motley  Fool.

[iii] Morningstar Direct.

[iv] Artisan Funds and Vontobel Asset Management. (Dec 31, 2014). Fund holdings.

[v] Wikipedia. Developed Markets and Emerging Markets.

[vi] Stoukas, T. and El Madany, S. (Jun 12, 2013). Greece First Developed Market Cut to Emerging at MSCI. Bloomberg Business.

[vii] Fox, E. (Sep 19, 2011). The History of Greek Sovereign Debt Defaults. Investopedia.

[viii] O’Brien, M. (Nov 14, 2014). Greece’s recession is over, but its depression will be the worst in history. The Washington Post.

[ix] Wikipedia. Economy of Greece.

[x] Wikipedia. Tax evasion and corruption in Greece.

[xi] TradingEconomics. (Feb 17, 2015). Greece and US Government Debt to GDP.

[xii] Chrysoloras, N. (Feb 2, 2015). Greece Seeks Third Debt Restructuring: Who’s on the Hook? Bloomberg Business.

[xiii] Ip, G. (Feb 11, 2015). Benefit of ECB’s Bond Buying: Fiscal Breathing Room. The Wall Street Journal.

[xiv] Morningstar Direct. 4/30/2011 to 9/23/2011 and 9/24/2011 to 6/6/2014.

[xv] Google Finance. EFA Index, price return only.


Do Nothing......Recently?

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depression era man napping on chair

Aside from your health, it's hard to imagine any endeavor other than investing where the outcomes can change so rapidly and matter so much.

If you examined equity performance before last week, you might have felt like you were exploring the depths of another major pull back. With the instantaneous media, access to so-called "credible" opinions, and real-time stock pricing at your fingertips, it's no wonder you might have felt anxious.[i]

Dow Jones and S&P during January 2015

[Note: Dow Jones Index (red line), S&P 500 (blue line).]

Now examine how strong a recovery we witnessed during the week. The S&P 500 was up 3.03% and the Dow was up 3.84%.[ii,iii,iv]

Dow Jones Index and S&P 500

[Note: Dow Jones Index (red line), S&P 500 (blue line).]

The bias to do something in the face of challenges is a common human reaction. It's very counterintuitive to just stand there.

That's why we rely on data to determine actions. Last week’s data was indeed very positive. To date, Q4 earnings have crushed estimates (71.8% of companies have beaten expectations), but overall growth (7.1%) is still below long-term averages (7.4%).[v]

q4 2014 growth rates and beat rates earnings revenue

We also had the following strong data on the general economy:[vi]

  • Nonfarm payrolls increased 257,000 last month, beating Wall Street forecasts.
  • Job creation data for November and December 2014 was revised upward by 147,000.
  • January marked the 11th straight month of job gains above 200,000, the longest streak since 1994.
  • The labor force participation rate rose 0.2% to 62.9%, indicating that more working-age Americans are employed or at least looking for a job.
  • Average hourly wages increased 12 cents last month, the largest gain since June 2007. Higher wages and lower fuel prices should provide a tailwind for consumer spending.

It's easy to get myopic in the face of bad data and react, particularly when your portfolio underperforms its respective benchmarks in the short run. It's critical to your success and well-being to stand back and reflect. Our job is to help you do just that.

First, if you have a properly allocated portfolio and a targeted rate of return, your objectives dictate you can expect to spend 40% of the time underperforming that benchmark over a 10-year period.[vii]

Some time is spent underperforming a benchmark

Conversely, you can also expect to spend 55% of the time outperforming that target. A mere 5% of the time your allocation will perform in-line with your expectations.[viii]

If you reacted each time you were disappointed from underperforming your benchmark, you would have a mess on your hands. “Don't do something, just stand there” while backwards sounding, has strong medicine for investors. 

  • Figure out what your portfolio needs to return over a long period of time.
  • Build a prudent allocation that matches those return objectives and time frame.
  • Rebalance appropriately.
  • Try not to time the markets, while still managing the risks.
  • Trust the long term averages and first principals of investing.

It's simple, but not easy. In fact, a recent (self-serving) survey suggested professionals can add up to 1.5% just on behavioral coaching.[ix] That's exactly what you should use us for - helping you to avoid the bias to action at times and to stay focused on your long-range performance expectations.

While volatility is increasing recently, you should rely on us for the appropriate amount of coaching.[x]

VIX volatility increasing over time 2014 2015

A revisit of your investment timeframes to continually adjust your target returns is always necessary. We will continually do our best to allocate to your objectives.

Sometimes it's a matter of doing something and sometimes it's a matter of just standing 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

Jeff Paul, Senior Investment Analyst – Phillips & Company



[i] Google Finance. (Feb 9, 2015). S&P 500 / Dow Jones Index chart (12/31/14-1/31/15).

[ii] Google Finance. (Feb 9, 2015). S&P 500 / Dow Jones Index chart (12/31/14-2/6/15).

[iii] Google Finance. (Feb 9, 2015). S&P 500 historical prices.

[iv] Google Finance. (Feb 9, 2015). Dow Jones Index historical prices.

[v] Mian, S. (Feb 6, 2015). Q1 Earnings Estimates Falling Sharply. Zacks Research.

[vi] Mutikani, L. (Feb 6, 2015). Strong U.S. job, wage gains open door to mid-year rate hike. Reuters.

[vii] Phillips & Company. (Jan 2015). Portfolio Returns over Time.

[viii] Ibid.

[ix] Kinniry Jr., F., et. al. (Mar 2014). Putting a value on your value: Quantifying Vanguard Advisor’s Alpha. Vanguard research.

[x] Yahoo Finance. (Feb 9, 2015). Volatility S&P 500 – VIX.

That Was Ugly

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ugly mountain bike crash on a gravel trail

With a large sigh of relief, we watched January fade to black. The US equity markets were down over 3% in the month.[i]

January equity markets performance 2015

Underlying their decline is some telling data that should come as no surprise to investors.

First, S&P 500 corporate earnings growth expectations were about 1.7%.[ii] Very meager compared to the 8.8% estimate back in early October.[iii] According to FactSet, 227 of the S&P 500 companies have reported earnings growth of 2.1% and revenue growth of 1.4%. 80% of companies reported earnings above estimates and 58% reported revenue above estimates. It's a bit of a split decision relative to the averages.[iv]

corporate earnings growth and beats q4 2014 

Unfortunately, Apple accounted for about 50% of the S&P 500’s earnings growth rate, as evidenced by the chart below. If Apple had reported actual EPS that matched the mean EPS estimate, instead of its 17.5% earnings beat, the S&P 500’s earnings growth rate would be 1.1% rather than 2.1%.[v]

S&P 500 q414 blended earnings growth rate q4 2014

Not surprisingly, and as noted in our past blog and look ahead, we also encountered some slowing in growth for the US economy. US GDP grew at a much reduced pace in the 4th quarter than Q3 2014.[vi]

United states GDP growth rate from 2012 to 2015

The predictable components of the GDP numbers were the very strong consumer spending numbers, while the big drag was in the trade balance (exports-imports).[vii,viii]

annualized change to real and nominal gdp with contributors break out

united states balance of trade graph

As we have discussed, the blistering strong dollar has created some headwinds for large companies and simultaneously created some very cheap overseas goods for US consumers to devour. For example, Proctor and Gamble shaved off 5% of its revenue and 14% of its core earnings per share due to the dollar’s strength.[ix]

As we opined in our Quarterly Look Ahead, the US Consumer can hold up the world for a while and perhaps emerging markets can sort themselves out in the meantime. I put it at a couple of quarters before we see some consumer headwinds.

Eyeballs on the Target

Here is what we are looking at very closely as the strong dollar, trade deficit, disinflationary expansion cycle unfolds:

  • Catalysts that can impact the dollar.
  • Continued sanguine US corporate earnings.
  • Foreign treasury rates (10-year) as a directional indicator of US Treasuries.
  • Consumer spending habits in light of the low gasoline price windfall.

What we will likely experience in this phase of the cycle is much more volatility and perhaps a full-fledged correction if earnings limp along at a below estimate pace.

Hang on because your resolve will be tested and hopefully your conviction in your plan will not weaken. Remember, you need some degree of risk to generate returns. Let’s just make sure it's the right level of risk. That's why your advisor is here for you.

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] Google Finance. (Feb 2, 2015). S&P 500 chart.

[ii] Butters, J. (Jan 30, 2015). Earnings Insight. FactSet. p 1.

[iii] Butters, J. (Oct 3, 2014). Earnings Insight. FactSet. p 8.

[iv] Butters, J. (Jan 30, 2015). Earnings Insight. FactSet. p 4-5.

[v] Ibid. p 2.

[vi] TradingEconomics. (Feb 2, 2015). United States GDP Growth Rate.

[vii] TradingEconomics. (Feb 2, 2015). United States Balance of Trade.

[viii] Hoyt, S. (Jan 30, 2015). United States: GDP. Moody’s Analytics.

[ix] (Jan 27, 2014). Procter & Gamble’s Q4 2014 Results – Earnings Call Transcript.

Going In Through the Exit

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a crowded chapel with ornate ceilings

It's not often I "go political" in the weekly commentary and certainly this edition has the potential to be misconstrued as political. 

The President was at the top of the list for major events with The State of The Union speech this week. Skipping the political posturing, there were some very specific recommendations the President made in the name of "middle class economics". 

Ideas like:

  • Paid Childcare
  • Free Community College
  • Paid Sick Leave
  • Paid Maternity Leave
  • Gender Pay Equality
  • Higher Minimum Wages

All of these ideas are noble and taken individually, who wouldn't want one or all of them?

In fact, many companies offer some or all of these ideas without pressure from the US Government. It's simply good business to offer these to employees and in many cases it’s a necessity to be competitive in the free market. 

Ironically, just a few days after the President offered his prescription for the middle class, Europe offered theirs. 

Europe has been stuck in a slow-growth economy since about 2001, as measured by GDP growth. The chart below shows EU GDP growth stagnant since the Great Recession.[i]

euro gdp annual growth rate from 2000 to 2014 

The EU announced massive quantitative easing to the tune of $68 billion of dollars per month lasting until at least September 2016.[ii] Not surprisingly, the President of the EU Mario Draghi made an extraordinary admission.[iii]

For that [to attract capital and create jobs], we need structural reforms which foster competition, reduce bureaucracy and improve the flexibility of labor markets.

His call for structural reform, while not specified, is not hard to figure out. Let's take a look at what Europe offers in structural social programs (middle class economics).[iv,v,vi,vii,viii]

social programs in European countries 

It's clear European Union countries are needing to leave the room while the US is trying to enter. 

When you consider our GDP growth over the last 15 years since the EU completed its final stage (Euro introduced), it's a remarkably stronger story.[ix]

GDP growth of US versus European countries

It's not to say we would experience the same outcomes Europe has faced, but what was good for Europe is certainly not what the US might need. European countries come from a different social structure than our country. "Old World feudalism, with its centuries of rigid class barriers and attendant lack of opportunity for mobility based on merit," drove European countries to contain the middle class through social welfare according to Nicholas Eberstadt in his recent article in National Affairs.[x]

On the face of where the President wants to go relative to Europe, it’s not good news. However, there is some good news for the investor class. The third year of presidential cycles tends to be the best performing for US equities.[xi]

third year of presidential cycles tends to be the best performing for equities 

Perhaps that's due to the lame duck nature of the President’s job in the final two years of his term.

Going in while Europe exits should be informative. We will watch closely, but expect little in the face of the current balance of power in Washington DC and the nature of political silly season. 

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] TradingEconomics. (Jan 26, 2015). Euro Area GDP Annual Growth Rate.

[ii] Migliaccio, A. and Costelloe, K. (Jan 23, 2015). ECB’s Quantitative Easing Program Is Open-Ended, Official Says. Bloomberg.

[iii] Geiger, F. (Jan 24, 2015). ECB’s Mario Draghi Calls for Deeper Economic Integration of the Eurozone. The Wall Street Journal.

[iv] Ray, R., et al. (May 2013). No-Vacation Nation Revisited. Center for Economic and Policy Research.

[v] Heymann, J., et al. (May 2009). Contagion Nation: A Comparison of Paid Sick Day Policies in 22 Countries. Center for Economic and Policy Research.

[vi] Organization for Economic Cooperation and Development (OECD). (Jan 5, 2014). Full-rate equivalent paid maternity, paternity, and parental leave, 2013.

[vii] OECD. (2014). OECD Family Database: Public Expenditures on pre-school per child, 2011.

[viii] Wikipedia. (Jan 2015). List of minimum wages by country.

[ix] Federal Reserve Economic Data. (Jan 26, 2015).

[x] Eberstadt, N. (Winter 2015). American Exceptionalism and the Entitlement State. National Affairs, issue 22.

[xi] Phillips & Company. (Jan 2015). Q1 2015 Look Ahead. p 14.

Disinflationary Expansion

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hot air balloon disinflating 

The world seems a bit confusing to the average investor. Generally, if the US economy is expanding you would anticipate inflation, especially if you consider all the money sitting on the Federal Reserve's balance sheet.

Inflation (dotted line) leads to higher interest rates (solid line) in most cycles.[i]

inflation and interest rates between 1976 to present

It's a bit counterintuitive to see the US economy expanding with no signs of inflation - as a matter of fact, perhaps even signs of emerging deflation.[ii,iii]

commodity price and CPI deflation during 2014

CPI deflation during the second half of 2015

This trend is coupled with continued drops in interest rates.[iv]

falling interest rates during 2014 10y bond

These periods of time, called disinflationary expansions, are when the economy is expanding and yet inflation is slowing. While not pure deflation, it could be a precursor.

We have experienced many periods of time with a disinflationary expansion context. Take for example the period of time from 1983 to 1989.

  • We saw the US economy expand by 7.8% a year on average, 141% above the long-term average growth rate of 3.24%.[v,vi]
  • We watched average annual inflation slow by 21.6% from 6.16% to 4.83%, reaching a low of 1.91% in 1986.[vii]
  • We also witnessed interest rates fall from 10.4% to 7.9%, a 24% decline.[viii]

There were plenty of naysayers about the sustainability of this type of economic juxtaposition. Yet if you sat out this period, you would have missed a market that rallied 153%, one of the strongest markets in the history of US stock markets.[ix]

1980s bull stock market graph 

The world is clearly slowing and central bankers are panicking across the globe. Switzerland, Turkey, Denmark, and India all took extraordinary measures in the last week, following China’s rate cut last November.

interest rate cuts at central banks round the world in 2014

Meanwhile, the US continues to move deeper into its disinflationary expansion phase.

So what asset classes and sub-asset classes can benefit from the underlying characteristics of this period?

  • Lower rates would benefit longer duration bonds, as well as high yield investments. 
  • Real estate has some very long duration and generally fixed payments.
  • Clearly from our 1980's example, the S&P 500 would also be an excellent asset class to exploit. 

While this period of time is fraught with the risk of turning purely deflationary, it can also be an excellent time to take advantage of this environment.

That’s exactly what we will try to do in the coming months. 

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] (Jan 20, 2015). US Govt 10-Yr Bond and Inflation Rate.

[ii] (Jan 20, 2015). Oil and Gold Price Charts

[iii] (Jan 20, 2015). US Consumer Price Index.

[iv] (Jan 20, 2015). US Government Bond 10 Year.

[v] Federal Reserve Economic Data. (Jan 20, 2015).

[vi] (Jan 20, 2015). US GDP Annual Growth Rate.

[vii] (Jan 20, 2015).

[viii] Federal Reserve Economic Data. (Jan 20, 2015).

[ix] Google Finance. (Jan 20, 2015).

[x] Baghdjian, A. and Koltrowitz, S. (Jan 15, 2015). Swiss central bank stuns market with policy U-turn. Reuters.

[xi] Candemir, Y. (Jan 20, 2015). Turkey Central Bank Cuts Rates Amid Political Pressure. The Wall Street Journal.

[xii] Durden, T. (Jan 19, 2015). Denmark Goes NIRP-er; Slashes Rates To -20bps Amid Currency Peg Fears.

[xiii] Bradsher, K. (Jan 14, 2015). Suddenly, India Cuts Interest Rates. The New York Times.

[xiv] Wei, L. (Nov 23, 2014). China Central Bank Cuts Interest Rates. The Wall Street Journal.

"Waiting for the Other Shoe to Drop"

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shoes falling from the sky cartoon

While scanning several economic indicators this week, one indicator had a small hiccup, which gave me a bit of indigestion. Auto loans appear to be increasing in delinquency. The data suggests we are seeing acceleration in delinquency rates not only from Q2 2014 to Q3 2014 of 18.4%, but also 2013 to 2014 of 13.4%.[i]

auto loan delinquency rates accelerating during 2014

Delinquency rates have also increased across all age groups.[ii]

auto loan delinquency rates increasing across all age groups

At the same time we are seeing a rise in loan debt per borrower along with an explosion in total outstanding credit.[iii,iv] It's clear we might be in an auto loan credit bubble. 

increase in loan debt per borrower post recession

Is it possible the persistent lack of wage growth is taking a toll on auto loans?  If so, a recent report on wages was not very helpful.[v]

persistent lack of wage growth post recession

What can be particularly troubling is our recent recovery has in large part been fueled by strong auto sales. Some expect the US to top 17 million in vehicle sales in 2015.[vi]

recovery in light weight vehicle sales post recession

So how much is our economy dependent on autos? The automotive industry, including dealerships, accounts for approximately 3.5 percent of U.S. gross domestic product.[vii]

It's possible we may see a mini financial crisis within the auto finance industry. That's one of the reasons we review our bond managers’ exposure to auto finance. If we experience a hiccup in auto sales, our economy is diversified enough to withstand it. However, we’re not going to "wait for the other shoe to drop". We’re limiting our exposure to auto-related credit. 

Please take a look at our Quarterly Look Ahead Presentation by clicking this link

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] TransUnion. (Nov 24, 2014). Auto Loan Delinquency Rate and Debt Rise Again.

[ii] Ibid.

[iii] TransUnion. (Q3 2014). Auto Loans.

[iv] Federal Reserve Economic Data.

[v] Ibid.

[vi] Ibid.

[vii] SelectUSA. (Retrieved on Jan 12, 2015). The Automotive Industry in the United States.


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divergent arrows split

One of the best returning asset classes this last year was the US Dollar.[i]

graph of US dollar rally during 2014

It's no surprise with so many things looking so good for the US Economy:

  • Interest rates and inflation remain low.
  • Consumers have more money to spend thanks to savings from low oil prices.
  • Consumer sentiment is at an 8-year high.[ii]
  • Year-over-year retail sales have consistently increased 4% to 5.1% since March 2014.[iii]

Forecasts for US GDP growth have been improving and not surprisingly the S&P 500 has given us another strong year. Compared to previous bull market periods, we may still have room for further gains.[iv]

historical forecasts of US GDP growth since 1877

Everything seems consistent with our economy. So how is it that China seems to be doing exactly the opposite?

China is having a slowdown in growth, its central bank is stimulating its economy, and property prices are declining, yet China’s stock market rallied over 40% in 2014.[v]

China declining GDP growth rate since 2011

China government 10Y bond rate decline

China new built house price YOY change decline

China Stock Market SSE increase over time

It appears China has the ultimate divergence. Illogical as this might appear, one thing China investors might be anticipating is a return of its strong export driven economy. China is, after all, the largest exporter in the world.[vi,vii]

Leading export nation information

In fact, when you look at China’s percentage of exports relative to its GDP, you can see how export dependent it really is. 

While the Command and Control (whatever they call their government) of China has emphasized internal growth through local consumption, China is poised to benefit from a resurgence in exports. 

When you consider how strong the dollar has been, which makes Chinese exports so much cheaper than our exports, perhaps the surge in China’s equity markets is warranted.[viii]

surge in chinese stock market versus US dollar strength in 2014

Perhaps the China market miracle is not as divergent as one might have thought. This is one of the reasons we are using emerging market managers that focus on China among a few other countries.

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] TradingEconomics. (Jan 5, 2015).

[ii] Ibid.

[iii] Ibid.

[iv] Short, D. (Jan 2, 2015). Secular Bull and Bear Markets. Advisor Perspectives.

[v] Trading Economics. (Jan 5, 2015).

[vi] Workman, D. (Jan 5, 2015). World’s Top Exports: Products and Countries.

[vii] (Jan 5, 2015). World GDP Ranking 2014. Data from IMF World Economic Outlook (Oct 2014).

[viii] Trading Economics. (Jan 5, 2015).

Season’s Greetings from the Stock Market

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santa with 50 thousand dollars cash

After declining during the first half of December, the Dow Jones and S&P 500 indices rebounded to close at new highs on December 26th, providing a nice holiday gift to investors. Historically, the month of December has performed very well with the S&P 500 averaging a 1.79% return over the 21-year period from 1990-2010 and declining in just 4 of those years.[i]

December market returns in equities markets

As of December 26, the S&P 500 is up 1.03% since November 30, so it’s a little below average.[ii] However, if we have a Santa Claus Rally to end the year, there could be some more upside. The Santa Claus Rally spans the last 5 trading days of the year and the first two in January. Since 1896, the Dow has seen a Santa Claus Rally 77% of the time, averaging a 1.7% gain.[iii]

average return for Dow Jones during holiday rally

Potential causes for this rally include an influx of cash from year-end bonuses, reinvestment of tax loss sales that occurred earlier in December, and positive sentiment during the holiday season. This year, we may also thank the Federal Reserve for saying it would remain “patient” with respect to interest rate increases, and of course, low oil prices are giving everyone a little extra money in their pocket.[iv]

Despite being at historic highs, there’s the potential for the market to extend its gains in January. This could bode well for the stock market in 2015 due to another phenomenon known as the January Effect, which states that “as goes January, so goes the year”. From 1947 to 2013, when the S&P 500 was up in January, it only declined for the full year 4 times. When the S&P 500 was down in January, full-year results were mixed.[v]

January Effect in equities markets

So what could support the stock market rally through January and 2015?

American motorists are saving $630 million on gasoline compared to what they paid at June prices, which equals $230 billion if prices stayed at current levels for a full year.[vi,vii]

12 month retail gasoline chart in 2014

Consumers are spending some of these savings, as U.S retail sales rose 5.5% from Black Friday through Christmas Eve compared to 2013, and the National Retail Foundation is forecasting a 4.1% sales increase for November and December, the biggest jump since 2011.[viii] Overall, the month-over-month change in retail sales has been positive for most of this year.[ix]

US Retail sales monthly changes

Retail sales growth may receive support from stronger consumer sentiment, which reached an 8-year high.[x]

United States consumer sentiment from 2006 to 2014

Positive earnings surprises in January could also fuel a stock market rally. Currently, overall Q4 earnings expectations are for just 2.2% year-over-year growth.[xi]

evlution of Q4 earnings estimates

Industries that benefit from lower fuel costs, either directly or indirectly (e.g. lower shipping costs), could deliver higher-than-expected earnings. For example, jet fuel prices have fallen from $2.88 to $2.46 per gallon since June. Every penny decline in jet fuel prices reduces the industry’s costs by about $190 million a year, yielding an estimated $8 billion in savings.[xii] Retailers and businesses should also benefit from reduced shipping and transportation costs. Goldman Sachs estimates that fuel cost savings invested by businesses and governments will boost economic growth by 0.1 to 0.2 percentage points over the next year.[xiii]

Regardless of January’s performance, the stock market may also benefit from 2015 being the third year of the presidential cycle. Since 1900, the S&P 500 has increased an average of 10.7% (excluding dividends) in the President’s third year and had positive returns 75% of the time.[xiv]

S&P 500 performance during the presidential cycle

While the President is a “lame duck”, if he wants to end his office on a higher note, he may work more with the Republican Congress. Potential areas that could see progress are a tax system overhaul and the Keystone oil pipeline.

We appear to be on-track for a positive end to the year and the stage is set for the December rally to continue into January. While the energy sector remains under pressure, energy-intensive industries (power users, transportation) will benefit from fuel cost savings. We will soon learn if the decline in oil prices helps their bottom lines enough to extend the stock market rally through January, which would be a positive sign for 2015 based on the January Effect.

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] Holmes, F. (Dec 17, 2010). Do You Believe in a Santa Claus…Rally?.

[ii] Yahoo Finance. S&P 500.

[iii] Anderson, K. (Dec 16, 2014). Santa Claus Rally 2014 Is Not the Real Reason Stocks Will Rise. Money Morning Insider.

[iv] Appelbaum, B. (Dec 17, 2014). Fed Says It Will Be ‘Patient’ on Interest Rate Timing. The New York Times.

[v] Yardeni, E. (Jan 7, 2014). Here Are The Complete Stats For The Stock Market ‘January Effect’. Business Insider.

[vi] Mufson, S. (Dec 1, 2014). As oil prices plunge, wide-ranging effects for consumers and the global economy. The Washington Post.

[vii] (Dec 28, 2014). Regular Gas Prices: 12-month Average Retail Price.

[viii] Layne, N. (Dec 26, 2014). Women’s apparel, dining drive U.S. holiday sales: Mastercard. Reuters.

[ix] (Dec 29, 2014). U.S. Retail Sales.

[x] (Dec 29, 2014). United States Consumer Sentiment.

[xi] Mian, S. (Dec 18, 2014). Handicapping the Q4 Earnings Season. Zacks.

[xii] Davidson, P. (Dec 7, 2014). Businesses reap windfall from cheaper gasoline. USA Today.

[xiii] Ibid.

[xiv] Constable, S. (Dec 7, 2014). Can the ‘Presidential Cycle’ Boost Stocks?. The Wall Street Journal.

Oil Again?

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Oil well geyser spurting black and white

I know we have opined on the price of oil for the last couple of weeks and perhaps the topic is getting a bit tired. However, when the price of any asset class drops as precipitously as oil has, the topic merits continued examination.

Those joyfully absorbed in the holidays perhaps haven’t realized the price of oil has dropped over 47% since June 20,2014.[i,ii]

WTI Cushing oil price per barrel in 2014 

I received an interesting chart from a well-respected CIO (Chief Investment Officer) this week, which put a bit of concern into my thinking.[iii]

S&P 500 and WTI Crude divergence

On the face of this chart, one would surmise that the price of West Texas Intermediate Crude (WTI) is highly correlated to the S&P 500 and the divergence since mid-2012 merits a large correction within the S&P 500. Fortunately, we have other data that suggests this is not necessarily the case. 

Our friends at JP Morgan presented an interesting perspective this week during an informative conference call I attended. When they examined past major drops in oil prices since 1974, 5 of the 8 episodes led to higher equity prices not lower.[iv]

Chart of equity markets during historical rapid declines in oil price

It really just depends on the circumstances associated with the drop. In the current case, it may be more of a supply shock than a precursor to a significant global slowdown. The International Energy Agency has reduced its outlook for 2015 global oil demand growth, but it is still projected to grow by 900,000 barrels per day and 2015 total demand is estimated above 2014 levels.[v]

World oil demand over time 

What's comforting about the drop in oil is much of the price decline will find an equilibrium level.  Here's why:

We know gas prices have dropped and that will motivate people to drive more, take trips, and buy larger cars. All of that is good for our economy.

Airlines will certainly benefit from lower jet fuel prices, driving lower fares and making trips more affordable for travelers. Perhaps this will be an impetus to buy more aircraft too. All of this is certainly good for our economy.

Manufacturers need oil for various parts of their process from inputs to energy for operating facilities. Energy savings will certainly benefit this cohort, which could lower prices to consumers and more importantly offset our rising dollar. This could help our manufactured goods to compete overseas in spite of a strong dollar. 

During my visit to Houston and Dallas a few weeks ago to explore energy investments, it was abundantly clear to me that the largest oil and gas producers were ready to benefit from more competitive service contracts from their vendors. As oil prices dropped, so did the demand for vendor services, helping oil companies to lower their extraction costs.

Further, if need be, energy companies can "lay down" rigs and shrink supply, which is exactly what's happening right now.[vi]

baker hughes oil and gas rig count

You get the point. Like other ecosystems, the energy sector has a self-correcting system that can help stabilize its pricing and profits. 

Further, there are some very strong indications from other areas of our economy based upon lower oil prices. Again from our friends at JP Morgan, sectors such as Basic Materials and Consumer Discretionary can benefit from the decline in oil prices.[vii]

five instances of 40% year on year oil price declines and consumer discretionary outperformance

One thing to note during this rapid decline in prices is the impact on high yield bonds. Currently energy debt comprises about 18% of all high yield bond issuance.[viii] The follow-on effect of a large drop in oil prices (shown in red) has caused investors to panic as it relates to energy debt and as a bystander, high yield debt in general (shown in blue).[ix]

energy high yield bonds versus oil price graph

While I don't think anyone, especially me, can predict macro events, I am quite comfortable in suggesting that panicky investors generally overreact and sell, which creates a buying opportunity for others. 

That's certainly been the case with MLPs (Master Limited Partnerships) to some extent, which is a position we have maintained in most of our allocations. While MLPs benefit from volume of oil not pricing, they too have been hit fairly hard. We expect rational thinking to return to the market. Unfortunately, markets and participants can act irrationally much longer than I have ever expected. We will certainly be examining this sector very closely for opportunities to add to our current allocations in the coming quarter.

On behalf of the entire Phillips & Company team, we want to wish you a very happy holiday and a healthy and prosperous 2015. We are grateful for your gift of trust and confidence and don't take that precious gift lightly.

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. (Dec 22, 2014). Crude Oil Prices (WTI).

[ii] (Dec 22, 2014). WTI Crude Oil.


[iv] Cembalest, M. and Pil, A. (Dec 16, 2014). The Shifting Landscape of Global Oil Markets and Implications for Financial Markets. JP Morgan. p 15.

[v] IEA. (Dec 12, 2014). World Oil Demand.

[vi] (Dec 19, 2014). Baker Hughes Oil & Gas Rig Count.

[vii] Cembalest, M. and Pil, A. (Dec 16, 2014). The Shifting Landscape of Global Oil Markets and Implications for Financial Markets. JP Morgan. p 16.

[viii] Fox, M. (Dec 3, 2014). Huge Opportunity in high-yield bond market: Pro. CNBC.

[ix] Hanlon, S. (Dec 16, 2014). Oil’s Price Decline Weighs On High Yield Debt.

Energy Deflation and Consumer Inflation

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up and down arrows

It appears market participants are growing more concerned about global deflation rather than focusing on the benefits of cheaper energy prices.

Across the spectrum of commodities you can see noticeable drops in prices.[i]

drop in prices across commodities during 2014

As most of these are industrial commodities, their prices certainly forecast a global slowdown. The steep price decline in oil, about 45% since July, has more to do with the current supply/demand imbalance in the market. The more moderate declines in the other commodities of about 6% to 11% suggest a slight global slowdown.

In fact, the IMF has lowered global GDP growth forecasts for this year as well as 2015 by 0.1% and 0.2% respectively.[ii]  

IMF projections for world output in 2014

The challenge for investors is to consider the slowdown relative to the benefits of much lower energy prices. Many of the largest economies in the world are energy importers. Up until recently, this included the United States. Earlier this year, the US government allowed us to start exporting ultra-light oil for the first time since 1974.[iii] The US government continues to debate ending the 40-year ban on crude oil exports.

You can see from the chart below which countries will add growth to GDP from much lower oil prices. Besides the losers on the chart, the other big losers not listed will be: Nigeria, Iran, Libya, Iraq, Saudi Arabia, Brazil, Venezuela and ISIS.[iv]

global economy gets an energy boost

When you think about a global GDP of $77 trillion, the winners amount to over 65% of that global GDP whereas the large losers only amount to about 9% of global GDP.[v]

Sure there will be small hits to capital expenditures on oil and gas equipment, but the vast majority of GDP growth comes from consumer spending as opposed to business spending.[vi] 

Components of Q3 2014 GDP

While it's certainly a time for caution, the overwhelming data suggest lower oil prices benefit the larger contributors to global growth. Certainly a period of slowness may be around the corner, but that could easily be offset by more global consumer spending. 

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] NASDAQ. (Dec 15, 2014).

[ii] International Monetary Fund. (Oct 7, 2014). Global Growth Disappoints, Pace of Recovery Uneven and Country-Specific.

[iii] Gallucci, M. (Nov 7, 2014). Larry Summers Says Lifting Export Ban on US Crude Oil Would Lower America’s Gasoline Bills. International Business Times.

[iv] Zandi, M. (Dec 12, 2014). U.S. Macro Outlook 2015: Spirits Unleashed. Moody’s Analytics.

[v] (Dec 15, 2014). World GDP Ranking 2014. Data from IMF World Economic Outlook, October 2014.

[vi] JP Morgan. (Nov 30, 2014). Q4 2014 Guide to the Markets. p 17.


The Economy Shifting to a Higher Gear

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ferrari gated shifter

The recent employment report released on Friday gave us the strongest sign of the year that the US macro-economic picture is looking very strong. The US economy added 321,000 jobs in November of which 314,000 were in the private sector.[i] This is the best year for employment since 2000 based on the annual change in total nonfarm employment through November.[ii,iii]

change in nonfarm employment graph 

Needless to say, more jobs mean more income and that in turn can drive more consumption and confidence. While it's hard to predict the overall impact of more jobs and spending on corporate earnings, we would expect corporate earnings to reflect these positive developments in the coming quarters.

What's particularly good news is that jobs increased across all sectors, except mining and logging which had no change in November.[i] Further, there is a wide dispersion from low income service jobs to higher paying professional type jobs.

jobs added in November 2014 

There continues to be a lack of wage growth in the economy on a midterm basis, but even wages had a nice uptick in November. Wages grew by 0.37% or about 4.5% annualized.[i] The year-over-year percent change in average hourly wages has steadily increased since 2010.[iv]

wage growth over time fred

Going forward, focus areas will continue to be consumption-oriented industries and perhaps cyclicals. As far as markets being over bought, you can see a compression of small-cap PE ratios from the start of the year until now, not an expansion, and growth stocks remain below their historic PE averages.[v,vi]

pe ratios vs the historical average

This certainly suggests companies are earning more and valuations, while elevated, may be sustained as consumers shift to a higher gear.

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] Bureau of Labor Statistics. (Dec 5, 2014). The Employment Situation – November 2014. U.S. Dept of Labor.

[ii] Federal Reserve Economic Data.

[iii] McBride, B. (Nov 28, 2014). Possible Headline for Next Friday: “Best Year for Employment since the ‘90s”. CalculatedRisk.

[iv] Federal Reserve Economic Data.

[v] JP Morgan (Jan 2014). 1Q 2014 Guide to the Markets.

[vi] JP Morgan (Nov 2014). 4Q 2014 Guide to the Markets.


The Virtuous Economy - Spinning at Last

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Diagram of a loom 

It's been well over 4 years since we wrote about the need for the return of the self-fulfilling economic cycle, one where the consumer earns and spends. In turn, US companies earn, hire, and produce, which drives more income earners to spend. It’s a "virtuous cycle" or a complex chain of events with a reinforcing feedback loop to be certain.

That's exactly where I think we are today. 

Last week we saw the US economy grow by 3.9% in Q3, revised up from a prior estimate.[i] Much of that growth came from consumption and an expansion of inventories, both strong components of the "virtuous cycle".[ii]

real personal consumption expenditures graph

Total business inventories over time 

Another strong indication of the cycle is the amount of savings the US consumer is willing to spend down. From the chart below you can see some relatively high savings rates and certainly a willingness to spend down.[iii]

Personal saving rate spike during 2008

Further, a historic drop in oil prices is a strong additive to the consumer’s wallet.

crude oil WTI graph over time

While we can speculate on the timing of a rise in oil prices, there are certainly some forces that are at play.

  • Incentives for the Saudis to keep production at current levels motivated by our involvement in Syria. Any punishment of Russia and Iran are added bonuses.
  • A dynamic US oil patch that can produce profitable oil in the low $40 per barrel range in many regions.

While production cuts can be made and felt in 3 months or less, these are some trends that can keep prices low and drive more disposable dollars into the US consumer's pocket.

Further, we are seeing a small lift in personal income and more Americans getting back to work. In fact, 2014 is setting up to be one of the best years for employment since the mid-1990's. If the November report comes in at 176k+ jobs we will certainly be on track to beat some employment records.[v]

As of the October BLS report, the economy has added 2.225 million private sector jobs, and 2.285 million total jobs in 2014.[vi] The consensus is the economy will add another 220 thousand jobs in November (215 thousand private sector jobs). If that happens, 2014 will be the best year for private employment since 1999.[vii]

Here is a table showing the best years for nonfarm employment growth since 1995. To be the best year since the '90s, the economy needs to add an additional 222 thousand total nonfarm jobs.[viii] This could happen in the November report to be released next Friday, December 5th, or in the December employment report to be released in early January.

top years since 1995, change in nonfarm payrolls

This is happening with only 60 thousand public sector jobs added so far this year. For comparison, there were 186 thousand public sector jobs added in 2005.[ix]

Confirming all of this is the amount of sales this weekend. While store sales on Black Friday were reportedly down 7%, special attention should be paid to two trends, the amount of sales occurring on Thanksgiving Day and the record amount of digital sales.[x]

  • Store sales on Thanksgiving Day increased 24% to $3.2 billion.[xi]
  • Thanksgiving Day online sales were up 14.3% compared to 2013.[xii]
  • Black Friday online sales were up 9.5% compared to 2013.[xiii]

We will soon find out if Cyber Monday sales follow this trend and provide a boost to the Thanksgiving weekend sales total.

All of this speaks to the amount of confidence that the US Consumer currently has. It's certainly higher than in the past several years.[xiv]

United states consumer sentiment

It's hard to imagine the largest single-country economy in the world, ours, being built on something as fragile as confidence. However, it's that simple concept that can keep the virtuous cycle spinning through the end of the year. 

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] Udland, M. (Nov 25, 2014). America Beats Expectations. Business Insider.

[ii] Federal Reserve Economic Data.

[iii] Ibid.

[iv] (Dec 1, 2014). Crude Oil WTI.

[v] McBride, B. (Nov 28, 2014). Possible Headline for Next Friday: “Best Year for Employment since the ‘90s”. CalculatedRisk.

[vi] Ibid.

[vii] Ibid.

[viii] Ibid.

[ix] Ibid.

[x] AP. (Nov 29, 2014). Black Friday Sales Fall as Sales Start Earlier. ABC News.

[xi] Ibid.

[xii] IBM. (Nov 2014). U.S. Retail Black Friday Report 2014. IBM.

[xiii] Ibid.

[xiv] US Consumer Sentiment.


Trying Not To Lose A Decade

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deflation shark

This week the European Central Bank President (Draghi) signaled what we had been anticipating for quite some time. He stated at a banking conference on Friday, the ECB would “do what we must to raise inflation and inflation expectations as fast as possible.”[i]

harmonized index of consumer prices in euro area

It's no wonder when looking at how very low inflation is in Europe. [ii]
Following those comments, but most likely uncoordinated, the Chinese Central Bank or Peoples Bank of China cut their interest rate. Mostly driven by concerns the country won't meet its 7.5% growth target. This is their first rate cut since July 2012. [iii]

Global slowing is confirmed by US based companies and their earnings. You can see from the image, US companies with more sales in the US are posting much higher earnings and revenue growth. [iv]

global slowing in earnings growth from companies with sales outside of US

Much of that international slowdown is from Europe and can be seen in some of the Dow 30 component companies.
With exception of one of our local companies in Oregon (Nike), European revenue growth by some of our largest US companies was either very anemic or declined in the 3rd Quarter. [v]

Dow 30 revenue growth in Europe

One reason world markets reacted very favorably to these Central Bank activities is the favorable perception the US Central Bank has garnered from their adventurous ways in the form of Quantitative Easing. The thinking goes something like "the US Economy looks stronger than global economies because the Federal Reserve cut rates and bought massive quantities of bonds." Only time will tell whether that is true or not.

The bottom line is there are very few economic tools once an economy slips in to a deflationary cycle. The cycle is simply hard to break.

deflationary spiral

Because deflation is hard on equity investors, companies, and wages, central banks will do just about everything they can to avoid a Japanese “lost decade”.

The Japanese economy went through a very prolonged period of deflation from 1991 - 2013 and their equity markets dropped 55.9% during that same period. [vi, vii]

Nikkei 225 vs inflation, a lost decade

It's no wonder bankers would rather spend to avoid a global lost decade. Perhaps that may provide for a payoff on allocations with international developed and emerging economy components as we currently 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
Jeff Paul, Senior Investment Analyst – Phillips & Company


[i] Jolly, D (Nov 21, 2014). Mario Draghi Says E.C.B. Will ‘Do What We Must’ to Stoke Inflation. New York Times.

[ii] Federal Reserve Economic Data.

[iii] Wei, L (Nov 23, 2014). China Central Bank Cuts Interest Rates. Wall Street Journal.

[iv] FactSet (Nov 21, 2014). Earnings Insight.

[v] Ibid.

[vi] Yahoo Finance Nikkei 225.

[vii] Federal Reserve Economic Data.


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lounging on a wooden chair on a white sand beach

The Q3 earnings season ended with a report from Walmart last week. When we kicked this season off, expectations were very low but gradually improved. 

S&P 500 companies were expected to grow earnings by 1.3% at the launch of the season and they produced a whopping 6.9% growth.[i,ii]

Evolution of Q3 total earnings growth estimates


Unfortunately, investing requires you to live in the future.  While we can allocate out some of the risk of uncertainty, in my estimation, you still need an opinion when allocating assets. So any deep breath that we can take is short lived.

One of the biggest fundamental challenges is the higher than normal valuations on my favorite valuation metric, the cyclically adjusted price-to-earnings ratio or CAPE. We've opined on this on several occasions.  

With an exceptional earnings season behind us, we can see the CAPE hardly moved.[iii]

shiller pe 10 cape ratio over time graph

With a current CAPE of 26.4, S&P companies are certainly valued at the higher end of the range. 

So what would it take to see a normalization in the CAPE?  Two things make up the CAPE: stock prices and earnings.

In order for the CAPE to revert to its mean of 16.6, stock prices could drop 37.1% in the next 3 years or an average annualized return of -14.3% on the S&P 500.[iv]

Another possibility is for earnings growth of 9% over the next 7 years, assuming 2% inflation and stocks increasing an average of 3%. The table below provides some other scenarios that could potentially get the CAPE closer to its long-term mean.[v]

potential cape ratio scenarios 

A key takeaway is that if the Shiller CAPE reverts toward its mean, stock returns will be muted unless earnings stay very strong.

So in our real world case with the US economy improving, something would have to materialize for us to be in the very fortunate scenario. What would create an environment to propel S&P 500 companies to post astounding EPS growth in the 10%+ range?

Here are a few milestones in my opinion and the catalyst to see that happen:

potential scenarios for cape ratios

Here's the good news - all of these catalysts have the possibility of materializing.

Congress is willing to act and so is the President. Presumptive Senate Majority Leader Mitch McConnell said the Senate “needs to be fixed” and that he and his Republican colleagues are willing to work with President Obama on some issues.[vii] White House press secretary Josh Earnest said,

“If there are things that the president can do differently to make sure that we're getting results for middle class families, for the American people, then he's willing to change his tactics to do exactly that.”[viii]

US housing is in very short supply.[ix]

milestones and catalysts 

Since 1964, annual wage growth has exceeded 2% every year, except the recent recessions in 2001-2002 and 2008-2010.[x]

US housing is in short supply, a graph from FRED

While it's no time (nor is it ever a time) to take a deep breath when you are invested in the equity markets, there are certainly some real catalysts that can push us to see a normalization in valuations and provide for reasonable returns for equity 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
Jeff Paul, Senior Investment Analyst – Phillips & Company



[i] Paul, J. (Nov 3, 2014). New Driver Needed for Economic Growth. Phillips & Company blog.

[ii] Mian, S. (Nov 13, 2014). Q3 Earnings Season in Final Stretch. Zacks Research.

[iii] (Nov 17, 2014). Shiller P/E.

[iv] Ibid.

[v] Calculations estimated using data from and assume 2% annual inflation.

[vi] Ehley, B. (Jun 3, 2014). Without Offshore Tax Havens, These Companies Would Owe the U.S. This Much. The Fiscal Times.

[vii] Chappell, B. (Nov 5, 2014). McConnell Says ‘Senate Needs To Be Fixed,’ Discussing GOP Gains. NPR.

[viii] FoxNews. (Nov 6. 2014). White House: Obama ‘willing to change his tactics’ to work with Republicans.

[ix] Federal Reserve Economic Data.

[x] Ibid.


Midterms and Earnings

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democrat and republican donkey and elephant jump ball mid term

With the Republican sweep of the midterm elections in the rear view mirror and both houses of Congress now in clear control by Republicans, markets may view this landslide in very favorable terms. First, most midterm elections have produced very positive short-run results for US equity markets.

Since 1964, the average S&P 500 increase was 16.5% for the 6-month period after the midterm elections vs 3.7% for all other election years.[i] That's a pretty strong track record.[ii]

s&p 500 after mid term elections

In fact, the best market results occur when Republicans control the House and Senate and a Democrat is in the White House.

The reasons seem fairly straightforward:

  • Gridlock is viewed as favorable to investors.
  • Pro-business policies could be enacted.
  • Republicans are less likely to issue massive debt, which puts less pressure on interest rates. 

In our current political environment you might see the 114th Congress tackle some pro-business issues like:

  • Harmonizing the corporate tax code to allow US-based companies to onshore $1.2 trillion dollars at a reasonable tax rate (5%) vs the nominal US corporate rate of 35%.[iii]
  • Approving trade agreements the President has been working on, such as the Trans-Pacific Partnership with countries like Australia, Malaysia, Singapore, Canada, Mexico, and Japan.[iv]
  • Approving the Keystone XL Pipeline that can create jobs and stimulate significant spending on energy.
  • Passing a massive transportation and infrastructure package that will create jobs and improve our surface transportation system.
  • Actually passing a budget that the President might sign and perhaps we can see a slight improvement to our creditworthiness. Standard & Poor’s currently gives the U.S. an AA+ credit rating, below its previous AAA rating.[v]

While there should be a very healthy level of skepticism for anything passing a "do nothing" government, hope is a uniquely American trait. Perhaps that's why the markets moved higher last week, and the energy sector rallied over 4% since the midterms on Tuesday compared to 1% for the S&P 500.[vi]

energy sector vs s&p 500 in november 2014 

It's hard to believe markets can move higher based upon current valuations. However, earnings continue to pour in and consistent with prior weeks they continue to beat expectations. Of the 446 S&P 500 companies that have reported Q3 earnings, 77% have beaten their mean estimate.[vii]

earnings beat by sector

Valuations continue to trend to the upper range by most measures. My favorite measure is the cyclically adjusted price to earnings ratio (CAPE). Unlike the traditional P/E ratio that compares the current price to its trailing 12-month earnings, the CAPE measures the current price to the average inflation-adjusted earnings over a longer period of time, in this case 10 years. You can see how the two valuations give a different perspective on current valuations.[viii,ix]

s&p composite price with trailing 12 month pe ratio

shiller pe ratio 10 year with an average 

I like using the CAPE because we all intuitively know companies don't reflect their valuations based upon one year's earnings. Company earnings move in cycles and capturing those cycles in a valuation methodology is probably more accurate, in my opinion.

If Congress and the President actually get things done, perhaps US equities merit higher cyclical valuations as companies and Americans can benefit from the simple list of policy improvements that I detailed above.

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] Egan, M. (Nov 5, 2014). Stocks love when midterm elections are over. CNN Money.

[ii] Yardeni, E. (Nov 3, 2014). Buying on Midterm Election Day Is One Of History’s Most Successful Trading Strategies. Business Insider.

[iii] Ehley, B. (Jun 5, 2014). Without Offshore Tax Havens, These Companies Would Owe the U.S. This Much. The Fiscal Times.

[iv] DePillis, L. (Dec 11, 2013). Everything you need to know about the Trans Pacific Partnership. The Washington Post.

[v] Detrixhe, J. and Katz, I. (Jun 6, 2014). U.S. Credit Rating Affirmed by S&P With Stable Outlook. Bloomberg.

[vi] Google Finance.

[vii] Butters, J. (Nov 7, 2014). Earnings Insight. FactSet.

[viii] Short, D. (Nov 3, 2014). Is the Stock Market Cheap?. Advisor Perspectives.

[ix] (Nov 10, 2014). Shiller P/E.

New Driver Needed for Economic Growth

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new driver bumper sticker

As expected, the Federal Reserve confirmed last week that it would end its QE3 bond-buying program. The Fed still holds over $4.4 trillion in assets that it has purchased over the last six years, but will no longer provide additional stimulus to the economy.[i] When previous quantitative easing programs ended, the stock market declined.[ii]

s&p 500 and quantitative easing chart

With the Fed taking its foot off the accelerator, what will keep the market moving forward? Right now it’s Q3 earnings, which are coming in well above the low 1.3% projection back in late September and over 70% of companies have beaten their Q3 earnings expectations.[iii,iv]

evolution of Q3 2014 earnings growth esimates

Going forward the US economy will depend on consumption, which makes up about 70% of GDP.[v] While initial estimates for Q3 GDP growth came in at 3.5%, this was mostly due to increased government spending.[vi] Q4 typically sees a decline in government spending, making consumer spending even more important. However, personal spending unexpectedly declined 0.2% in September, its first decline since January.[vii]

Change in United States personal spending over 2013 and 2014

There are positive indicators for consumer spending to pick up in Q4 though. First, consumer confidence is at a 7-year high as increased job security and cheaper gas brightened the economic outlook for many households.[viii]

United States Consumer Sentiment

The unemployment rate fell below 6% in September and Q3 wages grew about 0.8% from the previous quarter, the largest percentage increase since Q2 of 2008.[ix,x]

employment cost index for private industry wages

The US consumer’s pocketbook is also benefitting from gas prices falling below $3 per gallon for the first time since 2010.[xi] As we mentioned in a previous blog, this could provide the average household with an additional $500/year to spend.[xii]

48 month average retail price chart for gasoline

Higher spending will also depend on increased consumer borrowing. Though the Fed stopped buying bonds, it pledged to keep rates low “for a considerable time”.[i] Projections are for rate increases to start in mid-2015, but with low inflation and continuing concerns about growth (both in the US and globally), these increases may be delayed.

In addition, recent activities in Japan and Europe may also keep US rates low. Japan announced an unexpected quantitative easing program last week and the European Central Bank has also said it will begin buying bonds to provide a boost to its economy. This monetary policy could propel these developed equity markets higher, similar to what occurred in the US under the Fed’s QE policy. The new easing policies will lower interest rates in Europe and Japan even further, increasing demand for US bonds and lowering US bond yields.[xiii]

European Sovereign Funding Costs for 10 year bonds

But will consumers take advantage of the continued low rates to borrow and spend more? The answer appears to be “yes”, at least on the borrowing side. Banks keep loosening lending standards and recent trends show an increase in demand for auto and credit card loans.[xiv]

Percentage of banks reporting stronger demand for consumer credit

The stage is set for consumers to lead the economy forward. The big question is will we see higher spending? We will find out soon as Black Friday, the kickoff to the holiday sales season, is less than a month away.

Based on the current economic environment and data, we are:

  • Remaining slightly overweight in developed Europe and Japan, but expect to move them back to underweight in coming quarters.
  • Targeting duration of around 5 years for fixed income, perhaps moving higher as rate increases may be pushed out to battle deflation.
  • Continuing to monitor the second half of the Q3 earnings season for growth.
  • Watching for signs of increased consumer spending.

Expect market volatility if second-half Q3 earnings come in below expectations or if Black Friday sales are weak. With the S&P 500 and Dow at all-time highs and the Fed no longer providing stimulus, the market likely won’t be patient waiting for consumers to take the wheel and drive 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.

Jeff Paul, Senior Investment Analyst – Phillips & Company

Tim Phillips, CEO – Phillips & Company (Editor)



[i] Coy, P. (Oct 29, 2014). The Hawaiian Tropic Effect: Why the Fed’s Quantitative Easing Isn’t Over. Bloomberg Businessweek.

[ii] Murray, K. (Jun 9, 2013). Quantitative Easing and the Early Rally of 2013. The Queen’s Business Review.

[iii] Phillips, T. (Oct 27, 2014). Serenity Now! Phillips & Company blog.

[iv] Mian, S. (Oct 29, 2014). Q3 Earnings: The Halftime Report. Zacks Research.

[v] JP Morgan. (Sep 30, 2014). Q4 2014 Guide to the Markets. p 17.

[vi] Bureau of Economic Analysis. (Oct 30, 2014). GDP, 3Q 2014 (Advance Estimate).


[viii] Ibid.

[ix] Ibid.

[x] Federal Reserve Economic Data.


[xii] Randall, T. (Oct 17, 2014). Break-Even Points for U.S. Shale Oil. Bloomberg.

[xiii] JP Morgan. (Sep 30, 2014). Q4 2014 Guide to the Markets. p 47.

[xiv] Federal Reserve Economic Data.

Serenity Now!

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Serenity Now seinfeld george's dad

Finally market participants are focused on more of what matters and less of what doesn't. We had a plentitude of earnings last week and as a result we had a significant drop in volatility.[i]

CBOE Volatility VIX spikes in late 2014

There are some things in life that really matter and are hard to count, earnings are one thing that you can count and really matter.

According to Zack's Investment Research, "The composite growth rate for Q3, combining the actual results from the 207 S&P 500 members that have reported with estimates for the still-to-come 293 companies, is for earnings growth of +4.1% on +2.9% higher revenues. The composite Q3 growth rate has been steadily improving in recent days as companies report results and beat estimates."[ii] This is certainly well above the meager expectations in late September that we discussed in our Quarterly Look Ahead.[ii,iii]

Evolution of q3 earnings growth estimates in 2014

Another information vendor, Bespoke Investment Group, suggests the same thing, reporting that 66.2% of companies that have reported earnings beat estimates.[iv] This is better than in past quarters.

percent of companies beating earnings estimates by quarter since 1998

However, guidance from companies is certainly coming in much weaker than earnings per share growth projections suggest. Of the 37 S&P 500 companies with guidance changes so far, 78% have been negative (in red) while just 22% have been positive (in green).[v]

percentage of companies with positive and negative guidance

Markets certainly reacted favorably to the positive current earnings. Unfortunately at some point if we don't see better guidance in the weeks ahead, we will certainly see a return of the gut-wrenching volatility.

My strong advice is to continue to revisit your plan with your advisor, look at your future needs, examine what current expected rate of return on your portfolio you need to fund those needs, and adjust accordingly. Your behavioral reactions are an important component to investing, but your needs might suggest a different behavioral reaction. Serenity Now is only a philosophical concept.  

Again, please click to view our audio Q4 2014 Look Ahead. It may have a few interesting insights that you might find useful.

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] Mian, S. (Oct 24, 2014). In the Thick of Earnings Season. Zacks Research.

[iii] Mian, S. (Sep 24, 2014). Handicapping the Q3 Earnings Season. Zacks Research.

[iv] Bespoke Investment Group. (Oct 24, 2014). If You Blinked, You Missed It. The Bespoke Report.

[v] Butters, J. (Oct 24, 2014). Earnings Insight. FactSet. p 20.

"After a Wild Week on Wall Street, the World is"…the Same

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Time The Crash; after a wild week on wall street, the world is different

This magazine hangs in our offices as a constant reminder that the more things seem different and difficult on Wall Street, the more they stay the same.

I saved this Time magazine from the crash of 1987 as I was just two years into my career. At the time, the volatility seemed unsurvivable and indeed the world appeared to be different. 

Like with most things I have seen "on Wall Street" in the past 28+ years as a professional investor, I'm comforted by a long-term perspective.

This week was another example of a wild week:

  • Ebola in Texas and an inept US Government response.
  • ISIS on the Turkish border with limited reaction to our bombing campaign.
  • What appears to be a global slowdown signaled by a collapse in oil prices.[i]
  • A collapse in US interest rates with the 10-year treasury bond dropping from 2.61% to 2.17% since September 19th, 2014.[ii]

Crude oil prices and 10 year treasury yields, side by side

It's almost like investors have forgotten what drives valuation in equity prices. Truly over long periods of time, economic value drives price returns versus emotional value.[iii]

When I say economic value of a company, I'm talking about earnings per share growth and dividends. These are the two things investors can measure.

In recent postings, we have emphasized the upcoming earnings season as probably the most critical in years. With expectations so low for Q3, high for Q4, and valuations at peak levels, a lot rides on the outcomes. During this wild week, earnings season did ensue and there were some bright spots.[iv]

  • 63.1% beat earnings per share expectations.
  • Total earnings for the S&P 500 companies that have reported are up 2.1% year-over-year. (9.0% excluding the Finance sector)
  • Revenues for these companies are up 5.3%. (5.6% excluding the Finance sector)

(Note: The finance sector’s earnings were impacted by the large litigation charge at Bank of America, which negatively impacted the overall results.)

While only 65 of the S&P 500 companies reported last week, we will see an onslaught of reports this week. Pay particular attention to the earnings per share growth numbers and the forward guidance from companies. If you see more Q3 numbers above 3.0% EPS growth and Q4 guidance above 6.7%, then markets may just well stabilize.[v] If not, expect more of the same volatility as last week.

projected earnings growth, quarterly in 2014 and 2015

One special note on the significant benefits from the rapid drop in oil. While energy companies may suffer in the short run, the US consumer will receive a significant benefit. With gas prices down over 50 cents per gallon and at a 3-year low, the average US household will have an additional $500/year to spend.[vi, vii] I suspect this Christmas will be very beneficial to US retailers. 

48 month average retail gas price chart

I would not expect this trend to last. Some believe the drop in oil prices is an intentional dumping by the Saudis in exchange for our willingness to bomb ISIS.

"Saudi Arabia wants to get Iran to limit its nuclear energy expansion, and to make Russia change its position of support for the Assad Regime in Syria" 

according to Rashid Abanmy, President of the Riyadh-based Saudi Arabia Oil Policies and Strategic Expectations Center.[viii]

You can see from the chart below that our domestic oil production can survive some large cuts in oil prices.[ix]

break even point for US shale projects 

With their $800 billion cash surplus, Saudi Arabia can run a deficit while we help them achieve their geo-political goals.[x,xi]

Estimated oil price needed to balance 2014 government budgets 

While things seem unstable, and in fact they are, the key themes should be:

  • Earnings
  • Extra consumer spending for the holidays driven by reduced spending on gas
  • Interest rates staying lower for longer than currently anticipated

The actions we are taking are:

  • Adding a bit of duration to fixed income as our manager has been doing
  • Maintaining our US equity exposure
  • Keeping a very watchful eye this week on earnings

As for all the rest of the events in the world, the more they seem different, the more the world seems the same to me.

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] Ibid.

[iii] Bogle, J. (Jun 13, 2012). Thinking About What Lies Ahead for Investors. CFA Society of Washington.

[iv] Mian, S. (Oct 16, 2014). Is the Earnings Picture Good Enough?. Zacks Research. p 2-3.

[v] Ibid.

[vi] (Oct 20, 2014). Regular Gas Average Retail Price Chart.

[vii] Randall, T. (Oct 17, 2014). Oil Is Cheap, But Not So Cheap That Americans Won’t Profit From It. Bloomberg.

[viii] Cabbaroglu, N. (Oct 10, 2014). Saudi Arabia to pressure Russia, Iran with price of oil. Anadolu Agency.

[ix] Randall, T. (Oct 17, 2014). Oil Is Cheap, But Not So Cheap That Americans Won’t Profit From It. Bloomberg.

[x] Ibid.

[xi] Faucon, B, et al. (Oct 10, 2014). Oil-Price Slump Strains Budgets of Some OPEC Members. The Wall Street Journal.


The Financially Conservative Millennials

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millennials with social network heads

The Millennials, those born since 1979, have witnessed profound events during their young adult lives: the Internet Bubble, 9/11, wars in Afghanistan and Iraq, the Financial Crisis, and the Great Recession.[i]

US economic crisis timeline 

Based on recent investor profile surveys by Wells Fargo, UBS, and the Transamerica Center for Retirement Studies, entering adulthood amidst all of these events has impacted the financial priorities and investment behaviors of the Millennials.

Millennials understand that their retirement will look different than for previous generations. 81% expressed concern that Social Security would not be there upon reaching retirement.[ii]

Survey: I am concerned that when I am ready to retire, Social Security will not be there for me

Despite this sentiment, just over half of Millennials have started saving for retirement.[iii] Unemployment has been one cause, with Americans between the ages of 18 and 24 being 10% less likely to have a job now than they were a decade ago.[iv] Millennials are also worried about debt, mainly from student loans.[v]

biggest financial concerns of millennials 

With the combination of the Great Recession, high unemployment, and high debt levels, it is no surprise that Millennials are more conservative with their finances and have redefined risk as “permanent loss”.[vi] While this provides security during crises, in terms of long-term retirement, being too conservative can place retirement goals at risk.

For example, Millennials hold 52% of their assets in cash compared to 23% for non-Millennials.[vii] 

how millennials allocate their assets

This ultra-conservative allocation may be a temporary condition until Millennials feel more secure about their jobs and reduce debt levels. However, even Millennials aged 30-36 with at least $100,000 in assets reported holding 42% in cash.[viii]

The high cash allocation may be influenced by Millennials’ estimates of their retirement savings needs. 38% of Millennials thought they would need less than $500,000 to retire, though 52% of respondents said their estimate was a guess.[ix,x]

estimated retirement needs by demographic

If Millennials believe they will shoulder more of their retirement burden, then higher savings will be required, as well as investing more in stocks and bonds versus cash to achieve higher investment returns. However, when asked how they plan to achieve success, long-term investing rated much lower for Millennials than for other generations.[xi]

How do you plan to achieve success by demographic

The volatility of the Financial Crisis has made Millennials cautious about investing in the stock market. But instead of letting the times define their investment decisions, Millennials can use time as their ally. Over longer time periods, a blended portfolio has delivered positive returns within a much narrower range.[xii]

Range of stock, bond, and blended total returns

There is no denying the significant impact of the Financial Crisis and Great Recession on the US economy, stock markets, and investors. These events hit Millennials particularly hard, as they were just entering the workforce starting around 2001, and shaped Millennials into very conservative investors.

If Millennials eventually raise their retirement savings estimates and overcome their risk-aversion, their current cash and future income would supply new fuel for the stock market. However, with Millennials currently focused more on paying off debt, working hard, and living within their means than on long-term investing, this cash will likely remain on the sidelines for 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. For additional information on this, please visit our website.

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


[i] Hunkar, D. (Sep 7, 2011). Economic Crises Hold Back the Stock Market.

[ii] Transamerica Center for Retirement Studies. (July 2014). Millennial Workers: An Emerging Generation of Super Savers. p 27.

[iii] Wells Fargo. (2014). 2014 Wells Fargo Millennial Study. p 1.

[iv] Marks, M. and Martin, W. (Aug 31, 2014). Millennials battle persistent debt, jobless woes. Dallas News.

[v] Ibid.
[vi] UBS. (1Q 2014). Think you know the Next Gen investor? Think again. p 3.

[vii] Ibid. p 5.

[viii] Ibid. p 5.

[ix] Transamerica Center for Retirement Studies. p 36.

[x] Ibid. p 37.

[xi] UBS. p 10.

[xii] JP Morgan. (Sep 30, 2014). 4Q 2014 Guide to the Markets. p 64.


More Consumption = More Jobs = More Consumption When?

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consumption jobs cycle

The economy added 248,000 jobs during September as reported by the US Government on Friday.[i] With the revisions to July of 31,000 and August of 38,000 that brings this year's average monthly jobs gained to 227,000.[ii,iii]

net change in US nonfarm payrolls

At some point, we should expect the current pace of jobs to add to corporate bottom lines through increases in consumer spending.

As we have highlighted in the past, Q3 earnings expectations are anemic and certainly don't suggest the jobs we are adding are driving more consumption and profits.[iv]  

Evolution of Q3 estimates 2014

Certainly companies have ramped up their bet on the jobs driving consumption and profits paradigm. Business inventories suggest just that, registering a 6% change from a year ago in July.[v]

Total Business Inventories

Retailers are making the same bet with their inventories up over 6.5% from a year ago.[vi] 

Retailer inventories 2013 2014

So how long does it normally take for more jobs to equal more consumption and profits?  Well, we might just be getting into the sweet spot for consumption. 

You can see in the chart below that personal consumption actually leads jobs by about 6 months.[vii] By this logic, the consumption we are experiencing now is indicative of an even better jobs picture to come.

Personal consumption expenditures percent change

Carrying this forward, we might expect this holiday season to top 5% in consumption growth.[viii]

Personal Consumption expenditures change over time

All of this bodes well for the holiday shopping season and Q4 corporate profits. However, the biggest, most immediate concern is whether the anemic job growth will come back to haunt us with a drop in consumption and Q3 profits when companies report in the next couple of weeks.

Expect significant volatility until we get some answers to this critical question. 

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] Koropeckyj, S. (Oct 3, 2014). United States: Employment Situation. Moody’s Analytics.

[ii] Ibid.

[iii] Koropeckyj, S. (Sep 5, 2014). United States: Employment Situation. Moody’s Analytics.

[iv] Mian, S. (Sep 19, 2014). Q3 Earnings Estimates Fall Further. Zacks Research.

[v] Federal Reserve Economic Data.

[vi] Ibid.

[vii] Ellis, J. (Aug 17, 2014). Employment’s lagging relationship to consumer spending (PCE). Ahead of the Curve web site.

[viii] Federal Reserve Economic Data.

On the Rise

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Dollar sign with upward arrow trend

The US Dollar has been on a breathtaking rally we have not seen since 2010. The last time the US Dollar reached this level of value relative to other major currencies, our economy was finally emerging from the worst recession since the Great Depression and The Fed's Quantitative Easing policies were just taking hold.[i, ii] 

Trade Weighted US Dollar Index

It is clear that several factors are driving global investors back into US dollars as opposed to other currencies:

  • The US economy is apparently leading the world back to normalized monetary policy 
  • The Global uncertainty of Russia and ISIS
  • Europe's continued battle with deflation
  • China's uncertain path of contraction or expansion

Validating this flow of funds is our 10-Year Treasury Bonds.  In spite of the consensus view on the direction of interest rates and the clear direction provided by the Fed, actual rates are not rising. They are actually falling since January.[iii]

Chart of 10 year treasury yields over time

While a rising dollar is good news as an indicator of strength in the US economy, it also poses a set of challenges.

Mostly, US manufactured goods sold overseas become much more expensive. This hurts those companies’ earnings from operations after currency conversion (not that many companies are bringing those dollars back on-shore to pay high US taxes). Conversely, foreign manufactured goods and component parts become much cheaper to the US consumer, helping their earnings. 

Energy, materials, industrials, medical equipment, pharmaceuticals, and consumer staples companies are all facing the challenge of a rising dollar. You can see from the chart below the earnings growth expectations for these sectors during Q3.[iv] Perhaps there might be an earnings miss. What's troubling is these industries make up 47% of the S&P 500.[v]

Q3 2014 Earnings Growth by sector

What could cause a reversal in the dollar’s rise is certainly open to speculation, but here are some potential events that have driven the dollar down in the past:

  • The Fed changing its outlook on interest rate hikes.
  • Foreign countries raising interest rates, leading to reduced foreign demand for US Treasuries.
  • A growing US trade deficit.
  • Fear, which causes investors to sell dollar-denominated assets and purchase more tangible assets, such as precious metals.

Our tilts toward emerging and developed markets might help mitigate against some of these potential headwinds if we see a continued rise in the dollar. 

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] Murray, K. (Jun 9, 2013). Quantitative Easing and the Early Rally of 2013. The Queen’s Business Review.

[iii] Federal Reserve Economic Data.

[iv] Butters, J. (Sep 26, 2014). Earnings Insight. FactSet. p 14.

[v] S&P Dow Jones Indices (Aug 29, 2014). S&P 500 Sector Breakdown.



Open Sesame

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alibaba and the forty thieves painting

Last week was witness to the largest IPO in the history of the world.[i] Alibaba, the Chinese e-commerce company, launched its initial public offering on the New York Stock Exchange and raised a record setting $25 billion.[ii]

Alibaba record setting IPO graph

As of the close of trading on Friday, Alibaba had a valuation of $231 billion.[iii] That market cap makes Alibaba bigger than Facebook ($200 billion), Amazon ($150 billion), and Citigroup ($163 billion).[iv]

The name of the company comes from the Arabic folktale “Ali Baba and the Forty Thieves”, where the character Ali Baba learns the secret words to open a cave filled with the riches stolen by thieves, “Open Sesame.”

While many have heard of Alibaba, few know what they actually do. This video link does a nice job of describing the scope and range of Alibaba’s business. In summary, Alibaba is the Chinese version of, but only larger and much more profitable.

Transaction volume of Alibaba, Amazon, and Ebay

In 2013, just two of Alibaba’s businesses had transaction volume of $240 billion and the company made about $3.3 billion in annual profit, whereas Amazon had $100 billion in transactions and made just $274 million.[v,vi]

Here are a few more amazing statistics:[vii]

  • Alibaba’s sites account for over 60% of the packages delivered in China.
  • During the Chinese equivalent of Black Friday, Alibaba processed more than $5.75 billion in sales, three times more than America saw on Black Friday, on just one of Alibaba’s web sites.
  • Alipay, Alibaba’s Paypal equivalent, was responsible for 70% of the mobile-payments business in China in 2013.

What do the Chinese know about business that we don't? Clearly they know that profits matter.  They also know that the world of commerce is never standing still.

If you examine the GDP of countries (in terms of purchasing power parity) dating back to the first century, you can see one of the first principles of economics, valuations tend to be "mean reverting". Perhaps that applies to countries as well.[viii,ix]

GDP by country in 1 AD

GDP by country in 1500 AD

GDP by Country 1700 AD  

gdp by country

GDP by country

You can see from the series of charts how countries have risen and fallen in GDP leadership. Needless to say, Italy has lost its way and we have seen the rise and fall of the British Empire. The US has certainly been the dominant player since the industrial revolution of the 1900's. The one constant has been China.

The Chinese understand how economies have come and gone over a long period of time. They understand the natural rise and fall of economic super cycles. They understand the creative and technological destruction and reinvention of competition.

Alibaba may just be the biggest wake-up call China is giving to the world that they are back to pursuing global economic domination. If you carry forward the growth cycles of China, they should catch us by the year 2022.[x]

That's why, in spite of the short term struggles China is facing, we tilt emerging market assets toward China. 

Ali Baba knew the magic words, "Open Sesame", to gain access to a world of treasure and riches. Perhaps it's no coincidence China's largest company is appropriately named Alibaba. 

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] Barreto, E. (Sep 22, 2014). Alibaba IPO ranks as world’s biggest after additional shares sold. Reuters.

[ii] Roy, S. (Sept 22, 2014). 5 Facts You Did Not Know About Alibaba Group. Online Marketing Trends.

[iii] Yahoo Finance. (Sep 19, 2014).

[iv] Picchi, A. (Sep 19, 2014). Alibaba launches biggest IPO in U.S. history. CBS MoneyWatch.

[v] Osawa, J., et al. (Apr 15, 2014). Alibaba Flexes Muscles Before IPO. The Wall Street Journal.

[vi] Yahoo Finance.

[vii] D’Onfro, J. (Sep 19, 2014). 22 Astounding Facts About Alibaba, The Giant Chinese E-Commerce Company With The Largest IPO In US Stock History. Business Insider.

[viii] Wikipedia. List of regions by past GDP (PPP). Purchasing power parity values.

[ix] (2014). World GDP Ranking 2014. Purchasing power parity values.

[x] Jacob, J. (Nov 21, 2013). China to Replace US as World’s Biggest Economy in Eight Years. International Business Times. 

One Single Word From Our Sponsor

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Zip Ultra Sponsorship image

It should be no surprise to any investor that the economy, and in many respects the US equity markets, have been propped up by the Federal Reserve's quantitative easing (QE) over the last 6 years.[i]

On Wednesday of this week, the Fed will convene to discuss the future of interest rates and the actual amount of QE they will withdraw. It will come as no surprise if the Fed pulls another $10 billion a month from QE bond purchases, bringing their monthly bond purchase down to $15 billion.[ii] At the current pace, the Fed will have completed its QE bond purchasing program by the October 29th meeting, which is also entirely expected by the investment community.

Fed Chairwoman Janet Yellen's comments, as they relate to her guidance on the timing of interest rate increases, will be of particular interest.

In the Fed's July release, she stated the committee thinks it "...will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends...".[iii]

One Word – Considerable. What does that mean? 

From her prior statement in March, Yellen suggested considerable, "...probably means
something on the order of around six months, that type of thing.”[iv]

It's quite possible she could signal a change in that one word. Perhaps she could intimate a shorter period of time using words such as "immediate", "truncated", "transitory", or "ephemeral".

Just recently, the Fed came to terms with something we suggested in a recent post - Labor Force Participate Rate is mostly structural, not cyclical. In a paper released last week, some Fed economists suggest that Labor Force Participation Rate (LPFR) will not rise, but continue to fall.

They went on to suggest that policy makers should consider the structural nature of the declining rate when considering interest rate policy. In other words, don't expect the economy to return to normal participation any time soon, so you might want to get on with your rate increases. (My interpretation, not the Fed economists).

Take a look at their data, which forecasts a decline in participation mostly driven by retirees.[v]

Labor Force Participation Rate over time, signs of decline

They went as far as to study the trending declines over long periods of time. Depending on the way they calculated the LPFR, 1.3-1.5% points of the 2.8% decline is due to aging during the current financial crisis (see the first column in the table below).[vi] Going back to 2000, you can see a dramatic percentage of the decline attributed to aging.  

Estimated Contributions from Population aging to change in LFPR

The economists went on to build their own forecasts and compare them to other "reputable" prognosticators.  No one expects an increase anytime soon.[vii]

Comparisons of Projected Labor Force participation rate

Perhaps the Fed will now just get on with it and give more immediacy to their rate increases. In some corners, this could unleash a tsunami of borrowing and buying before rates rise. The downside is that many market participants are still expecting "considerable" to be the new normal and that means mid-2015 for the first bump in rates.

If there is one word to watch during this week, it's "considerable".

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] Heard, R. (Jul 6, 2013). QE: a timeline of quantitative easing in the US.

[ii] Sharf, S. (Jul 30, 2014). Fed Cuts Monthly Asset Purchases to $25 Billion While Underlining Labor Market Fraility. Forbes.

[iii] The Board of Governors of the Federal Reserve System. (Aug 20, 2014). Minutes of the Federal Open Market Committee (July 29-30, 2014). p 11.

[iv] Leubsdorf, B. (Mar 19, 2014). Yellen Suggests Roughly 6 Month Gap Before Rate Increases After QE Ends. The Wall Street Journal.

[v] Aaronson, S., et al. (Sept 2014). Labor Force Participation: Recent Developments and Future Prospects. Brookings.

[vi] Ibid., p 10.

[vii] Ibid, p 61.


Money in Motion

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Man chasing a dangling dollar bill

While the recent jobs report showed some weakness for the month of August, it's hard to argue that the US economy is slowing. US GDP is on an upward trajectory albeit slower than, and certainly not as strong as, most people would prefer. 

Real GDP growth over time

In last week’s post, we discussed some extraordinary benefits from consumers borrowing and banks lending. In fact, we indicated a possible 2.1 percentage points of additional growth in GDP through the following calculation.[i]

  • 1% of household disposable income = $127 billion.
    (based on total disposable income of $12.7 trillion).
  • Total increase in debt payments = $127 billion x 3 = $381 billion.
    (assumes household debt service increased from the current 10% to its peak of 13%).
  • Consumer borrowing supported by this payment level = $4.5 trillion.
    (assumes 18% interest rate and 8.5% minimum monthly payment)
  • $4.5 trillion is 28% of current GDP ($16 billion), for a 12-year annualized growth rate of 2.1%.

One thing that could occur as a result of this borrowing is an increase in the velocity of money in the economy. The frequency at which one dollar is used to purchase domestic goods or services in our economy is the measure of velocity; it's relevant as velocity is an indicator of growth and inflation.  

Let's take a look at where velocity is now. As you can see, the movement of money in our economy is at historic lows.[ii] Intuitively, this is why we have not seen any signs of significant inflation (excluding food and energy). Simply, not enough money is chasing the same goods and services and prices do not rise.

Velocity of M2 Money Stock over time

What's astonishing is banks are sitting on record levels of cash; in fact, one could use the word hoarding.[iii]

Cash assets of all commercial banks

The reason is simple enough, currently banks have been getting paid to sit on cash. The Federal Reserve is paying banks to hold cash through the Excess Reserve Interest Rate program.[iv]

reserve balances with Federal Reserve Banks

As an outcome, you can see that reserve balances are at historic levels, while currency in circulation is on a more normalized trajectory of a constant growing economy.

While earnings growth for financials lagged in Q2, banks are now poised to take a few more chances and lend (again see our previous week’s post).[v]

Q2 Earnings Growth by sector

So while banks are hoarding cash, the Federal Reserve has pumped trillions of dollars into banks’ balance sheets and provided them with risk free profits. The party could end though, which might actually help increase the velocity of money in the economy, driving more consumption, jobs and higher wages. 

If done dramatically, it can also create some hyperinflation. We will certainly be watchful and consider portfolio adjustments accordingly. Investments like commodities can benefit from aggressive inflation, if indeed it rears its ugly head. 

We will be watchful. 

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] Phillips, T. (Sep 2, 2014). More Fuel in the Tank – “Animal Spirits”. Phillips & Company.

[ii] Federal Reserve Economic Data.

[iii] Ibid.

[iv] Ibid.

[v] Butters, J. (Sep 5, 2014). FactSet Earnings Insight.


More Fuel in the Tank - "Animal Spirits"

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greedy person artwork

We have had some pretty strong confirming data the economy has been on a firmer path to recovery in Q2 of this year after a disastrous fall in Q1. Q2 GDP was confirmed to grow at an annual rate of 4.2% as reported by the US Department of Commerce.[i]

Looking back is at times an investor trap that leads many astray when attempting to make ongoing allocation adjustments. More critical is how companies are forecasting earnings in the future. We've been aggressive in tracking and reporting that data to you in our weekly blog. As earnings season officially ends for Q2, we now see forward guidance looking bleak at best.[ii]

2014 Q3 Projected Earnings Growth Zacks 

If we left the economic picture at that, I think a quick run for the hills might be in order. However, something extraordinary might be happening to US consumers. They might be actually starting to borrow more, and even more astonishing, banks may be matching the consumer’s appetite to borrow with loans.

According to a recent report by the Federal Deposit Insurance Corp, banks' loan and lease balances rose to $8.11 trillion, a 2.3% increase over the first quarter of 2014, and the largest quarter-over-quarter jump since the end of 2007*.[iii]

Total loan and leases quarterly change 

Further, banks are loosening lending standards at a pretty robust rate. Over 10% of banks recently reported easing standards on consumer and credit card loans.[iv]

net percentage of domestic banks tightening standards on consumer loans

On the consumer side of the equation, we also see a tremendous pick-up in demand. Nearly 20% of banks reported stronger demand and that's a new record since the Fed started tracking data in 2011.[v]

net percentage of domestic banks reporting stronger demand for credit card loans

So if consumers are willing to borrow more and banks are willing to lend more, could we be at the next phase of a consumption-driven economic growth and corporate profit rally?


The question I ask myself is how big could it be if consumers got back on their horses in earnest and shopped til they dropped while borrowing along the way? I readily admit this is not the most prudent economic strategy, but it's been the basis of American Consumerism over the better part of the last two decades until the Financial Crisis.

If we look at interest payments consumers are making as a percentage of their household disposable income, we see lots of room to add debt.[vi]

household debt service payments as a percent of disposable personal income

If each percent of debt service is equivalent to $127 billion, then we could see an additional $4.5 trillion in spending, assuming household debt service levels returned to 13%.[vii,viii] Take that amount over the next 12 years, assuming consumers will lever up at the same pace they did from 1995 to 2007, and you get an additional 2.1% of GDP to our economy.

Of course, it won't be a straight line, but it's possible to see valuations reach "nose bleed" levels if the consumer finds some extra fuel in their tank, and as Keynes suggests we see a return of the American Consumer's "Animal Spirits."

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] Bureau of Economic Analysis. (Aug 28, 2014). National Income and Products Accounts, GDP Second Quarter 2014. US Department of Commerce.

[ii] Mian, S. (Aug 6, 2014 and Aug 14, 2014). Zacks Earnings Trends. Zacks.

[iii] Tracy, R. (Aug 28, 2014). U.S. Banks Boosted Lending in Second Quarter, FDIC Says. The Wall Street Journal.

[iv] Federal Reserve Economic Data.

[v] Ibid.

[vi] Ibid.

[vii] Assumes a 36-month, 8.5% minimum repayment plan at 18% interest rate for debt service, and debt service payments returning to 13% of disposable household income.

[viii] Data from Federal Reserve Economic Data and

Fishing in Wyoming!

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Fishing a river in Wyoming

I recently spent 8 days in the middle of Wyoming seeing some amazing country and fishing on some spectacular streams that meander through some of the largest ranch property in America. In those 8 days, I didn't see another angler.

However, I know there are more people fishing in Wyoming than me. In fact, last week there were some of the leading economists, central bankers and policy makers in the world "fishing for answers" in Jackson Hole, Wyoming. The Federal Reserve convened its annual policy summit there and this year focused on the labor market.

The Federal Reserve’s congressionally mandated monetary policy objective is to foster maximum employment and price stability. According to Fed Chair Janet Yellen’s statement,

"In this regard, a key challenge is to assess just how far the economy now stands from the attainment of its maximum employment goal."[i]

As we all know, interest rates touch many aspects of our daily lives and certainly are a major factor in our investment approach. One thing is clear to me from reading her entire statement - fishing might be an understatement of what's going on in Wyoming. 

Yellen said, "More jobs have now been created in the recovery than were lost in the downturn, with payroll employment in May of this year finally exceeding the previous peak in January 2008. Job gains in 2014 have averaged 230,000 a month, up from the 190,000 a month pace during the preceding two years."[ii,iii,iv]

total private payroll employment through the recession

However, it's also apparent from her statement that the Fed is very uncertain as to how much of our current labor slack, most notably the persistent decline in the labor participation rate, is due to cyclical factors or structural issues.[v]

Labor force participation rate decline

It's noticeable from her statement that the Fed will spend considerable time trying to answer what is cyclical and structural in order to set interest rate policy. Yet they seem confused:[vi] 

"...the task has become especially challenging in the aftermath of the Great Recession, which brought nearly unprecedented cyclical dislocations and may have been associated with similarly unprecedented structural changes in the labor market--changes that have yet to be fully understood." 

"So, what is a monetary policymaker to do?" Yellen laments.

Perhaps we can answer the question for ourselves and get a bit of a jump on the Fed. A recent paper published by the Peterson Institute suggests of the 4 percentage point drop in participation from the 2000 peak, 1.5 to 2 percentage points were attributed to the aging of the labor force.[vii]

Labor force participation versus share of persons 55 and older

Another percentage point could be from the long-term unemployed whose skills may not match current labor needs. 

That leaves 1 to 1.5 percentage points of cyclical factors impacting participation in the labor force. On the face of it, that's not much in terms of cyclical factors and one might expect the Fed to jump sooner rather than later, perhaps as early as the first half of 2015.

However, one additional factor might be more structural, accounting for the points the Fed might be confusing as cyclical. 

As of 2012, there were over 109 million Americans receiving "means-tested" US Government provided benefits.[viii] That's 35% of the population.[ix] If you factor in the means-tested ObamaCare benefit (which is not included in these numbers, as the data has not been released for 2014) this statistic is going to grow substantially. The table below shows the number of recipients in 2012 for means-tested US Government programs and the income eligibility requirements.[x]

maximum monthly eligibility for government assistance

While I don't pass any professional judgment on these welfare programs, you can see from the data above, it's harder to move from welfare to work. To me that's structural, not cyclical.

The good news is the Fed can probably spend the next 6 months, or longer, trying to fish for answers on the 4 percentage point drop from peak participation. We might benefit from lower rates for a longer period than actually needed by the economy.

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] Yellen, J. (Aug 22, 2014). Labor Market Dynamics and Monetary Policy. Federal Reserve.

[ii] Ibid.

[iii] JP Morgan Asset Management. (Jun 30, 2014). Employment – Total Private Payroll. 3Q 2014 Guide to the Markets. p 24.

[iv] US Department of Labor. (Aug 1, 2014). The Employment Situation – July 2014. Bureau of Labor Statistics. p 1.

[v] JP Morgan Asset Management. (Jun 30, 2014). Labor Force Participation Rate. 3Q 2014 Guide to the Markets. p 25.

[vi] Yellen, J. (Aug 22, 2014). Labor Market Dynamics and Monetary Policy. Federal Reserve.

[vii] Cline, W. and Nolan, J. (July 2014). Demographic versus Cyclical Influences on US Labor Force Participation. Peterson Institute for International Economics.

[viii] Jeffrey, T. (Aug 20, 2014). The 35.4 Percent: 109,631,000 on Welfare. CNS News.

[ix] Ibid.

[x] Ibid.

False Start?

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mannequins on a track have a false start

In a recent blog, we noted that the stock market is near all-time highs with valuations at long-term historic levels, so earnings must deliver. We followed up with a mid-earnings-season data review that observed signs of economic strength, including 4% Q2 GDP growth, but left us with questions about consumer spending going forward and whether improving economic growth would translate into earnings growth and drive equity returns.

We remain in a low interest rate, low inflation, and improving employment environment. However, recent consumer confidence, retail sales, and mortgage data show signs of hesitation by consumers. With about 70% of GDP being driven by consumption, perhaps the rosy economic growth forecasts were a false start.[i] Let’s review the data and see if we can make a call.

Components of GDP in the US

With 469 of the S&P 500 companies reporting, 73% had Q2 earnings above estimates and all sectors had over 50% of companies beating expectations.[ii]

Q2 2014 earnings estimates by sector

In a sign that the market has priced in high expectations, our friends at Bespoke showed that companies with earnings misses had larger magnitude price changes than companies that beat earnings estimates.[iii]

Sector EPS beat and miss rates, and average returns

This suggests volatility if earnings or economic growth fall short of expectations. Recent consumer data show potential causes for concern.

Against expectations, the University of Michigan Consumer Sentiment index fell further in August, to its lowest level since April and its lowest level for 2014.[iv]

Consumer sentiment over time

Looking at the index components, consumers felt very confident about their present condition (99.6%), but expectations for the economy for the next year reached their lowest level since October 2013 (66.2%).[v] When consumers are worried about the future, it can impact their current spending, and sure enough, the retail sales data reflect this. Retail sales growth was unexpectedly flat in July and there has been a declining trend since March.[vi]

Retail Sales % change during 2014

While some sectors showed positive sales growth, two notable groups that lagged were autos and general merchandise.[vii]

retail sales by category

In addition to retail sales weakness, consumers are reluctant to spend on housing. Mortgage borrowing is at a 14-year low and mortgage applications are at a 6-month low, despite interest rates falling to their lowest level in a year.[viii,ix]

10 year treasury yields over time

While the Fed continues to taper its bond purchases, interest rates have declined due in part to even lower rates in European countries, which make US Treasuries relatively attractive.[x]

European Sovereign Funding Costs

European rates could decline even more, as European Central Bank president Mario Draghi recently acknowledged that European economic momentum had slowed and new geopolitical tensions would only do more harm.[xi] Slower European economic growth impacts US economic growth.

As we might expect, with all of these signs of concern, Q3 earnings forecasts have declined. Zacks reports that current Q3 earnings growth is projected at +4.0%, compared to +6.3% at the start of the quarter.[xii,xiii]

2014 Q3 projected earnings growth

So were the original forecasts for strong US economic growth in the second half a false start, or can the US economy meet the expectations? The stock market appears to have high earnings expectations priced in, yet Q3 earnings growth estimates keep declining along with consumer confidence. An economic slowdown in Europe and heightened geopolitical tensions will only make matters more challenging. If current trends continue, the stock market may need to adjust its expectations downward. Data releases are on tap that may provide more color on consumer spending.

This week, several retailers report earnings including Target, TJX, Gap, and Dollar Tree. We will also learn more about the housing market from the housing starts and existing home sales reports, as well as earnings reports from Lowe’s and Home Depot.

We will continue to monitor Q3 earnings projections and data releases, and provide further review. Be prepared for increased volatility as more data come out, particularly if the data indicate slower 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)


[i] JP Morgan Asset Management. (Jun 30, 2014). 3Q 2014 Guide to the Markets. p 17.

[ii] Butters, J. (Aug 15, 2014). Earnings Insights. FactSet. p 2.

[iii] Bespoke Investment Group. (Aug 15, 2014). The Bespoke Report: Earnings Season Ends. p 8.

[iv] Kelley, N. (Aug 15, 2014). United States: University of Michigan Consumer Sentiment Survey. Moody’s Analytics.

[v] Ibid.

[vi] Hoyt, S. (Aug 13, 2014). United States: Retail Sales. Moody’s Analytics.

[vii] Bespoke Investment Group. (Aug 15, 2014). The Bespoke Report: Earnings Season Ends. p 14.

[viii] Hughes, D. (Aug 16, 2014). Scaredy-cat consumers, housing stalls, Yellen in Jackson Hold: The week ahead. Yahoo Finance.

[ix] Federal Reserve Economic Data. (Aug 18, 2014).

[x] JP Morgan Asset Management. (Jun 30, 2014). 3Q 2014 Guide to the Markets. p 48.

[xi] Hughes, D. (Aug 16, 2014). Scaredy-cat consumers, housing stalls, Yellen in Jackson Hold: The week ahead. Yahoo Finance.

[xii] Mian, S. (Aug 14, 2014). Zacks Earnings Trends. Zacks. p 3.

[xiii] Mian, S. (Aug 6, 2014). Zacks Earnings Trends. Zacks. p 2.

The American Energy Revolution

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oil derrick pump jack with american flag

Earlier this summer, we celebrated Independence Day, commemorating both the adoption of the Declaration of Independence and the revolution that led to America achieving its independence. Today, there is another revolution going on in this country, one that could lead to independence of another kind. It centers on energy, specifically the shale deposits located across the central and northeast US, and has been referred to as The American Energy Revolution.[i]

Map of major shale plays in US

This is a well-earned title, as the rapid expansion in the US energy industry is driving growth that will likely have long-term impacts on the US economy and US energy self-sufficiency. The US became the world’s largest natural gas producer in 2010, and this year has overtaken Saudi Arabia to become the biggest oil producer as well.[ii]. Shale gas production is expected to grow significantly over the next 25 years, reaching 50% of US natural gas production by 2040.[iii]

US natural gas production by source US

Growth in US energy production is projected to reduce our need to import energy, to stabilize market prices, and to lead to more energy exports.[iv]

US oil and natural gas consumption supplied by imports

But for this to occur, additional infrastructure is required to gather, store, transport, and process all of these newfound resources. Previously, infrastructure was geared toward transporting energy into the U.S., not out of it.

Currently about 30% of the extracted natural gas is burned off due to a lack of infrastructure.[v] North Dakota recently implemented a gas capture mandate for all new oil and gas drilling permits to address this issue.[vi] This requirement has improved communications between drillers and midstream operators, allowing them to develop capital plans to meet future demands and provide investors with longer-range guidance.

The growth of shale gas production is projected to yield significant benefits to our economy over the next 25 years:[vii]

  • $1.9 trillion in capital expenditures.
  • 1 million new jobs by 2035.
  • $930 billion in federal, state, and local tax and royalty revenues.
  • Lower natural gas prices, which has also resulted in a 10% reduction in electricity costs nationally.

shale natural gas employment contribution

Demand for natural gas vehicles is also projected to rise. Citigroup estimates that 30% of the trucks on America’s highways will be burning natural gas by 2020. Companies including Procter & Gamble, UPS, and Waste Management already utilize natural-gas-powered vehicles, and Freightliner, a manufacturer of natural-gas-powered trucks, says that natural gas is one of its fastest-growing segments.[viii]

Lower electricity costs will benefit industrial firms. In its “Economic and Employment Contributions of Shale Gas in the United States” report, IHS Global estimated that by 2017 lower energy prices will result in a 2.9% increase in industrial production, and 4.7% by 2035.[ix] Some European companies are considering relocation of their manufacturing to the US, where energy costs are much lower than in Europe.[x] This could lead to more manufacturing jobs in the US.

Shale production has also led to a boom in natural gas liquids (NGLs), such as ethane and butane, which are petrochemical feedstock for the creation of everything from pharmaceuticals to plastics. With ethane prices 75% below oil-based alternatives, the chemical industry is investing $125 billion to construct or update chemical plants to use ethane and increase capacity.[xi] Increased demand for NGLs will drive more value to be extracted from natural gas production, instead of burning off NGLs with the natural gas.[xii]

natural gas liquid value addition

With production yielding so much supply, the US may become a net exporter of natural gas by 2020.[xiii]

US may become a net exporter of natural gas by 2020 

Global natural gas prices are higher than domestic prices, creating an opportunity for US-based energy companies to profit even after transportation and processing costs.[xiv]

global natural gas prices over time

There are still crude oil export restrictions in place, a result of the Arab oil embargo. However, the US Commerce Department recently ended a four-decade ban on the export of ultra-light oil, and domestic energy companies are pushing for government to loosen other fuel export restrictions.[xv]

The energy boom driven by the drilling of shale deposits has been nothing short of a revolution. It will likely have a significant and enduring impact on our economy, may lead to US energy independence, and should create long-term investment opportunities in energy, industrials, and other sectors. Contact your advisor to discuss ways to participate in the American Energy Revolution.

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] America’s Natural Gas Alliance. The Shale Gas Revolution.

[ii] Smith, G. (Jul 4, 2014). U.S. Seen as Biggest Oil Producer After Overtaking Saudi Arabia. Bloomberg.

[iii] U.S. Energy Information Administration. (May 7, 2014). Annual Energy Outlook 2014.

[iv] IHS Global Inc. (Dec 2013). Oil & Natural Gas Transportation & Storage Infrastructure: Status, Trends, & Economic Benefits. p 13.

[v] Nemec, R. (Jun 19, 2014). North Dakota Flaring Program Unprecedented, State Official Says. Natural Gas Intel.

[vi] Ibid.

[vii] America’s Natural Gas Alliance. (Dec 4, 2011). Shale Gas – What it Means for Our Economy.

[viii] ID Analysts. (June 23, 2014). Special Report: The Energy Revolution No One’s Talking About. Investing Daily.

[ix] America’s Natural Gas Alliance. (Dec 4, 2011). Shale Gas – What it Means for Our Economy.

[x] Parker Global Strategies. (Feb 2014). US Energy Infrastructure (MLPs) 2014 Outlook.

[xi] Galas, A. (May 31, 2014). 3 Ways to Profit From This $176 Billion Energy Megatrend. The Motley Fool.

[xii] IHS Global Inc. (Dec 2013). Oil & Natural Gas Transportation & Storage Infrastructure: Status, Trends, & Economic Benefits. p 25.

[xiii] U.S. Energy Information Administration. (May 7, 2014). Annual Energy Outlook 2014.

[xiv] Morgan Stanley. (Sep 2013). The U.S. Energy Revolution. p 3.

[xv] (Jun 25, 2014). US set to allow crude oil exports after four decade ban.

Knowing How to See

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da vinci portrait 

One of Leonardo da Vinci’s mottoes was “saper vedere”, which translates to “knowing how to see.” It refers to the continual refinement of our senses, especially sight, as a means to enrich experience and test knowledge. With the mountain of economic data released in the last week (see the table below), this is a good opportunity to practice “saper vedere” to develop an overall picture of the state of the economy and where it may be headed.[i]

economic scorecard 

Let’s examine some of this data and see what narrative develops. It is important to emphasize that these data points are lagging indicators, which follow changes in the economy and reflect historical performance.

Q2 GDP grew 4.0%, a welcome change from the negative growth rate in Q1. From the component analysis provided by our friends at Bespoke, we can see positive contributions to GDP in consumption and investment.[ii]

Q2 2014 annualized growth component contribution

The strong inventory build-up came after two quarters of declines. Bespoke noted that we can’t expect inventory growth of 1.66% annualized per quarter, but with demand growing at 2%, some continued growth should be expected.[iii] Consumption growth and fixed investments were also positive. Business investment recovered with labor market strength.

On the jobs front, payrolls grew by 209,000, but the unemployment rate ticked up one-tenth of a percent to 6.2%.[iv]

net change in US nonfarm payrolls 

The unemployment rate uptick was caused by an increase in labor force participation, workers coming off of the “sidelines” and re-entering the workforce, another sign of a growing economy. While it’s good news for more Americans to have jobs, until the slack in the labor force is exhausted wage growth will be limited.[v] On the plus side, 2% wage growth may help keep inflation in check and interest rates low.

consumer sentiment soars despite slowing home-price gains

Overall, Q2 data shows a growing economy and workforce, but will this continue into the second half of the year? Let’s look at some leading indicators that provide clues for Q3.

More Americans with jobs contributed to increased consumer confidence with the Consumer Confidence Index jumping to 90.9 in July from 86.4 in June, its highest reading since October 2007 and above economists’ estimates of 85.0. [vi]

consumer sentiment

More confident consumers will be important for second half economic growth, as about 70% of GDP comes from consumption.[vii]

Based on the Case-Shiller 20-city home price index, housing prices rose at a slower rate, but are still increasing from a year ago.[viii] Rising home prices can give consumers more confidence about their financial situation and can be a source of borrowing to fund purchases.

The ISM Purchasing Managers’ Index increased to 57.1 in July from 55.3 in June. Values above 50 indicate expansion.[ix]

confidence boost in consumer sentiment 

The ISM report also showed that inventories fell to 48.5, while new orders increased to 63.4. The widening gap between orders and inventories is good news for future production.[x]

Finally, while we experienced some volatility last week, the stock market has been reaching new highs.[xi] The stock market is a leading indicator, as it factors in current data as well as expectations for future corporate earnings growth.

S&P growth over 2013 and 2014

Q2 earnings have been generally positive and analysts forecast stronger growth in the second half of the year and into 2015.[xii]

Projected earnings growth

Looking across all of these data points, the US economy had strong Q2 growth and there are signs for more growth to follow. The manufacturing and business investment numbers point to an expanding economy, which should lead to more employment and higher consumer confidence.

The questions, which we have raised before, are:

  • Will the increased consumer confidence will translate into more spending to drive continued GDP growth?
  • Will the improving economic data be reflected in earnings growth, which is the sustainable driver of equity returns?

We’ll watch the next retail sales report coming up later this month and continue to monitor the Q3 earnings projections. Hopefully they confirm the positive signs that we are seeing so far. With such strong earnings forecasts, any disappointment may lead to more volatility in 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

Jeff Paul, Senior Investment Analyst – Phillips & Company



[i] Bespoke Investment Group. (Aug 1, 2014). The Bespoke Report: What to Remember from a Week to Forget. p 7.

[ii] Ibid., p 9.

[iii] Ibid., p 8.

[iv] Koropeckyj, S. (Aug 1, 2014). United States: Employment Situation. Moody’s Analytics.

[v] Federal Reserve Economic Data.

[vi] Madigan, K. (July 29, 2014). U.S. Consumer Confidence Rises. The Wall Street Journal.

[vii] JP Morgan Asset Management (June 30, 2014). 3Q 2014 Guide to the Markets. p 17.

[viii] Madigan, K. (July 29, 2014). U.S. Consumer Confidence Rises. The Wall Street Journal.

[ix] Sweet, R. (Aug 1, 2014). United States: ISM Manufacturing Index. Moody’s Analytics.

[x] Ibid.

[xi] Yahoo Finance. (Aug 1, 2014). S&P 500 historical chart.

[xii] Mian, S. (July 8, 2014). It’s All About the Guidance. Zacks Research.


Earnings Must Deliver

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earnings 3d dollar 

As many of our regular readers and clients know, Phillips and Company publishes a Quarterly Look Ahead. Here is a link to the 2014 Q3 presentation with an audio narrative. We attempt to give a look at the most pressing issues that will impact portfolio values in the coming quarter. 

In one of this quarter’s slides, we discuss the fact that "Earnings Must Deliver."[i]

shiller P/E 10 and projected earnings growth 

It seems relevant to give you a quick update on how earnings are actually coming in during this season. Our friends at Bespoke have compiled the following chart showing the percentage of companies beating earnings estimates by quarter.[ii]

% of companies beating earnings estimate by quarter

Taken at face value, earnings are delivering and exceeding expectations. 

Even more important than the earnings reports for Q2 is the guidance for Q3 from CFOs and executives. After all, the "Wall Street Peanut Gallery" or sell-side analysts have created the expectation we will see earnings grow by as much as 6.3% in Q3.[iii] For my money, I will go with the financial folks in the companies versus the Wall Street analyst crowd. 

Realize with market valuation trading at near historic highs, US equity markets are poised to correct on the slightest disappointment.[iv]

shiller p/e 10 year

Unfortunately, we are seeing some very dismal numbers being forecast for Q3. This graph from FactSet shows that a majority of Q3 EPS preannouncements so far have been negative.[v]

percentage of positive and negative EPS preannouncements Q3 2014 

While it's still the middle of earnings season, the guidance is not suggesting a strong Q3 and there is certainly a potential for disappointment to market participants.

At this point in time, I strongly suggest bracing for some potential volatility in the coming quarter and a higher probability for an earnings-induced correction.  

I know what many of you might be thinking. Why don't I sell now and reinvest later? Here is the answer in multiple choice format.

why don't i sell now and reinvest later, fallacy of market timing

Answer: (d) All of the above.

The time when you will need your resources should never be left up to the vagaries of the markets. If you think that you will need to draw money from your pool of equity capital within a 5-year window, adjustments to your portfolio are highly recommended. Again, from our Quarterly Look Ahead, time can shape risk if you have enough of it.[vi]

range of stock, bond, and blended total 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

Jeff Paul, Senior Investment Analyst – Phillips & Company



[i] Phillips & Company. (July 2014). Q3 2014 Look Ahead. p 5.

[ii] Bespoke Investment Group. (July 25, 2014). The Bespoke Report: Storm Clouds Brewing?

[iii] Phillips & Company. (July 2014). Q3 2014 Look Ahead. p 5. Data from Zack’s Research.

[iv] Phillips & Company. (July 2014). Q3 2014 Look Ahead. p 5. Data from GuruFocus.

[v] Butters, J. (July 25, 2014). Earnings Insight. FactSet. p 14.

[vi] JP Morgan Asset Management. (June 30, 2014). 3Q 2014 Guide to the Markets. p 64.

Small is Big and Big is Insurmountable

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Hank Paulson

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]

Total student loan debt in billions

Corporate profits after tax over time

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]

consumer price index for food, over time

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. 


  • 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]

earnings surprise by sector 

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

average hourly earnings growth

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

natural gas prices in decline

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

vistage confidence index and GDP chart 

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]

Dow Jones reaction to geopolitical crises

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


[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] (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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pothole with rain puddle

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]

components of GDP in US 

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]

monthly change in nonfarm payrolls 

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

employed part time chart

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

cost of healthcare over time

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



[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]

civilian unemployment rate chart 

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

longest private sector job growth streaks 

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.

monthly average change in nonfarm payrolls

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. 

evolution of q2 estimates 2014

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

q2 earnings growth by sector 

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]

projected earnings grwth 

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



[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.

[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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uncle sam i want you

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

global equity market return summary

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)

long term interest rates vs price earning ratio

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]

personal income vs spending, over time

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

university of michigan consumer sentiment index

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]

sentiment survey results in june 2014

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

estimated flows to long-term mutual funds

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



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

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

[iii] Ibid.

[iv] (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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man reading paper on railroad

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.

25 year chart of VIX volatility

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

VIX index

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%.

number of S&P sigma events

sigma event chart

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.

estimated range of returns for different portfolios

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)



[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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trafic jam in ukraine

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]

map of isis 

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]

richest terror factions

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]

map of Syria Sunni Kurdish state 

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]

oil prices above usd 110 will be a headwind for stocks 

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.

model effects of a usd 10 per barrel price increase

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



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

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

[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.

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

Are You Prepared for Retirement?

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retirement flow chart

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.

worker confidence in having enough money to retire comfortably

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.

percent having a retirement plan

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%.

200 dollars per month invested at 6 percent and 8 percent

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.

value of 100 month investment at 6 percent

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]

reasons for not consulting a financial advisor

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]

percentage of household income that wokers think they need to save

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)



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

[ii] Ibid.

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

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

[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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giants miss a catch

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]

10 year treasury yield 

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]

real gdp percent change 

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]

probability that the US will be in recession

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

gross domestic product by quarter

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]

 retail sales percent change by quarter 

  • 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]


durable goods orders percent change

  • 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.

[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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a storm broods over a lake

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]

household net worth is at record high, so is wealth disparity   

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]

percent share of consumption expenditures by top 20 percent

percent of personal consumption, bottom 80 percent 

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.

average household income by quartile

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]

job changes from january 2008 peak

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

pay rates of jobs by setor

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.

[viii] Bureau of Labor Statistics.

Courage, Confidence, and the Housing Market

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cowardly lion
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]

number of US households over time

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.

employment status by living arangement

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]

mortgage lending standards remain tight

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]

components of residential investment as percent of GDP

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]

case-schiller 20 city home price index 

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)



[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).

[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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janet yellen

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


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

stock market volume

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]

fed balance sheet

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]

deposits and loans 

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).
[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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surgery operation

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.

federal reserve balance sheet

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]

expected tapering schedule

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]

real gdp percent change 

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]

employment change in US 

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.

wages by sector

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

civilian labor force participation

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).

wage growth and corporate profits 

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.
[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.

s&p 500 year over year EPS growth

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]

percent of companies beating earnings estimates by quarter

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]

Earnings beat rate by sector this season

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]

average 1 day percent change for stocks this season 

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]

Q1 2014 revenues in various sectors

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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IRS monster coming out of bag

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]

Yield curve comparison between corporates, treasuries, municipals 

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]

Table with low default rates of municipal bonds

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

tax revenue change from post recession  

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

Bond insurance over the decade as percent of issuance

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.

ratings distributions for municipals and corporates

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]

yield curve of munis

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] 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.


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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earthquake with a wagon falling in it


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]

CBOE Volatility Index VIX

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]

evolution of q1 2014 estimates

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.


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]

labor force participation rate  

total unemployed and marginally attached

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]

job openings in total nonfarm payroll

layoffs and discharges

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.



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Balanced rocks

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]

private sector jobs over time

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.

percent job losses in post WW2 recessions

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

working age population over time 

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]

change in total nonfarm private payroll employment

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…”.
[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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cronies being cronies

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]

sovereign held US debt table

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]

Russian oil export breakdown

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

China oil production and consumption

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

China surpassed US as the world's largest importer of petroleum in 2013

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]

reserve currency status over time

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.
[2] (Mar 15, 2014). Crimea’s economy in numbers and pictures.
[3] (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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are we there yet inscribed on a long highway

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.

yield curve bump from Yellen speaking

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.

average FOMC expected fed fund rate 

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]

federal reserve bank holdings of securities as percent of GDP 

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%.

long term bond yields were slow to rise following WW2

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.

Total return since may 1 2013 and 10 year treasury yield

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]

s&p peak happens 18 months after fed tightening

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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house in a bubble about to be pricked

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]

p/e ratios of 10 largest S&P stocks in 2000

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

PE ratios of 10 largest s&p stocks in 2014

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]

record corporate margins over time]

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]

Labor share of national income over time

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]

characteristics of historical market peaks

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]

2014 expected returns by asset class

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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reflection on lake

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

households and nonprofits net worth

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.

lower credit card debt since recession

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

mean credit card balances of US households

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]

range of s&p returns from 1926 to 2009

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. 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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illustration of piano falling on man with umbrella

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:


Market Cap


Valuation per Employee




 $       345,454,545

Sherwin Williams



 $                528,525

Waste Management



 $                440,690

Whole Foods Market



 $                247,500

The Gap



 $                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.


 R&D Expenses

Cash and Equivalents














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.

[ii] 2013 Shareholder Letter. Berkshire Hathaway. 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.

[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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Frankenstein black and white

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.

net change in US nonfarm payrolls during 2013

(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]

average hourly earnings of production employees

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]

civilian labor force participation rate

person savings rate over time

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]

nikkei index over the 2000s

(Source: Google Finance)

japanes inflation rate over the 2000s

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.

The Handoff

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speed skaters touch eachother

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. 

component contribution to Real GDP

(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]

net interest margin for all US banks over time

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]deposits from all commercial bank

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

loan to deposit ratio over time

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

consumer debt service is historically cheap

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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nascar slip streaming

(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?

net change in US nonfarm payrolls

(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.

s&p 500 and gdp during fed actions

(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.  

Company and EPS beat graph

(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,
[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,
[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,


Lowering Expectations

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Broncos looking dismayed

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]

s&p 500 year over year total return

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]

EPS beat rate by quarter

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]

revenue beat rate by quarter

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]

s&p earnings and revenue growth from 2011 to 2014


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]

sperad between percent of companies raising and lowering guidance

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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a stolen image of wile e coyote

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]

indu index

(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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base jumping at grand canyon

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]

s&p 500 and dow jones in january 2014

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]

equity price returns from each valuation decline

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]

europe offers more opportunity

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]

PE ratio and total return over 1 year and 5 year

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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snowy weather

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]

stormy weather causes labor shortage

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]

net job losses by industry sector

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]

civilian labor force participation rate

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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nuclear explosion

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]

deficit spending in trillions

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

total spending by federal government

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]

deficit spending and GDP overlay

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.

deficit spending and GDP since recession

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]

europe grows despite less deficit spending (this turned out to be very wrong)

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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street sign

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.

s&p 500 targets by various banks

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%.


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]

highest and lowest market returns in history

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]

2014 predictions

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

forecast for ex US markets

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

gdp growth forecasts

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.


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shark following a kayaker

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.

year to date returns as of 2013
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.

real gdp percent change annualized

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]

phillips portfolio performance over time

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

financial crash SPX bloomberg chart

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.

rebound following the crash SPX bloomberg graph

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 fallacy of trusting averages

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]

evolution of q4 earnings estimates in 2013

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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racers taking off from starting block

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]

month in which economists said Fed would begin tapering

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]

2011 QE pullback results

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

consumer price index in 2013

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.

interest paid on excess reserve balances over time

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]

yield curve as of december 2013

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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expensive medical treatment

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.

market selloff in december 2013

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.

consumer credit expansion in 2013

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]

real gdp percent change by quarter

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

drop in home sales

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]

growth of consumption over 2013

personal savings rate over time

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]


10 year yields by day during december 2013

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]

real compensation per hour over time

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


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following money off a cliff

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]

price earning ratio over the last 10 years

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]

shiller PE ratio over history

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]

shiller PE by asset classes globally


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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two people fly with wingsuits

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]

dividends vs stock price

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]

dividend growth rate chart s&p 500

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]

earnings growth rates of SPX

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]

PE ratio since the start of 2013

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 ratio over last two decades

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.

PE Expansion periods historically

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”,
[v]  “S&P 500 Earnings Growth Rate”,
[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]

obamacare fine structure

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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painting of rome burning

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]

real GDP percent change

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.

percent job losses in post WW2 recessions

(Image source: Calculated Risk)

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

consumer credit expansion in 2013

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]

historic housing crises

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]

consumption growth over time

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]

revolving credit growth in 2013

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]

sector job estimated annual pay

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]

declining labor force participation rate over time

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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a surfer flies off of a wave

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]

percent of companies beating earnings estimates by quarter

percent of companies beating revenue estimates by quarter

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

total retirement assets in trillions over time

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]

number of beneficiaries social security over time

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]

value of investment on 12/31/2012 while missing best days

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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pouring sugar in the gas tank of a hooptie

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]

monthly change in nonfarm payrolls

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]

bed balance sheet asset breakdown

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]

s&p 500 and GDP during fed actions since 2008

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]

s&p case-shiller 20 city home price index

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]

total revolving credit owned and securitized

total nonrevolving credit owned and securitized

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]

percent of companies beating earnings

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

companies beating by quarter

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]

CFOs paint a dreary earnings picture

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.

PE multiple and earnings relatioship graph

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]

s&p 500 index over time

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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black and white person sitting on a bench

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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uncle sam with empty pockets

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

market during october 2013

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.  

gallup economic confidence index

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]

poll that we likely had no right to take

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]

10 year treasury yields declining during 2013

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]:

s&p performance during the last 17 government shutdowns

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]

household wealth keeps rising

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]

economic policy uncertainty index

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,

[iii] “Shutdown would shave US Growth as much as 1.4 pctg. points in Q4”, Bloomberg, September 27, 2013,

[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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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]  

FOMC economic projections

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]

central tendency of projections from Fed

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,  

[ii] “Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, September 2013”, Federal Reserve,

[iii] “Fed’s Economic Projections – Myth Vs. Reality (Sep 2013)”, STA Wealth Management,

[iv] “The Fed’s About-Face”, Guggenheim Partners,


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]:

real clear politics obama job approval
RCP congressional approval in 2013

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

american confidence in federal government's handling of international problems

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's still theater.

number of continuing resolutions passed by congress by year

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]

performance in each year of a presidential term since 1946

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, “Congressional Job Approval”, Real Clear Politics,

[ii] “Fewer Americans Than Ever Trust Gov’t to Handle Problems”, Gallup,

[iii] “A budget, you say?”, Chris Stirewalt, Fox News

[iv] “Congress’s use of continuing resolutions is a common practice”, National Journal,

[v] “2012 Election Senate”, Real Clear Politics,

[vi] “The Economic Sweet Spot of Presidential Terms”, New York Times,

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]

nonfarm payroll monthly change

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.

10 year treasury constant maturity rate

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]

fed funds and employment

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]

zero rate policy

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]:

s&p performance during various wars

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.

asset allocation 5 year rolling returns

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]:

10 year average total return from 1992 to 2001

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].

probability of a peak to trough loss

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.

high yield average yield

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. 

low money market rates

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. 

aggregate bond index yields

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]:

15 year average returns from 1998 to 2013

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]

current PE ratios vs 10 year averages

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]

consumer confidence index

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]

all investor sentiment survey

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:

Total returns on stocks, past and future

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.

same thing

(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]

PE multiple for SPX

(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:

events and their effect on markets

(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.

Wages as a percent of GDP in decline

(Image source: Federal Reserve)

Second, the percent of people participating in the workforce is also at a low not seen in decades.[i]

labor force participation

(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].

employment level part time for economic reasons

(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]

jobs added in various sectors

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]

union members as a percentage of all employed

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.


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]

10 year treasury rate over time

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.

time period and real GDp growth

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”).

increase in VIX

We have also seen a pullback in most sectors and asset classes.

performance of equity classes in 2013

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]

asset allocation is most important

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.

growth of 10k over 10 years with perfect market timing

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]

range of stock, bond and blended total returns

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.

max spend rate given portfolio

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]

job market not supportive of fed tapering

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]

calendar year EPS estimates

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:

commodity trailing 3 month performance

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:

correlation between asset classes

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).

10 year treasury rate

(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:

interest rates affects

Note that I said all this could happen, in theory.  In practicality, stocks tend to rise during rising rate environments up until a point:

stocks and rates correlation

(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:
household debt service payments
  • 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.

corporate cash in billions

(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 “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 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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money bomb

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. ( United States GDP 5/28/13)

s&p intraday april 10 2013

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.

VIX 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

Tim Phillips, CEO—Phillips & Company

The Most Undervalued Asset Class? Can Cheap get Cheaper?

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for sale sign house

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]

average 10 year PE ratios

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]
PE ratios as a percent of 10 year average

One asset class that appears to be below its mean by multiple measures is emerging market equities.

MSCI Emerging Markets Index [3]
PE of msci emerging market index

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]

valuations of middle east markets

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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achilles heel

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]

consumer credit outstanding

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.

student loans vs auto and credit cards

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]


percent higher education spending of GDP

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