Economics

Thin, Thinner, Thinning

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Webster's definition for the verb form of "thin" is to become less dense, crowded, or numerous. Thin, thinner, thinning. Market leadership has certainly thinned in recent months and is now quite thin indeed. As of about a month ago Goldman Sachs put out this list of just 10 stocks having contributed 122% of the S&P 500 year-to-date return meaning that the ENTIRE other 490 stocks suffered losses in the aggregate:

Share of SP500 Returns.JPG

The S&P 500 Index returned 1.8% for the first half of 2018. If you remove the famous FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google) plus Microsoft, then the return would have fallen to -0.73%. This means that increasingly, recent stock market gains have been generated by price gains in the gargantuan tech stocks. These stocks have come to dominate the US stock market averages. Just five of these huge companies (throw out Netflix for now) have a combined market capitalization of over $4 trillion dollars. This sum is equal to the entire combined market value of the smallest 282 companies in the S&P 500!  

(Additional investment specific commentary follows for client subscribers)

References:

https://techcrunch.com/2018/07/26/facebook-officially-loses-123-billion-in-value/
https://www.cnbc.com/2018/07/10/amazon-netflix-and-microsoft-hold-most-of-the-markets-gain-in-2018.html
https://www.financialsense.com/chris-puplava/and-then-there-were-none-0
https://twitter.com/michaelbatnick/status/1019680856837849090
https://www.merriam-webster.com/dictionary/thin

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISOR.  INFORMATION PRESENTED IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. AN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GREATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS.  ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

Liquidity

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As we wrap up the first half of 2018, Liquidity is still king.  Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset's price. It also refers to the flow of purchasing power into or out of a market. In recent years the largest source of liquidity entering the market has been central bank asset purchases (aka Quantitative Easing or QE). These asset purchases started as a reaction to Great Recession of 2008-2009. The largest three central banks (the US Federal Reserve, the European Central Bank, and the Bank of Japan) have added liquidity to global markets in relay fashion over the past eleven years as shown here in the following charts from Haver Analytics and Yardeni Research:

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While each of these banks have not individually bought continuously, the combined effect has been continuous purchases of nearly $12 Trillion of assets bought with money created  "out of thin air" for that purpose.

CentralBankTotalAssets.JPG

Rather unsurprisingly, these continuous asset purchases, and the confidence such liquidity has inspired among investors, have driven prices of stocks and bonds upwards for years...

(Additional investment specific commentary follows for client subscribers)

References:

http://stockcharts.com
https://www.yardeni.com/pub/peacockfedecbassets.pdf
https://abcnews.go.com/Politics/wireStory/trump-backs-off-imposing-china-investment-limits-56197065
https://www.yardeni.com/pub/peacockfedecbassets.pdf
https://www.investopedia.com/terms/l/liquidity.asp

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISOR.  INFORMATION PRESENTED IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. AN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GREATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS.  ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

Everything is Awesome!!

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Everything is awesome
Everything is cool when we’re part of a team
Everything is awesome
When we’re living our dream
— The Lego Movie theme song (2014 Warner Brothers)

The theme song (at least the first line of it) from Warner Brothers 2014 surprise hit, The Lego Movie, is an apt illustration of our current market and economic situation. Everything is awesome. US construction spending increased to an all-time high of $1.25 trillion. Payrolls are increasing and unemployment has reached official levels only rarely seen in the past century. According to ADP and Moody's Analytics, private companies hired 234,000 jobs in January. This was well above expectations for 185,000. Service-related industries led with 212,000 new jobs; manufacturing added 12,000 and construction 9,000.

Not only are jobs being added, but wages are now increasing at the highest rate since 2008 (shown below in the rising Employment Cost Index YoY as calculated by Bloomberg).

 Household Net Worth to US GDP

Stock markets remain in one of the biggest bull markets in history. Over the past year, rising prices and optimism have surged to new highs. In fact just this week the Conference Board Consumer Confidence released data showing that the percentage of respondents who think the stock market will be higher this year reached an all-time record. Since the question was first asked back in early 1987, we can't look back any farther than 30 years with this data point. But this much is clear, at no time in recent decades have people been as bullish on stocks as they are today.

 Effective Federal Funds Rate

Everything is awesome, indeed!

If you've seen The Lego Movie (and we highly recommend it), you know that when everything is awesome, it might only be surface deep. That, in fact, is one of the main points of the wonderful satire. Smiley faces are not the same as deeply anchored joy.  Bread and circuses (Starbucks, Netflix, and XBox?) are entirely different than independence, freedom, and opportunity. But, we digress.

As bond market maven, Jeffrey Gundlach (he of Bond King fame) succinctly pointed out this week, there is another way to look at things.

Interest rates up, $ down, and mania sentiment everywhere...a dangerous cocktail.
— Jeffrey Gundlach (CEO of DoubleLine Capital)

At the same time that stock markets and optimism have surged, interest rates have soared, inflation has gathered steam, and the international purchasing of the US dollar has fallen off the proverbial cliff. Why?

One reason is the long term structural concerns of the United States' fiscal position. This has recently been far from the radar of most casual economic observers. Do you even hear about  budget deficits anymore?  According to this chart of Google searches over the past decade, it has clearly fallen from public conscience.

 Household Net Worth to US GDP

Household Net Worth to US GDP

In 2017, the US Federal budget deficit was $700 billion in round numbers. The public debt surpassed $20 trillion. Only a few years ago, (2008) the debt surpassed $10 trillion for the first time. The budget deficit is expanding and doing so late in the market/business cycle which would typically be a period of decreasing deficit (and ideally a surplus). Under the new tax bill, this yawning discrepancy will grow by hundreds of billions. 

Rising interest rates will likely have a significant additional impact. The Congressional Budget Office (CBO) estimates that for each percentage increase in interest rates, the deficit will rise by about $140 billion. This impact will be felt soon because about half of the debt matures in the next three years.

On top of that, there isn't much room for a reduction in total government spending without cutting welfare and other transfer program payments (and breaking the associated social contracts). 70% of federal spending is either interest payments or these transfer programs. (The largest remaining component, defense spending, appears more likely to increase than decrease in the current geopolitical environment.) 

Additionally, a large amount of tax receipts are directly or indirectly related to rising asset prices. Capital gains account for about $0.20 of every tax dollar brought in by the Treasury. If asset prices were to stop rising (no decline necessary) then this alone would substantially impair the fiscal outlook.

In recent years, much of the debt financing was absorbed by the Federal Reserve (and other central banks) quantitative easing (QE) programs. As central banks shift policies away from bond buying (QE) to bond selling or balance sheet reduction known as quantitative tightening (QT), the net issuance of bonds that the rest of the market has to support increases dramatically. For example, the US net issuance of treasury bond in 2017 was $357 billion, but in 2018 is forecast by JPMorgan to increase to $828 billion.    

The math fiscal math isn't pretty. Since the need for funding won't slow down, government borrowing will need to increase. This need to attract funds from lenders will put continued upward pressure on interest rates, downward pressure on the purchasing power of the dollar, or both. Financial assets are valued by projecting a future stream of income and then discounting these future dollars by an interest rate. Interest rates and currency concerns affect the value of them all. 

(Additional investment specific commentary follows for client subscribers)

References:

https://www.cnbc.com/2018/01/31/private-jobs-up-234k-in-january-vs-185k-est-adp-moodys-analytics.html
https://www.bloomberg.com
http://tocqueville.com/tocqueville-gold-strategy-fourth-quarter-2017-investor-letter/
https://www.cnbc.com/2018/02/01/us-construction-spending-rises-as-private-outlays-hit-record-high.html
https://www.ft.com/content/8eae2e72-fb74-11e7-a492-2c9be7f3120a
https://www.etftrends.com/2018-outlook-for-equity-fixed-income-alt-investors/

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISOR.  INFORMATION PRESENTED IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. AN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GREATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS.  ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

It's beginning to look at lot like...a boom!

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Stock and bond markets have looked richly valued for several years. Until recently, those rich valuations have existed without overt evidence of euphoria. It now feels (and that is admittedly not a precise verb) like a boom. A Da Vinci painting changes hands at half a billion dollars. Bitcoin surges more than 1000% since January to over $11,000 earlier this week. We’ve discussed Bitcoin in previous letters, but suffice it to say that what certainly appears (another wonderfully squirrely verb) to be a mania has now reached far into popular awareness. Ugly Christmas sweaters now proudly feature Bitcoin. Katy Perry discusses cryptocurrencies with Warren Buffett, and then memorializes the event on Instagram to over 200,000 likes. What perfect illustrations of pop culture mind share gained by Bitcoin this year!

 Household Net Worth to US GDP

Enough about Bitcoin, how about certain junk bonds yielding less than Treasury bonds? How about historically low levels of volatility and Goldman Sachs pointing out last week that US market valuations currently sit at their highest since 1900 (see chart below).

 Effective Federal Funds Rate

Booms can go on a while and this one certainly may. In fact, from a general economy and well-being sense, we probably should hope for exactly that. Obvious warning signs do pose a challenge to us investors. On the one hand, we would certainly prefer to be averaging into investment positions that are generally and historically undervalued. However, those conditions are rare and while we will certainly exploit those when available, in the meantime we shouldn’t simply be out of the market. It is far too easy to see a perceived overvaluation and sell, only to miss another 50-100% upside. The market doesn’t particularly care about our perceptions of general valuation. It only matters what everyone else thinks. As we’ve seen in recent low interest rate and central bank quantitative easing (QE) driven markets such conditions can continue to grow even more extreme for a while. The ultimate frustration lived out by many would-be market timers, is to correctly see overvaluation, sit patiently on the sidelines, and then miss the buying opportunity because things never got “cheap enough”. The odds of consistently guessing right that many times in a row are minimal and better left to the gamblers.

Far better is to consistently seek relative value at all times and maintain a properly balanced and risk-adjusted portfolio capable of taking advantage of market opportunities that periodically arise. To demonstrate this, we’ve going to use the recent example...

(Additional investment specific commentary follows for client subscribers)

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISOR.  INFORMATION PRESENTED IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. AN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GREATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS.  ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

Hurricanes!

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Much of the nation has been transfixed in recent days by the destruction wrought by Hurricane Harvey, its 50+ inches of rainfall, and the ensuing record flooding.  Harvey will probably end up being the most expensive natural disaster in American history at an estimated cost of around $200 billion. "You had the greatest rainfall ever measured in the continental United States" said Dr. Joel Myers, Accuweather's founder and president. In addition to the damage to houses, businesses, and automobiles (1,000,000 vehicles are estimated to have sustained flood damage!) Harvey also hit the distribution supply chain across the country, affecting the countries largest port and an estimated 10% of all truck shipments nationally. We would not be surprised to see these recent weather events contribute to some upward pressure on general price levels in future months.

Meanwhile, recent economic data points have been strong. The latest revision of US second quarter GDP was for 3% growth (above estimates). Business and consumer spending is strong (and recovery and restoration spending related to Harvey will likely add to this and increase the general spending level in the economy). The headline unemployment rate continues to decline with a current reading of 4.3%. 

The US Federal Reserve seems reluctant to hike interest rates too aggressively, in large part due to perceived "weakness" in overall price levels as measured by the CPI and PCE. The normally newsworthy Jackson Hole central banker meeting was quiet this year. However the combination of strong spending, possible constraints on the supply of goods and materials (including importantly gasoline), and an increasingly tight labor market might change things at some point. Gold was strong (+4%) and is now up more than 10% on the year. Many of the industrial metals have moved upwards even more with aluminum (+10%), palladium (9%), platinum (7%) and copper (+7%) leading the way. Copper is shown below. After experiencing years of weakness beginning in 2011, the economically sensitive metal has reversed trend and is now rising strongly.

(Additional investment specific commentary follows for client subscribers)

References:

https://www.cnbc.com/amp/2017/08/31/hurricane-harvey-likely-most-expensive-natural-disaster-in-us-history-accuweather.html
https://www.bloomberg.com/news/articles/2017-09-01/u-s-manufacturing-expanded-in-august-at-fastest-pace-since-11
https://www.bloomberg.com/news/articles/2017-09-01/not-so-august-report-fails-to-shake-faith-in-u-s-labor-market

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISOR.  INFORMATION PRESENTED IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. AN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GREATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS.  ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.