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InnOvation Capital & Management, LLC

LAW  –  POLICY  –  FINANCE  –  MARKETS

INFORMATION FOR THE ENTERPRISE AND INVESTOR

August 31, 2016

Contact Richard Power with comments or questions.  IntelDigest is intended for the use of our clients and colleagues.   Material may not be reproduced, forwarded or shared without express permission.

The focus for IntelDigest this week is Yield. We touched on this subject last week in our discussion of the Federal Reserve and interest rates … “ interest rates are not just the cost of borrowing liquid capital; ultimately, interest rates are the “price” of money.”

After the 2008 financial crisis, all the major central banks slashed interest rates repeatedly; ostensibly, the thought was that lower rates would encourage people to borrow and spend, thereby stimulating economies. We are now at the point where the Federal Reserve has held rates near Zero for eight years, and negative interest rates are becoming more and more common every day in Europe and Japan.

We pointed out the folly and irony of the central bank policies last week:

“Central bankers postulated that reducing rates would encourage spending and produce inflation; instead, low and negative rates appear to induce more saving (to compensate for lost interest) and deferred spending (in anticipation of lower prices due to deflation).”

Ironically, the reality of the situation is that negative rates penalize saving, but then motivate people to SAVE MORE, rather than spend.

Further, manipulation of economies by the central banks (“quantitative easing”) has skewed those economies. Economist Ed Yardeni has written that the U.S. Federal Reserve, the Bank of Japan, the European Central Bank, and the People’s Bank of China have cumulatively increased their assets (central bank balance sheets) by $10.5 trillion since 2008. That implies that real financial assets in these countries have surged 166% since 2008, but that is totally out of line with the 15% growth in global industrial production and the 17% increase in global exports over the same period.

The leading world economies are ACTUALLY growing at the slowest rates in decades, and bond yields have cratered. As an example, the 10-year U.S. Treasury paid an average annual interest rate of 7% for almost 50 years; it now pays 1.50%. In other countries, such as the U.K., Switzerland, Germany, France, and Japan, yields are much lower.

For decades, investors around the world could earn a safe, decent return on these bonds. Not anymore; investors now have to own risky assets to have any chance of earning decent returns.

So, what do you do when the central banks have skewed economies and you can’t earn a decent yield on traditional, safe investments?

Searching for Yield

The safest income still comes from U.S. Treasuries, either individually or in mutual funds dedicated to Treasuries. The 10-year U.S. Treasury yield is the world’s benchmark interest rate. But, as mentioned above, it now yields only 1.50%.

Most municipal bonds and many corporate bonds are still relatively safe. Although they pay about half of what they did nine years ago, their returns are still higher than Treasuries.

If you want more income, you have to take more risk, in areas such as real estate, stocks, and gold.

Real Estate

For those who prefer tangible assets, the extended run of low long-term interest rates continues to lift real estate. Mortgage rates are at or near record lows. The supply of new homes is low. Employment is relatively stable. So, there can be more upside in housing.

Rental properties are a very good source of income, and it is easy to restructure your IRA or 401(k) plans to allow such investments.

Until the next recession hits, house prices should continue to rise, and stocks in the housing industry should continue upward. A well-managed rental property will usually continue to produce income throughout a market downturn.

Equities

The S&P 500 has an average annual dividend yield of 2% (not counting stock price appreciation). In the last 50 years, the S&P 500 has had a higher yield than 10-year Treasuries only twice, during the 2008 financial crisis.

So, investors have piled into dividend-paying stocks. In fact, dividends have become a driving force of the stock market …. more so than corporate earnings …. for many investors. When a broad stock market index yields as much as long-term Treasuries, many investors feel that the choice is easy and the risk is worthwhile.

People around the world are looking for positive yields, and the U.S. stock market remains the top choice. Investors seeking income gravitate to certain areas of the stock market. One is Consumer Staples …. the basics, such as soaps and cleaners, soda, cigarettes, toothpaste, and diapers. These businesses are relatively stable and able to pay regular dividends.

The top four holdings of the Consumer Staples Select Sector SPDR Fund (XLP) are Procter & Gamble (consumer goods), Coca-Cola (beverages), Philip Morris (cigarettes), and Altria (tobacco and wine). These are popular dividend stocks, and all are trading at or near long-term highs.

Another income-producing segment is Utilities. Utility companies provide power, water, and natural gas. State and/or local law often sets utility prices, limiting the companies’ ability to raise prices. In exchange, utilities enjoy monopoly positions in their markets, and guaranteed profits. Investors like Utilities for their regular profits; they often pay much larger dividends than other stocks.

As with Consumer Staples, Utility stock prices are hitting long-term highs, and dividend yields are near long-term lows. Reference the Utilities Select Sector SPDR Fund (XLU); the yield on this fund is currently around 3%.

Note that the Dividend Aristocrats Index, which tracks companies that have increased their dividends for at least 25 consecutive years, has climbed 275% since March 2009. The S&P 500 is up 221% over the same period.

Options

A more sophisticated approach to equities is the use of stock options, particularly selling Puts and Calls on the stocks of stable companies. This requires more attention to the portfolio and market research, but results in a steady stream of income.

The Danger Zone

There are potential pitfalls to consider:

Stocks are at historically high valuations, while corporate profits are plunging. Earnings for companies in the S&P 500 are on track to decline for the fifth straight quarter. That hasn’t happened since 2008–2009. Normally, periods of falling earnings have led to bear markets, because earnings are the most important driver of stocks.

According to The Wall Street Journal (WSJ), the S&P 500 has historically been about 90% correlated with earnings. In other words, stocks and earnings are supposed to move together. But right now, stocks are rising while earnings decline.

WSJ also has recently reported that, at the end of June, the annual dividend level of the S&P 500 components was the highest in quarterly records going back to 1936. The dollar amount of dividends was just shy of a record last quarter, and is expected to mark new highs this quarter.

Further, according to FactSet, companies in the S&P 500 are spending almost 38% of their profits on dividends; some companies are paying out more in dividends than they make in profits.

In the second quarter, 44 S&P 500 companies paid an annual dividend that exceeded their latest 12 months of net income, the FactSet data show. That is the most in a decade and a practice some analysts deem unsustainable. This includes iconic American companies such as pharmaceutical giant Pfizer (PFE), toymaker Mattel (MAT), and food staples Kellogg (K) and Kraft Heinz (KHC).

According to credit rating agency Standard & Poor’s, “there will come a point when dividend growth will be slowed if earnings and sales don’t improve.”

According to FactSet, analysts expect third-quarter earnings for the S&P 500 to decline 2.1%. This would mark the sixth straight quarter that earnings have declined from the previous year. If earnings continue to fall, many companies will stop raising their dividends. Some will have to cut or even stop paying their dividends.

This could trigger a selloff in dividend-paying stocks.

Gold & Silver

We subscribe to the theory that gold and silver are likely to move much higher over the next year or two. We addressed this topic in the July 19 and July 26 issues of IntelDigest ….. you can find archive copies of those issues on our website.

Highly-regarded equities investors and hedge fund managers … such as Stanley Druckenmiller, David Einhorn, George Soros … have increased their investments in gold significantly in the last year, and are holding historically high proportions of their respective assets in gold ETFs and gold mining companies.

Steps to Take Now

1. All investors should analyze their portfolios to determine if the dividend is sustainable in each of their dividend stocks. A sure sign of trouble is a company which pays more in dividends than it earns in profits.

2. Look for companies with proven dividend track records. For example, if a company has increased its dividend for more than 10 years in a row, you know it can manage its dividend through ups and downs of the business cycle. Those are the companies that we want to hold for the long haul.

3. Try to avoid companies with significant indebtedness. If there are serious problems in the economy over the next year or two, many companies will struggle to make money. Companies with too much debt may have to cut their dividend, or stop paying dividends entirely, in order to pay their debts.

4. In these “unusual” times, investors should have positions in gold, and should consider holding 10% to 15% of their money in gold. This small position could protect against catastrophic losses if stocks plunge.

InnOvation Capital & Management, LLC

LAW  –  POLICY  –  FINANCE  –  MARKETS

INFORMATION FOR THE ENTERPRISE AND INVESTOR

August 24, 2016

Contact Richard Power with comments or questions.  IntelDigest is intended for the use of our clients and colleagues.   Material may not be reproduced, forwarded or shared without express permission.

IntelDigest returns from a Summer hiatus, and will be published on a new schedule, appearing in your inbox every Wednesday. Today, we provide an outline of The Federal Reserve, an organization which has an influential role in all our financial futures.

The Federal Reserve is not a single central bank, but a system of twelve regional reserve banks under the supervision of a board of governors in Washington, D.C. The current chairperson of the Fed Board of Governors is Janet Yellen. Recent past chairmen have included Ben Bernanke, Alan Greenspan, Paul Volcker, and Arthur Burns. The current vice chairperson is Stanley Fischer.

There are, typically, five other governors, so that the Board of Governors would normally have seven people; however, there are currently two vacancies, so the Board of Governors currently consists of Janet Yellen, Stanley Fischer, and governors Jerome Powell, Daniel Tarullo and Lael Brainard. All governors are nominated by the president of the United States, and are subject to confirmation by the U. S. Senate.

All governors are nominated for 14-year terms; nominees for chair and vice chair serve four years in those positions. The chair and vice chair typically serve for the full four year term, although most governors resign before serving full 14-year terms.

The board of governors oversees the “system,” but they are not in charge of any particular bank. There are twelve regional reserve banks located in major cities: Boston, New York, Philadelphia, Chicago, and San Francisco, plus Atlanta, Cleveland, Dallas, Kansas City, Minneapolis, Richmond, and St. Louis.

The reserve banks are privately owned by the commercial banks in each district. For example, Citibank and J.P. Morgan Chase are shareholders in the Federal Reserve Bank of New York because those banks have their headquarters in the Fed’s Second District, which includes New York.

The regional reserve banks are privately owned, and they elect their own boards of directors based on voting by the private member banks. In turn, these boards hire the president of each Reserve Bank. Note: this means that the bankers hire their own regulator.

As an example, William Dudley is now President of the Federal Reserve Bank of New York. He is a former partner with Goldman Sachs. The New York Fed has direct supervisory authority over Goldman Sachs. Further, Stephen Friedman, another former Goldman partner, was Chairman of the Board of Directors of the New York Fed at the time Dudley was hired.

This is “business as usual” at the Fed.

The twelve regional reserve bank presidents come to Washington for each meeting of the Fed Board of Governors to offer their opinions on monetary policy, but most have little power. The exception is the president of the Federal Reserve Bank of New York. While interest rate policy decisions are made in Washington, they are carried out by the open-market trading desk in New York, which gives the New York Fed unique power to affect money markets.

So, you have a Board of Governors in Washington holding power, but having no bank. And eleven regional reserve banks around the country which are privately owned, but have little power. And one regional reserve bank in New York – controlled by the largest private banks and wielding considerable market power – which implements the policies of the Board of Governors of The Federal Reserve.

Now, the true power resides with the Federal Open Market Committee (FOMC). Monetary policy is not set directly by the Board of Governors or the regional reserve banks; policy is set by the FOMC, which is comprised of representatives from the Board of Governors in Washington and the regional reserve banks. The current regional representatives come from the reserve banks at New York, Boston, Cleveland, Kansas City and St. Louis.

The FOMC has a standing membership of twelve voting members, although it currently stands at only ten because of the two vacancies on the Board of Governors. Typically, seven votes come from the Board of Governors and five are presidents of certain regional reserve banks. Four of the five regional votes are selected on a rotating basis each year, while the fifth vote is a permanent seat which belongs to the Federal Reserve Bank of New York. In summary, there are twelve votes on the FOMC, seven from the governors, four from the regions, and one from New York.

This arrangement is clearly designed to keep power in Washington and New York. If the Board of Governors and the Federal Reserve Bank of New York agree on policy, they have eight votes to four from the other regions.

That describes the structure and power blocs of the Federal Reserve. Now, we’ll look at the primary responsibility of the Fed, which is to set “monetary policy” – the availability and cost of money and credit. Its primary weapon, to put it simply, is setting interest rates.

Interest rates are not just the cost of borrowing liquid capital; ultimately, interest rates are the “price” of money. Rates tell us a lot about confidence among lenders, borrowers, and consumers. The state of interest rates at this time (low) illustrates a failure to restore growth in the U.S. economy and around the world.

One can argue that the failure was inevitable. The Fed and other central banks have implemented monetary “solutions” to the problems in the world economy, but these problems are “structural,” having to do with demographics, taxation, regulation, and a host of other factors beyond the abilities and mandate of a central bank. Policymakers cannot solve structural problems with monetary tools.

Interest rates are near Zero or Negative in many places around the world. Central bankers postulated that reducing rates would encourage spending and produce inflation; instead, low and negative rates appear to induce more saving (to compensate for lost interest) and deferred spending (in anticipation of lower prices due to deflation).

Unfortunately (for us all), central bankers have extolled the virtues of low rates for years, but do not seem to have paid attention to the facts on the ground. “However beautiful the strategy, you should occasionally look at the results.” (an apt sentiment incorrectly attributed to Winston Churchill). Low interest rates are disastrous for banks, insurance companies, pension plans, and fixed-income investors.

Again, governments and central banks have been throwing monetary solutions at structural problems, thereby exacerbating the problems. The inescapable fact is that economies are cyclical, and they include recessions. For the last 15 years, we have been plagued by a Federal Reserve which has tried to disavow the business cycle and a Congress which has steadfastly refused to do its job.

The Fed’s efforts to avoid small, cyclical recessions have created bubbles in the debt and equity markets, skewed the economy, encouraged consumers and investors to engage in extremely risky behaviors, and resulted in larger, more dangerous recessions, such as 2008. There is a high probability that a recession in the next year will dwarf the 2008 downturn.

The Congress and Administrations over that same time period have failed to address the serious structural issues involving government spending and debt, restructuring Social Security to extend its efficacy, military spending, unfunded liabilities, et al.

Structural solutions are not likely because of political gridlock, so the best case scenario is a U.S. economy which remains stuck in a low-growth, Japanese-style pattern indefinitely. But a more likely scenario is a serious economic downturn, a global liquidity crisis, and financial panic.

Our goal today is to give you a better understanding of the Federal Reserve and how it operates. When you read about and hear references to Fed actions (or other central banks), either here in IntelDigest or in the general media, you may have a more clear context and perspective for analyzing that information.